What is the Escrow Account?
The escrow account is a temporary account held by a third party (usually a bank or an escrow agent) on behalf of two parties in a transaction and its purpose is to reduce the risk of failing to oblige the transaction by either of the parties involved. It is a temporary account and operates until a transaction is completed and all the conditions between the buyer and the seller are settled.
From an escrow account, the amount is not transferred to the seller until they meet the terms and conditions. Real estate projects, business deals, issues of sharesIssues Of SharesShares Issued refers to the number of shares distributed by a company to its shareholders, who range from the general public and insiders to institutional investors. They are recorded as owner's equity on the Company's balance sheet.read more, and project financing mostly use this type of account.
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How does Escrow Account Work?
- Let’s take a simple case of buying/selling between two parties- A & B. Party A wants to buy some goods from party B, and the transaction amount involved is huge. Party A has a risk of making payment but not receiving the goods. Party B has a risk of supplying the goods and not receiving the payment.
- So, in this case, Party A and B will enter into a contractual agreement to open an escrow account. It is a central account where the buyer parks the funds and transferred them to the seller only when the transaction completes, i.e., the buyer receives goods.
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#1 – Real Estate
It is the most common transaction where this type of account service is required. While buying any property, it is often the area of concern that the buyer will make the full payment but will not get possession of the property on time. So, to mitigate this risk, an escrow account is opened where the buyer deposits money. The payment is transferred to the builder only when the possession of the property transfers to the buyers.
#2 – Mergers and Acquisitions, Business Deals
Suppose Company A takeover Company B. Now the company A does not want to make complete payment to B till the time full handover completes. In this case, company A will deposit the payment in an escrow account. Company B will make the complete handover of all the assets, properties, documents, etc. as per the agreement. Once done, the payment transfers to company B.
#3 – Project Financing
In the case of project financingProject FinancingProject Finance is long-term debt finance offered for large infrastructure projects depending upon their projected cash flows. Moreover, an investor has to form a Special Purpose Vehicle (SPV) to acquire the same. read more, banks often have the concern that the company may divert the loan amount to other projects instead of the one mentioned while entering the agreement. In this case, the Bank and the Company will enter into an agreement where the bank will transfer the loan amount in an escrow account. The amount is paid to the company as per the stage of project completion, i.e., first 20% on completion, then again 20% on further completion, etc.
#4 – Issue of Shares
As per SEBI, India guidelines, there has to be a 90% subscription of shares by the general public. If it is less than 90%, the company returns application, money to the public. Hence, the company opens an escrow account and deposits the application money paid by the public for the subscription of shares. If the total subscription is 90% & above, the money transfers to the company, and if it is less than 90%, the money transfers to applicants.
#5 – Public-Private Partnerships
There are certain projects where both government and private agencies are involved. In such cases, revenue sharing/profit sharing models are used, for example, toll plazas, coal extractions.
Suppose the government enters into an agreement with company A for coal extraction project, terms of the agreement include full expense by company and revenue sharing ratio 30% to government and 70% company. In this case, all the expenses for coal extraction will be borne by company A. Once the revenue starts generating, it will be deposited into a central account, i.e., escrow account from where the revenue will be distributed as agreed.
Why do we Need “Escrow”?
- Reduces transaction risks and trust issues;
- In the event of any of the parties fails to adhere to the terms of the escrow agreementEscrow AgreementAn Escrow Agreement is a financial agreement in which a 3rd party (Escrow Agent) holds an asset of value until all the participants fulfill the specified terms, conditions, & responsibilities in the document. read more, it will be easier to settle the escrow than it would be if both the parties are directly transacting with each other.
- Helps protect the interest of both parties;
- Ensures that the funds, assets are kept safe till the time the transaction is not settled.
Who Manages It?
An escrow account is managed by a third party who can be an escrow agent, Bank, a financial institutionFinancial InstitutionFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more, or a company providing such services.
Conclusion
This can be used under various arrangements. It helps to protect the interest of all the parties involved in the agreement. It is not only used to hold funds, but there can also be a financial asset or any other security. It reduces the transaction riskTransaction RiskTransaction risk is the uncertainty or loss caused to the contracting party due to a change in the foreign exchange rate or currency risk on delay in settlement of a foreign transaction.read more and provides fair treatment to all the parties involved.
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