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Selling Your Business — Practical Tips for Sellers — Part 11: Indemnification (Part Two)

Published on
23 May

This post was jointly written by Casey W. Riggs and Jennifer Wilson.

This is part 11 of our series discussing the sale of a business from the seller’s perspective.  We’ve covered commencement of a potential deal through the closing and are now discussing indemnification.  If you missed the first section of this post, you can find it here.

In this post, we’ll jump into some of the specific negotiation points with indemnification provisions, providing tips and explanation at the same time.

Tip 1 – Include Deductibles and Caps. It’s customary to limit the maximum amount the seller may have to pay to the buyer under the indemnification provisions with “deductibles” and “caps.” Deductibles are thresholds below which the seller will not have to indemnify the buyer even if the buyer has a loss (sort of like a deductible on your automobile policy).  And caps are ceilings on the maximum amount for which the seller may be required to indemnify the buyer.  There are multiple variations on how deductibles and caps can be structured but just know that both are important and should be reviewed with your lawyer and considered in light of your deal. Your lawyer will be able to tell you what amounts are customary given the size of the transaction and other factors.

Tip 2 – Consider the Term of the Indemnity.  If you’ve sold your business, you don’t want the buyer coming back to you many years later attempting to recover for some supposed loss or damage.  You want your indemnity obligation to expire as quickly as possible.   Therefore, you should include a time limit(s) within which the buyer must provide notice to you of any potential claims it may have. Actual negotiations of the time limits are usually very detailed and complicated and it’s customary to have various time limits depending on the source of the potential claim by the buyer.  For example, the limit to bring a claim for breach of most of the representations and warranties might be one or two years, but the limit for tax claims might be the applicable statute of limitations that governs when the IRS can bring an action; and there might be no time limit at all for, say, environmental issues.  Your lawyer will need to help you understand and negotiate these provisions.

Tip 3 – Be Sure Indemnity Is the Buyer’s Exclusive Remedy. From your perspective as the seller, you want to make sure the indemnification provisions are the only mechanism through which the buyer can recover from you after the closing.  You don’t want to spend substantial time and energy negotiating indemnification terms and then have the buyer essentially circumvent the contract by suing you on some other basis.  Therefore, be certain to include a clause making indemnification the buyer’s exclusive remedy. Including such a provision means the buyer won’t be able to bring other types of actions, at least with respect to those liabilities covered in the indemnification provisions, and gives more certainty to the seller (for example, the seller knows the caps discussed above will be the maximum liability). A buyer will generally contest such a provision, and may successfully carve out some types of liabilities, especially those that are due to a seller’s fraud or intentional misrepresentation.  But for the most part, the negotiated indemnification terms should be the buyer’s sole remedy.

Tip 4 – Limit the Types of Damages the Buyer Can Recover. The buyer will want to recover as many types of damages as possible, while the seller wants to limit the types of recoverable damages. Types of damages that can be sought in court include direct, indirect, incidental, consequential, special, exemplary, and punitive, and different courts may interpret these in different ways. The seller generally attempts to include in the indemnification provisions a limitation on the types of damages that the buyer can recover. Lawyers and academics argue over what these categories of damages actually cover and whether it is appropriate or customary for them to be excluded in the indemnification provisions. The key point, however, is that you don’t want to be liable for remote, indirect damages that arise from circumstances of the buyer that the buyer did not communicate to you when the transaction was underway. Your lawyer should be able to propose a provision that will limit your damages appropriately.

Tip 5 – Carefully Limit Setoff Rights. The right to setoff is an issue that arises when part of the purchase price is to be paid over time (e.g., via a promissory note), a term the buyer will often push for to, among other reasons, provide a readily available fund from which indemnity payments can be deducted if the buyer should make a claim. The note’s maturity date may correspond to the time limitation in the indemnification provisions. If the buyer has the right of setoff and reasonably believes it has a claim for indemnification, it can withhold payment under the note until the matter is settled. This mechanism gives the buyer much more power in the event of a potential indemnity claim, so the seller should be careful to clarify and limit the boundaries of any right to setoff.

Tip 6 – Consider Including Adjustments for Tax Benefit/Insurance Proceeds. If a buyer suffers a post-closing loss related to the acquired company, it may derive some tax benefit from the loss. If the indemnification provisions are silent with respect to tax benefits, then the buyer can bring an indemnification claim against the seller for the entire amount of the loss, while possibly still enjoying at least some of the tax benefit occasioned by the loss. Similarly, a buyer who suffers a loss may receive insurance proceeds for the loss, but unless the indemnification provisions provide otherwise, these are not deducted from the amount of the claim brought against the seller. The indemnification provisions can provide that indemnification should be net of tax benefits and insurance proceeds, but such provisions can be extremely complicated (and expensive, given the time they take lawyers to draft and negotiate) to include in the purchase agreement. As a buyer, you should certainly consider adding such provisions but discuss these with your lawyer.

This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.