What is an Escrow Agreement?

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.read more 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 a refund before the performance of obligations. Such deposits secure both parties from any fraud.

Escrow is a deposit of a document or formal instrument or a money deposit with 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. An agreement between two parties provides specific guidelines or directions for the party who accepts the escrow delivery.

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How Does Escrow work?

The deposit owner 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 the depositor fulfills. The third-party cannot return the depositor’s property without a performance of his obligation.

For example,

The 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 payment, whereas the buyer is insecure about making a payment without receipt of goods. They both agreed 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 the seller shall send verification. 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 involvedImportant aspects of the promise to be fulfilledDeposits made in escrowConditions to the release of escrow fundsObligations and liabilities of the escrow agentExpenses and fees associatedLegal Jurisdiction

Who is Using Escrow Agreements?

These agreements are a secure mode of financial transactions. Various businesses use these agreements.

Internet Escrow

This Escrow is the most fundamental type. Internet escrow allows money deposits with an independent licensed third party to protect buyers and sellers.

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 for 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.read more 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 joint 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.read more for multiple licensees to add or remove them without any notification when the minimum service period is over.

Types

Below are the seven types which are as follows:

#1 – Banking

In banking businesses, Escrow is used to protect automatic banking and vending equipment like ATMs; the money is deposited in the vending machine (ATMs) before completing 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.read more also. The defendant deposits 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 payment amount. The buyer makes earnest moneyEarnest MoneyEarnest money is a good faith deposit that a buyer makes to the seller to indicate their serious interest in buying their property. This amount acts as an incentive for the seller if the buyer cancels the deal at the last minute. Also, it gives the buyer enough time to arrange funds and do various checks on the property. read more checks to an escrow to show his credibility in buying the properties. These agreements are used for attorneys, title agents, and notaries.

#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.read more on the seller to recover all the money. These agreements not only complete the transfer of assets but are extended to longer periods.

#5 – Gambling

Since gambling is based on a contingent future event, such agreements are mostly used in these transactions. A disinterested person becomes a stakeholder to hold the money until the event and distribute the funds accordingly.

#6 – Securities Industries

These agreements are famous in securities industries for initial public offeringsInitial Public OfferingsAn initial public offering (IPO) occurs when a private company makes its shares available to the general public for the first time. IPO is a means of raising capital for companies by allowing them to trade their shares on the stock exchange.read more, 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.

Conclusion

In today’s era, Escrow agreements have proved 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 –

  • Contingent Liabilities DefinitionLoan ServicingTrust AccountRestricted Cash Examples