Importance and Implications of the Indemnification Provision in M&A Contracts (AKA “Hold Harmless”)

Among the many clauses included in an effective business transaction contract are the indemnification provisions. These provisions lay out the allocation of risk between the buyer and seller after a merger and acquisition. In its simplest form, the indemnified party (in this case, the buyer) is covered in the event that a representation and warranty made by the seller is false and causes the buyer damages.

After a seller sells their business, the last thing that they want to do is give money back to the buyer for an indemnification claim. This article discusses a few of the easy ways in which the seller can shape the indemnification provisions in their favor.

Disclose, Disclose, Disclose.

A typical purchase agreement or merger agreement will contain a host of written representations and warranties from the seller to the buyer. These representations can range in the topics they cover. Here are some examples of representations, but this is an overly simplified list. Typical representations and warranties can consume dozens of pages of the agreement.

  • Authority (do the parties have the authority to enter into the transaction?)
  • Capitalization (who are the stakeholders in the company and what do they hold/own?)
  • Sufficiency and title to assets of the business (are the assets encumbered with liens? Are they in good condition?)
  • Financial Statements (how were the financials that were given to the buyer prepared? Do they fairly represent the state of the business?)
  • Permits (are there permits or compliance issues with the business?)
  • Litigation (are there known pending or threatened claims?)
  • Contracts (are there contracts in place? What kind of contracts? Are any in breach or violation?)
  • Intellectual Property (is there any IP that is registered? Are you infringing? Is anyone else infringing?)
  • Inventory (is inventory in salable condition?)
  • Employees (who are they? What are they paid?)
  • Employee Benefits (are you in compliance with benefits plans and applicable laws?)
  • Environmental (are you in compliance with environmental laws?)
  •  

    To place yourself in a good position, you should be exhaustive in your efforts to disclose pertinent information. Try to be forthcoming and leave no stone unturned when you are giving information to the buyer. In some cases, the disclosures will consist of hundreds of pages. You’ll need to work with your lawyers to make sure everything is being disclosed properly.

    Survival Periods

    Another way you can swing the pendulum your way when negotiating the indemnification provision is to minimize the “survival period” of the written representation and warranties you provide. The survival period is the time period (similar to a statute of limitations) in which the buyer may bring an indemnification claim. Outside of the survival period, the buyer will be liable for damages arising from the transaction.

    Indemnification Caps and Baskets

    A common way for sellers to better their standing in indemnification clauses is to institute a “cap” on the amount they would be responsible for in the event that a claim is brought. The size of the cap may depend greatly on the size of the deal size. In smaller deals, the cap is likely to be higher (e.g., 100% of the purchase price). But, in larger deals, the cap can get negotiated down to a lower amount (the median for “mid-market M&A deals is about 10% of the purchase price).

    Conversely, a “basket” lays out the threshold for the indemnification claim amount to reach before the seller is responsible for damages related to the claim. So, for example, if a basket is set at, say $100,000, then the buyer cannot bring an indemnification claim until they have aggregate damages that exceed $100,000. In addition, you can make the basket a “deductible” (i.e., in our example, the buyer can get damages in excess of $100,000 up to the cap) or it can be a “tipping basket” (i.e., in our example, the buyer can recover all of the damages up to the cap).

    Anti-Sandbagging Provisions

    Within the business transaction contract, there are sometimes provisions or clauses related to “sandbagging.” Buyers will want to include a pro-sandbagging provision, while sellers are attracted to anti-sandbagging provisions. In an anti-sandbagging provision, the buyer agrees to waive the right to bring an indemnification claim related to information that was disclosed if it can be shown that the seller did make the buyer aware of the information (e.g., by having included the information in the data room). As of late, however, mergers-and-acquisitions contracts are eschewing these sandbagging provisions.

    Contact Doida Law Group

    Doida Law Group is committed to helping businesses thrive and not spend too much time on legal matters that can be detrimental to your company’s operations and bottom line. We can provide effective guidance on how your contract’s indemnification provision should be structured in order to be deemed enforceable – and on a fixed-fee structure. Our firm’s innovative billing model is designed to give you certainty and promote efficiency when resolving your legal matters. Reach out to us today for quality legal representation for your business now and in the future.

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