What escrow does in a business sale, and why you should insist on it

What is escrow?

Escrow is an arrangement where a neutral third party holds the money until both sides have met the conditions they agreed to. The buyer sends funds to the escrow agent rather than to the seller. The agent releases them only when the agreed conditions are satisfied. Neither side has to trust the other with a wire transfer, because neither side is holding the money in between.

Why use escrow when buying a business?

Because without it, one party has to hand over everything before receiving anything. A buyer wiring $400,000 directly to a seller is relying entirely on the seller then signing the transfer documents. A seller signing first is relying on the wire arriving. Escrow removes that ordering problem, and it is also where wire fraud gets caught: an escrow agent verifies instructions rather than acting on an email that appeared to come from the other side.

How does escrow work in practice?

Money in, conditions checked, money out, in that order. The sequence is the same on almost every deal:

• Both sides sign the purchase agreement, which lists the closing conditions
• The buyer deposits funds with the escrow agent, and the lender wires its portion there too
• The seller delivers the transfer documents, bills of sale, assignments and any consents
• The agent confirms every condition is satisfied and the liens are cleared
• Funds release to the seller and ownership transfers to the buyer, on the same day

What is a holdback?

A holdback is part of the purchase price left in escrow after closing, as security against problems that surface later. Typically 5% to 15% of the price, held for six to eighteen months. If a liability the seller warranted did not exist turns up, the buyer is paid from the holdback rather than having to sue for it. Sellers dislike holdbacks and buyers should ask for one anyway, particularly in a stock sale where liabilities transfer with the entity.

Who pays for escrow?

It is usually split, and it is cheap relative to what it protects. Escrow fees on a small business sale are generally a fraction of a percent of the transaction, and who pays is negotiable like any other cost. Sellers occasionally resist escrow on the basis that it slows things down. On a six figure transfer to a person you met a few months ago, that is not a saving worth taking.

What conditions should closing depend on?

Everything that would make you want the money back if it were not true. The conditions written into the purchase agreement are what escrow actually enforces, so vague ones protect nobody. Common ones worth naming specifically: lender funding is in place, the lease assignment is signed by the landlord, all liens against the assets are released, required licences have transferred or been reissued, and the key employees named in the agreement have signed on.