As mentioned in the first post of this series, the goal of many entrepreneurs is to seek venture capital financing or ultimately sell their company in an “exit” merger or acquisition. Upon making representations and warranties (which are essentially, assurances) associated with any of these transactions, the seller opens itself up to risk. If these assurances turn out to be false or are breached, the seller is subject to suit for breach of contract. Often, however, the parties negotiate an additional protection mechanism called indemnification.
So why is indemnification expected?
In a traditional acquisition, the seller affirmatively agrees to indemnify the buyer for damages or costs related to various things; most notably, breach of a representation or warranty. The seller agrees upfront to hold harmless and to reimburse the buyer for any and all expenses related to their breach. For example, if the seller represented that its equipment was in working condition and it turns out it was not, the seller must make the buyer whole. Essentially, the seller is insuring the buyer on its purchase. Just like an insurance policy, this agreement to insure lasts for a certain period and covers certain events. As this creates ongoing obligations and future potential liabilities for the indemnifying party, the indemnification provisions in transaction documents, and particularly the scope and extent thereof, are often heavily negotiated and should be approached with extreme caution.
There are many protections that can be built into indemnification provisions and transaction documents that limit the scope of the seller’s liability beyond simply excluding scenarios which are covered. For example, the seller may agree to indemnify the buyer but only:
- when the damages or costs exceed a certain amount in the aggregate (what’s known as a “basket”);
- when the damages or costs exceed a certain amount for a particular claim (a “mini basket”);
- in the aggregate up to the purchase price or some other set number (a “cap”); and/or
- for a set period of time from Closing (the “indemnification period”).
In the transactional context, indemnification serves as the enforcement of representations and warranties. A buyer can truly rely on the seller’s representations if the seller has also agreed to hold harmless and reimburse the buyer if the representations are false or breached. The seller can effectively affirm the value of its business, but in doing so exposes itself to risk as a de facto insurer. As this is generally unavoidable in the context of a transaction, limiting the scope of this risk is key for sellers. For these reasons, indemnification provisions should be approached and drafted with extreme caution.