Escrow Account

What is an escrow account?

Escrow account (Treuhandkonto, escrow for short) is an account on which a neutral trustee holds money for several parties and pays it out only under the agreed conditions. In a business acquisition, it serves above all to retain part of the purchase price as security for the buyer's claims or to link payment of the purchase price to the transfer of the shares. The principle resembles an online purchase through a platform that passes the buyer's money on to the seller only once the goods have arrived. Escrow accounts also exist outside business acquisitions, for example for rent deposits, for funeral provision, for real estate purchases through a notary's escrow account (Notaranderkonto) or for client funds of payment service providers.

The parties involved are the buyer, the seller and the trustee (escrow agent), in Germany often a notary, a bank or a specialised escrow service provider. The basis is the business purchase agreement and a separate escrow agreement, in the case of a notary a custody instruction. The typical purpose is to secure claims under warranties, that is, assurances about the condition of the company, and under indemnities, by which the seller assumes individual risks. In addition there are the handling of closing (the transfer of the shares against payment) and the securing of a purchase price adjustment after the reference date.

Forms of escrow account

Notary's escrow account (Notaranderkonto)

In a share deal involving shares in a GmbH (German limited liability company), a notary is involved anyway, because the assignment and the obligation to make it must be notarised under Section 15 (3) and (4) of the German Limited Liability Companies Act (GmbHG). Custody in a notary's escrow account is therefore an obvious choice. It is regulated in the German Notarisation Act (Beurkundungsgesetz) and presupposes, among other things, a legitimate security interest of the parties and a written custody instruction. The notary pays out exclusively according to this instruction; the notary does not decide on disputed claims.

Account at a bank or an escrow service provider

In cross-border transactions or with longer terms, a bank or a specialised service provider is often engaged. The basis is a three-party agreement between the buyer, the seller and the trustee. The account is opened by the trustee; beforehand, the trustee identifies all parties under the German Anti-Money Laundering Act (Geldwäschegesetz), which takes time where there are several sellers or foreign companies.

Purchase price retention and other security

A simpler option is a retention by the buyer itself, which pays part of the purchase price only later. This saves costs, but the seller bears the risk that the buyer cannot or will not pay when the amount falls due. Alternatives are a bank guarantee, which the seller provides through a guarantee facility (a guarantee line from its bank), and a right of set-off for the buyer. The buyer then offsets its claims against later parts of the purchase price, for example a performance-based earn-out or a deferred part of the purchase price (vendor loan).

Amount and term of the escrow amount

The amount depends on the risks that the due diligence (the buyer's review of the company) has revealed and on the agreed liability rules. In practice, escrow amounts of roughly 5% to 15% of the purchase price are common; with a warranty insurance policy they are considerably lower or fall away. The term is usually based on the limitation period of the business-related warranties. For known tax or litigation risks, a separate amount with its own term is often agreed.

The escrow amount is not to be confused with the liability cap. If justified claims exceed the amount held, the seller remains liable for the remainder, unless the agreement expressly restricts the buyer to the escrow balance.

Release mechanics

Economically, the conditions under which the trustee pays out often weigh more heavily than the amount. The following building blocks are customary:

• Automatic release: On the agreed date, the trustee pays the amount out to the seller without any further declaration, less claims notified in good time.
• Qualified claim notice: Only what the buyer has notified in writing, with reasons and quantified, before the release date is retained. Blanket notices block nothing.
• Partial releases: Part is released earlier, for example half after twelve months, the rest at the end of the term.
• Time limit for suing: If the buyer does not bring an action in court or before an agreed arbitral tribunal within a certain period after the notice, the retained amount is released.
• Payment of disputed amounts: against a joint instruction, final judgment, arbitral award or settlement, combined with an obligation of both parties to give the instruction as soon as the conditions are met.

In addition, the escrow account serves to handle closing. The buyer pays the purchase price in before closing, and the trustee passes it on as soon as the closing conditions have been proven, for example merger control clearance. The assignment of the shares then usually takes effect only on payment of the purchase price (condition precedent), so that performance and counter-performance coincide.

Interest, costs and taxes

Interest on the balance, in the common arrangement, follows the capital, so it belongs to the party to which the respective amount is paid out. The costs of the trustee and of account administration are often shared. For tax purposes, the retained part of the purchase price generally counts towards the sale price already in the year of the disposal. This applies in any case to founders holding at least 1% (Section 17 of the German Income Tax Act, EStG) and to sales through a holding company. How a specific retention is to be treated is clarified by the tax adviser on the basis of the contract structure.

Worked example: release of an escrow account after the sale

A company is sold for EUR 15 million. 8% of the purchase price, that is, EUR 1.2 million, is paid into an escrow account for 24 months. After twelve months, half is released, insofar as the amount is not needed for notified claims. After ten months, the buyer notifies a quantified claim of EUR 150,000.

• After 12 months: EUR 1.2 million minus EUR 600,000 for the second tranche minus EUR 150,000 for the notified claim = EUR 450,000 released to the seller
• Remaining blocked: 600,000 plus 150,000 = EUR 750,000
• After 18 months, the parties agree on EUR 90,000: EUR 90,000 goes to the buyer, EUR 60,000 to the seller
• After 24 months without further notices: EUR 600,000 to the seller
• Total to the seller: 450,000 plus 60,000 plus 600,000 = EUR 1.11 million; together with the EUR 90,000 to the buyer, this gives the EUR 1.2 million

If, by contrast, every notice blocks the entire escrow amount until it is resolved, EUR 1.2 million instead of EUR 750,000 remains tied up after twelve months, although only EUR 150,000 is in dispute. With the same escrow amount, the difference lies solely in the release mechanics.

Distinction: escrow account, retention, earn-out and vendor loan

• Purchase price retention: The buyer retains the amount itself. This saves the trustee but leaves the seller bearing the buyer's payment risk.
• Earn-out: a conditional part of the purchase price whose amount depends on future performance. The escrow amount, by contrast, is fixed by agreement and retained only as security.
• Vendor loan: a deferred part of the purchase price, which the buyer repays; it serves financing, not security.
• Warranty insurance: replaces the security from the purchase price wholly or partly by the obligation to pay of an insurer (W&I insurance).

Common mistakes

• Joint release without a duty to cooperate. If every payout depends on a joint instruction, one party can block the amount by doing nothing.
• Blanket notices suffice. If an unquantified assertion is enough, a single letter blocks the entire amount.
• No time limit for suing. Without a time limit, a notified amount can remain tied up for years although the buyer never pursues its claim in court.
• Confusion with the liability cap. The seller assumes that its liability is exhausted by the escrow amount, without the agreement providing for this.
• Late opening of the account. Identification and coordination with the trustee can delay closing if they start only shortly beforehand.
• Tax on the retention not planned for. If the amount held already counts towards the capital gain of the year of sale, the seller lacks liquidity without planning.

Frequently asked questions

How high is an escrow amount in a business sale usually?

As a rule of thumb, roughly 5% to 15% of the purchase price. The decisive factors are the findings of the due diligence, the scope of liability and whether a warranty insurance policy is taken out.

How long does the amount stay in the escrow account?

Usually 12 to 24 months, matched to the limitation period of the business-related warranties. Amounts for known tax or litigation risks often remain tied up for longer, until the respective risk has been resolved.

Is a notary's escrow account or a bank account more common?

In German share purchases, the notary who notarises the transaction is often appointed as trustee. Banks and specialised service providers are used mainly in international transactions, with several currencies or long terms.

What is an open escrow account?

An account where the bank knows that the balance economically belongs not to the account holder but to third parties. The notary's escrow account is such an open escrow account. Disclosure makes it easier for the settlors to protect their money from the trustee's creditors and in the trustee's insolvency. With a concealed escrow account, the trust relationship is not recognisable to the bank.

What happens if buyer and seller dispute the release?

The disputed amount remains blocked until a joint instruction, a judgment, an arbitral award or a settlement is available. The trustee does not decide itself. A time limit for suing prevents an amount from remaining blocked indefinitely without proceedings.

Does the seller have to pay tax on the escrow amount before receiving it?

Often yes. With a fixed purchase price, the retained part also generally belongs to the sale price of the year of sale, at least for holdings of 1% or more and for sales through a holding company. If it is later paid out wholly or partly to the buyer, this generally reduces the capital gain retroactively, and the assessment is amended.

The Roemer Capital view

We build the escrow amount into the sellers' proceeds calculation from the outset. It shows what amount flows at closing, what amount is released on what date, and what tax may fall due even before that. This makes it clear early whether an offer with a higher purchase price and longer retention is actually more favourable than a lower one with faster release.

In the negotiation, we focus on the release mechanics: automatic release, quantified notices, partial releases and a time limit for suing. The law firm and notary draft the escrow agreement itself; we coordinate amounts and dates with the liability cap and the limitation period.