Translation: Escrow Account - Escrow Account.

Simplified Definition: It is a neutral and temporary bank account managed by a trusted third party (such as a commercial bank or financial institution), where part of a transaction's funds (or all of it) is held and not released to the seller until certain agreed-upon conditions in the contract are met, or a specified period has elapsed. In other words, it is a "financial shield" that ensures the buyer the safety of the transaction and that it is free from any hidden liabilities or unexpected legal claims that may arise after the purchase and transfer of ownership.

How is it recorded in the accounts? It is recorded in the balance sheet (statement of financial position). For the acquiring company (the buyer), it is classified as restricted cash within current or non-current assets (depending on the holding period). For the seller, it is recorded as receivables or held assets, and is not recognized as free cash available for use until it is released.

Note (Factors for Building the Escrow Account): The structure of the escrow account in acquisition and merger deals is built to hedge against several potential risks that may arise after completing due diligence, including:

  • Contingent Liabilities: Legal or labor issues raised against the target company that have not yet been resolved.
  • Tax and Zakat Claims: Potential claims or differences from the Zakat, Tax, and Customs Authority for previous financial years.
  • Unrecorded Debts: Ensuring there are no obligations to suppliers or creditors that have not been disclosed by the management of the target company.

Example: Suppose a medical company acquired a hospital for 1.59 billion riyals. During the due diligence process, the possibility of tax claims or legal issues emerged that could cost up to 100 million riyals, but their occurrence is uncertain. Instead of canceling the deal or paying the full amount and taking the risk, 1.49 billion riyals is transferred to the seller immediately, and 100 million riyals is held in an "Escrow Account" for 6 months. If the six months pass without any claims, the 100 million riyals is transferred to the seller. If a fine or claim of 30 million riyals arises, it is paid from the escrow account, and the remaining amount (70 million riyals) is transferred to the seller.

What does it mean for you?

  • Having an Escrow Account (of a studied size): Indicates maturity and high investment awareness from the management of the acquiring company, as it protects the shareholders' funds from any "skeletons in the closet" that may appear after merging with the target company, reflecting efficiency in risk management.
  • Ignoring the Escrow Account in complex deals: May raise concerns among financial analysts, as it means the acquiring company bears all previous legal and financial risks, which may later surprise investors with significant unrecorded losses impacting the income statement.

Sector Differences: This concept is the fundamental "safety valve" in acquisition and merger (M&A) deals across all sectors without exception. However, it is particularly prominent and daily in the real estate sector (to ensure the completion of projects on the map before handing over buyers' funds to the developer), and in the technology sector (to ensure the integrity of codes and software and that there are no intellectual property violations before paying the full valuation to the founders).

Common Question: Why does the seller agree to have part of their money held in an escrow account instead of receiving it all immediately, especially since they are relinquishing their shares entirely on the day of signing the agreement?

Answer: Because the alternative in the corporate world is often either the complete failure of the deal and the buyer's withdrawal, or the buyer sharply reducing the overall valuation to hedge against the worst-case scenarios. Accepting an escrow account gives the seller the opportunity to obtain the "fair and rewarding valuation" they aspire to, while deferring the receipt of a small part of it (usually ranging from 5% to 10%) for a specified period. It also accelerates the closing of complex deals that may stall for months due to disputes over uncertain potential liabilities.