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.
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
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.
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.