You have owned and operated a successful business for years. A potential buyer has just put a 60-page purchase agreement in front of you. The price is right and everything looks great to you, but what about all that “fine print” in the back?
Everyone knows the adage “buyer beware”. However, in a business sale, it is often the sellers who find themselves facing more liability after closing than they expected or negotiated for, who should beware.
One example of a trap for the unwary seller without representation by a corporate attorney is indemnification. Almost always found in the “fine print” of a purchase agreement, the provisions dealing with indemnification are often overlooked or underestimated by sellers.
What is Indemnification?
Indemnification is a contractual remedy for losses incurred by either party after the closing of a transaction, typically as a result of breaches of representations made in the purchase agreement by the seller.
For example, seller and buyer have entered into a purchase agreement. Seller represented in the agreement that “Seller’s business has complied with all laws.” Unbknown to seller, this was untrue, and buyer later discovers that the business in fact was not in compliance with a particular law, and faces a $50,000 liability after closing. Buyer may be able to seek indemnification from seller for this liability and require seller to reimburse buyer for the $50,000, or assume the defense of any legal proceeding, or both. While this is a worst-case-scenario that is unlikely to occur, the inclusion of indemnification rights in purchase agreements is standard practice. Nonetheless, seller’s attorney can and should negotiate for limitations on indemnification.
Limitations in the Reps & Warranties
One limitation on indemnification actually takes place within the representations and warranties made in the purchase agreement. The most common limitations are qualifiers based on materiality and knowledge.
Using the example above, the representation that “seller’s business has complied with all laws” may instead read “to seller’s knowledge, seller’s business has complied with all material laws”. These qualifiers reduce seller’s liability under any future indemnification, as the representation is limited to seller’s knowledge and the compliance only with material laws. Of course, how “knowledge” and “material” are defined is crucial.
Seller would want “knowledge” to only mean the actual knowledge of seller individually, whereas buyer would want “knowledge” to cover matters that seller knows or should know. Seller may want “materiality” to be defined as only involving matters that involve an amount above a certain dollar threshold, while buyer may want “materiality” to be broadly defined or intentionally vague.
Buyers may try to add provisions called “scrapes”, which would actually remove these materiality or knowledge qualifiers in calculating losses or damages and/or in determining whether there was a breach. Sellers should beware of and reject these “scrape” provisions, which can negate the protections built into representations and warranties.
Limitations in the Indemnification Provisions Baskets
Indemnification “baskets” can be included in a purchase agreement to require a certain amount of losses or damages to be incurred by a party before it can seek indemnification. This operates as a form of “deductible” and serves an important function of reducing indemnification claims for smaller losses. In the example above, if the purchase agreement included a $100,000 basket, buyer would not be entitled to compensation from seller for the breach, since the amount of loss was only $50,000.
Baskets can either be structured as thresholds (a.k.a. “first dollar” or “tipping” baskets), meaning Seller would be liable for the total amount of losses once the minimum threshold has been met, or deductibles, where seller would only be liable for losses in excess of a minimum amount. Naturally, sellers advocate for a deductible basket, and buyers prefer a threshold or tipping basket.
Indemnification “caps” can also be incorporated into a purchase agreement to limit the amount recoverable by a party under indemnification claims to a maximum amount. This amount is typically calculated as a percentage of the total purchase price.
If the example purchase agreement included a $10,000 cap on indemnification, Seller could only be liable for $10,000 of the $50,000 in losses.
Buyers and Sellers often negotiate for certain representations and warranties to be excluded or included from the cap, or made subject to a higher cap altogether.
There are a number of additional limitations to indemnification that that may be implemented by the parties to M&A transactions.
First, the parties may choose to escrow funds from the purchase price for a specified period after closing. These escrowed funds would be accessible to the party seeking indemnification in accordance with the purchase agreement. Buyers will typically push for this arrangement, especially if a breach is anticipated.
Second, the party seeking indemnification may be subject to a duty to mitigate its losses or damages which may result from a breach.
Finally, indemnification may be limited to the amount of losses or damages that are not covered by insurance proceeds, with the party seeking indemnification being required to use reasonable efforts to recover under any insurance policies before seeking indemnification.
Business owners should be wary of the various pitfalls to selling their businesses, especially with respect to indemnification, and know that there are many protections and limitations available to them when negotiating a purchase agreement.