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.
Indemnity Provision Component
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.
Important Provision For The Seller
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.