The Role of an Escrow Agent when Selling or Buying a Business

Executive Summary

If you’ve bought or sold a house, you’re likely familiar with “escrow.” When it comes to buying or selling a business, however, an escrow is more than simply an account where money is held until the details of the sale are complete. Escrow serves several essential functions in the sale of a business. The decision on whether or not to work with an escrow agent is an important consideration in a business sale.

An escrow agent is a third party charged with the responsibility of holding all monies and papers until all conditions of the escrow are observed. They are also sometimes called settlement agents, closing agents, and escrow officers. Escrow is often required if third-party (e.g., bank) financing is involved.

The escrow agent ensures regulatory compliance, prepares routine transaction documents and closing statements, and handles administrative details in a cost-effective manner. Business escrows protect the interests of buyers and sellers and are used extensively by transaction attorneys and intermediaries.

Escrow serves several important functions in the sale of a business. The primary duties of the escrow agent include:

• Holding the earnest money deposit. Earnest money deposits are commonly provided by individual buyers but not corporate buyers.
• Ensuring clear title of assets is transferred at closing.
• Acting as a third-party clearinghouse for payment of liens, debts, or other bills.
• Holding and releasing funds.

An escrow agent is an impartial intermediary who acts only on mutually agreed-upon instructions. This is important because escrow agents often hold substantial sums of money during various phases of a transaction, and it is critical that an independent third party hold these funds. Read on to learn more about the role escrow plays in selling your business and get answers to some common questions.

Advantages of Using an Escrow Agent

Escrow agents are licensed and regulated at the state level.

Escrow agents must undergo an annual audit by a certified public accountant and adhere to a strict code of conduct. During this annual audit, the escrow holder must account for every penny that was either received or dispersed. They must also go through a criminal background check in most states.

Additionally, most states require escrow agents to be bonded and to adhere to minimum asset and liquidity requirements. Having a trustworthy third party is paramount anytime large sums of money are being handled.

Escrow agents have an obligation to maintain confidentiality and privacy.

In other words, they can escrow not only money but also information.

For example, the seller may be in arrears or behind on their royalty payments to their franchisor. These royalties may need to be paid off completely before the franchisor allows the franchise agreement to be transferred to the buyer. In some situations, the seller does not have enough money to pay off the royalties before the closing. As a result, the escrow holder must hold the buyer’s down payment and pay off the franchisor’s royalties before releasing the money to the seller. The seller may wish to maintain privacy or confidentiality on being behind with the royalties. Whether the seller should have disclosed this as a material fact will not be addressed here. The escrow agent would enable this to happen.

Escrow agents have a fiduciary relationship with both the seller and the buyer.

Professional advisors, on the other hand, almost always have a fiduciary relationship with only one party. These professional advisors, such as accountants, attorneys, and brokers, are often held to a strict code of ethics that prevents them from representing more than one party in a transaction — they often define this as a conflict of interest. By definition, this would prevent a professional advisor involved in the transaction from functioning as the escrow agent because they would not be an impartial, unbiased, neutral third party.

Escrow agents must act only on mutually agreed-upon instructions.

A fiduciary relationship means that the fiduciary, or escrow agent, holds a relationship of trust along with legal obligations when handling financial assets or information. This relationship requires one to place complete confidence and trust in the fiduciary for a particular transaction. A fiduciary is necessary for the sale of businesses primarily for timing reasons.

For example, the fiduciary holds funds or sometimes documents (e.g., a signed lease or franchise agreement) pending completion of events, or they may hold the funds until certain events are completed and then later release the funds.

Services Provided by an Escrow Agent

Now that we understand the roles of escrow agents let’s discuss some of their specific services.

Clear Title

Escrow agents ensure the seller is transferring a clear title of the business assets to the buyer. The sale of a business is primarily the sale of personal property, as opposed to real property, and is covered under the Uniform Commercial Code (UCC).

Escrow agents check whether the title of the assets is clear by searching for UCC liens at the state or local level, although the exact process varies based on the state. This can become quite complex, as there are certain situations in which a UCC lien might not have been filed, but the seller may not be free to transfer those assets. An experienced escrow agent is essential in this regard.

Settlement Services

Escrow agents also act as a third-party clearinghouse (also discussed above) for payment of liens, debts, or other bills prior to or after the sale of a business. The sale of a business is complex, thanks to dozens of interdependent chains of events. A clearinghouse is “an agency that collects and distributes something.” In the context of an escrow, this is either money, information, or documents. Acting as a clearinghouse also requires the escrow agent to provide an accounting, another duty of the escrow agent, to all parties involved in the transaction.

Intermediary for Third Parties

Escrow agents sometimes act as third-party intermediaries for both private and public parties, such as franchisors, landlords, brokers, and banks. Public parties include the IRS as well as state and local governments. The sale of a business involves a dizzying array of tax payments. We suggest you employ professionals to ensure you are in compliance with all direct and indirect parties to your transaction.

We have personally experienced many closings being stalled for technical reasons.

For example, one seller neglected to file the annual report for their corporation with the secretary of state. As a result, the corporation was not properly registered, and its assets were not, therefore, authorized to be sold.

In another situation, one seller neglected to file and pay their personal property taxes for over a decade. The sale was held up by the county treasurer, and the taxes and penalties had to be paid.

Note that a successor’s liability can also exist in certain situations. This means that the buyer may be held liable for certain liabilities that the seller has incurred, even though the buyer might not have been made aware of these.

Successor’s liability primarily relates to payroll taxes, sales taxes, and environmental issues; however, employing professionals is always wise. Certain licenses must also be transferred through an escrow agent, such as a liquor license in the state of California.

Disbursement of Funds

Perhaps the most critical service that escrow agents provide is holding and releasing funds pending the completion of an event. This is important for timing issues, as we discussed above.

For example, we strongly prefer that a neutral third party hold earnest money deposits. The escrow agent holds the earnest money deposit pending the completion of due diligence. They may only release the earnest money deposit upon mutual instructions from both the buyer and the seller.

Typical duties of the escrow holder

The typical duties of the escrow holder in a business asset sale/purchase transaction include:

• Collect and disburse all closing funds according to escrow instructions.
• Distribute final transaction documents to all parties.
• Drafting escrow instructions according to the terms and conditions of the purchase agreement.
• Filing and recording all necessary documents with the appropriate authorities.
• Filing UCC-1 Financing Statements with the secretary of state when seller financing is involved.
• Holding earnest money in a safe and secured escrow account pending closing.
• Providing a Notice to Creditors of Bulk Sale, if included in the instructions.
• Ensuring that secured creditors are satisfied and coordinating any necessary payoffs.
• Notify and obtain clearances from county, state, and federal agencies, as required.
• Notifying the county tax collector.
• Obtain a Corporate Status Report from the secretary of state of all entities involved in the transaction, and confirm that the entities exist and are in good standing.
• Pro-rating and paying the rent, deposits, taxes, and other expenses out of the proceeds, as required.
• Performing a UCC-1 lien and property tax search on the business to make sure that a clear title can be conveyed.
• Preparing estimated closing statements prior to the close of escrow.
• Preparing fictitious business name statements.
• Preparing final closing statements for the parties and accounting for the disposition of all funds deposited in escrow.
• Preparing separate buyer and seller settlement statements reflecting that all funds are being handled through escrow.
• Requesting demands from existing lien-holders and receiving claims.
• Handling UCC-3 terminations, amendments, and/or releases of lien.

FAQs

Do I need to use an escrow company?

No, this is not an absolute requirement in any state that we are aware of. Certain states, such as California, require that you comply with specific laws (e.g., bulk sales laws), and typically only escrow agents offer this service. You should, however, strongly consider the use of an escrow agent. Why? It’s always a good idea to have an objective third party hold the funds, make sure there are no additional encumbrances against the business, and ensure that both you and the buyer are in agreement on the closing prior to releasing funds.

What is a holding escrow?

A holding escrow is when an agent limits their services to the holding of funds. For example, the agent may hold the buyer’s earnest money deposit and may not perform any other services.

What is a bulk sale?

A bulk sale refers to the sale and transfer of nearly all of the business’s inventory to a single buyer where the transaction is not part of the ordinary course of business. Bulk sales laws are meant to protect creditors by giving them notice of a bulk sale. This would be necessary if the supplier had sold the inventory to the business on terms — the business owner could quickly liquidate the inventory to a single buyer and skip town with the cash. Bulk sales statutes require advance notice, often released 14-30 days before the sale, typically through publication in a newspaper. Creditors are given the opportunity to submit claims to the escrow holder. Most states, however, have repealed the bulk sales laws because they have done little to protect creditors. Additionally, bulk sales laws only apply to certain types and sizes of businesses.

Should my broker handle my escrow?

No, your broker cannot provide a fiduciary relationship to both parties. This represents a compromise of the broker’s ethics if they simultaneously function as the escrow agent.

Is the escrow process for a business different from the escrow process for a house?

The primary purpose of escrow for a business transaction is the same as that for buying or selling a house, which is to provide a neutral third party to handle the money and paperwork. However, a business transaction has a different set of laws to follow and generally involves many other parties.

Is the escrow process the same in every state?

No. In states that have not repealed the bulk sales statute (in other words, you must comply with bulk sales laws), the closing process is more complex and time-consuming than in states that have repealed these laws. Additionally, business sales on the West Coast tend to be handled by escrow agents, whereas those on the East Coast tend to be handled by attorneys.

How do I secure my note when financing the sale of my business?

Your note is secured with a UCC-1 lien that is filed with your local county or state. It is also protected with a promissory note and a personal guarantee.

What does not get handled in escrow?

Because the escrow officer is a neutral third party, they do not negotiate or try to settle any disputes between the parties in the transaction. This includes providing legal advice and resolving disagreements, which are the responsibilities of the attorney or business broker in the transaction. The escrow officer also does not send notice of the completion of the sale to the landlord or to the utility and insurance companies.