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It started from the old French word escroue, a piece of paper or parchment as a deed to be held until a transaction was completed. Now it is better known as escrow, the system designed to ensure that everyone keeps to their contractual obligations during a business deal.
You may be very familiar with how escrow works on a basic level, but how it applies to online businesses makes it worth a closer look. What are the advantages and disadvantages of escrow for online business deals? Who can do escrow for you? Do the advantages make the cost worthwhile?
The Benefits Of Using Escrow At Closing
Most buyers and sellers know that escrow is supposed to help add security to your transaction. But it actually does this in multiple ways:
- It places a critical asset (money) in the hands of a neutral 3rd party.
- It forces both buyer and seller to plan the transfer in more detail.
- It can provide extra security for a seller who is holding a seller note.
- It can help resolve disputes before they arise.
Escrow Provides an Extra Level of Trust Offering Equal Protection
When a great deal of money is on the line, and the two parties have not met one another, trust can often be an issue, even if you personally like your counterpart. In many cases, the buyer and seller will never meet in person, and you will just be a voice on the telephone (and vice versa).
When a great deal of money is on the line, and the two parties have not met one another, trust can often be an issue.Click to tweet
Even if you do meet face to face, this does not always alleviate issues of trust.
The escrow agent who holds the money will be bound by rules that you and your counterpart agree to in advance. Having a neutral 3rd party hold the money helps ensure both you and the other party receive equal protection during the transfer of the business.
This ensures that neither the buyer or the seller have control over the funds. The seller has the assurance that the buyer no longer has complete control over their funds, and the buyer has the assurance that the seller won’t receive their funds until the transfer is completed and confirmed.
Placing the money with a neutral 3rd party allows you and your counterpart to focus on transferring the assets in their entirety.
But this, of course, requires that you and your counterpart take the time to plan the transfer of the business in detail.
An Escrow Agreement Plans the Transfer in Detail
An escrow agent is not supposed to act as a mediator. Rather, the agent is more like a referee who simply follows and enforces the rules that are laid out in an escrow agreement.
An escrow agent is not a mediator. Rather, a referee who follows and enforces the rules laid out in the escrow agreement.Click to tweet
The goal of an escrow agreement is to plan the transfer, set the rules and definitions of what will be transferred, what will trigger the release of funds, and how to resolve any potential dispute between a buyer and seller.
But an escrow agreement forces you and your counterpart to do more than just set up rules, it forces you to plan your transfer in detail.
How will your closing day look? What do you need to transfer? Are there any spots that might be difficult to transfer?
A well thought out escrow agreement will help make the transfer as smooth as possible.
In addition, your escrow agreement will also lay out ways that certain disputes can be resolved easily and amicably. It is much easier to resolve a dispute before it happens rather than trying to resolve a dispute when you are in the middle of it.
An escrow agreement forces you and your counterpart to do more than just set up rules. It forces you to plan your transfer in detail.Click to tweet
Secure a Seller Note Through a Domain Holding Agreement
When a seller is asked to finance the sale of their business, they are usually doing so without any real security. The purchaser might sign a personal guarantee, and there is always the possibility to sue the purchaser to get the business back, but actually acting on both of these options involves a significant commitment of time, money, and emotional energy by the seller.
So if the buyer decides to stop paying the note, a seller might decide that it isn’t worth the hassle of trying to collect on those funds.
A better and more efficient alternative is to hold the business domain name in escrow for the duration of the seller’s note.
Having the domain in escrow means that if the buyer fails to make their payments without filing a formal dispute, the domain name will revert ownership to the original seller. And owning that domain name gives them quite a bit of leverage.
This process involved is much faster and easier than going to court. This makes it a powerful weapon to have and can be faster than filing a lawsuit.
Joe Valley, the director of QLB brokerage services, encourages sellers to use domain holding agreements:
Escrow will use a domain name holding agreement as security. They take possession of the domain and if the buyer defaults on the note then the domain reverts back to the seller. While it is not perfect, the domain can be a big stick to wield to get payment.
Finally, Escrow Can Settle Miscellaneous, Post-Closing Costs
When closing the sale of an online business, there is often a period of time that elapses between funding escrow and closing. During this time, some expenses might be incurred or inventory spent.
These small adjustments are easy to take care of using money from escrow.
In some cases, a seller might anticipate bills from vendors to come in a few weeks after the closing. Using a holdback – a small percentage of funds that are held in escrow for up to 30 days after closing – can be an effective and easy way to manage these bills.
In fact, in some states (such as California), state laws require that funds be held in escrow until all bulk sale tax notifications are met and local tax authorities are notified. Any outstanding tax liabilities are then paid for directly from escrow.
Who Can Handle Escrow: Escrow Companies, Attorneys, Banks (Brokers Are Not Recommended)
You have more than one option when deciding who can deal with the escrow process during a negotiation to buy an online business.
Escrow Companies Are The Most Popular, But Most Expensive Option
Most buyers and sellers opt to use an escrow company to close their sale, and there are plenty of options.
The company that has been around the longest is escrow.com, which has been around since the toddler days of the Internet. There are other companies available as well, some that specialize in online transactions, and others that may specialize in local laws.
Using an escrow service has a few couple of advantages. First, they are a specialized service, so you can be sure they know their business. Their agreements will likely be solid, neutral, and well thought-out. Second, any local regulations and government notification requirements will be handled cleanly. Finally, if you decide to set up a domain holding agreement for a seller’s note, you would typically do this with an escrow company.
Most Attorneys Can Provide Escrow Service
Many people are not aware that attorneys are also licensed to hold escrow funds. If you are already using an attorney to help you with your closing documents (and you probably should), it can be much more cost-effective to ask your attorney to hold the funds for closing rather than paying the fees from an escrow service.
However, even though an attorney is licensed to hold the funds for your transaction, not all will. Some attorneys are not allowed to hold funds for transactions on which they are advising. In addition, some attorneys just don’t want to take on the potential liability of holding funds due to the potential conflict of interest that may arise.
You may also feel uneasy if the other person’s attorney is the one holding the funds. But given that the penalty for abusing escrow is significant for an attorney, this generally shouldn’t be an issue so long as the escrow is set down in a well-written agreement.
If You Are Financing Through a Bank, They May Agree To Escrow
The last option are banks. If you are applying for a business loan through your bank, they would likely offer to take care of escrow for you (unless you told them otherwise that you had an alternative arrangement set up).
Just speak to the bank officer in charge of your loan application to see what the bank offers its customers. Along with attorneys, banks may also prove to be one of the cheaper options, compared to an escrow company.
Brokers are NOT a Good Option to Hold Escrow Funds
Some web brokerage companies may offer to act as escrow for your transaction. In the past, Quiet Light actually offered this service for no additional fee. However, we discontinued that practice several years ago.
Having a broker offer escrow services is a bad idea for a few reasons:
Not a Neutral Party
An effective escrow agent needs to be third-party and neutral. The web broker is neither. Not only are they involved in the transaction, they are paid if, and only if the transaction goes through. This immediately removes any neutrality from the deal.
Local Law Compliance
Certain states have local laws regarding the sale of any business, including online businesses, such as notifying local tax authorities of the sale. It is unlikely that web broker is familiar with all of the laws in your jurisdiction.
The key difference between using an attorney and a broker for escrow is that the attorney is not being paid based on the success or failure of the transaction. In addition, the consequences of mishandling escrow funds are significant for an attorney.
If you are working on a transaction with a broker who offers escrow services, it is entirely up to you if you choose to use them. During the time that Quiet Light offered escrow, we never had any significant issues. For the most part, it actually helped the transactions.
But the concerns in using your broker for escrow should not be taken lightly.
The Biggest Potential Downside – Cost
Cost only really becomes an issue if you choose to use an escrow agent or some attorneys. But as we have discussed earlier in the article, sometimes you may need to use an escrow agent.
Formal escrow firms are not cheap. On a one million dollar sale price, escrow fees can run around $8,000. Not only is this a pretty steep cost, but there is always the question of who should be responsible for the escrow cost (which should be discussed and agreed to as early as possible).
Looking at those fees, using an attorney seems like a sensible alternative, assuming your attorney is willing and allowed to act as escrow.
Peace Of Mind Trumps Paying Another Fee
With good planning, adding escrow into a transaction adds an additional layer of security for both the buyer and seller which is never actually needed. But that doesn’t mean you shouldn’t use escrow.
With good planning, adding escrow into a transaction adds an additional layer of security for both the buyer and seller.Click to tweet
Drafting an escrow agreement helps you plan the transfer and closing. In addition, even with the best planning, surprises can arise. If they do, you’ll be very happy to have that extra layer of security.
With all of the moving parts involved in transferring the ownership of a business, bringing in a 3rd party to act as custodian of the funds can reduce the number of items you need to focus on, especially if they help with local law compliance.
While the fees can run high, the benefit is extra insurance. As with any insurance, the fee is always worth it, if you need it.
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