There are many terms in the financial world that can apply to more than one situation, and escrow is one of those. Escrows are commonly used in the real estate industry, but it’s also an important concept for stock market investors to understand.
What is escrow?
In the simplest terms, escrow is a situation in which a third party holds something valuable in a transaction between two parties. Many people have been a part of a real estate transaction when their down payment was held in escrow. In this situation, the amount of money they were going to put up for their real estate transaction is held by a third party in an account with very specific rules attached to it.
Those rules act like keys to the account, unlocking the contents only once all the terms and conditions have been met. In a real estate transaction, those terms might be that the buyer’s loan is funded, and the seller’s title search proves they can transfer the title. Only at that time will the down payment be unlocked, allowing the transaction to complete.
Escrows are used in other investment activities, including as part of a merger or acquisition or as a way to pass time-locked stock-based compensation to an employee.
When is escrow used?
Generally speaking, escrow is used in transactions with low trust and high value. For example, when you’re buying a house from a stranger, you have no idea if that person is telling you the whole truth about their home. Likewise, they don’t know if you’re actually able to complete your financing. A third party is brought in to create trust.
With mergers or stock-based compensation, escrows are often used as a time-lock to ensure contractual obligations are followed. For example, a c-suite executive given stock-based compensation may be tempted to divest their stock early if the price spikes, but if it’s held in escrow, this isn’t possible because they have little to no control over their property until the terms of the escrow (in this case, a set passage of time) have been fulfilled.
Escrows can be used in a wide variety of transactions, including transactions we might not initially think should necessitate an escrow, like the international transfer of goods. Regardless of the purpose, all escrows are based on a lack of trust over something of significant value. The most common, though, involve real estate, mergers and acquisitions, and stock-based compensation.
Types of escrow in real estate
There are two kinds of escrow that can be used in a real estate transaction. First, there’s the escrow used as an example above, when a brokerage, title company, or lawyer establishes an account to hold a down payment that’s part of a real estate sale. This account keeps the money safe from everyone, ensuring the seller of the property that the buyer will not back out of the transaction without incredibly good reason. It also ensures the buyer that the seller won’t simply run off with their money without passing the title to the property.
The other type of real estate escrow is mortgage-based. These generally are only available to home buyers using specific types of mortgages. In a mortgage-based escrow, a homeowner pays an extra amount of money every month to their mortgage lender, which then places the money in escrow for the yearly payment of items like taxes and insurance. The homebuyer establishes the escrow with initial funding at closing, which can increase closing costs. However, this can prevent significant losses later on from a lapsed insurance policy or back taxes.
Escrows in mergers and acquisitions
An escrow established for merger and acquisition (M&A) works very similarly to those set up for a real estate transaction, and for many of the same reasons. However, since M&A can take a great deal longer than a basic home sale, it’s especially important that escrows are used properly to ensure that each party involved completes the transaction in a timely manner.
Often, the escrow for this type of transaction requires a lot more than a simple deposit. Depending on the arrangement, a company performing a merger may need to keep all or most of the funding or shares required to complete the transaction in escrow until the process is complete. This way, those assets are protected regardless of what the rest of the market is doing.