Escrow vs. Earnest Money: Understanding Their Role When Buying or Selling a Business
The terms escrow vs. earnest money are important when it comes to buying or selling a business, as their role is to reduce risk and confirm commitments during the transaction. Both involve finances, but they serve different purposes. Escrow is when a neutral third party holds assets or funds until agreed conditions are met, while earnest money is a buyer’s deposit that shows serious intent.
What is Escrow?
Escrow is a legal arrangement where a neutral third party (like a brokerage or title company) temporarily holds funds or assets during a transaction. The escrow company makes sure that both parties fulfill their obligations before the deal is completed. In business sales, escrow accounts are often used to hold deposits, funds for taxes, or operational costs until all conditions are met.
Escrow is typically required in transactions involving
- SBA loans, where the lender needs assurance that funds will be properly disbursed
- Traditional bank financing, which usually requires escrow to protect the lender’s interests
- Large seller-financed deals, particularly when the down payment exceeds $50,000
- Complex transactions involving multiple parties or contingencies
While escrow is usually associated with real estate transactions and the home buying process, it is not exclusive to home sales. Escrow is also common in mergers and acquisitions to hold funds until deals are finalized. In a holdback escrow, a certain amount of money is set aside for potential post-sale liabilities.
The key parties in the escrow process are the potential buyer, seller, and the escrow agent. The escrow agent manages the account and releases the funds or assets once all terms of the sales agreement are met. This system offers security and transparency and minimizes financial risk for the parties involved in the sale.
What are Earnest Money Deposits?
Earnest money is a deposit from the buyer that shows serious intent to proceed with a business transaction. In both real estate transactions and business deals, it’s considered “good faith” and represents the buyer's commitment while contract terms are finalized.
If the deal falls through, earnest money acts as a financial stake, incentivizing the buyer to follow through on the obligation outlined in the purchase contract. For small business transactions, earnest money amounts usually range from 1% to 5% of the purchase price and are agreed upon in the sales contract. While the amount varies, a buyer’s good faith deposit should be enough to reassure the seller without being overly burdensome.
Going back to the homebuying analogy, escrow vs. earnest money is like the difference between a holding account (escrow) and a commitment to purchase (earnest money). Once a seller accepts a buyer’s offer, the home buyer typically puts down a deposit to show a good faith interest and demonstrate commitment to the purchase.
In small business sales, if the purchase doesn’t go through due to the buyer’s default or withdrawal, the seller typically keeps the earnest money deposit as compensation for removing the business from the market during the negotiation period. However, if the deal fails due to circumstances outlined in the contract’s contingencies (such as unfavorable inspection results or inability to secure financing), the deposit is usually returned to the buyer.
The Escrow Process in Small Business Sales
Escrow creates a secure and organized transaction by using a neutral third party to hold funds and documents until all conditions of the buyer’s offer are met. The escrow period typically lasts 30 to 90 days, but can vary based on the complexity of the deal and due diligence requirements.
Steps in the Escrow Process
- Opening escrow: After agreeing to the terms, the buyer and seller appoint an escrow agent to handle the funds and documents.
- Depositing funds: The buyer transfers the agreed amount into the escrow account, typically via personal check or wire transfer. This escrow deposit can be a down payment or full the purchase price.
- Due diligence: The buyer reviews the business, finances, and legal details, while the escrow agent holds the funds.
- Closing escrow: Once all conditions are met, the agent releases the funds, usually via wire transfer, and completes the documents to finalize the sale.
Documents Needed for Escrow
- Purchase agreement
- Business licenses
- Financial statements
- Title deeds and legal documents
- Any required lender documentation (for SBA or bank financing)
- Seller financing agreements (if applicable)
Benefits of Using Escrow
Escrow services protect both buyers and sellers in business transactions. For sellers, escrow ensures that funds are available before transferring ownership and prevents the risk of non-payment. Sellers can be confident they won’t lose the business without receiving full compensation.
For buyers, escrow guarantees their money is only released after all conditions are met, such as asset transfer, any appraisal contingencies, or resolution of outstanding liabilities. Escrow prevents buyers from paying upfront and not receiving agreed upon assets.
Escrow also makes transactions smoother by using a neutral third party to handle payments and ensures compliance with the terms of the sale. It reduces misunderstandings, simplifies complex deals, and adds security to large financial transactions.
Negotiating Escrow Terms and Earnest Deposits
Negotiating escrow terms and earnest deposits requires careful planning by both the buyer and seller. Escrow duration depends on the complexity of the transaction, due diligence timelines, and regulatory or financing requirements. Both parties should agree on a reasonable timeframe that allows for the necessary inspections, financial approvals, and contract finalization. Shorter escrow appeals to sellers that want a quick closing, while longer periods give buyers more time for inspections and approvals.
For small business transactions, earnest money deposits typically follow these guidelines:
- 1-2% for deals under $500,000
- 2-3% for deals between $500,000 and $2 million
- 3-5% for deals over $2 million The exact amount should reflect the business's size, value, and complexity of the transaction.
When SBA or traditional bank financing is involved, the escrow terms must align with the lender's requirements, which may include specific conditions for fund release and longer escrow periods to accommodate the loan approval process.
Clear escrow instructions and agreements are just as crucial as the sale price. These documents specify when funds are released, outline contingencies, and detail the responsibilities of all parties. The agreements help avoid misunderstandings and legal complications and protect both parties from unforeseen disputes or delays. Strong negotiations and clarity contribute to a successful business transaction. To navigate this process smoothly, consider assembling a team of experienced professionals. A qualified business broker, in particular, can provide invaluable guidance through each stage of the transaction. BizBuySell's Broker Directory can help you find the right expert for your needs.