What is an Escrow Agreement?
Often, the founders of a start-up will be issued stock at the same time notwithstanding one of the founder’s main contribution occurring in the future. However, if the founder has already received the shares, he or she might not be incentivized to satisfy his or her obligations. This blog will describe how an escrow agreement may ameliorate some of the problems resulting from these arrangements.
(2) What is an Escrow Agreement
An escrow agreement is a legal document defining the arrangement by which one party deposits shares with a third-party, an escrow agent. The Escrow Agent will release the shares to the beneficiary upon the beneficiary satisfying specific terms and conditions outlined in the escrow agreement.1
By depositing the shares with an escrow agent, all the founders can rest assured the beneficiary will not receive the shares unless he or she has satisfied the obligations under the escrow agreement.
A founder receiving shares without having contributed to the business raises several issues. Firstly, it may cause resentment amongst the founders. This resentment might impede founder productivity or result in the founders sabotaging the business. Secondly, outside investors are often hesitant to invest in businesses if they perceive a shareholder is not contributing to the company. In this regard, it is important to distinguish growth companies from publicly traded companies which have many inactive shareholders. Thirdly, this may result in a hold-out risk. If the founder possesses enough shares, he or she may impede the other founders from making important decisions on how to grow the company.
Examples of Situations Where an Escrow Agreement Would Have Been Useful
The following are some examples of where an escrow agreement could be useful.
Firstly, changes in business plans may render the founder’s contributions superfluous.2 The risk of a business having to change its business model should not be underestimated. For example, Blockbuster started out with a compelling business model. Its value proposition was clear – enabling consumers to watch hit movies in the comfort of their homes.3 However, ultimately Blockbuster failed because they failed to adequately adopt their business model to compete with Netflix.4
Secondly, the founder may quit the company, or choose to dedicate his or her time to other ventures, upon receiving shares within the growth company. This is not unheard of. For example, Facebook founder Eduardo Saverin opted to commit his time to develop Joboozle rather than Facebook.5 In turn, Mark Zuckerberg chose to dilute his shares, and costly litigation ensued.6
Thirdly, the founder may be ineffective. Although the founder may look impressive on paper, his or her skills may be ineffective in that industry. For example, Apple chose John Sculley to replace Steve Jobs as the CEO of their company. Mr. Sculley had developed an impressive marketing resume during his time with Pepsi Co. However, Mr. Sculley knew little about marketing computers.7 When Steve Jobs returned to Apple, the company was on the brink of failure.8
In conclusion, an escrow agreement can be a useful legal tool for those wishing to start a growth company. It is particularly useful if one of the founder’s main contribution to the growth company does not come till after the business is formed.
Sunny Uppal is a member of the BLG Business Venture Clinic, and is a 3rd year student at the Faculty of Law, University of Calgary.
2 Bryce C Tingle, Start-Up and Growth Companies in Canada, LexisNexis Canada Inc. 2018 at p 110.
3 Saul Kaplan, Business Model Innovation: How to Stay Relevant When the World is Changing (John Wiley & Sons, 2012) at p 5.
4 Ibid at p 9.
Blog posts are by students at the Business Venture Clinic. Student bios appear under each post.