This post is part of our First Year Associate series, where we’ll provide explanations to simple issues faced by first year corporate associates. We’ll focus on the basic problems that you might be embarrassed to ask a senior attorney. And if you already asked, the answer was so brief it provided just enough context to bring you here.
The Escrows — Part II of III
The escrow fund is one of the key components for any corporate transaction—few transactions close without some money held in escrow. Let’s start by thinking about the escrow you set up when you buy a house. To give you a mortgage, the bank wants to make sure that you have money available to meet certain future obligations associated with your home—namely, your property taxes and homeowners insurance (if you default, they could be stuck with the bill). So the bank takes a little bit of money each month and holds it in an escrow account until those amounts are due at the end of the year. The bank then pays the taxes and insurance on your behalf, and if there is any left over, they give that money back to you.
The escrow fund in a corporate transaction
In corporate transactions, the concepts are similar: one or more parties involved in the deal could owe money to the other at a certain point in the future, so the parties want to ensure that the necessary funds are set aside to handle those future obligations. They take a little bit of the closing proceeds and put that money in an escrow fund to cover these future obligations, which a third party will pay out on their behalf. If the funds are not needed after a certain period of time, then they are returned.
Why the escrow fund is necessary
So why would money be owed after the deal closes? Well, there are many reasons, but the escrow fund is primarily to protect the buyer from a breach of the representations and warranties by the seller. In the purchase agreement, sellers will make certain representations and warranties about their company—for example, whether they own certain intellectual property, the condition of the company’s assets, or their relationship with certain customers. As the buyer takes over ownership of the company after closing, they may discover that certain of these representations were misleading or inaccurate. If this results in a monetary impact to the company, the buyer usually wants to be made whole for these misrepresentations. The escrow fund ensures that these funds are available, if and when they are needed.
Common attributes of the escrow fund
Here are some more details about the escrow fund, though these may vary significantly depending on a number of factors involved in the transaction and negotiation:
- How large is the escrow? It is typically between 5-10% of the total purchase price.
- How long does the money stay in escrow? The escrow period is usually between 12 and 24 months.
- Who keeps the money? The parties will appoint an independent third-party escrow agent (usually a bank).
- Who determines if escrow funds are released? The claims process is highly negotiated in the purchase agreement, usually giving parties an opportunity to appeal claims. Instructions for the escrow agent are laid out in the escrow agreement.
- What if money remains at the end of the escrow period? Since it came from the closing proceeds, the remaining funds (and accrued interest) are usually released to the sellers.