In business transactions, people like to get paid—and to get what they pay for.
In most cases, both parties to a transaction are fairly comfortable because there‘ll be a simultaneous exchange between the party with the cash (the "payor" or "buyer") and the party delivering the goods or services being purchased (the "payee" or "seller"). Even when the transfer doesn't happen concurrently, both parties might feel minimal risk because they have good reputations or enjoy a degree of trust due to their prior dealings.
But sometimes you want extra assurance that the other side is going to hold up their end of the bargain before you deliver on your end. If you want some extra security in the deal, you should consider an escrow.
This article examines what an escrow is, an escrow agent's responsibilities, and common situations where an escrow arrangement would be useful. You can also consider speaking with an attorney if you need additional guidance on whether you should hire an escrow agent and where you can find one.
An escrow is a compromise between the two parties in a transaction. It's an agreement between the parties where something being transferred (usually money) leaves the hands of the sending party but is held in trust by a third party (the "escrow agent") before being delivered to the receiving party.
For example, consider how your money is transferred when purchasing a house. You, the buyer, send the funds to your real estate lawyer's trust account. Your attorney—the escrow agent—holds on to the money (in escrow) until the seller signs the deed over to your name. Once the deed is signed, your lawyer will transfer your money to the seller.
Typically, the escrow consists of cash, but realistically almost anything of value being transferred from one party to another can be put into escrow—whether it be money, an asset, or an instrument.
You might, from time to time, need an escrow agent or company for business transactions.
Sometimes, unique circumstances can create what's often described as a "chicken-and-egg problem" in a transaction. In this type of situation, the payor is nervous about delivering funds before receiving the expected goods or services, while the payee is similarly apprehensive about fully performing their end of the agreement before getting paid.
You might be hesitant to pay for goods or services upfront if:
Likewise, you could be uneasy about providing a good or service without first receiving payment if:
If you're worried, you can use an escrow to lessen—if not completely eliminate—your concerns about getting what you're owed (or the "consideration" you were promised).
For instance, Ralph's logging company wants to purchase six log loaders from a heavy equipment dealer for $300,000 in total. The dealer has only been in business for three years and has some negative reviews. But Ralph can't find that particular loader model anywhere else for a lower price. Instead of passing on such a good deal, Ralph agrees to buy the loaders on the condition that the full purchase price be held in escrow by an escrow company until Ralph receives and inspects the loaders.
To set up an escrow, the payor and the payee will need to sign an escrow agreement.
An escrow agreement is a document that lays out the terms for how the escrow will work. The escrow is usually agreed to by the payor, the payee, and a third party (an "escrow agent") that looks after the escrowed amount.
The escrow agreement usually provides information on:
As previously mentioned, an escrow agent is a third party chosen by the payee, payor, or both that safekeeps the escrowed property until they're instructed to transfer the property. Usually, an escrow agreement will tell an escrow agent when and how to transfer the property, and to whom.
The escrow agent maintains an escrow account to hold the property—often called a trust account—that neither the payor nor payee has access to. If the property can't be held in a bank account, the escrow agent might keep the property in a safe deposit box or locked in their office or a storage facility.
Depending on the relative bargaining power of the parties, the selected escrow agent can take various forms.
The payor would likely prefer an escrow agent the payor completely trusts and has already worked with. For example, the escrow agent could be the payor's attorney, agent, or other representative. In the instance of a real estate transaction, the payor's title agent or broker could be a reasonable choice.
Conversely, the payee would prefer an agent the payee finds trustworthy or reliable. For instance, the payee could prefer their own attorney or agent.
The most equitable option for the parties is to mutually agree upon an independent intermediary to serve as the escrow agent. Ideally, this person would be someone completely unbiased towards the parties in the transaction.
For fairness, an attorney who has no prior relationship with either party can be an optimal solution. Most attorneys already have an escrow account (also known as a trust account or IOLTA) to hold client retainers. However, only certain attorneys are willing to enter into escrow arrangements, due to liability concerns.
Alternatively, you can use a financial company specializing in commercial escrow services. Before choosing between an escrow attorney and various escrow companies, make sure the potential escrow agent has a good reputation and a trust account with an FDIC-insured bank.
An escrow agent's primary responsibility is to safekeep the escrowed property. In addition, escrow agents are expected to:
Depending on why they're needed, an escrow agent might have additional transaction-specific responsibilities.
For example, in a house or office building purchase, an escrow agent might also be responsible for ensuring that the seller is providing the buyer with clear title—that is, there are no liens on the house—which usually requires a title search and examination.
In other instances, an escrow agent might be responsible for notifying certain creditors or filing documents with the secretary of state's office.
Once you're able to find a lawyer or company willing to serve as the escrow agent for your transaction, the parties will sign the escrow agreement, which will include the escrow agent's fee.
The escrow fee can take many forms, but will usually be a percentage of whatever amount is deposited with the escrow agent, plus expenses. Outside of the agent's expenses, you can expect to pay around 1% of the escrow amount as their fee. In smaller transactions, your escrow agent might require a flat fee amount for their trouble. Some others might charge a base fee plus a percentage of the escrow amount. Their fee, along with the expenses, will vary mostly by the kind of transaction.
Some more common expenses an escrow agent could charge are:
The payor and the payee would also have to agree between themselves whether one of the parties should be fully responsible for the escrow fee, or if the escrow fee should be split between them.
You know what an escrow agent is and why you might use one. But how do you know when you might find yourself in need of an escrow agent and what can you expect in such a situation?
You should keep the escrow solution in the back of your mind for any situation in which the only roadblock to getting a deal done is that neither the payor nor the payee wants to risk being the first one to pull the trigger on performing its obligations.
Here are some common scenarios where you might use an escrow agent:
A common situation where an escrow can be useful is in the purchase and sale of goods. Typically, the payment mechanics of buying and selling a product isn't an issue in our daily lives. For instance, when you buy office supplies at the store or make copies at the print shop, you're able to pay for the product and then walk away with it in the next moment. However, this simultaneous exchange isn't always possible.
For example, take the situation where an American interior design company wants to buy a rare painting from a private seller in Germany. Clearly, the seller will have to ship the painting to the buyer in the United States. Unfortunately, because the parties have no prior relationship, they have no trust that the other will honor their agreement.
More specifically, the buyer doesn't want to send any money to the seller without certainty that the painting will be delivered. The buyer's caution is quite reasonable because once it pays the seller, the buyer no longer has any leverage to compel the seller to perform in a timely fashion or at all. If the seller fails to perform, the buyer would prefer not to have to chase down the seller for the painting or a refund—through a lawsuit or otherwise.
On the other hand, the seller doesn't want to run the risk of shipping the painting to the buyer without any guarantee of being paid. This is a common chicken-and-egg scenario.
In this situation, both sides could alleviate their concerns by hiring an escrow agent to hold onto the purchase price. The escrow agreement could lay out the following instructions to the escrow agent:
The use of the escrow agent gives both the buyer and the seller comfort in knowing that a third party has a contractual obligation to honor the expectations of the transacting parties.
Another prevalent scenario where escrows prove useful is when the payor must make a partial deposit of the total purchase price—for example, 20%—with the seller. Unlike the example described above, in these cases only the 20% deposit would be placed with the escrow agent.
Changing up our previous example, if the art seller would be willing to ship the painting once the buyer makes a 20% good faith deposit, then the deposit could remain with an escrow agent until the product is shipped. Once the escrow agent confirms the shipment, they would immediately release the deposit to the seller. Afterward, the buyer would be under a contractual obligation to deliver the remainder of the purchase price directly to the seller after the painting had been successfully received.
Note that in this example, placing a deposit with the escrow agent (rather than the entire purchase price) likely lowers the escrow fee—since many escrow agents charge a percentage of the escrow amount—but also increases the ultimate risk to the payee who must now trust the buyer to deliver the remaining 80% of the purchase price.
Transactions not only involve the purchase of goods; sometimes they involve services to be completed (or "rendered").
Consider an example where a concert promoter wishes to hire a performing artist to hold a concert at a particular venue. Here, a chicken-and-egg issue could easily arise because the artist would be unwilling to perform without any guarantee of payment, and the promoter would be unwilling to advance payment without having any guarantee that the artist will perform as agreed.
The promoter-artist stalemate is a particularly high-stakes situation because concerts involve many upfront costs including rental of the venue, ticket sales, staff preparations, and so on. As such, concert promoters and musical artists regularly use an escrow agent to hold either a deposit or the artist's entire fee.
Note that this situation serves as a good example of when relative bargaining power can have an influence on the escrow agent selected. In most cases, artists with increasing fame and popularity can demand the use of an escrow agent that they fully trust or is within their employ (their booking agent, for example). In such cases, the promoter has little leverage to demand an alternate escrow agent.
If you find yourself in one of the situations above or in a similar scenario and have case-specific questions, you can reach out to a business attorney. A lawyer can help you determine whether you need an escrow agent, and if you do, help you draft an escrow agreement.