Escrow accounts and escrow agents can take many forms and are used in a variety of situations. For the purposes of this guide we are looking at the operation of escrow accounts and escrow agents within Mergers & Acquisitions (“M&A”).
Academic research has found that escrow contracts are employed in 52.1% of acquisitions, with an average of 12.2% of the sale proceeds placed in escrow for approximately 17.4 months.
What is an Escrow?
An escrow is a contractual arrangement whereby a third party receives and, subsequently, disburses money or documents on behalf of the principal contracting parties, subject to the fulfilment of certain independent conditions.
The Escrow Agent is the third party that holds and administers the assets that are subject to the escrow. The Escrow Account is the segregated bank account used to hold the cash or, in some circumstances, assets that are the subject of the escrow.
How is an Escrow used in M&A?
Escrow is primarily a risk mitigation tool and is used to ensure that funds are available without having to obtain the funds directly from the other party. Set out below are a variety of circumstances when escrow can be used, although the primary use is to help reduce the due diligence costs in M&A and manage the risks presented by the asymmetry in knowledge between the buyer and the seller.
Indemnities and Warranties
Rather than carrying out extensive due diligence on the target, the seller(s) will provide extensive indemnities, representations and warranties on the state of the target. These will be backed by a sum held in escrow, to assure the buyer that funds are available to satisfy the covenants. As set out further below, this can lead to an increase in value for both the buyer and the seller(s).
Good faith deposit
Where the seller is investing considerable time, money and/or risk in entering the sale process, they can ask for a deposit to be placed in escrow. This will be released to the seller in the event that the buyer withdraws.