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How Escrow Protects You In A Business Transaction

Contributed by Tawnya Gilreath, CBB

In dealing with business sales, often times the seller or the buyer will ask about the use of an escrow company. The seller may say 'Why can't the buyer just pay me cash or give me a cashier’s check'?

Escrow does a number of things during the business for sale transaction that are designed to protect both the buyer and the seller. First, it is important for the seller to know that the buyer's earnest money deposit or good faith deposit actually has some cash behind it. Escrow will deposit the buyer's check and hold these funds in an escrow account until such time as the transaction closes or is cancelled by the buyer and seller.

On occasion, the buyer will discover during the due diligence period that the income of the business was overstated by the seller. The buyer may decide that the business will not generate sufficient cash flow for his/her needs and may choose to cancel the transaction. If the buyer has given the seller a cashier's check or cash as a deposit, there may be substantial difficulty in getting the deposit back. However, it is generally a simple process to have the deposit funds returned by Escrow.

It is important for the buyer to know if there are any liens against the business and if so to ensure they are paid by the seller. Escrow orders UCC searches to see that the seller doesn't have other liens or encumbrances against the assets of the business. Imagine if a buyer simply handed over a cashiers check for $200,000 only to find out six months later that there was an outstanding lien for $125,000 that had been recorded against the assets of the business. Additionally, Escrow ensures that a "Notice to Creditors of Bulk Sale" is published so that any other creditors can file any claims they may have against the business or the seller prior to the transaction closing. All of this is done to protect the buyer in the transaction.

The buyer's funds have to be deposited into escrow several days prior to the closing date. The funds may come from a lending institution, cashiers check, wire transfer. However, typically the funds are required a few days in advance. This is to protect the seller. There have been situations where buyers have paid sellers directly with cashier’s checks and then proceeded to the bank to stop payment. Since escrow requires the funds in advance, it prevents this type of situation from occurring.

There are many other benefits to using an escrow company and most legitimate business brokers will not be involved in transactions where buyers and sellers are transferring funds directly between themselves.

It is always a good idea to have an objective third party hold the funds, make sure there are no additional encumbrances against the business and make sure both the buyer and seller are in agreement on closing prior to releasing funds. After all, once the funds have been disbursed, there's no going back.

About The Author: Tawnya Gilreath is the managing broker of First Choice Business Brokers in Los Angeles County. Tawnya can be reached at 818-781-0082 for assistance in buying or selling a business, or see her listings and more information about her services.

Posted on April 25, 2011 | Email This Blog Post | Print This Blog Post | All Contributions From Tawnya Gilreath, CBB

Categories: BizBen Blog Contributor, Buying A Business, Deal And Escrow Issues, How To Buy A Business, Selling A Business

Comments:

Yes, escrow has been a fair way for Buyer to guarantee delivery of project, product or service, and Seller to guarantee payment. But in some cases escrows have their own problems too. A dispute without an earlier agreed on resolution mechanism can hold up an escrow to the detriment of the Seller or Provider. If the Seller has contracted third party sources to deliver the project, then delays will accrue unnecessary interest or invoke treats of legal suits. For the Buyer, once an escrow is released, there are few chances of redeeming any compensation for defective products or malfunctioning software. I will like escrow for well-known Buyers and Sellers but I will like a Milestone payment for new Clients or Buyers. This way, money is released in phases as the project proceeds.

Posted by: Kwasi S

Escrows do not guarantee future problems with tax agencies for tax issues that come about as a result of the seller not disclosing or verifying that all taxes have actually been filed and paid. For example, Internal Revenue Code 6020(b) allows the IRS to bill responsible and willful officers, employees etc., with unpaid trust fund taxes. These can be billed after the sale of a business. For example, a seller takes on the financing of the sale of company to buyer. Buyer then is issued a garnishment against the seller for future payments due on the seller financing to be paid to IRS or State tax agency. Seller gets upset at buyer and threatens physical harm. The only recourse that the buyer has is to file a report with local tax agencies about the treat. However, the buyer must comply with sending the payments to tax agency that issued the garnishment. Escrows are important. Financial statements and copies of tax returns do not prove full compliance with tax payments. I would suggest that buyers of businesses verify full payment of taxes by securing copies of all transcripts for all tax quarters and years in which the business has been operating for the past 10 years. These can be secured by the seller directly from tax agencies. Do not rely on tax returns and journals only.

Posted by: Martha de la chaussee, Advocate Tax Group LLC

What is the typical length of a business escrow? Can you have contingencies in the escrow that go to the verification of income?

Posted by: Todd C.

What are the typical costs for a business escrow and who pays those fees?

Posted by: Michael M

You can say that again (the part about making sure the escrow holder knows how to handle business sales). If a broker has a relationship with someone like that and keeps bringing deals, the escrow holder will work with the broker to make sure that everything moves forward and the parties do what they're supposed to. That way, you can close the escrow. The escrow officer who doesn't know what they are doing will wait for the buyer and seller to do what they are supposed to and maybe nothing will ever happen. The good escrow holder is proactive to make sure the deal closes.

Posted by: Lawrence Ing

We also insist on escrow for all our transactions. A good escrow agent can simply make a transaction flow much smoother. They are the go between with the different state agencies, the financing company (if one is involved), and buyer and seller. They make sure that the assets being transferred are clear of any liens and that all the paperwork is completed properly.

Posted by: Steve FitzGerald, Acquisition Services Group | Link

Dealing with bulk sale escrows on a day to day basis, I do hear stories(?) from buyers and sellers who have sold the business to each other with no business broker or an escrow company, ended up with losses due to tax issues or underlying debts. By all means, it should be a teamwork with all parties involved...it makes it easier for all parties to have the knowledgeable escrow holder be the neutral party to handle the closing of the business transaction.

Posted by: Helen Yoo, New Century Escrow, Inc.

Can I use a lawyer to handle business sale? Can he do the same as the escrow company does? Pls advise the advantage and disadvantage of using a lawyer. Thank you.

Posted by: Roy H

Using an escrow company is extremely important, but, not all escrow officers are familiar with business opportnity escrows. Be sure you retain an escrow officer who is experienced in this area and, when applicable, one who is up to date on the bulk sale laws for the State where the business is located. Trying to save money by using a friend who handles residential transactions may actually cost you much more in the long run.

Posted by: Darleen Sweet, Old Republic National Commercial

My favorite story about what can go wrong is about a buyer and seller who wanted to do their deal without the broker finding out. So they decided the buyer would put $30,000 in a bank account that would need the signatures of both parties before the money could be withdrawn. They thought this was a way they could have a do-it-yourself escrow when the listing expired. Guess what? Then they had a big disagreement at some point and the deal hasn't been able to get closed. That was several months ago. The money is still in the bank and neither of them can touch it. HA HA!

Posted by: Steve C.

What makes so much sense about what you are saying is that using an escrow is an important protection for both buyers and for sellers. Not just one or the other.

Posted by: Chaz A.

Good article! Escrow is an important part of any business sale process. If you are selling or purchasing a business use an escrow company! As a business broker I would not be involved in a business sale that does not use an experience escrow company. I have known persons that have gone with out an escrow, only to find a dept to the state (Franchise Tax Board) for $35,000 or in another instance find out about an undisclosed lien on the assets purchased. Be smart. I would be suspect of anyone who wants to deal without an escrow company or legitimate third party.

Posted by: Joe D. Robertson, Southern California Business Brokers