How Does Indemnification Work When Buying or Selling a Business?

March 14, 2022
Weavil Law
Overview

Indemnification rights give the purchase agreement’s representations and covenants teeth, imposing liability on the seller (or sellers) for the buyer’s losses due to the reps not being true or the covenants not being fulfilled.  Usually, these provisions are heavily negotiated, with the buyer wanting full, long-lasting protection, and the seller wanting narrow, short-lived indemnification obligations.  Some key elements are as follows:

Key Provisions


Who’s Liable
In stock deals and mergers, the stockholders of the target will be on the hook; in asset deals, it may be the stockholders or the target entity itself, guaranteed by the stockholders.

Time Limits
Buyers want as long as possible to discover and bring claims, while sellers want a more limited period. Periods from 1 to 2 years are common for so-called “non-fundamental reps,” discussed below.

Caps
Similarly, buyers want high total liability for claims, while sellers want to cap their exposure. Around 10-20% of the deal value is typical for non-fundamental reps, but the appropriate number depends on the specific transaction. If there is an indemnification escrow, it will often function as the exclusive remedy and effectively establish the cap.

Baskets
Indemnifiable losses usually have to hit a threshold (“fill the basket”) before indemnification obligations kick in. That protects the seller from being subject to small claims. Once the threshold is met, liability can be either for amounts over the threshold (a “deductible”) or for the entire amount back to the first dollar (a “tipping basket”). Baskets of 0.5%-1% of deal value are common. Typically, if there is a basket, the “materiality” and other qualifies will be read out of the reps as though they’re not there (a “materiality scrape”), and the basket will then serve as the threshold.

Carve-Outs
Certain types of breaches should be carved out from the indemnification limitations. For example, so-called “fundamental reps” concerning authority to enter the transaction and title, as well as reps concerning tax, environmental, and employee benefits matters are usually not subject to the same limits as other reps. Fraud, willful misconduct, and covenant breaches are also usually carved out from the limitations.

Offsets
If all or a portion of the purchase price is subject to future payments from the buyer, as in the case of seller financing or an earnout, indemnification provisions may provide that the payments may be offset by losses.

Indemnification Escrow + Holdbacks
Sometimes, part of the purchase price is put into escrow to secure the seller’s indemnification obligations.  Alternatively, the buyer may hold back a portion of the purchase price.  In many deals, the escrow or holdback will be the purchaser’s exclusive remedy for indemnification losses, but in others, it may be the starting fund prior to proceeding against the seller.

In our next post, we will continue with a discussion of closing conditions and covenants.

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