Selling Your Business — Practical Tips for Sellers — Part 10: Indemnification (Part One)

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

This is part 10 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 now turn back to the purchase agreement to discuss the indemnification provisions, which deal with post-closing events.  Indemnification provisions are among the most heavily negotiated portions of a purchase agreement, yet business owners may be tempted into thinking they are simply something lawyers like to argue over without realizing their importance.  In this post, we’ll try to give a simple explanation of the indemnification provisions, explain how these provisions may come up after the closing, and give a few generic tips for sellers in handling indemnification.  In the next post, we’ll provide some detail on specific provisions of the indemnity section and provide more seller tips related to those provisions.

A very basic seller indemnification provision reads something like this:

The seller and each shareholder, jointly and severally, will indemnify and hold harmless the buyer and its shareholders and subsidiaries (collectively, the “Buyer Indemnified Parties”), and will reimburse the Buyer Indemnified Parties for any loss, liability, claim, damage, or expense (including costs of investigation and defense and reasonable attorneys’ fees and expenses), whether or not involving a third-party claim, arising from or in connection with … [a list of matters].

So what does all of this legalese mean? In simple terms, the duty to indemnify and hold another harmless means to compensate the other for a loss suffered. In the context of a purchase agreement, the indemnity given by the seller and its shareholders is a contractual agreement by them to compensate the buyer for certain losses the buyer suffers after the closing and which are related in some to way to representations, warranties, covenants, or other obligations of the seller and/or its shareholders set forth in the purchase agreement. [1] (We discussed what “joint and several” means in this post.)

In short, if the buyer is harmed or damaged in specific ways after the closing, then the seller is contractually agreeing to compensate the buyer for that damage or harm.  From the seller’s perspective then, it’s critical to review and understand the seller’s indemnity obligations and to be sure they are as narrowly drawn as possible. [2]

Some of the matters typically made part of the seller’s indemnification provision are as follows:

  • breaches of representations or warranties made by the seller or shareholders;
  • breaches of covenants or other obligations of the seller or shareholders;
  • any liabilities arising out of the ownership or operation of the company’s assets before the closing;
  • any product manufactured by or shipped by the seller or any services provided by the seller before the closing;
  • certain specific matters which may be disclosed in the disclosure schedules; and
  • all liabilities specifically retained by the seller.

Here are two short examples of situations where post-closing indemnity might come up. One, suppose the buyer purchases the seller’s business based on a multiple of 5 times the seller’s EBITDA (based on seller’s financial statements).  The purchase agreement contains a representation and warranty from the seller that its financial statements are true, correct, accurate, in accordance with GAAP, etc.  After closing, the buyer discovers that the seller has not properly booked certain sales, and that revenues and earnings are overstated.  Here, the buyer may attempt make an indemnity claim based on the allegation that it overpaid for the business based on the seller’s misrepresentation of its financial statements.  And if the buyer purchased the business for a 5x EBITDA multiple, then the buyer might attempt to use the indemnity provision to reduce the purchase price based on this multiple.

Second, suppose that after closing, the IRS audits the business the seller has sold and finds an underpayment of taxes for one or more years ending before the closing. If the buyer is harmed by the under reporting of tax (either because the buyer overpaid for the business or perhaps because the deal was a stock sale and the purchased business is responsible for the tax), then the buyer will expect the seller to indemnify it for its losses.

With this background in mind, here’s a list of tips for sellers in negotiating the indemnification provisions of the purchase agreement:

Tip 1 – Don’t Leave It All to Your Lawyer.  Indemnification is a little more esoteric than the parts of the purchase agreement that deal with business issues, but it’s a critical part of the purchase agreement.  Make sure you read the indemnity section and ask your lawyer to review it with you (several times).

Tip 2 – Thoroughly Review the Representations, Warranties, and Disclosure Schedules.  One of the causes for indemnification by the seller is the seller’s breach of representations and warranties.  In fact, this is how the indemnity section and the representations and warranties are connected (the seller breaches a representation which causes the buyer loss or damage and the seller must indemnify).  Therefore, it’s vital that the seller thoroughly review and understand the representations and warranties and make adequate disclosures if there are potential issues related to the representations and warranties.  For more on this discussion, see this post.

Tip 3 – Thoroughly Review Retained Liabilities. – Another cause for indemnification is liabilities or obligations retained by the seller.  Therefore, it’s important to review and understand what the seller is retaining and, if applicable, to properly discharge those liabilities after the closing.

In the next post, we’ll get into some specifics of the indemnification provisions, such as damages subject to the indemnity, baskets (deductibles), caps, set-off rights, and others, and provide more practical tips for sellers with respect to these specific provisions.


Footnotes

[1] Note that indemnification is not strictly limited to post-closing matters but that’s the major concern and the focus of this post.  Also, it’s important to note that, even without indemnification provisions, if either party breaches the purchase agreement, the other can bring a claim for damages (lawsuit) for breach of contract. But the indemnification provisions broaden (or narrow) the scope of potential claims and add many important details, such as the procedure to be followed if a third-party brings a claim against either the buyer or the seller after the closing.

[2] There will likely be indemnity required of the buyer if the seller is harmed in some way but this tends to be much less important and is not the focus of this post.


© 2013 Casey W. Riggs and Jennifer Wilson — 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.