What is Escrow?

Escrow is a term that often sounds like complex legal jargon, but the concept is actually quite simple. It acts as a safety valve for transactions where trust alone is not enough to mitigate risk. At its core, escrow is a contractual arrangement in which a neutral third party receives and disburses money or documents for the primary transacting parties. This third party holds onto these assets until specific conditions agreed upon by both sides are met.

For a founder, this usually comes into play during high stakes moments. You are likely to encounter this term when buying a premium domain name, securing a large partnership, or most commonly, selling your company.

In a typical scenario, neither side wants to make the first move without a guarantee. The buyer does not want to hand over cash until they are sure they received the asset. The seller does not want to transfer the asset until they know the funds are secure. Escrow bridges this gap.

The process generally follows a linear path designed to protect everyone involved. It removes the need for blind faith between two parties who may have competing interests. Here is how the flow typically operates:

• Agreement: Buyer and seller agree on terms, including what conditions must be met for the deal to close.
• Selection: An escrow agent is chosen. This is a neutral entity, often a bank or a specialized legal firm.
• Deposit: The buyer deposits funds or assets into the account managed by the agent.
• Verification: The agent verifies that the conditions of the contract, such as the transfer of IP or due diligence clearance, have been fulfilled.
• Release: Once verified, the agent releases the funds to the seller and the assets to the buyer.

When you sell your startup, you rarely receive 100 percent of the purchase price on day one. A portion of that money, often between 10 percent and 20 percent, is placed into escrow for a set period. This usually lasts anywhere from 12 to 24 months.

This money sits there as an insurance policy for the buyer. It is there to cover potential breaches of the acquisition agreement. These might include:

• Undisclosed liabilities or debts that surface after closing.
• Inaccuracies in the financial statements provided by the startup.
• Issues with intellectual property ownership.

If everything remains quiet and no issues arise during the holding period, the money is released to you and your investors. If a problem does come up, the buyer can claim damages against that escrowed amount rather than trying to sue you directly to get money back.

Founders often confuse escrow with earnouts, but they serve different purposes. It is helpful to view them through the lens of certainty.

Escrow is money that is technically yours, held back to ensure you were honest about the past state of the business. It is about risk protection.

An earnout is money you might get in the future if you hit specific performance targets. It is about future growth potential.

Escrow assumes you get the money unless something goes wrong. An earnout assumes you do not get the money unless something goes right.

There is one other area where this concept is vital for technology companies. This is known as source code escrow.

If you are licensing critical software to a large enterprise, that enterprise might be worried about your stability as a startup. They will ask what happens if your company goes bankrupt. To solve this, you place your source code with an escrow agent. If your company fails or stops supporting the product, the agent releases the source code to the client so they can maintain it themselves.

This allows you to close deals with large clients who would otherwise view a startup vendor as too high of a risk.