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Basics of Indemnification in Business Purchase Agreements

By Robert A. Sternberg

Kovitz Shifrin Nesbit, Principal

In most transactions involving the purchase and sale of a business, the seller and buyer include a section in the purchase agreement relating to indemnification. Often the basic terms of the indemnification section are agreed to in advance in a non-binding letter of intent.

The provisions of the indemnification section generally state that the party providing indemnification (“Indemnitor”) will reimburse the party receiving the indemnification (“Indemnitee”) for losses that result from Indemnitor’s conduct or liabilities relating to the business purchase transaction.

Business buyer beware?

Although the indemnification obligations generally apply to both seller and buyer, the buyer generally faces greater risk and, therefore, is more concerned about the indemnification provisions.

Typically a seller will indemnify a buyer for losses arising from:

  • breaches in the seller’s warranties and representations;
  • breaches of seller’s covenants;
  • seller’s taxes incurred before closing;
  • environmental issues;
  • certain employee claims;
  • seller’s liabilities that the buyer is not assuming;
  • business operations before the closing; and
  • specific matters peculiar to the particular transaction.

 

Likewise, typically a buyer will indemnify a seller for losses arising from:

  • breaches of buyer’s covenants;
  • breaches in the buyer’s warranties and representations;
  • seller’s liabilities that the buyer is assuming; and
  • business operations following the closing.

 

Sellers want short-term; buyers prefer long-term provisions

A seller wants its liability under the indemnification provisions to last a short time.  Conversely, a buyer wants the seller’s liability under those provisions to last as long as possible. The survival times for the indemnification claims generally fall into the following categories.

  • So-called fundamental representations, which commonly include representations relating to: (a) organization of the entity; (b) capitalization and ownership of assets: (c) entity authority and enforceability; and (d) lack of indebtedness to the business except for indebtedness assumed by the buyer. Fundamental representations typically survive indefinitely without an expiration date.
  • Representations relating to taxes, employee benefit matters, and environmental, health and safety matters, which generally survive for as long as the respective statute of limitations for each of those matters.
  • All other representations and warranties that will survive for a negotiated period of time, usually somewhere in the range of 1 to 2 years.
  • Covenants that survive for the time period stated in the covenants, and if no time is stated in the covenant, then indefinitely.

A seller also wants to limit the dollar amount of its liability under the indemnification obligations. Generally, if the buyer is asked to put a maximum amount or “cap” on the seller’s liability, the buyer will offer to limit the liability to the amount of the purchase price of the transaction. In many transactions, through negotiations, the seller is able to limit the cap – sometimes as low as 10% of the purchase price, depending upon the amount of the purchase price.

Limiting Your Exposure to Indemnification Claims

Another technique for limiting exposure to indemnification claims is to set a threshold amount that must be met before an obligation to indemnify arises. Many times the threshold amount is negotiated to be approximately 1% of the purchase price, but can vary depending upon the amount of the purchase price.

In some instances, once the threshold is reached, the Indemnitor is responsible for both the amount up to the threshold and all amounts in excess of the threshold – this is sometimes referred to as a “basket” or “tipping basket.” In other instances, once the threshold is reached, the Indemnitor is only responsible for the amount of losses in excess of the threshold – this is sometimes referred to as a “deductible.”

An indemnification section in a purchase agreement will also include procedures for making claims and defending third-party claims made against an indemnitee. In many instances, a buyer may require that a third-party escrow be established at the closing with a portion of the purchase price, from which a buyer can receive funds to satisfy an indemnification claim against the seller.

Intermediaries and counsel for seller and buyer should explain to the seller and buyer, in simple terms, the basic concepts of the indemnification section. These provisions are complex and the negotiation of these provisions may be critical to the success and closing of a deal.

About Robert A. Sternberg

A savvy dealmaker, Robert Sternberg has been a practicing attorney since 1972. He focuses in the areas of business/corporate law, real estate law, loan transactions, and provides general counsel to business clients. Robert represents individuals, partnerships, corporations, limited liability companies, and banks in negotiating and closing modest to multi-million dollar transactions involving commercial real estate, mergers and acquisitions, and commercial and real estate loans.

In addition to his practice, Robert also counsels Kovitz Shifrin Nesbit and other professionals outside the firm on ethical considerations and issues relating to attorneys and the practice of law. He has received an AV Preeminent Peer Review Rating from Martindale-Hubbell, which is their highest peer rating for ethical standards and professional ability.

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