A purchase and sale agreement for a business (whether an asset purchase agreement, stock purchase agreement or merger agreement) will usually include extensive representations and warranties made by the seller for the benefit of the buyer. Such a purchase agreement will also contain corresponding indemnification provisions, whereby the seller agrees to hold the buyer harmless from claims and losses, including attorneys’ fees, which arise out of a breach by the seller of its representations and warranties included in the purchase agreement.

Indemnification extends not only to claims brought by third parties, but claims brought directly by the buyer.

Indemnification needs to be taken very seriously by the seller. It is one thing to be offered millions of dollars for your business. It is another to be able to keep the net proceeds (after taxes and deal costs). While many business owners, even those with middle-market businesses, have limited experience in working with corporate attorneys who are experienced in mergers and acquisitions, a business owner contemplating a sale needs to retain such a lawyer as soon as possible.

While every situation is different, and each seller should consult with its own counsel to protect its own interests, there are some techniques that a seller can generally use to try to limit its indemnification obligations.

Get the Company Ready for Sale. Just like you fix up your house before you put it on the market to maximize the sales price, you need to fix up your business. Contingent liabilities need to be identified and addressed. Without planning, most middle-market privately-held businesses are not prepared to respond rapidly to the due diligence request of a sophisticated strategic buyer or private equity firm.

Limit Representations and Warranties. Since the indemnification obligation is based on the representations and warranties in the purchase and sale agreement, the seller can try to limit or “water down” the representations and warranties it needs to give in the purchase agreement. Not only can some language potentially be stricken; but the seller’s lawyer can try to qualify certain matters to the “knowledge” of the seller. This in turn requires the parties to clearly define “knowledge” in their agreement—for example, “knowledge” can be defined as the seller’s constructive knowledge; the seller’s actual knowledge; or on some other basis. In some cases, there might be different definitions or standards for “knowledge” which apply depending on the representation or warranty.

The seller’s lawyer can also try to qualify certain matters as to materiality; however, the buyer’s lawyer may object to materiality qualifiers as “double dipping” when considered with the indemnity threshold or basket contained in the purchase and sale agreement.

Indemnity Threshold or Basket. It is customary for the indemnification provisions to have a “threshold” or “basket”, under the theory that the seller does not want to be held responsible for minor, immaterial breaches. The indemnity threshold or basket usually applies to the aggregate indemnification claims in the deal.

A basket usually refers to a true deductible; if, for example, the basket is $100,000, the seller has no indemnification obligation until the aggregate amount of indemnified claims exceeds that amount, and then only for the excess. Under a threshold, sometimes referred to as a “tipping basket”, the seller has no indemnification obligation until the aggregate amount of indemnified claims exceeds the negotiated amount, but then has liability back to the first dollar of all claims. For these reasons, a threshold can normally be negotiated to be a higher amount.

The size of a threshold or basket in a given deal depends on a number of factors, such as the general market environment at the time of the deal; the buyer’s and seller’s respective bargaining power; and how free from contingent liabilities the seller’s company is perceived to be by the buyer. However, thresholds and baskets in middle-market deals tend to average about 75 basis points. Thus, on a $10,000,000 deal, one might expect to see a $75,000 basket.

Indemnity Cap. It is also customary for the seller to attempt to negotiate a cap on its aggregate obligation to indemnify. The buyer will try to exclude certain fundamental matters from the liability cap. For example, usually the parties can agree that a claim that the seller does not own the assets or stock purportedly sold would fall outside of the liability cap. More contentious are issues such as whether environmental, ERISA and tax liabilities fall inside or outside of the liability cap. In some deals, there might be several different caps for different kinds of claims.

Again, the amount of an indemnity cap depends on a number of factors, including those listed above, and the size of deal. For mid-sized deals, an average cap might be 10-15% of the purchase price.

Survival Period. We’ve all heard of the statute of limitations. In California, the statute of limitations for a breach of contract claim is four years from the date of breach. But in the context of a purchase and sale agreement, it is customary for the seller to attempt to shorten the statute of limitations for a breach of the representations and warranties from four years to a shorter period.

First, note that we are talking about shortening the statute of limitations. A California court will want evidence that the parties actually intended to shorten the statute of limitations by agreeing to a shorter survival period for bringing claims for breach of the contract representations and warranties. Any ambiguity in this regard will be construed in favor of not shortening the statute of limitations.

The buyer will want at least one full audit year to make claims after the closing. So if the sale closes in October of a given year and the company is on a calendar year, the buyer would want the survivability period to end in April of the year two years after the closing.

The average survival period in middle-market deals is about 18 months. However, the buyer might try to provide for a longer survival period for some breaches. For example, for a company with any possible environmental exposure, it would not be unusual for the survival period to be three to four years, if not longer.

Exclude Claims for Consequential Damages. The seller should attempt to exclude from the claims subject to indemnification any claim for consequential damages, which would primarily exclude lost profits.

Make Indemnification Obligation Net of Insurance and Tax Benefits. The seller should attempt to make its indemnification obligation net of any insurance proceeds actually received by the buyer, and net of any tax benefits realized.