The uncertainty in today’s economic climate due to rising interest rates and geopolitical risk makes it critical to protect business assets. When making business transactions or investments, owners should safeguard their funds until the deal goes through as agreed. You can get that protection by placing funds in a business escrow account.
Understanding Escrow
When you ask people, “What is escrow?” Most will say it is where you put your downpayment when applying for a mortgage. They would be right, as mortgage escrow is one type of escrow account. However, escrow comes in various forms.
Escrow is a legal concept where two parties agree to deposit funds with a third party until the transaction goes through satisfactorily. For example, someone wants to buy a home and contact a lender. The lender agrees to process the loan but requires a 20 percent downpayment.
The buyer puts the downpayment in an escrow account until all the loan documents are complete. The escrow agent will then release the money to the lender. If the transaction falls through, the money goes back to the buyer.
Business escrow has a similar function. When two parties engage in a large transaction, such as purchasing equipment, they enter into a contract. The buyer will deposit funds in an escrow account to assure the seller of payment. The money is said to be “in escrow.”
When the seller delivers the equipment, they receive payment from the escrow agent per the contract terms. Suppose the seller fails to deliver the correct equipment within the contracted time or manner. In that case, the escrow agent returns the funds to the buyer.
Business Escrow Services
The main idea of putting funds in escrow is to entrust it to a neutral party with nothing to gain from either side of a transaction. An escrow agent is a third party holding funds, property titles, or anything of value that interests the transacting parties.
A business would need such escrow services when significant risk is involved in the transaction. It would be wise to use business escrow accounts when dealing with a company for the first time. It is also an excellent idea if the reputation of one or both parties is less than stellar. Even in a longstanding business relationship, escrow can protect the parties in case of insolvency.
The pandemic illustrated the need for escrow accounts when many businesses closed or went bankrupt. Organizations working with them suffered financial losses either through the inability to collect on accounts receivables or suspension of deliverables. They would have had some protection from such losses if they had placed their funds or valuables in escrow.
Outsourcing the mortgage process, for example, often includes expert escrow management, ensuring a smooth and secure transaction for both parties.
Use Cases
An escrow account protects businesses on both sides of a transaction. A supplier of products or raw materials will likely request an upfront payment in part or full from the buyer before starting production. It is a reasonable request as the supplier will incur costs, so they want to ensure they will get their money.
However, the buyer may have misgivings about paying for something on faith, especially if it is a first order. They may not receive the materials for a long time, so they risk losing money if the supplier does not come through.
The solution is not to pay the supplier directly but to place the funds in escrow with instructions for release. For example, the buyer may agree to release the funds based on specific milestones. The supplier would receive a particular amount upon approval of the prototype. Upon delivery of the first batch of products, they would receive a further amount. Escrow ensures that both parties get what they want without risking financial losses.
Investing in a company through a merger or acquisition is also a scenario where an escrow account is critical. These deals often include a cash holdback requirement as part of the agreement.
Mergers and acquisitions are often complex, particularly if they involve multiple parties, and may take months or years to conclude. An escrow provider can be the repository of company assets and investment funds until that happens. That would assure all parties that each one will meet their obligations within the terms of their agreement.
What is in an escrow agreement?
The escrow agreement contains the terms of how it will work as indicated by the transacting parties. It usually includes the following information:
- The asset or funds in escrow
- Name and responsibilities of the escrow agent
- The escrow service fee
- Where the agent will hold the escrow, e.g., trust account or safe deposit box for non-monetary assets
- Terms of the release and return of escrow
The parties in the agreement are typically the payor, payee, and escrow agent. The agent has a fiduciary duty to all parties in the contract. The agent shall be liable for any losses resulting from negligence or failure to comply with the terms of the escrow agreement.
While an escrow agent is often a lawyer, it is not always the case. It may be an individual, an escrow company, or a mortgage servicer. Some states require an escrow agent to have a license, but there are no special qualifications to become one. So, how do you choose one?
Choosing an Escrow Agent
The escrow agent can be anyone the parties agree to be reliable and trustworthy. It could be the payor’s or the payee’s lawyer or previous escrow agent. It could also be an independent agent who does not have a prior relationship with any of the parties.
Generally, choosing a lawyer as an escrow agent is an excellent idea because most already have an escrow account.
Named Interest on Lawyer Trust Accounts (IOLTA), lawyers maintain these interest-bearing accounts to hold client funds. Lawyers also have an accounting system to keep track of these client accounts for transparency, making it easy to provide escrow services.
Escrow companies are also an option, as they specialize in providing escrow services to businesses. However, it would be best to do your due diligence before choosing an agent. They should have a solid reputation in the industry and put trust accounts in an FDIC-insured bank.
What are the costs of using escrow accounts?
As you can probably imagine, availing of escrow services comes with a cost. The escrow agent’s fee will depend on your agreement. Typically, it is a percentage of the escrowed amount or the value of the escrowed asset plus expenses. These may include the following:
- Wire transfer fees
- Legal fees
- Processing fees
- Filing fees
The standard agent’s fee is one percent of the escrow amount for large transactions and a flat fee for smaller ones. Some agents may charge a base fee plus a percentage.
The escrow agreement will include the agent’s fee details, including who will pay. Sometimes, the deal will spread the agent’s fees evenly among the parties in the transaction.
Should you use business escrow services?
Business escrow accounts protect companies when engaging in risky transactions that involve significant amounts of money in cash or kind. It is not mandatory for every exchange of assets. However, it’s essential to make a cost-benefit analysis in specific dealings to determine if business escrow accounts are necessary.
