In any acquisition, the Seller and the Buyer have differing opinions about what should happen with the purchase price post-closing. The Seller wants to take the full purchase price, retire to a tropical destination and never think about the business again. The Buyer, on the other hand, wants to make sure he/she gets the business he/she paid for and does not have to work too hard to recover damages from the suddenly-distant Seller if the Buyer subsequently discovers that the Seller breached the purchase agreement. The dynamics of this facet of the deal are set forth in the “indemnification” section of the purchase agreement, often nestled between (i) a painstakingly dense set of representations and warranties, and (ii) a relatively boilerplate set of miscellaneous provisions at the back of the agreement.
Beware – if you are buying a Company and you overlook the details of the indemnification provision, you could find yourself without recourse if you discover that the Seller breached the purchase agreement (e.g. the Seller failed to disclose a large potential litigation matter involving the assets you just purchased).
In a negotiated acquisition of a business from a Seller represented by competent counsel, the Seller will likely negotiate for at least three critical limits to your indemnification rights: (1) the duration of time during which you can seek reimbursement; (2) the amount that can be recovered; and (3) types of damages covered.
No Seller will want a perpetual indemnification obligation and any Seller’s counsel who is modestly competent will demand that a reasonable time limitation be placed on the Seller’s indemnification obligations to the Buyer.
The key here is determining how much time is reasonable. One approach is to ask: how long should it take the Buyer to discover defects that the Seller should be on the hook for? It’s not unusual for the Seller’s indemnification obligation to survive for as short as six months and for as long as the limitation period dictated by the applicable statute of limitations.
Let’s start this part of the discussion with a question. If you’re buying a startup IT company for $1,000,000, would it be reasonable for you to ask the Seller to indemnify you for up to $10,000,000 of damages?
Of course not, because doing so could offset any profit made by the Seller on the sale – even asking for this would likely make the Seller run in the other direction before you have a deal. Accordingly, the Seller will likely push hard for a “cap” on the maximum indemnifiable damages to which the Buyer will be entitled; that “cap” will likely be a fraction of the total purchase price and almost never more than the total purchase price. For example, the Seller might push for a “cap” that is 10% of the total purchase price (so, $100,000 in our hypothetical $1,000,000 IT company acquisition).
In our experience in the middle market, we typically see a “cap” ranging from 10% to 45% of the aggregate purchase price. Two factors that impact where your deal will end up within that range: (i) Leverage – if the Seller has more power in the negotiations, the “cap” will trend lower, and visa versa, and (ii) Deal Size – a mammoth deal can still provide Buyer with plenty of protection for indemnification claims with a smaller cap (hence, a smaller portion of the aggregate purchase price).
But if you try sometimes, you just might find, you get what you need. The Seller will often try to limit the types of damages the Buyer can recover under the purchase agreement. For example, the Seller may argue that it should not have to indemnify the Buyer for lost profits, consequential damages or punitive damages suffered as a result of its inaccurate representations or other breach of the purchase agreement. While some Buyers may overlook the value of consequential damages, they do so at their peril. In many cases, consequential damages make up a significant portion of the Buyer’s actual damages. On the other hand, it’s not unusual for Buyer’s to negotiate away their rights to indemnification for punitive damages.
One final suggestion on this topic for the Buyer: consider conceding that some type of damages (e.g., punitive damages) will not be subject to indemnification by the Seller, in exchange for a favorable concession from the Seller elsewhere in the agreement.
In summary, a thoughtful Seller will seek to limit your rights to be reimbursed for damages you as the Buyer suffer as a result of the Seller’s breach of the purchase agreement. But here’s the take-away: there should be limits on those limits, driven by concerns and issues you’ve surfaced during your due diligence review of the business that you’re buying. The better your due diligence was, the better able you’ll be to negotiate and assess the reasonableness of the limits proposed by the Seller. So be thorough in your due diligence, and proactive in determining where the risks are and what level of limits you can tolerate on Seller’s indemnification obligations to you.
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The contents of this Alert are for informational purposes only and do not constitute legal advice. If you have any questions about this Alert, please contact the Shulman Rogers attorney with whom you regularly work or a member of the Shulman Rogers Business and Financial Services department.
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