Indemnification in Purchase Agreements | M&A Basics

by Jacob Orosz (President of Morgan & Westfield)

Executive Summary

What is indemnification?

The indemnification clause in a purchase agreement requires the buyer and seller to indemnify, or compensate each other, for breaches of representations, warranties, covenants, and other types of claims that may arise after the closing, such as those related to tax, the environment, or employee issues.

Sometimes called a hold harmless clause, this provision functions similarly to an insurance policy and requires the breaching party to reimburse the other for all expenses resulting from a breach.

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

Limitations to Indemnification

Indemnification can be limited by:

• Knowledge of a representation or warranty
• Actual losses, as opposed to other types of damages, such as punitive or speculative damages
• Baskets, or deductibles, that function as a minimum threshold that must be met before a claim can be submitted
• Caps, or the maximum amount of liability
• Survival periods, which limit the length of time one party may be liable to another for breaches

Indemnification vs. General Provisions

In the purchase agreement, there may be some overlap between the indemnification provisions and general provisions. In some agreements, these sections may be combined, and in others they remain separate. 

• The Indemnification section usually addresses parties, scope, remedies, survival, limitations, etc. 
• The General Provisions section usually addresses jurisdiction, enforcement, waivers, governing law, expenses, notices, severability, etc. 

Common Purchase Agreement Disputes

Examples of potential disputes regarding the purchase agreement include inaccurate financial statements, violations of post-closing covenants, tax claims, loss of key employees, loss of key customers, inaccurate working capital calculations, and undisclosed pending litigation.

How are disputes handled?

Disputes regarding the purchase agreement are usually governed by the terms in the Indemnification section of the purchase agreement in conjunction with the terms of the escrow. The language is often hotly debated.

In most cases, if a buyer discovers a problem or a breach, they must notify the seller, then the seller may be given time to resolve the problem, known as the right to cure. The seller may also contest the damage or choose to reimburse the buyer.

If the parties cannot resolve the issue, the money will remain in escrow until they can.

What happens if reps and warranties are breached?

When a problem arises after the closing, the parties look to the Indemnification and General sections of the purchase agreement. In most cases, an indemnity offers a party the right to recover losses and legal expenses. 

The indemnification limitations collectively serve to limit the seller’s exposure and to allocate risk between the parties beyond the specific language provided in each individual representation. The escrow of 10% to 20% of the purchase price can fund any indemnification claims.

How Your Advisor Words the Indemnification Section

The language of the indemnification clause should be tailored to the unique characteristics and circumstances of the business and the specific risks identified during due diligence. The purchase agreement should also carefully define who is providing indemnification and address the procedures involved. 

Buyer’s Indemnification

The buyer normally agrees to indemnify the seller against breaches of the purchase agreement. Common clauses include the buyer’s covenant to offer employment and certain benefits to the seller’s key members of staff. The buyer may also indemnify the seller regarding environmental liabilities or accounts payable.

As with seller breaches, the buyer’s breaches are funded through a portion of the purchase price. 

Introduction

If due diligence is proceeding as planned, the buyer’s attorney will prepare a purchase agreement. There, you’ll find the transaction described in detail, the purchase price broken down or allocated, and your reps and warranties – those key provisions that guarantee the state of the business you’re selling – carefully explained. 

But what happens when those guarantees are breached? In this article, I’ll cover the crucial indemnification clause – its uses, limits, and language. I’ll also discuss how indemnification protects both parties in the event of a dispute or a case of buyer’s remorse. 

The Basics of Indemnification in M&A

What is the indemnification clause?

In a purchase agreement, the indemnification clause requires the buyer and seller to indemnify, or compensate each other, for breaches of representations, warranties, covenants, and other types of claims that may arise after the closing, such as those related to tax, the environment, or employee issues.

Sometimes called a hold harmless clause, this provision functions similarly to an insurance policy and requires the breaching party to reimburse the other for all expenses resulting from a claim.

Indemnification vs. General Legal Rights

Indemnification rights are much more specific than the general legal rights included in most purchase agreements. Indemnification provisions include specific rules governing the level of involvement the parties may have in defending suits or other claims and further options rarely covered under general legal rights.

Why is a percentage of the purchase price held in escrow?

In most M&A transactions, 10% to 20% of the purchase price is withheld in a third-party escrow account to fulfill any post-closing indemnification obligations. This helps to mitigate problems that may arise with a less-than-creditworthy seller.

Limitations on Indemnification in a Purchase Agreement

Indemnification can be limited by:

• Knowledge of a representation or warranty
• Actual losses, as opposed to other types of damages, such as punitive or speculative damages
• Baskets, or deductibles, that function as a minimum threshold that must be met before a claim can be submitted
• Caps, or the maximum amount of liability
• Survival periods, which limit the length of time a party may be liable to another for breaches

Indemnification vs. General Provisions in the Purchase Agreement

The Indemnification and General Provisions sections govern how disputes will be handled. Depending on the purchase agreement, these sections may be combined, overlapping, or entirely separate. 

Indemnification in M&A

The Indemnification section usually addresses the following questions:

• Parties: Who exactly is providing the indemnification? Is the indemnification limited to one shareholder, or are all shareholders indemnifying the buyer? If multiple shareholders are indemnifying the buyer, are they jointly and severally responsible? Is the buyer also indemnifying the seller?
• Scope: What specifically does the indemnification cover? What is its scope? Most cover breaches of the reps and warranties and covenants, non-compliance with laws, liabilities arising from the assets, etc. Is the indemnification limited to the four corners of the agreement, or are ancillary documents – such as those provided to the buyer during due diligence – subject to indemnification? The precise scope of indemnification can be subject to intense negotiation. Some agreements also contain separate remedies that aren’t covered by this section, such as a non-compete agreement, which will be governed by the provisions outlined within it.
• Remedies: Is the indemnification the parties’ sole remedy, or are other remedies available?
• Survival: For how long will the representations, warranties, covenants, and other obligations in the agreement remain in place?
• Limitations: What are the financial limits (baskets, caps, etc.) of the indemnification obligations?
• Escrow: Will a portion of the purchase price be held in escrow? If so, how much, for how long, and what are the terms of the escrow?
• Right of Offset: Does the buyer have a right of offset against the promissory note, consulting agreement, or other obligations?
• Indemnification Process: How are indemnification claims handled? What role does the indemnifying party have in the defense of the claim?

General Provisions in M&A

The General Provisions section of the purchase agreement usually addresses the following:

• Dispute Related
  • Jurisdiction: Addresses dispute resolution options (litigation, arbitration, mediation, jury trials, etc.), forum, selection of mediators or arbitrators, rules for mediation or arbitration, remedies, who pays expenses, to what extent the decision is final, etc.
  • Enforcement: May provide the parties additional remedies, such as specific performance or injunctive relief.
  • Waiver: May state that rights are cumulative and a failure to exercise a right does not constitute a waiver.
  • Governing Law: Specifies which state’s laws govern the agreement.
• Non-Dispute Related (may be indirectly dispute-related)
  • Expenses: How are transaction-related expenses allocated between the parties?
  • Notices: To whom are notices to be sent, and when are they deemed received?
  • Entire Agreement: Usually states that the purchase agreement constitutes the entire agreement and supersedes all previous agreements, written or oral.
  • Severability: If any provision is determined to be invalid by a court, the remaining provisions will remain in effect.
  • Assignment: Usually limits assignment of the agreement and provides that it does not create any rights for third parties.
  • Time of Essence: States that time is of the essence, which helps the parties enforce deadlines, such as drop-dead and other dates.
  • Execution: The agreement can be executed in counterparts or electronically.

Most Common Disputes in M&A

Examples of potential post-closing 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
• Inaccurate working capital calculations
• Undisclosed pending litigation
• Undisclosed material liabilities, such as unpaid bills
• Undocumented employees

How are disputes handled in a purchase agreement?

Disputes will be governed by the terms of the purchase agreement in conjunction with the terms of the escrow agreement. In some cases, supplemental agreements, such as a non-competition agreement, may provide separate dispute mechanisms.

Most disputes will be governed according to the terms laid out in the Indemnification section of the purchase agreement. There is no such thing as a standard indemnification provision and the language may be hotly debated by both parties.

Disputes will be governed by the terms of the purchase agreement in conjunction with the terms of the escrow agreement.

In most cases, if a buyer discovers a problem or a breach, they must notify the seller, and the seller may be given time to resolve the problem, known as the right to cure. The seller may also contest the damage or choose to reimburse the buyer. If the parties cannot resolve the issue, then the money will remain in escrow until they can.

A final question to consider is whether the escrow should be the buyer’s sole remedy or whether they may be afforded additional remedies.

How can sellers limit their exposure?

In most cases, an indemnity offers a party the right to recover losses and legal expenses, and the escrow of 10% to 20% of the purchase price can fund such claims. The indemnification limitations collectively serve to limit the seller’s exposure and allocate risk between the parties beyond the specific language in each representation.

The seller’s goal is to limit their exposure through the following:

• Tightening the Language
  • Limiting the language of each representation individually
  • Limiting joint and several liability
  • Adding knowledge qualifiers, such as “to the best of the Seller’s knowledge”
• Reducing Financial Exposure – Money
  • Increasing the basket (deductible) that must be met before a claim is paid
  • Reducing the maximum payout (cap)
  • Reducing the amount of the escrow
• Reducing the Length of Exposure – Time
  • Reducing the survival period
  • Reducing the length of the escrow
• Other
  • Requiring the buyer to self-insure against certain risks 

Tips for Negotiating Indemnification in M&A 

Tip 1: The Language Should Be Tailored

Indemnification language should be tailored to the unique characteristics and circumstances of the business and the specific risks identified during due diligence. The relationship between time and dollar limits should also be taken into consideration. Businesses in certain industries may be better served by higher dollar limits and shorter time limits, and vice versa.

Tip 2: Limit Who Is Providing Indemnification

Shareholders vs. the Entity: If there are multiple shareholders of the selling company, you should ask questions about who is responsible for the indemnification. For example, are all shareholders indemnifying the buyer or only the majority shareholders? Or is the selling entity indemnifying the buyer?

Shareholders Indemnify the Buyer: In most cases, the majority-selling shareholders are required to personally indemnify the buyer. 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 the entity does continue to exist, the proceeds from the sale are usually distributed to the shareholders, and the selling entity is left with few assets with which to fund a potential indemnification claim. 

Separate vs. Joint Liability for Shareholders: If there are multiple selling shareholders, you should also attempt to limit your liability to proportionate liability, where you’re liable just for your own obligations, also known as several or separate liability. This is different from joint and several liability, where any and all shareholders may be held liable.

It’s difficult for the buyer to chase down multiple shareholders, which is why escrows are so widely used.

Tip 3: Address Indemnification Procedures and Specifics

The indemnification clause should also address the following questions:

• What recovery is available to the party in the event of a breach?
• What is the process for resolving a dispute? Most agreements require an initial complaint in writing. If the parties can’t resolve the issue, then the agreement determines the next steps.
• What are the procedural aspects of indemnity claims?
• What are the rights of the parties to take part in any legal proceedings?
• What notice requirements exist?
• Who controls the defense of a claim from third parties?
• How will a party collect on an indemnification claim? Is collection limited to the amount in escrow?
• What rights do both parties have to access information?
• What are the parties’ rights of subrogation?
• Is indemnification the parties’ exclusive remedy?
• How do insurance proceeds affect the parties’ indemnification obligations?
• Does a failure to act on a breach constitute a waiver?
• How do the parties choose counsel to defend a claim? Who has control over the defense and the fees?

Sample Buyer’s Indemnification Language 

Normally, the buyer also agrees to indemnify the seller. Common areas include the buyer’s covenant to offer employment and certain benefits to the seller’s key people. The buyer may also indemnify the seller regarding environmental liabilities or accounts payable.

Here are some examples of language for the buyer in the purchase agreement:

“Each of the Sellers and the Shareholders, jointly and severally, covenants and agrees to indemnify, defend, protect, and hold harmless the Buyer and any of the Buyer’s officers, directors, stockholders, representatives, affiliates, assigns, successors in interest, and current and former employees, each only in their respective capacities as such (collectively, the “Buyer Indemnified Parties”), from, against, and in respect of:

“(a) any and all liabilities, claims, losses, damages, punitive damages, causes of action, lawsuits, administrative proceedings, demands, judgments, settlement payments, penalties, and costs and expenses (including, without limitation, reasonable attorneys’ fees, travel expenses, expert witness fees, and disbursements of every kind, nature, and description) (collectively, “Damages”), suffered, sustained, incurred, or paid by Buyer or any other Buyer Indemnified Party in connection with, resulting from, or arising out of, either directly or indirectly:

• (i) any misrepresentation or breach of any warranty of the Seller or any Shareholder set forth in this Agreement or any Schedule or certificate delivered by or on behalf of the Seller or any Shareholder in connection herewith; or
• (ii) any nonfulfillment of any covenant or agreement on the part of the Seller or any Shareholder set forth in this Agreement; or
• (iii) the Business, operations, or Assets of the Seller prior to the Closing Date or the actions or omissions of the Seller’s directors, officers, shareholders, employees, or agents prior to the Closing Date (except with respect to the Assumed Liabilities); or
• (iv) the Excluded Liabilities.

“(b) any and all Damages incident to any of the foregoing or to the enforcement of this Section.

If the Indemnifying Party, within a reasonable time after receipt of such Claim Notice, fails to assume the defense of any Third-Party Claim, the Indemnified Party shall (upon further notice to the Indemnifying Party) have the right to undertake the defense, compromise, or settlement of the Third-Party Claim, at the expense and for the account and risk of the Indemnifying Party.“

How M&A Breaches are Funded Through Escrow 

The majority of M&A transactions include some form of escrow, where a portion of the purchase price, normally 10% to 20%, is held by a third party for a period of time, typically 12 to 24 months. This amount is used to satisfy any indemnification claims in the purchase agreement. If there are no claims, the money is released to the seller once the period expires.

What are the major terms of the escrow agreement?

The parties should consider the following as terms of the escrow agreement:

• Amount of Money: Most transactions include an escrow that ranges from 10% to 20% of the purchase price. The size of the escrow should correlate to the likelihood and magnitude of the potential risks and whether other forms of deferred payments also contain an explicit right of set-off.
• Time Period: Most buyers will prefer to prepare a full year’s P&L statement and close the books so they can examine an entire accounting period, hence, most time periods range from 18 to 24 months. I’ve seen some as short as 12 months and some as long as 36 months, but two years is usually more than sufficient to uncover potential risks.
• Conditions: The escrow agreement should prescribe the conditions of the escrow, how disputes are settled, and who controls the release of escrow, which is normally handled mutually.
• Interest: Who should receive interest on the amount held in escrow?

Why is a portion of the purchase price escrowed when selling a business?

Escrows give the buyer assurance that money will be available to cover their expenses from litigation, losses, etc., if any of the seller’s reps or warranties later prove to be untrue or if there are other breaches in the purchase agreement.

For example, the sale of a manufacturing plant includes expensive machinery, and the seller may have represented that the machinery is operable and in good repair. If a piece of machinery breaks after the closing, and the buyer determines that there was deferred maintenance on the machine and the problem was concealed by the seller, the buyer will file a claim to seek reimbursement.

A portion of the purchase price, known as a holdback, goes into an escrow account with a third-party escrow agent. The funds are governed according to an escrow agreement.

In most cases, the funds may only be released upon the mutual consent of the buyer and seller. If there are no claims, the money is released to the seller once the escrow period expires.

Are there alternatives to escrowing part of the purchase price?

Most M&A transactions include some form of deferred payment and nearly any deferred payment can also function as a form of escrow.

Here are several alternatives:

• Promissory Note: The promissory note can include explicit language affording the buyer the right to withhold future payments in the event of a breach. This is called the right of offset.
• Earnout: Earnouts can also include a right of offset, though the likelihood of the seller receiving any earnout payments should be considered.
• Consulting or Employment Agreement: Consulting and employment agreements can also include a right of offset, but this may not be allowed in certain states that prohibit set-offs against employment agreements.

Sellers are likely to resist a right of offset against guaranteed, deferred payments such as a promissory note and consulting or employment agreements. This is because such an arrangement affords the buyer a significant amount of leverage since they control the money. 

Allowing the buyer to simply withhold payments may afford them too much power and sellers may justifiably prefer an escrow.

Successor Liability in M&A

What is successor liability in M&A?

Successor liability is a state law doctrine that allows a creditor to seek recovery from the buyer of a business for liabilities they didn’t contractually assume in the purchase agreement. Successor liability occurs as a function of state law, not as a result of the contract.

When is successor liability a risk?

Successor liability is a particular risk if the business can be labeled a continuation or successor. The business is considered a continuation if the transaction was structured as an asset sale and the product lines, employees, and other aspects remain substantially similar both before and after the closing. This is true in the majority of business sales. 

If the business is essentially the same, the courts may characterize it as a “mere continuation” and impose successor liability.

In other words, if the business is essentially the same, the courts may characterize it as a “mere continuation” and impose successor liability. Regardless of deal structure there’s always a possibility of successor liability, and many of the reps and warranties are designed to address this.

How is successor liability mitigated?

Successor liability can be mitigated to a certain extent with thorough reps and warranties, an escrow, and other protective measures. Remember that the risks can never be completely eliminated, such as those arising from tax or environmental issues.

Here are some tips for reducing successor liability as much as possible:

• Perform Thorough Due Diligence: The buyer should conduct thorough due diligence to uncover potential successor liabilities, especially those related to environmental, tax, and employment law.
• Use a Triangular Acquisition: The purchase agreement can use a triangular acquisition structure to isolate liabilities in the subsidiary entity. Here, the buyer entity forms a subsidiary entity, which either acquires or merges into the target. This structure isolates the liabilities within the subsidiary entity.
• List All Liabilities: In an asset deal, the buyer should explicitly list any liabilities the buyer is assuming and any liabilities the seller is retaining.
• Include Stringent Reps and Warranties: Cover potential issues that may be susceptible to successor liability in careful reps and warranties.
• Include Reduced Baskets: Indemnification should feature reduced baskets for issues relating to successor liability.
• Reduce Business Continuity: Minimize the appearance of continuity so that a court is less likely to label the business as a mere continuation and, therefore, impose successor liability.
• Keep the Entity Open: Require the seller to keep their entity open and liability insurance in place as long as possible. In certain cases, such as environmental or tax issues, liability may be indefinite, so the time the entity remains open should be carefully weighed against the potential risk.

Conclusion

In a purchase agreement, indemnification is the insurance, the serious bit, the muscle. Without indemnification, your reps and warranties are like pie crust – liable to crumble under the slightest pressure. 

But as you’ve seen, enforcing reps and warranties isn’t as simple as tough language and the threat of a withheld percentage of the purchase price. Indemnification is far more nuanced and must be thoroughly clarified and understood. 

The nitty-gritty of the indemnification clause centers on what the seller can really know about the business, what they can reasonably be liable for, and what the seller has actually lost financially.

Nailing down the language now, in careful purchase agreement negotiations, can prevent expensive consequences after the closing.