WHAT IS ESCROW?
Let us understand the concept of escrow from the most relatable example. Most people purchase goods through e-commerce websites nowadays. Now, if you are not paying Cash On Delivery (COD), you make the payment to the e-commerce company at the time of placing the order. The e-commerce company holds your payment on behalf of the seller. Depending on the contract between the seller and the e-commerce company, the seller gets paid after certain conditions are met such as satisfactory fulfilment of the order and no refund request from the buyer.
The e-commerce company here acts as an escrow agent who holds the payments in trust for third parties (buyers and sellers) until the contractual requirements of a transaction are fulfilled. This is the basic concept of escrow – a reliable third party managing funds for buyers and sellers.
An Escrow account is a third party account which holds money on behalf of others and the money is released upon fulfilment of contractual obligations.
BENEFITS OF AN ESCROW ACCOUNT
Some contracts may involve a significant investment of funds and time for the seller. For example, a real-estate developer invests a lot before the properties are handed over to the buyers after the buyer and the developer gets into a contract. It is possible that after the properties are developed, the buyer refuses or unable to abide by the contract i.e. pay for and procure the properties. This introduces a considerable 'payment risk' for the seller. Now, the seller may demand advance from the buyer. Giving advance before the development of the property introduces 'delivery risk' for the buyer.
An escrow account manages the 'payment risk' for the seller and the 'delivery risk' for the buyer. As the money is parked at the escrow account, the seller gets the assurance that he will be paid at the fulfilment of the contractual obligations. The buyer, on the hand, gets the assurance that if delivery is not made, his money is safe in the hands of a trusted third party and will be returned.
USE OF ESCROW ACCOUNT
Conceptually an escrow account can be used for any transaction which involves payment and delivery risk i.e. there is a waiting period after the terms of the contract are decided and the actual delivery. The cost and time of opening an escrow account though may not be justified for small transactions.
An escrow account is primarily used in the real estate transactions, Merger and Acquisition deals and some capital market transactions such as Foreign Direct Investments (FDIs).