Business acquisition contracts contain indemnification clauses to allocate the risk of potential liabilities that may arise after a sale has closed. Despite buyer due diligence, pre-existing liabilities and inaccurate information are discovered with some frequency post-closing.
Understandably, a business buyer is not interested in assuming the seller’s liabilities or in being misled about the sale of the business. Indemnification clauses require business sellers to assume financial responsibility for their promises.
Strong indemnity clauses in business acquisition contracts ensure fairness when not all relevant information is on the table at the time the deal closes. The business and commercial litigation attorneys at Fee, Smith & Sharp LLP negotiate comprehensive indemnity clauses in business acquisition contracts so buyers can move forward with confidence.
Frequent Post-Closing Liabilities in Business Acquisitions
The general legal rule for business buyers is ‘buyer beware’. Buyers are responsible for thoroughly investigating all aspects of a business before deciding to purchase it. A buyer who is not careful might end up inheriting outstanding liabilities, legal battles, and operational dysfunction that could lead to financial ruin.
Indemnification clauses protect buyers from becoming legally responsible for liabilities not anticipated in the sales agreement. Buyers want sellers to indemnify them for all liabilities existing before the sale and for losses arising from inaccurate information provided by the seller.
Buyers want to seek indemnification for the following types of circumstances that could pop up after the sale closes:
- Financial statement inaccuracies
- Undisclosed debts
- Legal disputes
- Breaches of warranties, representations, or covenants
- Specifically identified risks (unpaid taxes, regulatory violations, employment issues)
Business acquisition contracts should clearly identify the circumstances that will give rise to indemnification, the duration of the indemnity obligation, and the amounts and types of costs to be paid. Buyers should be relieved of all third-party liability arising before closing and of any incidental costs incurred as a result of the third-party claim.
Buyer’s Obligation for Past Due Business Taxes in Texas
If an existing business is sold in Texas and back taxes are owed to the state, the buyer can become liable for the unpaid taxes, plus accrued interest and penalties. The Texas Tax Code requires a buyer to withhold the amount of tax due from the purchase price unless:
- The seller provides proof that the tax has been paid, or
- The seller and buyer request a Certificate of No Tax Due before closing
If a Certificate of No Tax Due is not timely requested and the unpaid tax is not withheld from the purchase price, the buyer is liable for the unpaid taxes up to the purchase price of the business.
Using an indemnification clause in the purchase agreement that allocates responsibility for back taxes to the seller will not absolve the buyer of the tax liability, but it will give the buyer the right to seek reimbursement from the seller in civil court.
Key Issues to be Negotiated in Defining the Scope of Indemnification
The scope of indemnification can be a hotly debated issue between a business buyer and seller. Buyers want sellers on the line for as long as possible, and sellers want just the opposite. Some of the terms and conditions buyers want to be particularly aware of include:
Indemnification Period
Indemnification obligations are typically limited to specific time periods or known liabilities. A seller’s representations and warranties indemnity obligation might survive the closing for 12 to 24 months unless the misrepresentation regards information fundamental to the sale, in which case the survival period is usually longer.
A buyer who discovers a violation within the specified period would typically have 4 years to bring a breach-of-contract claim. Parties may agree to a lesser statute of limitations (2 or 3 years) if the aggregate value of the transaction is less than $500,000.
Damages to be Indemnified
The types of damages or losses a seller will be responsible for should be clearly spelled out to avoid confusion and disputes. If only ‘direct damages’ are indemnified, it’s very likely ‘incidental, special, or consequential’ damages are not covered. If ‘all damages, losses, or expenses’ are to be indemnified, it is more likely that consequential losses can be indemnified, but court interpretation may still be required.
Buyer Minimum Loss
A ‘basket’ provision in an indemnity clause designates a minimum threshold of loss that must be sustained before the seller is liable. There are two common types of basket provisions.
- Deductible basket – the seller is liable only for amounts exceeding the threshold
- Tipping basket – once the threshold is reached, the seller becomes liable for the full amount of loss
Baskets are often set as a percentage of the transaction value. Baskets typically won’t apply if the buyer’s loss is the result of seller fraud, intentional misconduct, or the breach of representations considered to be fundamental to the deal.
Indemnity Cap
An indemnity cap sets the maximum amount the seller will pay for indemnity claims. Caps are often calculated as a percentage of the purchase price or can be a fixed amount. Buyers may require sellers to reserve a percentage of the cap amount (10% to 20% is common) in escrow during the indemnification period (unless the seller has purchased insurance to cover the risk).
Like baskets, caps will not apply if the loss was the result of fraud, willful misconduct, or breach of fundamental representations.
Materiality Scrape
Materiality scrape clauses remove the requirement that a breach or resulting damage be ‘material’ before the indemnification provisions apply. A materiality scrape for determining a breach allows a non-material loss to count toward the indemnification basket threshold. A materiality scrape for determining damages makes a seller liable for actual damages, not only material damages.
Defense of Third-Party Claims
While buyers want sellers to be financially responsible for all third-party claims, they do not want sellers to be in charge of defending them, because the outcome could influence the business’s future success. What often happens is that the seller assumes the defense and the buyer retains the right to participate. The level of buyer participation can be negotiated.
How Business Buyers Can Negotiate Strong Indemnity Protections
Strong indemnification protections in business acquisition contracts protect buyers from liability and determine the financial responsibility sellers will assume after the sale and for how long. Each key issue regarding the application of indemnification clauses should be negotiated to provide a buyer with comprehensive protection against loss.
Business buyers can strengthen their indemnity protections by negotiating:
- Longer indemnity survival periods, especially for fundamental representations
- Broad damages coverage to include incidental, special, and consequential damages
- Lower deductible baskets
- Higher indemnity caps
- Greater amounts of the purchase price are held in escrow
- Materiality scrapes for breaches and damages
- Settlement authority in third-party claims
Buyers usually have to agree to specific procedures for notifying the seller of a claim. Failure to timely notify a seller will waive a buyer’s right to indemnification.
Strategic Acquisition Planning Promotes Business Success
Buying a business may fulfill a dream, but it’s also a financial risk. The good news is that financial risk can be successfully managed with the appropriate legal strategy. The indemnity provisions in a business acquisition contract are intended to provide the buyer with assurance that they are not taking on more risk than anticipated.
At Fee, Smith & Sharp LLP, we have extensive experience negotiating and enforcing business contracts for clients in Texas. In Dallas, Austin, and Houston, Fee, Smith & Sharp LLP can help business buyers achieve their goals while protecting their interests.
