When you are buying a business—whether it is through a stock purchase or an asset purchase—there is one provision in the purchase agreement you should never overlook: indemnification. While it may sound like nothing more than legal jargon, indemnification clauses can make or break the success of your deal by protecting you from unexpected liabilities.
Below, we’ll break down what indemnification is, why it matters, and how a real-world scenario (like a slip-and-fall accident) can illustrate its importance.
What Is Indemnification?
In broad, over-simplified terms, indemnification is a contractual promise by one party (often the Seller) to reimburse or “make whole” the other party (usually the Buyer) for certain losses or liabilities that arise out of events or conditions that occurred prior to the closing of the deal.
It is comparable to an insurance policy—if an issue arises after closing that stems from the Seller’s breach of representations or warranties prior to closing, the Seller agrees to shoulder the resulting financial burden.
Example: The Slip-and-Fall That Wasn’t Disclosed
To illustrate how indemnification works, consider this scenario: You acquire a small café through a stock purchase. A few weeks after taking ownership, you receive notice of a lawsuit from a customer who slipped on a wet floor before you officially owned the café. The Seller failed to disclose this incident in the disclosure schedules or elsewhere in the purchase agreement, despite having knowledge about it.
Suddenly, you are facing legal fees and potentially a damages payout. Ideally, a well-drafted indemnification provision would allow you to shift the burden of defending this lawsuit back to the Seller.
Key Terms to Review in Indemnification Provisions
- Survival Period. Indemnification obligations in M&A transactions usually come with an expiration date. Under most agreements, representations and warranties survive for a set number of month beyond the closing date. Certain “fundamental” representations (like title to assets) or specific liabilities (such as taxes) may have extended survival periods. Once the applicable survival period runs out, the Buyer can no longer bring indemnification claims for new or undiscovered breaches, so it’s critical to ensure these deadlines align with the most likely risks and liabilities facing the business.
- Caps and Baskets. In many M&A indemnification provisions, caps and baskets help define the boundaries of the Seller’s liability. A cap sets the maximum total amount the Seller might have to pay—think of it as a ceiling on their financial exposure. Meanwhile, a basket (sometimes referred to as a deductible) establishes the minimum threshold of losses the Buyer must incur before making a claim for indemnification.
- Example: If the basket is $50,000, the Buyer can’t seek indemnification until covered losses exceed $50,000. Some baskets function as a “tipping basket,” meaning once you cross that threshold, you can recover the entire amount of losses, not just the portion above $50,000. Others work like a true deductible, allowing recovery only for damages beyond the threshold.
Tips for Negotiation
- Push for Thorough Disclosures
- Request detailed disclosure schedules so that any known issues—like a slip-and-fall—are revealed up front.
- This allows you to adjust the purchase price or require the Seller to address the issue before closing.
- Consider an Escrow
- It’s common to hold a portion of the purchase price in escrow for a set period post-closing.
- If a claim arises, you can draw from the escrow to cover losses instead of chasing the Seller.
Why This Matters
Indemnification provisions can dramatically affect your financial exposure after a deal closes. Whether you’re on the buying or selling side, clarifying indemnification clauses ensures everyone understands which party shoulders which risks. Thorough negotiation and attention to detail can save both time and money—allowing you to focus on running (or successfully exiting) the business rather than dealing with surprise lawsuits and liabilities.
If you have questions about indemnification provisions in a stock or asset purchase agreement, reach out to a qualified attorney who can guide you through the nuances and safeguard your interests.
