How Escrows Can Safeguard Your Business Transaction

Companies often need to move quickly when a deal comes together. The stakes are high, but the risk of potential fraud, misrepresentation, or loss of property is higher. This is when setting up an escrow can be an effective risk management tool. In fact, in some cases it is a regulatory requirement for specific types of transactions such as an initial public offering (IPO) on TSX.

What is an escrow?

Escrow arrangements involve engaging the services of an independent third party, such as TSX Trust, to hold, safeguard, and release some form of property, such as cash, securities, source code and financial models according to the agreed terms. The escrow agreement outlines the description of the property to be held in escrow, the duration of the arrangement, the escrow release conditions, release protocols, and beneficiaries.

Every transaction is different and a template approach can be ineffective. Oftentimes, the escrow agent collaborates with the clients' legal and financial advisors to tailor the escrow arrangement to the unique needs and expectations of all parties involved.

Considerations for escrow arrangements

It is important to have a clear understanding of some of the different types of escrow arrangements, and the benefits to your business transaction. Here are six situations where setting up an escrow can protect your interests.

1. Holdbacks in M&A Deals – In this scenario, a portion of the purchase price is set aside to be held in escrow subject to a purchase and sale agreement or an acquisition. Indemnity escrows generally seek to protect an acquirer from risks and claims that may come up within a specified period post-closing. Holdbacks (e.g. earn-outs) also ensure that the amounts being held in escrow are only released upon certain occurrences as agreed upon by the parties.
   
   
2. Purchase and Sale of Goods – Commonly used in cross-border transactions, a buyer and seller of specified goods might wish to deposit a portion of the purchase price of the goods with a neutral third party to minimize the occurrence of fraud and/or misrepresentation. For example, the parties may agree that a portion of the purchase price be deposited in escrow, and that the escrow agent can only release the funds to the seller upon the buyer's written confirmation that the goods have been delivered in good condition.
   
   
3. Directors and Officers Trust – The COVID-19 pandemic has raised unique challenges for companies, and for their directors and officers as a result. This type of escrow provides additional protection for directors and officers of a company with respect to liability claims which are not covered by the company's directors and officers insurance. The structure of the escrow could be in the form of a trust fund to be administered by the escrow agent/trustee.
   
   
4. Custody Arrangement – An example of a custody arrangement is where the parties agree to deposit a specified material e.g. financial model (and any updates thereof) of a project with a custodian pursuant to the terms of a project agreement. A custody agreement generally outlines the terms by which the custodian will perform its duties, and the form in which the material will be deposited amongst others.
   
   
5. Intellectual Property – It is common for a developer and the buyer of a technology solution to agree that the source code or intellectual property be deposited with a trusted escrow agent. The goal is to protect technology that is critical to the buyer's business functions and provide the buyer access to the technical knowhow and source code in certain situations e.g. bankruptcy and insolvency of the developer, or a disruption in the developer's business.
   
   
6. Share Escrows – Lastly, shares or other forms of securities may be held in escrow voluntarily or as a result of a regulatory requirement. For example, mandatory security escrow is required under the TSX Venture Exchange Policy 5.4 in connection with a reverse takeover, change of business, qualifying transaction or other transactions, such as an IPO. A voluntary share escrow on the other hand is often entered into pursuant to a share purchase agreement where a portion of the share consideration is required to be held in escrow for a specified period.

In structuring business transactions, an escrow arrangement can provide an extra protective layer and enhance trust between parties. While an escrow is primarily used to minimize the inherent risk in any business transaction, it serves an additional purpose of providing peace of mind with regard to business continuity.

As the largest Canadian-owned Transfer Agent and provider of Corporate Trust Services, TSX Trust offers independent, third-party escrow services and solutions to both public and private companies. To learn more about our offerings or to get in touch with our team, please visit www.tsxtrust.com.