What is an Escrow Agreement?
The escrow agreement is a financial agreement in which a third party holds the financial payment of a transaction between two parties. A third party is an independent person who holds the funds just to make sure the security of the transaction.
The payer may resist making payment to another party before the performance of the obligation, whereas the receiver may resist performing the duty before receiving the payment. A third party acts as an escrow agentEscrow AgentAn escrow agent is an individual or a company that is probably better termed as a trusted third-party that holds a document or an asset for the first party to deliver to the beneficiary or second party as the event mentioned in the escrow agreement takes place. who holds the transaction money, to secure the trust factor among the two parties in a transaction. The payer deposits some valuables in an escrow account, signing an agreement that does not allow refund before the performance of obligations. Such deposits secure both the parties from any fraud.
Escrow is a deposit of a document or formal instrument or a money deposit that has monetary value e.g., Documents or legal instruments like deeds, written instruments, promise to pay, license, patents, checks, bonds, mortgage, etc.
In an escrow agreement, three persons are involved – depositor, beneficiary, and escrow agent. It is an agreement between two parties that provides specific guidelines or directions for the party who accepts the escrow delivery.
How Does Escrow work?
The owner of the deposit is putting the escrow with the third party, who is an independent party to both the parties involved and keeps it with him until the promise made by the depositor fulfills. The third-party cannot return the property of the depositor without a performance of his obligation.
The two parties, buyer and seller, initiate a transaction where the seller has to dispatch 1000 pieces of merchandise to the buyer. The seller is insecure about the dispatch of goods without receipt of payment, whereas the buyer is insecure about making a payment without receipt of goods. They both agree to appoint an escrow agent and signed the terms and conditions of the escrow agreement. The buyer deposited the required amount of money in escrow with the agent, and verification shall be sent to the seller. The seller shall dispatch the ordered merchandise and provide the tracking information to the agent and the buyer. Then, on receipt of goods by the buyer, the agent shall release the deposited amount to the seller.
Components of Escrow Agreements
The main components are as follows –
- Details of the three parties involved
- Important aspects of the promise to be fulfilled
- Deposits made in escrow
- Conditions to the release of escrow funds
- Obligations and liabilities of the escrow agent
- Expenses and fees associated
- Legal Jurisdiction
Who is Using Escrow Agreements?
These agreements are a secure mode of financial transactions. Various businesses use these agreements.
This Escrow is the most fundamental type. Internet escrow allows the deposit of money with an independent licensed third party to protect both buyer and seller.
Types of Internet Escrow Agreements
There are various types:
- Third-Party Agreement: This is the most basic type where parties to the agreement are a software vendor, a licensee, and a software escrow agent. This agreement is suitable when there is a single licensee who needs a software escrow agreement, and the vendor doesn’t provide such agreements to other licensees.
- Multiple Party Agreement: When a software vendor provides escrow arrangements for all licensees, the software vendor keeps one escrow account for all the licensees. It becomes more comfortable for the vendor to manage all the escrow paymentsEscrow PaymentsEscrow payment is a legal concept involving a financial arrangement between three parties whereby a third party agrees to hold an asset or money on behalf of the other two engaged in a particular transaction at a given time. through one standard account.
- When multiple licensees are spread over various software with a single software vendor, one central agreement for all licensees and software is developed for effective management.
- When a single licensee buys software from multiple vendors, they face problems with multiple escrow account. So, licensee creates one single escrow account for all software vendors, which becomes flexible for the licensee to manage the transactions.
- Minimum Service Escrow: This agreement is used when a software vendor does not charge fees from the licensee for the software to provide minimum service or use of the software. So, they develop a common escrow accountEscrow AccountThe escrow account is a temporary account held by a third party on behalf of two parties in a transaction. It reduces the risk of failing to oblige the transaction by either of the parties. It operates until a transaction is completed and all the conditions are met. for multiple licensees to add or remove them without any notification when the minimum service period is over.
Below are the seven types which are as follows:
#1 – Banking
In banking businesses, Escrow is used for protecting automatic banking and vending equipment like ATMs; the money is deposited in the vending machine (ATMs) before completion of the transaction between the customer and the bank.
#2 – Law
Escrow is used in the judiciary cash settlementsCash SettlementsCash settlement is a settlement option frequently used in trading futures and options contracts, where the underlying assets are not physically delivered at the expiration date. At the same time, only the difference is paid by either of the parties, depending on the market rate. also. The defendant deposit money with the escrow fund of law, and the fund distributes the money as per the settlement of the law.
#3 – Real Estate
Escrow payments are mostly made in real-estate transactions due to the substantial amount of payment. The buyer makes earnest money checks to an escrow to show his credibility to buy the properties. These agreements are used for attorneys, title agents, and notaries as well.
#4 – Mergers & Acquisitions
Escrow agreements are used in M & A arrangements to secure warranties and indemnities offered by the seller because of the high credit riskCredit RiskCredit risk is the probability of a loss owing to the borrower's failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt's principal and an interest component, resulting in interrupted cash flow and increased cost of collection. on the seller to be able to recover all the money. These agreements do not only complete the transfer of assets, rather are extended to longer periods.
#5 – Gambling
Since gambling is a game based on the contingent future event, such agreements are mostly used in these transactions where a disinterested person becomes a stakeholder to hold the money until the event takes place and distribute the funds accordingly.
#6 – Securities Industries
These agreements are famous in securities industries also for initial public offeringsInitial Public OfferingsInitial Public Offering (IPO) is when the shares of the private companies are listed for the first time in the stock exchange for public trading and investment. This allows a private company to raise the capital for different purposes., under stock option plans, depositories, etc. to secure the allotment money or deposits amount of the investors.
#7 – Businesses
These agreements are commonly used in various transactions of businesses for their financial security.
In today’s era, Escrow agreements have proved to be essential for secure transactions among various businesses. It avoids insecurities and maintains trust among unknown parties, which enhances the smooth working of businesses.
This has been a guide to what is an escrow agreement. Here we discuss how escrow agreement works along with examples, components, types, and uses. You can learn more about financing from the following articles –