The Challenge of Managing Financial Risk Post Transaction.
Indemnification Provisions are very complex and the negotiation of these provisions may be critical to the success and closing of a deal. It is essential to seek legal advice from your attorney and input from your intermediary. These procedures need and should be explained by the attorney and intermediary in simple English to both the buyer and the seller.
The following is an overview of the Indemnification challenges. Work with your legal counsel and intermediary to fully understand the responsibilities that can emerge post-closing.
“Indemnification.” Restoring back to original condition prior to loss.
Basic Terms of the Indemnification Provision
During the negotiating process, when concluding the sale of a business, the seller and the buyer will incorporate a section into the purchase agreement that identifies financial risk and the assumption of financial risk post transaction. This is referred to as the Indemnification Provisions.
Usually the basic terms of the indemnification section are discussed and agreed to in advance of signing the Agreement to Purchase, often in the non-binding Letter of Intent. Simply, the party providing indemnification (“Indemnitor”) will reimburse the party receiving the indemnification (“Indemnitee”) for losses that result from the Indemnitor’s conduct or liabilities relating to the transaction. The indemnification obligations apply to both the seller and the buyer, but the buyer generally faces greater risk and naturally is more concerned about the unique indemnification provisions.
A seller (current business owner) wants the liability under the indemnification provisions to last as short a time as possible. The buyer would want, and will request, the seller’s liability under the provisions to last as long as possible.
When these provisions are discussed they seem to cover the following areas:
A seller will indemnify a buyer for losses arising from:
- Seller’s liabilities that the buyer is not assuming
- Business operations before the closing
- Environmental issues
- Seller’s taxes included before closing
- Breaches of any seller’s covenants
- Breaches in the seller’s warranties and representations
- Employee claims and,
- Any matters peculiar to this particular transaction
The buyer will indemnify a seller for losses arising from:
- Business operations post-closing
- Any seller liabilities that a buyer is assuming
- Breaches in the buyer’s warranties and representations
- Breaches of the buyer’s covenants
Survival Time for Indemnification
As the provisions are incorporated into the final agreement to purchase, survival times for indemnification claims will be identified. They typically fall into the following areas;
- Fundamental Representations – which commonly include:
- Organization of the Business Entity
- Ownership of assets
- Entity authority and enforceability
- Indebtedness to the business except for indebtedness assumed by the buyer
These fundamental representations typically survive indefinitely without an expiration date.
- Representations regarding, but no limited to;
- employee benefit matters, and
- environmental, health and safety situations
These representations generally survive for as long as the respective statute of limitations for each.
- Covenants that survive for the time period stated in the agreement to purchase covenants, and if no time is stated in the covenant, then indefinitely
- All other representations and warranties that will survive for a negotiated period of time, usually somewhere in the range of 1 to 2 years.
Techniques for Limiting Exposure to Indemnification Claims
During the negotiation and implementation of these provisions the seller will want to limit the dollar amount of their liability. While naturally, the buyer will seek extensions of time and coverage.
- Often the seller will attempt to establish a “cap” on the seller’s liability. The buyer will attempt to limit the liability to the amount of the purchase price of the transaction. Through negotiations, the seller will often be able to limit the cap – sometimes as low as 10% of the purchase price.
- Another technique for limiting a seller’s 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. In some instances, once the threshold is breached, 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 the 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. It is important to establish a time limit for that provision.
As you can sense, this can be very complicated contractually and financially the exposure could be considerable. Work with your legal counsel to tighten the agreement to purchase and clearly delineate all obligations for both buyer and seller post transaction.