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September 14, 2016

Best Practices: A Refresher on Indemnification Clauses in Purchase Agreements

by Katie O'Brien

When financing the purchase of a business, one of the most important pieces of due diligence that a lender collects is the purchase agreement. Most lenders review a purchase agreement and its exhibits for details such as the parties to the purchase agreement (to confirm that the buyer is the same entity or individual as the loan applicant), the purchase price and purchase price breakdown, a description of the assets being transferred, the duration and geographical scope of any non-compete clause, the terms of any seller financing or consulting agreements, bulk sales or successor liability provisions, etc. But one important provision that is sometimes overlooked in a lender’s review is whether or not the purchase agreement contains an adequate indemnification clause for the benefit of the buyer.

An indemnification provision benefitting the buyer is intended to make the buyer whole for certain losses incurred by the buyer in connection with the business due to the seller’s conduct. For example, the seller might indemnify the buyer for losses arising from the seller’s failure to adhere to contractual covenants, inaccuracies or breaches of representations and warranties, and third party claims arising out of the seller’s operation of the business prior to closing. The seller may further agree to indemnify the buyer for liabilities that the buyer is not assuming, unpaid taxes and environmental issues that were present prior to closing.

Indemnification provisions may be heavily negotiated. Below are a few of the considerations that arise during negotiations:

  • Time limitation – Indemnification may be limited to one year, two years, etc. The parties may also place different time limitations on different covered acts. For example, the seller might indemnify the buyer for third party claims that arise within three years of closing, but the seller might only indemnify the buyer for contractual breaches that transpire within a year of closing. If no time is specified in the contract, the applicable statute of limitations generally controls.
  • Maximum amount – Indemnification may be limited to a maximum specified amount, such as a percentage of the purchase price.
  • Threshold amount – The seller, as the indemnifying party, may not have any obligation to indemnify until a certain threshold has been reached (e.g. a $5,000 loss to the buyer).
  • Definition of indemnified party – Sometimes affiliates, employees and representatives of the buyer are included in the definition of “indemnified party” and thus given the same protections as the buyer.
  • Escrow – Funds may be escrowed at closing to ensure that the seller has the financial wherewithal to cover a claim under the indemnification clause.

Although an indemnification clause does not take the place of a buyer’s thorough due diligence of the seller and the business, it can be a significant protection for the buyer. Thus, it is important for borrowers to consider an indemnification provision when appropriate as it could be an important factor in the future success of the business.

For questions regarding contract provisions and indemnification clauses, contact Katie at 267-470-1107 or via email kobrien@starfieldsmith.com.