Surprise Liability and Indemnification after the Business Sale
In a business sale, the buyer and the seller make numerous promises to each other in the form of representations, warranties, and covenants. The purchase agreement contains these promises and also provides remedies if they are breached.
Many of the seller’s promises relate to the business’ liabilities – creditors, contracts, lawsuits, taxes and environmental hazards, to name a few. The buyer wants to know that the business is only subject to the liabilities disclosed by the seller before closing. On the other hand, the seller does not want future exposure after disclosing liabilities in good faith and completing the transaction.
Indemnification is both a remedy for the buyer, and a tool to allocate risk when an unforeseen liability arises out of events occurring before closing. It identifies certain types of events, and states to what extent the seller has to bear responsibility for the associated liability. Indemnification is one of the most heavily negotiated parts of the purchase agreement.
A seller who agrees to indemnify the buyer and hold the buyer harmless against all undisclosed liabilities will be on the hook if a creditor later comes out of the woodwork to sue the business for a claim that arose when the seller owned the business. The business, now owned by the buyer, is liable to the creditor. The indemnification terms require the seller to pay the buyer the amount collected by the creditor, plus legal fees and costs incurred by the buyer in defending against the creditor’s claim.
The seller who understands and appreciates the concept of indemnification may lose sleep over the thought of suddenly being liable for a large obligation. The seller understandably wants to receive payment for the business and move on without fear of a significant chunk of the proceeds being clawed back at some unknown future time.
It is important for the parties to perform due diligence that brings potential liabilities to the forefront before closing. It is also important to thoroughly negotiate the indemnification terms in the purchase agreement, so that protection for the buyer is balanced against reasonable limits to give the seller peace of mind.
A floor may be set, requiring the buyer’s damages to reach a certain amount before the seller is held responsible for any indemnification. The buyer assumes the risk up to the threshold of the floor. Above the floor, the seller’s responsibility begins.
A ceiling may be placed, to establish a worst case scenario for the seller’s indemnification obligations. Often, this ceiling is based on a fraction of the purchase price. Sometimes, it can equal or exceed the purchase price. Also, there may be exceptions to the ceiling. Indemnification is often uncapped for undisclosed or unknown tax liabilities.
The indemnification time period should also be negotiated. Typically there is a cutoff one or two years after closing. After the cutoff, the buyer can no longer come to the seller with indemnification claims. As with the ceiling, there are often exceptions, particularly for liabilities that have longer statute of limitation periods such as unreported taxes.
For the buyer, securing the ability to collect indemnification is a priority. One way to accomplish this is with an escrow fund that receives part of the purchase price. The escrow fund protects the buyer from the risk that the seller becomes financially unable to pay an indemnification obligation. The escrow fund is held for a number of months, or even years. If an indemnification event occurs, the buyer can collect from the escrow fund. After the escrow period expires, the balance is distributed to the seller.
Indemnification is a crucial part of the business sale, and is applicable whether the sale is structured as a stock purchase or an asset purchase. Both the buyer and seller should understand indemnification and think critically about the terms. Each case is different, so it is important to consult with an attorney to fully analyze the facts and options.