Insights

Let’s Talk Indemnification 
POSTED 9.24.19 M&A

After an M&A deal closes – and there are breaches of any of the Representations and Warranties from the Seller – the Indemnification provision protects the Buyer from the resulting damages. In most cases, a portion (10% of the transaction value) is held back from the Seller to pay for these financial losses.

Indemnification provisions, which are enshrined in the Purchase and Sale Agreement, are an ideal way for a Buyer to mitigate risk. But at the same time, Sellers aren’t too pleased with having a significant amount of cash they expected from the sale of their business held in escrow in case of a breach.

In short, Buyers want very “broad” Indemnification provisions, covering any potential loss, while Sellers strive to narrow the scope of what breaches are covered, the amount to be potentially paid out in case of a breach, and how long Indemnification provisions can be enforced – the survival period.

As you might expect, Indemnification – and all the elements that go into it – is one of the most hotly contested deal points when an M&A deal is being negotiated.

As an advisor in an M&A deal or an owner/founder who is selling their company, it’s important to understand just how important Indemnification is – it’s definitely not an afterthought but rather a critical part of negotiations with the Buyer. It could have a tremendous impact on the amount of money you take home after a deal closes and have ramifications for years down the road if any liabilities pop up that the Buyer blames you for.

Here’s a quick analogy to break this down into simple terms:

You want to buy a Tesla. You ordered it, gave the dealer your specs, and put down a down payment. You don’t want to show up at the dealership and be given a Nissan Leaf. If that happens, you want your money back. That’s the mindset of the Buyer.

But, from the Seller’s point of view… they sold you a car. Once you drive off the lot (the deal closes), it’s not their problem anymore. They want no liability for what happens after. They expect the Buyer, after having done their due diligence, to assume all the risk.

Indemnification Provisions and Survival Period

Reps can be divided into fundamental and non-fundamental, with fundamental being core reps covering the basic operations of the business, like stock ownership, authority to sell the company, or tax issues. Of course, this isn’t set in stone. Buyers want to move as many reps into the fundamental category as possible (such as intellectual property), with Sellers resisting that effort. For good reason…

In general, survival periods can run from six months to two years on non-fundamental reps. However, when considering so-called fundamental reps, the survival period is longer.

Of course, that’s where negotiation comes into play again. Buyers and Sellers will often disagree on what constitutes a fundamental rep. For example, environmental liabilities can be very expensive and time consuming to clean up… and often these issues don’t come up until long after closing. Buyers would prefer these to be fundamental reps.

Some items are subject to survival periods negotiated separately. For example, say the target company is the subject of a government investigation – that may or may not go to the courts. Buyers will advocate for a survival period for “special” Indemnification provisions for any related reps and warranties that is indefinite – because the legal process could be very slow.

Indemnity Cap

Not only do Sellers want to limit the time Indemnification provisions are in force and which types of claims can be brought, they also want to “cap” how much they might have to pay out in case of a post-closing breach.

The indemnity cap is typically a percentage of purchase price. A portion of that cap is held in escrow for at least a year or until the survival period ends. That’s money that the Seller doesn’t get to take home or distribute to shareholders at closing. The feeling is that the money might never come home because Buyers will find any reason to retain it.

A Better Alternative

Indemnification is such a contentious topic that it can slow down or even shut down deals entirely. There is a way to sidestep all of this.

Representations and Warranty (R&W) insurance is a specialized coverage that transfers all the indemnity risk to a third-party – the insurer. If there are any breaches of reps and warranties post-closing, the Buyer simply files a claim and the insurer covers the Buyer’s damages. And unlike other types of insurance, this coverage is affordable (costing less than ½ of 1% of the transaction value) and more widespread than ever, with about 20 insurers now offering this coverage, even for deals under $20 million.

Savvy PE and VC firms, as well as corporate strategic buyers, are recognizing its benefits to smooth out deals and mitigate risk and increasingly making it a must-have in their M&A deals.

With IP becoming a standard fundamental rep, R&W insurance is ideal for small technology companies, at $20M or less, being sought after by larger firms. And if the Buyer is not interested in R&W coverage, which can often be the case for big companies, it is possible to insure only the IP reps in the deal. The premiums are just $125,000, with $30,000 in underwriting fees. A small price to pay for the Seller’s peace of mind.

If Indemnification has your M&A deal hung up, or if you’re a Seller concerned about this issue because you’re about to put your business on the market, I’d invite you to speak with me about Representations and Warranty and other types of M&A focused insurance that could protect you.

You can reach me, Patrick Stroth, at pstroth@rubiconins.com or (415) 806-2356.