Indemnification in a Business Sale, in Plain Language
What indemnification means in a business sale: who pays if something you said turns out wrong, how much, for how long, and what you can negotiate.
Words by
Matan Michael
Most owners meet the word indemnification when the buyer's attorney sends the first draft of the purchase agreement. By then the section runs several pages and it was written to protect the buyer. The idea underneath it is short. If something about the business turns out to be wrong after closing, who pays, how much, and for how long. Every paragraph in those pages is an answer to one of those three questions, and every answer can be negotiated.
Start with the statements you are making
A purchase agreement contains a long list of statements of fact by the seller. They are called representations and warranties. The financial statements are accurate and were prepared the way the agreement describes. Taxes have been filed and paid. The business owns what it says it owns. There are no lawsuits you have not mentioned. The employees are paid and classified correctly. The equipment works. Nobody has threatened to cancel a major contract.
Nobody expects you to guarantee the future. The statements describe the business as of a certain day, and the buyer is paying a price based on that description. Indemnification is the clause that says what happens when one of those statements turns out to be false, or when a debt or claim from the time before closing shows up afterward.
Without the clause a buyer could still sue for breach of contract. The clause exists because lawsuits are slow and uncertain, and both sides would rather have a set procedure, a set limit, and a set time period agreed on while everyone is still friendly.
Who is on the hook
In an asset sale, the seller is usually your company, and after closing that company has sold its operations and holds cash. If you distribute the cash to yourself and dissolve the company, the buyer has nobody to collect from. A buyer's attorney knows this and will deal with it in one of three ways. They ask you to sign the indemnity personally, alongside the company. They hold back part of the price in an escrow account for a period of time. Or they reserve a right to deduct a claim from any note you are owed, if you are financing part of the price.
Each one has a different feel for the seller. A personal signature follows you for as long as the clause runs and reaches beyond the money in the deal. An escrow limits the exposure to a pot of money that is already set aside, which is usually the cleaner outcome for you, though the money is out of reach until the period ends. A right to deduct from a seller note is convenient for the buyer and can be used aggressively, so we like to see it limited to claims that have been agreed or decided, not merely asserted. Our posts on holdbacks and working capital pegs and seller financing cover how those pieces fit with the rest of the price.
Ask early what form the protection will take. A buyer who is happy with an escrow in the letter of intent will sometimes come back later asking for the escrow and a personal signature too, and that is easier to push back on when the first agreement is in writing.
The deductible and the ceiling
Two features decide most of the economics. One is the threshold, often called a basket. The other is the cap.
A basket says that small claims do not count until they add up to a certain amount. If it works as a deductible, the buyer absorbs losses up to that amount and recovers only what exceeds it. If it works as a tipping basket, once the losses cross the line the buyer recovers everything from the first dollar. A deductible is better for you. The reason for a basket at all is that nobody wants to argue about a few hundred dollars in a misbilled invoice, and the size should be set so that ordinary after-closing noise stays out of the claims process.
The cap is the most you can be asked to pay for ordinary breaches of the statements. In smaller deals it is commonly set at the size of the escrow, or a fraction of the price. A cap tied to the escrow gives everybody a clear picture. The buyer knows where the money comes from and you know the worst case on the general statements.
Some matters sit outside the cap. These are often called fundamental representations, and they cover whether you own the business and have authority to sell it, and in most agreements taxes as well. The ceiling for those is usually the full purchase price. Fraud is outside any cap. Sellers sometimes resist this and it is rarely worth the fight, because nobody can ask a court to protect a person who lied.
How long the clock runs
Every claim has to be made within a survival period, and the agreement will say how long the statements stay alive after closing. A year or two for the general statements is common. Tax statements often run until the time the tax authorities have to examine the returns has passed, and the fundamental ones run longer.
A buyer wants a long period so that one full tax season and one audit cycle pass before the door closes. A seller wants a short one. Your argument is usually that the buyer controls the business after closing and has every incentive to look hard for problems in the first year. A claim that surfaces three years in is more likely to reflect the buyer's own operation than yours.
Watch for the way claims are notified. A good clause requires written notice with a description of the claim within the survival period, and lets you respond and, in some cases, take over the defense when the claim comes from a third party like a customer or a former employee. Make sure you are not required to pay on the buyer's say-so before anything has been proved.
The schedules protect you more than the language does
Behind the statements sit disclosure schedules. They are lists, attached to the agreement, of the exceptions to each statement. Yes there is a pending dispute with a former employee, here is what it is. Yes one contract needs consent to assign, here it is. Yes the license expires next year.
A buyer cannot claim a breach over anything properly listed. This is where an owner can do the most for themselves. A seller who prepares full schedules, slowly and with the attorney, has used up most of the risk before signing. A seller who rushes the schedules and signs the statements flat has taken on every surprise. The schedules take effort and nobody enjoys them. They are also the part you control.
Two phrases reward a careful read. One is the qualifier "to the seller's knowledge," which limits a statement to what you personally knew or should have known. The other is materiality, which limits a statement to matters that would matter to a reasonable buyer. A statement with neither, such as "the business has no liabilities of any kind," makes you responsible for things you could not have known. We try to put knowledge and materiality qualifiers on anything that is outside the seller's direct control, such as the compliance of a vendor or the history of a lease before you took it over.
There is a related point that is easy to miss. Some agreements say that a buyer who found a problem during diligence can still make a claim for it after closing. Others say the buyer gave up that claim by closing anyway. This is called sandbagging and rules vary by state, so your attorney confirms what applies. If your buyer found something in diligence and priced around it, you want the agreement to say so directly. Our post on due diligence describes where those discoveries usually come from.
Insurance and the size of the deal
At the upper end of the market buyers sometimes buy a policy covering breaches of the seller's statements, and the policy replaces most of the seller's exposure. In the range of businesses we work with it is uncommon, because the premium and the fees are heavy against a modest price. Ask whether the buyer has considered it. If they have, you may be able to trade a smaller escrow for the policy.
What to do this month
You can lower your exposure now, before anyone has a draft in hand. Go through the statements you expect to make and find out whether each is true. Are the tax returns filed. Is every license current. Do the contracts in your files match the contracts in force. Are employees classified the way your payroll provider says they are. A statement that is true on the day you sign cannot hurt you later, and one that you find false in advance becomes a line in a schedule.
Keep a folder of the support. When a claim comes in two years from now, the quickest defense is a document showing what the business looked like on the closing date.
Raise indemnification while the letter of intent is still being written. The cap, the basket, the escrow size and the length of survival can be written into the letter in a sentence each, and they are far harder to change once the buyer has spent money on diligence. Our post on letters of intent covers what to put there. Have your attorney read the first draft with these questions in front of them, who pays, how much, and for how long, and ask for the answers in plain words before the first redline goes back.
