Escrow agreements play an important part in M&A transactions. We explain their unique role and how they should be executed.
An escrow arrangement is set up by a neutral third party to hold funds or other assets that will be exchanged in a transaction involving a buyer and seller. In an M&A deal, an escrow account is typically used to ensure that the buyer and seller will fulfil their respective financial and other obligations.
Escrow arrangements enable the safe facilitation of transactions even if the counterparties cannot meet in the same place or time. They also act as a repository for deliverables and transaction documents that may be at different stages of execution and deliverability. Essentially, escrow arrangements offer mutual protection to the buyer and seller by minimising the risk of counterparty non-completion, failure to deliver and inability to attend.
Escrow arrangements are particularly useful when conducting cross-border transactions. There are many scenarios where one of the parties may be unable to perform certain undertakings. For instance, a seller may need to transfer its shares, real estate, special assets (such as artworks or antiques) or other assets to a buyer. This process may involve delays, such as those related to title-transfer registration with local authorities, changes to internal registers or the issuance of share certificates. The buyer will want a reliable, neutral repository for funds to complete the purchase. And in many cases, both parties will agree that an escrow arrangement is the optimal solution to ensure that deal terms are met.
When there is a delay in title transfer, the buyer will likely want to defer the purchase payment until confirmation of the title-transfer registration. In this situation, the buyer and seller can retain a third-party escrow agent as a solution. The escrow agent will ensure that the title is registered and transferred to the buyer, which will in turn trigger the release and transfer of funds to the seller.
Buyers can also use escrow accounts to provide so-called "proof of funds" to reassure sellers that they have available funds or financing to complete a transaction.
Escrow agreements in M&A transactions are sometimes used to retain or “hold back” part of the purchase price — typically around 10 to 25 percent. Holdback amounts are negotiable and vary according to the nature of the deal and other factors. The retained amount is kept for a warranty period, allowing the buyer to confirm that representations and warranties made by the seller in the sale documents are true and correct. The seller will typically demand that the retained amount be paid into the escrow account held with the escrow agent. This arrangement ensures that the holdback amount will be released automatically if no warranty claim is submitted.
The warranty period varies and may last from several months to years. During this period, undisclosed liabilities may surface, for example during annual audits, tax filings, licencing applications or legal proceedings. In the event of undisclosed liabilities, the amount of cash released to the buyer will depend on the escrow agreement terms, and in particular the list of trigger events (described in the next section).
Unfortunately, buyers and sellers often leave the drafting of escrow agreements until the last stage of a deal, after all sale documents have been finalised. This approach leaves little time to structure an escrow arrangement and develop the escrow agreement, despite their importance to ensuring that remuneration is received and assets are delivered to the respective parties. We recommend finalising escrow arrangements early in any commercial transaction process to ensure that the interests of both sides are protected.
When preparing an escrow agreement, it is important to identify a clear and unequivocal list of events that trigger the release of escrow materials. Once conditions are fulfilled, the escrow agent will deliver the escrow assets to the relevant parties. A trigger event can be as simple as joint signatures from the buyer and seller, or may be more complicated, such as third-party law firm or audit firm confirmations or references to publicly available information.
This is an updated version of a previously published article.
For more information, read our eBook "A comprehensive guide to cross-border M&A."
