Indemnity Caps: The Purchase Agreement, Part 5

This is a multi-part blog post that describes the various sections

of a typical business purchase agreement.  This post covers

Indemnification Caps.

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

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.