What Is An Indemnification Obligation?
In the simplest sense, indemnification obligations protect one party to a contract against claims that arise after a transaction that should be the other party's responsibility. In the context of the sale of a business, a seller often indemnifies a buyer for any claims related to the business for the period prior to closing.
For example, seller has issued a $10,000 credit to a good customer to be used on future purchases from the seller's business. Shortly thereafter, seller sells the business to buyer without disclosing that credit to the buyer. The unsuspecting customer looks to buyer to honor the credit after buyer purchases the business. Buyer should be able to seek indemnification from seller for that obligation since it arose prior to the closing and buyer must expend funds to honor it. A well-crafted indemnification provision in the contract for the purchase of the business would give buyer a clear way to recoup any costs it incurs for the pre-closing credit or any other matters that the buyer did not agree to assume.
An indemnity obligation does not have to be limited to third party claims (i.e. the customer credit discussed above). Much like disclosures provided in the sale of a home, at the closing of the sale of a business, a well-drafted contract will require the seller to give certain representations to the buyer about various operational matters of the business. If it later turns out that those representations were misleading or untrue, and the buyer incurred expenses or losses as a result, an indemnification provision in the sales contract would allow the buyer to recoup those funds from the seller. For example, if the seller represented in the closing documents that all of the business's equipment was in good working condition as of the closing date, and a major piece of equipment failed mere hours after the purchase from a preexisting condition or lack of maintenance, the buyer should be able to recoup the costs to fix that equipment by virtue of the indemnification obligation in the contract.
Indemnity obligations are therefore important to negotiate in the sale of a business because they apportion risk between the buyer and seller. The broader the indemnity one party gives to the other, the more money that is at risk to pay on account of the indemnified obligation. The narrower the indemnity is, the greater the risk that the indemnified party will have to pay out-of-pocket after the closing to cover the indemnified matter.
Protective Measures That Can Be Negotiated
There are several protective measures that can be negotiated into indemnity provisions to either expand or mitigate risk on either side.
- Should there be a cap on indemnity liability? A cap will limit the total potential exposure either party has under an indemnification obligation. For example, in a business sale, often the seller's indemnification liability is capped at some negotiated number. This number limits the maximum amount the seller would owe to the buyer to cure any indemnity claims.
- Should a party be able to seek indemnity forever? The answer is often "no." While indemnity obligations can survive indefinitely after a closing, in practice, many are negotiated to a limited time period after closing. The indemnified party will not be able to seek indemnity from the other party after the time period has expired. A two-year survival period is common in many deals, but any time frame can be negotiated.
- What about including a deductible amount? Yes, in the sale of a business, often there is a deductible amount that will apply before a party may seek indemnity. This makes sense because after a sale of a business, it is common for small things to occur that would technically be the other party's obligation. Part of apportioning risk then, is for the parties to recognize that small things do happen after a sale. Most often, a deductible ensures that a buyer will not run to a seller for indemnity for every small item after the closing, and will only do so after a minimum amount of claims is met. Depending on the total sale size, a deductible as low as $500 or greater than $25,000 may be appropriate.
- Can the buyer hold back money to cover indemnity claims? Yes, an indemnification holdback for some period of time is common. If a buyer believes that there is risk of a future indemnification claim, the buyer may negotiate that a portion of the sale funds be held back for a period of time after closing to cover those claims. A holdback makes money technically belonging to the seller immediately available to the buyer to cover its indemnity claims, should any arise after closing. A holdback also prevents the seller from spending all of the money from the sale by the time an indemnity claim arises. A holdback requires negotiation as to the length of time the money is held, who holds it (a buyer or independent third party), and the terms of release to the seller if any of the holdback is not used.
Indemnification obligations are negotiated to spread risk between the buyer and the seller in a sale transaction. They are commonly used to make the seller responsible for matters that occurred prior to closing and which the buyer does not expressly assume, but they can cover any matter and benefit either party. Indemnification is often a hotly negotiated part of any business sale transaction.
While many sellers and buyers don't always appreciate the risk they have undertaken or opportunity they have lost until they have lived through an indemnity claim, a lawyer's job is to adequately advise and protect the client on all aspects of the purchase and sale of a business, including, particularly, indemnification obligations. At Ward and Smith, P.A., we have experienced attorneys who regularly help clients negotiate the purchase and sale of a business and draft contracts with appropriate indemnification obligations and limits.
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This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.