Skeletons in the Closet and Indemnification

The indemnification clause requires the parties to indemnify one another for breaches of representations, warranties and covenants, and other types of claims that may arise after the closing, such as those related to tax, environmental, or employee issues. The indemnification clause, sometimes called “hold harmless,” functions similarly to an insurance policy and requires the breaching party to reimburse the other party for all expenses resulting from a breach. 

The value of the indemnification depends on the financial strength and creditworthiness of the party providing the indemnification. In most M&A transactions, 10% to 20% of the purchase price is withheld by a third party in an escrow account to fulfill any post-closing indemnification obligations, which mitigates any impact of a less-than-creditworthy seller.

Indemnification rights are more specific than the general legal rights included in most contracts. The indemnification provisions include specific rules governing the level of involvement the parties may have in defending suits or other claims, and other options that are rarely afforded to the parties under other general legal rights in most purchase agreements. 

Examples of potential disputes include:

  • Inaccurate financial statements 
  • Violations of post-closing covenants, such as non-competes or non-disclosure agreements
  • Tax claims
  • Loss of key employees
  • Loss of key customers
  • Working capital calculations
  • Undisclosed pending litigation
  • Undisclosed material liabilities, such as unpaid bills 
  • Undocumented employees

Who Provides Indemnification

It’s important to consider who specifically is providing the indemnification. If there are multiple shareholders of the selling company, are all shareholders indemnifying the buyer, or only the majority shareholders? Or is the selling entity indemnifying the buyer? 

In most cases, the majority-selling shareholders are required to indemnify the buyer personally. To be obligated under the indemnification clause, a selling shareholder must sign the purchase agreement directly or through a “joinder.” This is often the case because the selling entity normally ceases to exist after the closing date. If it does exist, the proceeds from the sale are normally distributed to the shareholders, and the selling entity is left with few assets with which to fund a potential indemnification claim. 

It’s difficult for the buyer to have to chase down multiple shareholders, which is why escrows are so prevalent. If there are multiple selling shareholders, the sellers should also attempt to limit their liability to “several,” or separate liability, as opposed to “joint and several” liability.