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: Peter Siegel, MBA is the Founder & Senior Advisor (ProBuy & ProSell Programs) at BizBen.com (established 1994, 8000+ California businesses for sale, 500 new & refreshed postings/posts daily) working with business buyers, small business owners/sellers, business brokers, agents, investors, and advisors. Reach him direct at 925-785-3118 to discuss strategies regarding buying, selling, (or financing a puchase of) California small to mid-sized businesses.
Categories: BizBen Blog Contributor, Buying A Business, Deal And Escrow Issues, How To Buy A Business, Selling A Business
Comments Regarding This Blog Post
While it is legal for a licensed business broker to hold deposits in the broker's trust account, I find this to be a dubious business practice. We don't even take the buyer's deposit and instruct instead that the deposit be made by wire transfer directly to the escrow agent upon acceptance of the offer by the seller. We also discourage using checks for any further payments into escrow: a wire transfer is secure, immediate, and irrevocable, unlike checks, even if a cashier's check or a certified check.
Occasionally we encounter a buyer's attorney he says that he will conduct the escrow process and handle the funds through his trust account. We just don't allow it. Escrow agents are licensed by the state, bonded against negligence and malfeasance, and are the most experienced and skilled in this part of the business transfer process.
Another benefit of using a licensed escrow agent is creating credible documents and a verifiable "paper trail" that will satisfy any future IRS audit of the buyer or the seller.
The expense of escrow is negligible compared to the benefits derived by both the buyer and seller, typically costing well under 1% of the total price.
If two parties do a deal without going to escrow, I can only imagine that there also is no purchase agreement and no disclosure forms with regard to income and expenses. I always request that the phrase, "...the buyer has verified the books and records and understands any future profits is on his/her own endeavor" be put in the escrow instructions. In California, which is a very litigious state, it's crucial that training, price, terms, agreement not to compete, and contingencies such as a the buyer obtaining a new or transferred lease/state & city licenses and permits are specified in the escrow instructions.