This is a multi-part blog post that describes the various sections of a typical business purchase agreement.  This post covers Indemnification Caps.

1. Introduction
2. Price and structure of the acquisition / purchase
3. Representations and warranties of the buyer and seller
4. Covenants of the buyer and seller
5. Conditions to closing
6. Indemnification
7. Termination clauses and remedies
8. Miscellaneous
9. Representations and warranties of the buyer and seller

As I explained in the last post, indemnity is one of the most contentious issues in a purchase agreement.   A buyer doesn’t want to inherent ANY pre-close risk while a seller at some point in the future wants to relax and know someone isn’t going to the knock on the door and ask for all the money back (or even more). A compromise invariably gets worked out, and it involves indemnity caps and baskets.

Indemnity Caps, in Theory

A cap is simply a limit for what a seller is liable for, for pre-close issues.   From a buyer’s perspective, there should be no cap.  The seller was liable for EVERYTHING before the buyer entered the picture and it should remain that way for anything that happened before the close.  That doesn’t sound unreasonable, doesn’t it?  That means that if a company was sold for $3 million and the new buyer had to pay a settlement of $5 million for a product liability issue that occurred pre-close, the seller would have to give back all the purchase price, PLUS $2 million.  There goes the retirement. However, if the seller had not sold the business, they would still have to have paid the $5 million settlement.  So really, nothing has changed. Right?

From a seller’s perspective, there absolutely should be a cap.  They are almost invariably selling to a larger entity that may be more likely to attract lawsuits (the deeper pockets lawsuit rule of thumb).  It is also possible the new owners mismanage the company enough that customers, employees, etc. decide to sue for something that happened to have occurred pre-close.  Using the example above, the $5 million settlement may have been much less if the lawsuit involved the original seller only, who at at the time didn’t have much in the way of liquid assets, and it is entirely possible the lawsuit wouldn’t have even happened at all under the seller’s ownership.

Both perspectives are valid, so it is up to the attorneys, intermediaries, buyer and seller to work out a compromise.

Indemnity Caps, in Practice

Caps are common in some form in about 80% of deals (according to a study published by the American Bar Association).  Sometimes liability is capped at the purchase price, and often it is capped at less than purchase price.  A typical range for a cap is 20% to 50% of the purchase price.

It is also common to “carve out” certain types of reps and warranties that have no caps.  Fraud, taxes, ownership and authority to do the sale are common cap carve outs.  In other words, the buyer is saying, “Hey, I kind of see your point on the other stuff, but I want you COMPLETELY on the hook for fraud, paying your taxes, whether you actually own the company you are selling me, etc.”  It is hard to argue with that logic, thus the cap carve outs.

I’ve had ownership issues pop up during a transaction (“Oh, I forgot that I promised my sales guy 5% of the company.  I never got around to actually doing that, so how do I give him shares right now, just before close?”).  Fortunately, I’ve never run across a situation where a transaction closed, and someone popped up later claiming that they actually own all or part of the company.

Earlier in the purchase agreement, and an earlier blog post, I described how a business owner makes representations and warranties to the buyer.  The indemnity section describes what happens when the buyer later finds out some of those reps and warranties were not true.

This is a multi-part blog post that describes the various sections of a typical business purchase agreement.  This post covers Indemnification.

1. Introduction
2. Price and structure of the acquisition / purchase
3. Representations and warranties of the buyer and seller
4. Covenants of the buyer and seller
5. Conditions to closing
6. Indemnification
7. Termination clauses and remedies
8. Miscellaneous
9. Representations and warranties of the buyer and seller

Indemnification, in its most simple definition, describes how to compensate someone for any loss that they may suffer during the performance of a contract.  The indemnitors indemnify the indemnitees for all losses, expenses, damages and liabilities arising out of breach of a representation, warranty, covenant by the other party in the purchase agreement.

The indemnity section is one of the mostly hotly contested sections in a purchase agreement, for good reason.  This is where a buyer wants not only clearly drafted language defining the damages, they also typically want an escrow account (also called a hold back) set up so they know they will actually get paid for the damages.

Escrow

Business owners should realize that in most cases there will be around 10% of the purchase price held back in an escrow account to be used for damages or the appearance of any previously unknown liabilities (or any number of things, such as final reconciliation of the books at closing, inventory at close, etc.).   In a study done by the American Bar Association of middle market transactions, they found approximately 80% of transactions used an escrow account.  The other 20% probably were probably using seller notes or another structure which allowed the buyer access to seller funds.  In other words, if you are selling your company and you get an all-cash-at-close offer, don’t expect to walk away with all cash at close.

The same study shows that 71% of the escrow/holdback accounts are between 6 and 15% of the purchase price.  16% are below 6%, while 10% are above 15%.   The average was right about 10%.

How long to expect your money to be held back?  12 to 18 months is the norm.

It is also important to realize that the buyer’s claim against the seller is rarely limited to the amount held in escrow.  The escrow merely provides easy access to a set amount, and the buyer will likely have to sue for the rest.

How much is the seller ultimately on the hook for?  In next blog post I’ll cover caps and baskets in order to describe the indemnity limits.

This is a multi-part blog post that describes the various sections of a typical business purchase agreement.  This post covers Covenants and Conditions to Closing.

1. Introduction

2. Price and structure of the acquisition / purchase

3. Representations and warranties of the buyer and seller

4. Covenants of the buyer and seller

5. Conditions to closing

6. Indemnification

7. Termination clauses and remedies

8. Miscellaneous

9. Representations and warranties of the buyer and seller

Covenants within the purchase agreement are promises, or agreements between the buyer and seller. Conditions to Closing typically provide an escape hatch for a buyer to legally walk away from the deal at the last minute if certain conditions are not meet.

Covenants, usually a seller’s obligation to a buyer, may be a promise to conduct the business in an ordinary course between the time of signing and closing, or it may be an agreement to cooperate with the buyer on an outstanding tax issue in future after the close. Here are some other common covenants:

– The seller agrees to pay their taxes

– The seller agrees to settle outstanding liens

– The seller agrees to cooperate on future employee issues

It can be important to pay attention to the conditions of closing in the purchase agreement. It may be boilerplate text about the buyer being able to walk away should he find out any of the seller representations are false, but the covenants may also contain financing contingencies or other conditions that would be critical to know about.

For example, a financing contingency means that the seller could expend significant time and expense in working through due diligence and signing an agreement, yet the buyer could fail to get financing. In that case, with a financing contingency in place, there would be no consequence for the buyer. You can’t always get rid of financing contingencies, but you can work to minimize the risk, and you should at least be very aware of the contingency and an idea of what the odds are for financing success.

I always identify financing contingencies at the letter-of-intent stage, and ideally you should force the buyer to have financing commitments in place before the definitive agreement stage, but of course it is possible for a lender to back out at the last minute.

Financing contingencies are very common for smaller deals as they often relying on an SBA loan. For larger deals it is on a case by case basis.

For us, I’ve had two financing contingencies in the last year. In one, the private equity fund that our seller had signed with put in a condition on financing. When I asked about where they expected to raise the debt from, they said it was actually from their own fund, they just called it debt instead of equity. No problem. The other deal was also a private equity fund, and they failed in the due diligence phase to produce financing. Unfortunately that killed the deal with that buyer.