Indemnification: The Purchase Agreement, Part 4

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.

1. Introduction
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
6. Indemnification
7. Termination clauses and remedies
8. Miscellaneous
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.

Escrow

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.