The Ins and Outs of Indemnification

This is the fifth article in our series on selling the family business. For a refresher on how we got to this point, read our previous articles on letters of intent, marketing, and preliminary diligence.

When selling a family business, ideally the benefits of the sale will outweigh the risks. However, just as there are inherent risks in running a business, so too are there inherent risks in selling one.

Indemnification provisions in the purchase agreement are one of the key ways sellers and buyers allocate such risks in order to distribute the liabilities of the business and the sale in a transparent and pre-determined manner. As a result, indemnification clauses are some of the most important provisions in a purchase and sale agreement.

Due to their importance, indemnification clauses should be custom-tailored and should not be approached with a "one size fits all" mentality. Here we discuss some of the potential variations within indemnification clauses and highlight which variations are most advantageous to family businesses.

What Is "Indemnification?"

Indemnification provisions are contractual tools that allow buyers and sellers to agree in advance as to who will bear the liability associated with certain specified risks (such as pre-closing liabilities, breaches of contract, tax issues, etc.). So, what is indemnification exactly?

"Indemnification" is an overarching term that is often used as a "catch-all" for three distinct concepts—to "indemnify," to "defend," and to "hold harmless." A summary of these operative provisions is below, from the perspective of the seller:

• To indemnify means that the seller will reimburse the buyer for a loss or liability.
• To defend means that the seller will pay the buyer's legal fees for suits that arise from specific risks articulated in the contract.¹
• To hold harmless means that the seller cannot pursue the buyer for liability that the seller is exposed to due to the buyer's own actions.

Although indemnification provisions are usually mutual (meaning the seller indemnifies for some matters, and the buyer indemnifies for other matters), indemnification provisions typically create more risk exposure for (and are therefore more pertinent to) sellers than buyers.

As a result, sellers should narrow the scope of the indemnification, defense, and hold harmless clauses to the extent possible. However, it is common for sellers to provide some level of indemnification, and so it is unlikely that such concepts will be eliminated altogether except in unusual circumstances. A realistic and market-based approach considering leverage and deal context are important to streamline negotiations and expectations.

Scope of Indemnification

Identifying what is covered by indemnification is one of the most important parts of an indemnification provision. For example, what types of losses must a seller reimburse a buyer for? In what situations must a seller defend a buyer or hold a buyer harmless?

A family business seller should carefully review the "nexus" clause in the indemnification provision in order to determine what types of claims are covered. A nexus clause dictates what types of events give rise to actionable damages. Some examples include:

• Broad nexus clauses: Seller must indemnify for losses in connection with … related to … arising out of . . . certain specified risks.
• Narrow nexus clauses: Seller must indemnify for losses solely resulting from . . . directly related to . . . certain specified risks.

Although differences between nexus phrases may seem pedantic, such phrases can have a significant impact on a seller's scope of liability exposure.

Similarly, it is important to clearly articulate the types of claims covered by indemnification. Such claims typically include breaches of the representations, warranties, and covenants in the contract, as well as fraud and intentional misconduct.

Depending on the transaction structure, indemnification may also cover pre-closing taxes, excluded liabilities (the definition of which is usually heavily negotiated), and other known risks. Sellers should carefully review the list of claims that are subject to indemnification in order to ensure the scope of indemnification is in line with seller's risk expectations and tolerance.

As mentioned above, indemnification provisions are highly customized, and below are some additional considerations that should be analyzed when drafting and negotiating an indemnification provision:

• Who is entitled to indemnification? Is it just the buyer or also buyer's affiliates, owners, officers, managers, etc.?
• Who is the indemnifying party? Is it just the seller, or are seller's owners and affiliates also liable for indemnification?
• Should indemnification cover all breaches of the contract or just material breaches?
• Should indemnification cover direct claims between buyer and seller or just third-party claims?
• What types of damages are subject to indemnification? Does it make sense for seller to indemnify buyer for lost profits, consequential damages, punitive damages, and diminution in value, or are these damages just inherent in buying a business and not something seller should pay for?
• How long should seller be on the hook for indemnification? Should such claims expire in six months / one year / two years? Does the appropriate survival period vary depending on the type of claim and the type of business?

Once again, family business sellers should strive to limit who is entitled to indemnification, the types of claims that are subject to indemnification, and the types of damages for which the buyer is entitled to indemnification. Sellers should also limit the survival period for most indemnification claims to just a short time after closing, i.e., six months to two years (although certain "fundamental" claims or particularly risky claims typically survive for much longer periods).

Narrowing Indemnification Exposure—Baskets and Caps

Sellers should also strive to limit their indemnification exposure by including a "basket" and a "cap" in the indemnification provision.

A basket is a dollar threshold under which the seller is not required to pay for buyer's damages. There are two kinds of baskets: tipping baskets and deductible baskets. Below is a summary of these types of baskets, again from the seller's perspective:

• A tipping basket requires the seller to pay for all covered damages suffered by the buyer once the pertinent trigger threshold is met, starting with the first dollar of damages.
• A deductible basket functions like an insurance deductible, i.e., once it is triggered, the seller is only responsible for the damages that exceed the basket threshold.

To better illustrate the differences in the types of baskets, consider a scenario where the basket threshold is set at $10,000 and the buyer suffers $15,000 in damages. A tipping basket would require the seller to pay all $15,000 in damages, while a deductible basket would only require the seller to pay $5,000 (i.e., the amount by which the damages exceed the basket threshold).

As sellers, family businesses should strongly advocate for the indemnification clause to include a basket, preferably a deductible basket with as high a threshold as possible, in order to avoid being liable for frequent, immaterial claims.

In addition, many purchase and sale agreements also include a cap on liability. This cap sets the upper limit that a seller is responsible for paying. Some agreements contain two caps—one for general indemnification claims (often set at a percentage of the purchase price), and one for "fundamental" claims or fraud (often set at the purchase price itself).

As mentioned above, it might not be worth it for a family business to sell while facing potentially unlimited exposure for claims under the purchase agreement. A reasonable cap provides some transparency to sellers of their ultimate dollar risk exposure after closing, which ultimately can help sellers decide whether the deal is worth pursuing.

Conclusion

While this article highlights some of the key provisions that are typically included in an indemnification provision, there are many intricacies to consider. Please be sure to consult with qualified legal counsel in order to determine how best to negotiate and draft an indemnification provision based on your circumstances.

FOOTNOTE

1 Some "defense" clauses also give the indemnitee full control over the litigation (selection of counsel, discretion to settle, etc.) so be aware if that is included in the contract.