When business owners receive an agreement for the purchase
of their business, it is easy to feel lost in a sea of legalese. The agreement generally
can be anywhere from 40 to 100-plus pages, covering a broad range of
representations and warranties, tax matter procedures and so on.

Although it is obviously imperative to have experienced
counsel guide a business owner through this process, it is also helpful for the
owner to understand certain fundamental components of the deal, to be able to
analyze the risk profile and assist the attorney in negotiating a final
agreement that protects the owner to the fullest extent possible.

One such fundamental component of the deal is the
indemnity provision, which is a mutual obligation of the buyer and seller to
defend and hold one another harmless from certain acts or breaches of the
agreement. When a party’s indemnity obligation is triggered, that party will
have to pay attorney fees and costs of defending any claim, as well as paying
for any monetary loss, arising from that claim, including a settlement,
judgment, fine or penalty. In other words, the indemnity provision is (generally
speaking) the one way that a seller will have to pay money back to the buyer
from the sale of the business. Because of this, it is vital for a seller to understand
the mechanics of indemnity, and the ways in which indemnity obligations may be
limited.

As an initial matter, a seller’s indemnity obligation
generally applies to the following: (1) a breach of the seller’s representations
and warranties in the agreement; and (2) a breach of the seller’s contractual
obligations in the agreement.

The first prong is the source of most post-closing
indemnity claims. In the sale agreement, a seller will typically make a lengthy
series of representations and warranties, from basic items such as attesting to
full and unimpaired ownership of the equity and assets of the company, to
highly detailed representations and warranties regarding compliance with
employment or environmental laws, and an absence of claims for violating any
such laws. If there is any legal violation that seller is aware of, that will
be listed on a disclosure schedule to the agreement. In typical sale
agreements, there are twenty to thirty such representations and warranties,
covering the full spectrum of the business. Therefore, unless an item of
potential liability is specifically excluded, any breach of the representations
and warranties that the business has been run in compliance with the laws, is
not encumbered, and is not subject to any claims, can serve as the basis for an
indemnity claim by the buyer.

Because of this, it is important for a seller to thoroughly
review all the representations and warranties with counsel and identify any
potential gaps in compliance and/or future claims. Once identified, seller and
counsel can address the matter with buyer’s team and negotiate provisions to
address the matter. In most cases, the parties are able to reach agreeable
terms on the issue, but identifying it ahead of time and being able to decide
whether or not to proceed is invaluable for a seller. It is far better to
decide to proceed with a known risk than it is to be surprised later.

A seller can also have certain protections built into
the indemnity section of the agreement to limit the indemnity obligations in
most instances. For example, the use of baskets and caps are typical in sale
agreements, both of which limit a seller’s obligations.

An indemnity basket functions like a deductible of
sorts; i.e., until the amount of buyer’s loss reaches X dollars, the seller
does not have to make payment for any indemnified loss. Most agreements use
what is called a tipping basket, so that when the loss threshold is met, the
seller owes indemnity on the entirety of the loss from dollar one.

An indemnity cap is an even more important tool for
the seller. A cap will limit the amount of money a seller has to pay for
indemnified claims post-closing, subject to certain exclusions. In most
mid-market deals, the typical indemnity cap ranges from 5-15% of the total
purchase price. Say for instance the indemnity cap is 10% of the purchase
price; in such event, if the purchase price is $20 million, the seller’s total
indemnity obligation would be limited to $2 million, again subject to certain
exceptions. The logic behind this limitation is that the seller needs a certain
level of assurance that once it sells the business, the buyer is not going to
come back with a slew of claims to essentially claw back the entirety of the purchase
price, while still remaining in control of the business.

The limited exceptions to the applicability of the cap
track this logic as well. For example, fraud is the main exception to applicability
of the indemnity cap. This makes logical sense in that, if the seller has actively
defrauded the buyer about the state of the business, the seller should not be
able to hold buyer to an indemnity limit that was negotiated on the presumption
all parties were dealing in good faith. The inapplicability of the cap to what
are deemed “fundamental representations” like unencumbered ownership of equity
and assets is logical as well – if the seller does not truly own what it is purporting
to sell, then the buyer should not be bound by any cap, as it truly did not
receive what it paid for.

Lastly, a common protection for the seller in the indemnity
section is that indemnity will be set forth as the exclusive remedy for
breaches of the agreement, subject to common exceptions for fraud or for a
party seeking equitable relief. This is an important provision for seller,
because it prevents a buyer from making an “end run” around the
carefully-negotiated indemnity provisions and seeking relief from the seller
which is not subject to the baskets and caps, among other things.

The various permutations of an indemnity section in an
agreement for sale of a business are too involved to address fully here, but
identifying some fundamental components of how indemnity works can help facilitate
communications with counsel when that large stack of deal documents hits the
seller’s inbox.

Jeffrey Petersen

This blog is for informational purposes only
and does not constitute legal advice.