Utilizing Escrow in Acquisition Deals for Small Business Owners

Utilizing Escrow in Acquisition Deals for Small Business Owners

Escrow Can Replace a Seller Note for Clawback Provisions

For small business owners considering acquisition deals, understanding escrow agreements is crucial. These agreements are often used in 100% financed loans to provide a safeguard through clawback provisions. Typically, the seller receives most of the purchase price at closing, wired directly from the lender.

A portion of the purchase price—generally between 20% and 50%—is set aside for the clawback provision and placed into an escrow account once the loan closes. Some lenders manage the escrow internally, while others may require the borrower to engage their own escrow firm. Regardless, an escrow agreement is established between the buyer and seller, outlining the distribution timeline and calculation methods.

If the retention provisions are met, the seller receives all proceeds. However, if the agreed attrition delta is triggered after the look-back period, the seller will be given an adjusted amount with the remaining balance "clawed back," usually applied toward the buyer’s loan balance.

An escrow account serves as a secure holding place for part of the purchase price, protecting both the buyer and seller by ensuring funds are available to meet specific obligations outlined in the acquisition agreement.

How Escrow is Used

Attrition Offset Clawbacks: Small business owners often use escrow to handle potential client attrition offsets. Funds are allocated in an escrow account for a set period, and if client loss exceeds certain thresholds, these funds help absorb the financial hit.

Seller Payment Distribution: Many sellers prefer staggered payments over several years rather than a lump sum at closing for tax optimization. Escrow allows for an initial down payment to the seller, with the remaining balance held and disbursed annually.

Purchase Price Adjustments: Escrow also allows for adjustments to the purchase price based on accurate financial disclosures, resolution of legal issues, or regulatory approvals. The release or retention of funds depends on these factors.

The Escrow Process

Establishing the Escrow Account: An escrow agreement is formed between the buyer, seller, and an escrow agent, outlining funding amounts and duration.

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

Distribution of Escrow Funds: Funds are distributed according to the escrow agreement. Compliance with conditions releases funds to the seller, while activated clawback provisions adjust payments as necessary.

Tax Deferral and Constructive Receipt

Seller-financed deals bring unique tax implications. A significant consideration is avoiding constructive receipt, which can jeopardize tax deferral. To sidestep this, sellers must ensure they relinquish control or access to sale proceeds, even if those funds are in an escrow account.

Key Considerations:

Escrow Beyond Basics: Just placing funds in an escrow account isn't sufficient. It's crucial that the seller has no control over or access to those funds to maintain tax deferral benefits.

Alternative to Escrow: While escrow services are common, an attorney-client trust account can also serve this purpose, provided it denies the seller access to funds. Some lenders may manage future distributions internally.

Unambiguous Agreements: Terms of the escrow or trust agreement should clearly prevent seller access to funds. Any ambiguity could lead to constructive receipt, creating immediate tax obligations and nullifying deferral aims.

Loan Risk and Sale Price: Seller financing usually doesn’t lower the asset's sale price. Instead, the risk tied to the loan is balanced by the interest charged, clearly differentiating it from the sale price.

Interest Rates and Risk: Establishing a fair interest rate is vital, reflecting the risks the seller takes. This distinction helps prevent confusion and minimizes potential disputes between parties.

Explore escrow service firms on the vendor portal at LoanBox to find the right fit for your needs.

This article is authored by Darin Manis, founder of LoanBox.