The concept of escrow seems vague and confusing when people first encounter it. Fortunately, the ideas behind it can be simplified so that they are much easier to understand. Today we are defining escrow, exploring situations in which escrow applies, and going through a step by step example.
At its essence, escrow is the middleman in a deal, a neutral third party that hold assets during an ongoing deal of some sort. The assets are held to ensure that the exchange is completely fulfilled on both ends. If one end of the deal falls through, the escrow provider releases all assets to the original owners. Essentially, it takes the risk out of large and complicated transactions. Most commonly, it is used for real estate deals.
When Is Escrow Used?
- Real Estate. This is the most common usage of the process. You may have heard of a home being “in escrow.” Now you know what that means!
- Business Purchase. The escrow process is also used in most business acquisitions. Business purchases can take a long time to complete. Escrow deposits help ensure that a potential buyer is serious.
- Internet escrow. The Internet version originated with the rise of Internet auctions and ecommerce. They are often used to help prevent fraud.
- ATMs and vending machines both use a small-scale version to refund a customer’s money.
- Legal matters. Clerks of court are often used to hold money owed to other people involved in a lawsuit. Common examples of lawsuits involving escrow funds include rent owed in landlord-tenant case, or settlements in class action lawsuits.
This is a step-by-step process related to the sale of a small business and how escrow is used in the transaction.
1. Offer to Purchase
Once you find a business you want to buy, you submit an offer. Typically, the offer needs to be in writing. If the business is listed with a broker, the broker will likely use a standard pre-printed asset purchase agreement. Most escrow deposits are negotiable, however, the seller makes the final call. The escrow deposit is usually made to a neutral third party called an escrow agent. This is often the attorney that is selected to handle the closing. The escrow agent will usually have the buyer and seller sign a separate “escrow agreement” that relates only to the duties and responsibilities related to the escrow deposit.
2. Due Diligence!!!
Buying a business can be very risky business. Businesses and their owners have a lot of risks and responsibilities. Even if you are only purchasing the assets, liens can still attach to the assets. And, certain liabilities can still transfer to an innocent purchaser. Additionally, the buyer will likely need to sign new contracts and leases. These contracts and leases often require personal guarantees of the owners. So, the risk of loss is not only the purchase price of the business, but the personal guarantees on the contracts and leases.
Before you commit to buying a business, do your due diligence. Every business has its risks. And, almost all of them require a lot of work. But, when you are buying a business, you must understand what you are buying. The seller always thinks their business is worth more than it is. The numbers are always going to be massaged in a light most favorable to the seller. At the end of the day, you have to make a profit or have a clear plan how to get there. Therefore, you must do lien search and understand the truth behind the numbers.
The escrow deposit in a business purchase is made to show the buyer is a serious purchaser. However, most escrow deposits are fully refundable if the buyer is not completely satisfied with the due diligence results. If the business purchaser is not satisfied with the due diligence results, they must usually notify the seller and the escrow agent in writing prior to the expiration of the due diligence period in the asset purchase agreement in order to receive a refund of their escrow deposit.
3. Close The Account
You completed the sale! The closing attorney will handle all the closing documents and loan documents, as well as most of registrations and recordings. The closing and escrow agent costs owed by the sellers are often subtracted from the escrow deposit with any balance being paid out to creditors and he net proceeds paid out to the seller.