Volume 12, Issue 2, January 28, 2025

By: Alfonso Zambrano & Michael Gawargi

When buying or selling a business, understanding indemnification is crucial. Indemnification clauses in merger and acquisition (M&A) agreements help protect both parties from potential losses and liabilities. This article will explain the types of indemnification protections available to Buyers and Sellers and provide practical considerations for each side.

What is Indemnification?

Indemnification means reimbursing the other party for a loss suffered due to a third party’s claim. In M&A, it also covers first-party liabilities, such as breaches of promises or issues that arise before or after the deal closes.

Purpose of Indemnification

The main purpose of indemnification clauses is to transfer liability from the party that incurs the loss to the party whose actions caused it. This ensures that the responsible party bears the financial burden of any claims or losses.

How to Protect Myself as a Buyer:

• Representations and Warranties Insurance (RWI): This insurance protects Buyers against losses from breaches of the Seller’s promises. It covers unknown risks and can make negotiations smoother. However, like any insurance, RWI has exceptions and limitations, and the Buyer may be responsible for paying all or part of the premium.
• Holdbacks: A portion of the purchase price is held back in an escrow account or a similar holding mechanism for a specified period to cover any potential claims. This ensures that funds are available if indemnification is needed and offers additional security to Buyers.
• Seller’s Note: This is similar to a holdback, but without using escrow or a third-party. The money is held by the Buyer and can be used to offset any claims against the Seller. This means that if the Buyer needs to make a claim, they can reduce the amount they owe the Seller in future payments. This method generally requires less upfront capital and provides another way for the Buyer to recover funds if needed.
• Earnouts: Part of the purchase price depends on the business achieving certain performance targets after the deal closes. This aligns the interests of the Buyer and Seller and provides protection against overpaying.

How to Limit Exposure as a Seller:

• Limiting Scope of Indemnification: Sellers should aim to limit their indemnification obligations to avoid excessive liability. This can include specifying time limits for types of claims or setting an overall time limit for all potential claims.
• Preparing for Potential Liabilities: Sellers should address any known issues before the sale and disclose all relevant information to avoid future claims. Sellers must ensure that all information and promises included in their representations and warranties to the Buyer are accurate and fully up-to-date.
• Negotiating Terms: Sellers should negotiate terms that minimize post-closing risks, such as including a lower cap and a larger deductible basket, as explained hereafter.
• RWI for Sellers: Sellers can use RWI to protect themselves against claims from the Buyer. This insurance covers breaches of the Seller’s representations and warranties, reducing the financial impact of potential claims and providing peace of mind to the extent covered.

M&A Transactions’ Special Indemnification Provisions:

• Escrow Agreements: This provisional agreement sets aside a portion of the sale proceeds in an escrow account until certain conditions are met to cover potential indemnification claims.
• Indemnification Thresholds/Baskets: This provision establishes a minimum amount of losses that must be incurred before indemnification kicks in. Baskets can be “first dollar” or “tipping basket” (covering all losses once the threshold is met) or “deductible” (covering only losses above the threshold). A Buyer will prefer a tipping basket because all losses will be covered. A Seller will prefer deductible to limit the money claimed.
• Indemnification Caps: An indemnification cap limits the Seller’s indemnification obligation to a certain dollar value, typically equal to the indemnification escrow. This is a Seller friendly provision that will be capped to at least the value of the purchase price.
• Other Common Limitations:

1. Mitigation: Indemnified parties must take reasonable steps to mitigate any loss, including incurring costs only to the minimum extent necessary to remedy the breach.
2. Insurance: Payments by an indemnifying party are limited to the amount remaining after deducting any insurance proceeds or similar payments.
3. Tax Benefits: Payments are reduced by any tax benefits realized as a result of the loss.

Special/Consequential Damages: Indemnifying parties are not liable for punitive, incidental, consequential, special, or indirect damages, including loss of future revenue or income, loss of business reputation or opportunity, or loss of value.

Conclusion:

Indemnification is a key part of M&A transactions, providing essential protections for both parties. Clear and well-drafted indemnification clauses help ensure a smooth transaction and protect against unforeseen liabilities. To that end, it is important you consult with an experienced professional to assist you in drafting and negotiating these types of provisions in healthcare transactions.

Alfonso Zambrano, Shareholder – Brown & Fortunato, P.C.
Alfonso Zambrano is a shareholder and director at Brown & Fortunato with a broad corporate practice emphasizing on mergers and acquisitions, corporate finance, business start-ups, real estate transactions and corporate governance. Alfonso has served as the principal legal advisor on numerous transactions in various industries to help clients achieve their goals and implement their business strategies. Alfonso is a member of the State Bar of Texas, the State Bar of New York, and the Amarillo Area Bar Association. He is also an active board member of the Amarillo Museum of Art, and the Harrington Regional Medical Center. He is currently serving as President of the Amarillo Local Government Corporation. In recognition of his community service, Alfonso received the Amarillo Chamber of Commerce Top 20 under 40 Award in 2019.

Michael Gawargi, Associate Attorney – Brown & Fortunato, P.C.
Michael Gawargi is a member of Brown & Fortunato’s Corporate Group where his practice is focused on drafting and negotiating complex agreements, assisting in mergers and acquisitions, managing corporate governance issues, and guiding business entities through formation and strategic growth initiatives. Michael’s work is characterized by a detail-oriented approach to transactional matters and a commitment to delivering sound legal counsel. Michael is a proud alumnus of Texas A&M University, where he graduated magna cum laude with a Bachelor of Arts in Communication and a minor in Philosophy. He earned his Juris Doctorate from Southern Methodist University Dedman School of Law. During his time in law school, he was awarded scholarships recognizing his academic dedication and achievements.