If you’ve ever made a deal with someone and you weren’t sure that they were going to follow through with their end of the arrangement, then you know why escrow providers exist.

Historically, this is how most financial transactions were made — a buyer or investor would wire funds to the seller or issuer without complete confidence that they would hold up their side of the bargain and that their representations during due diligence were truthful and accurate.

As a result, any participant in a private market transaction would be subject to meaningful counterparty risk.

Today, this risk is limited by using an escrow provider during a transaction. An escrow provider is a type of company that acts as a neutral third party in private market transactions to hold certain funds related to the transaction until both sides meet their contractual obligations in the deal.

In addition to mitigating counterparty risk, escrow providers introduce many transaction-related benefits to stakeholders, such as custodying funds before dedicated bank accounts are set up or if a transaction is delayed for ongoing negotiations or simply for procedural reasons.

History of escrow transactions

Years ago, financial transactions were handled offline, in person — with the buyer and seller meeting to close the deal and transfer funds. However, as transactions became digitized and buyers and sellers started transacting from different parts of the world, the need for escrow services surged.

As a response to the developments in private market transactions, regulatory bodies followed suit and created rules governing who can provide regulated escrow services, as well as what processes and controls such service providers need to have in place, bringing compliance and transparency to the ecosystem.

When to use an escrow provider

Private market participants benefit from using an escrow provider, particularly given the inherent fragmentation and opacity in private market transactions.

Escrow providers can help bring transparency, confidence, and standardization to each deal, allowing parties to focus on the merits of the deal itself, rather than either side keeping their word. Depending on the type of transaction and which financial partners are involved, it may be required to use an escrow agent.  

Private market capital raises

Private companies and investment leads (such as venture capital funds, private equity funds and family offices) use escrow providers when raising capital from investors. In either case, the escrow provider is typically hired by the issuer—i.e., the party raising capital—and custodies the investor’s commitments until the issuer's obligations are met, at which point the escrow provider can transfer the investor’s funds to the issuer.

Escrow agreements in private capital raises are a set of documents that stipulate which conditions must be met in order for the escrow funds to be transferred to the receiving party. Most commonly, an escrow agreement will define the minimum amount of capital that the issuer must raise before investor funds are transferred to them. This contingency can also be accompanied by the escrow agent’s responsibilities, the timeframe for the issuer to raise investor capital, and due diligence contingencies. These stipulations instill confidence in investors — particularly those who write smaller checks or ones who commit funds early in a fundraising process — as they know their investment will be returned if the issuer can’t raise the amount they need to execute on their plans.

On the issuer’s side, and especially in the case of newly established entities or those creating holding companies for the purpose of the transaction, this may also be beneficial as a means to gather the funds until they are able to open a bank account. A process which often takes some time to complete.

Mergers and Acquisitions (M&A)

In M&A transactions, an escrow provider is used to ensure that both sides of the transaction are truthful in their representations and are acting in good faith throughout the process. Three common use cases for escrow providers in M&A transactions include:

• Complex asset, intellectual property, or license transfers: Large M&A transactions can get quite complex, including transferring unique assets, regulatory approvals, or business licenses. This presents the opportunity for the deal to run into roadblocks which could materially change the value of the transaction. Buyers use escrow providers for complex M&A transactions to stipulate the conditions that certain assets must be successfully transferred and deal terms must be met before their funds are sent to the seller. Cross-border transactions, which are increasingly common, can create additional complexity around the transfer of company assets, increasing the value of using a trusted escrow provider.

• Buyer submits proof of funds to indicate good faith negotiations: Sellers often request buyers to submit a certain percentage of the purchase price as proof of funds to an escrow account. This providers assurances to the sellers that the buyer is serious and has the financial means to acquire the business. An escrow provider can hold the buyer’s proof of funds in a safe, third-party account which can be returned to the buyer if the deal falls through.

• Holdback period after transaction closing: “Holdbacks” represent a percentage of the purchase price that remains in the escrow account after the transaction closes. Holdbacks allow for the buyer to confirm that the seller’s representations and warranties during negotiations were true and not misleading. If certain material information is found that was hidden or omitted during the sale, the buyer may receive some of the funds back based on the escrow agreement terms and could result in further litigation.

Benefits of using an escrow provider

Ultimately, an escrow provider serves both sides of a transaction to facilitate a clean and transparent deal, while providing downside risk to each party and ensuring that all stakeholders are acting in good faith. Some key benefits of using an escrow provider include:

• Regulation and compliance: Escrow providers are licensed and regulated by governing bodies and are held to a high standard to manage complex, global transactions.

• Protection for buyers and sellers: Escrow providers create downside protection for both parties and act as a formal intermediary to ensure funds are only transferred upon meeting certain contractual obligations.

• Professionalized transaction: Using a regulated escrow provider can attract larger and more sophisticated buyers and sellers by professionalizing the offering.

• Stakeholder verification and anti-money laundering protections (AML): Escrow providers act as an additional layer of protection to reduce the risk of money laundering by often verifying stakeholders' identities through KYC verification and AML checks.

• Reduction in counterparty risk: Escrow providers reduce counterparty risk so the buyer and seller can focus more on the merits of the transactions than the administrative considerations of how to best hand over their funds.

• Increased Transparency: Escrow providers follow the instructions set forth in the mutually agreed upon escrow agreement, providing transparency to both sides.

• Managing complex deals: Escrow providers can help facilitate complex deals that involve the transfer of unique assets and ensure each party receives what they’re owed before any funds are transferred.

How Zest can help

Zest is digitizing private market transactions, building tools to streamline how entrepreneurs, funds, and investors transact. Our platform is designed to save you time, reduce administrative costs, and bring transparency to your transaction process.

Get started with Zest today.