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