Utilizing Escrow in Acquisition Deals

Escrow Can Replace a Seller Note for Clawback Provisions

Escrow agreements are typically utilized in 100% financed loans for a clawback provision. The seller will typically receive most of the purchase price at closing wired from the lender. 

The portion set aside (usually from 20% to 50%) for the clawback provision, is wired into the escrow account when the loan is closed. Some lenders will handle the escrow internally and others will require the borrower to find their own escrow firm. In either case, there is an escrow agreement between the buyer and seller. 

The agreement spells out when the funds will be distributed and the formula that will be used to calculate the distribution(s). If the retention provisions are met, then all of the proceeds will be delivered to the seller. However, if after the look back period the agreed upon attrition delta is triggered, then the seller receives the adjusted amount and the balance is “clawed back” and usually applied to the buyer’s loan balance. 

An escrow account acts as a secure holding account for a portion of the purchase price. It provides protection for both the buyer and the seller by ensuring that funds are available to fulfill specific obligations or contingencies outlined in the acquisition agreement.

How Escrow is Used

Attrition Offset Clawbacks: Escrow is frequently utilized to manage potential attrition offsets. Funds are set aside in an escrow account for a defined period, and if client attrition exceeds certain thresholds, these funds help mitigate the financial impact.

Seller Payment Distribution: Often, sellers prefer to receive payments over several years instead of a lump sum at closing to optimize tax strategies. With escrow, a transaction can close with an initial down payment to the seller, while the remaining balance is held in escrow, with annual disbursements scheduled.

Purchase Price Adjustments: Escrow also accommodates adjustments to the purchase price based on factors such as the accuracy of financial disclosures, resolution of pending legal issues, or regulatory approvals. The release or retention of funds hinges on these outcomes.

The Escrow Process

Establishing the Escrow Account: An escrow agreement is typically initiated between the buyer, seller, and an escrow agent, outlining terms such as the funding amount and duration.

Funding the Escrow: At closing, the specified portion of the purchase price is transferred to the escrow account, where it is managed by the agent until the conditions of the agreement are fulfilled.

Distribution of Escrow Funds: Distribution follows the stipulations of the escrow agreement. Compliance with conditions releases funds to the seller, while activated clawback provisions adjust payments and redirect any remaining balances as necessary.

Tax Deferral and Constructive Receipt

Seller-financed deals provide unique opportunities and challenges, particularly concerning tax implications. A key consideration is preventing constructive receipt, which can undermine tax deferral benefits. To avoid constructive receipt in these agreements, sellers must relinquish control or access to the sale's proceeds, even if the funds are held in an escrow account.

Key Considerations:

Escrow Beyond Basics: Simply placing funds into an escrow account is not enough. It is crucial that the seller cannot exert control over or access the escrowed funds to maintain tax deferral benefits.

Alternative to Escrow: While escrow services are common, an attorney-client trust account can also serve this purpose. This alternative must adhere to the same principle of denying the seller access to the funds. Some lenders may also manage future distributions internally.

Unambiguous Agreements: The terms of the escrow account or any trust agreement should explicitly prevent the seller from accessing the funds. Ambiguous language can lead to constructive receipt, creating immediate tax obligations and negating deferral objectives.

Loan Risk and Sale Price: The presence of seller financing typically does not reduce the asset's sale price. Instead, the risk associated with the loan is balanced by the interest charged, clearly distinguishing it from the sale price.

Interest Rates and Risk: Setting a fair interest rate is crucial, reflecting the risks the seller assumes. This distinction between the purchase price and interest helps prevent confusion and reduces the likelihood of disputes between parties involved.