Buying A Business: What Should Be Included In Escrow Instructions?

Dear Reader, while I have been a member of California Association of Business Brokers for 3+decades, most all my business sales have been the small mom and pop businesses that no one else wants to touch because the business is just too small. While the largest I've sold was (in today's market) about at $4-million hardware store, I have found simple ways to serve as consultant to help sell these small businesses. I can't help everyone this way but I can help a surprising number. These transactions are often stealth in nature where only a few people even know they are taking place. This article below is written by persons (competitors actually) who I hold in very high regard as to their experience, wisdom, and knowledge and so I share it with you while giving them credit. I work in the East SF Bay Area, Livermore, CA, but their comments are universally applicable. Rich Buckley 

Once you have successfully negotiated the Asset Purchase Agreement ("APA") for your acquisition it's natural to relax a little and let your guard down. But it's still important to carefully review every document you receive for signature from the broker or escrow.

One of the most common places I have been finding potential problems in transaction documents lately is the Escrow Instructions. While they seem to be an afterthought for many buyers and sellers, Escrow Instructions are important documents and formalize the agreement between the buyer, seller, broker and escrow. When not properly drafted, escrow instructions can create critical problems.

For example, I represented the buyer in one recent transaction. I had carefully revised the APA to make sure that the seller was making the representations and warranties as to the assets and the business we needed to protect the buyer. In one particular representation the seller represented that the financials fairly and accurately portrayed the business' financial position as of their dates. 

But when escrow sent out the Escrow Instructions, they had decided (without asking either party) to include a provision where the buyer acknowledged that they were not relying on the financials in deciding to purchase the business.

If it turned out that the Seller had intentionally misrepresented the financials we'd typically have a claim against them for fraud. But a fraud claim for misrepresenting the financials requires that the buyer reasonably relied on the representation that the financials were accurate. 

If we had left in the new provisions, it would be much harder for the buyer to pursue the seller on a fraud basis if the seller had intentionally (or even negligently) misrepresented the financials.

Unfortunately I see issues like frequently. While most escrow instructions state that conflicts between the purchase agreement and the instructions are governed by the purchase agreement language, you may not always have a direct conflict. It's much easier to simply not have conflicting provisions in the escrow instructions in the first place.

I also frequently see escrow drafting promissory notes, personal guarantees and security agreements if they are not drafted along with the APA. These documents frequently have (or lack) important provisions that can substantially change the balance of rights from the buyer to the seller or vice-versa. 

On the buyer side, these include rights to notice if there is a missed payment (and time to cure that delinquency) and rights to offset claims against the seller by withholding payments on the note.

As a seller your rights to accelerate the note and the way you address whatever security interest and personal guarantee you have in place can make a major difference in your rights if you ever have to sue to collect. You can also put in provisions which make it much easier for you to sell the note to a third party down the line if you know how to structure it-- such as provisions allowing you to audit the business, run credit checks and get notification of issues with the business down the line.

Before you sign anything from escrow, including instructions, amendments, or additional documents, make sure you know what you're signing and that you aren't giving away any rights the purchase agreement provides or failing to acquire rights that you should have in your promissory note, security agreement and personal guarantee.