This week, we will be covering how indemnification clauses can impact liability in M&A transactions.
As you likely already know, an exit is the end goal for many companies. We emphasize the word “end” because it bears importance–an M&A transaction is the culmination of a company’s life cycle (or a substantial phase of its life cycle). For this reason, a Buyer is often concerned with managing risk that could arise after closing from events and circumstances that arose before the “end”. Buyers also want to ensure that they are getting what they paid for when buying a company; this often leads to endless pages of Seller representations and warranties that are buttressed by voluminous disclosure schedules that, effectively, recount the entire history of the company being purchased. In contrast to the Buyer, a Seller naturally looks at an M&A transaction as the “end” of not only the company, but also of the issues and liabilities that might arise from the company.
For these reasons and interests, indemnification provisions in M&A transactions are often the most time-consuming and intense aspect of the negotiations. Because it is impossible to practically cover every specialized nuance in one blog post, the following is meant to provide a high-level introduction to some of the considerations.
Why should a founder consider indemnification in an M&A transaction?
In previous posts, we mentioned that it is helpful to start any analysis by considering market standard indemnification obligations for the specific type of agreement.
M&A market standards are largely driven by the roles of the parties in the transaction. At the most basic level, a Buyer’s role is purchasing a company from a Seller for a purchase price. A Seller’s role is to deliver the company at closing and to state the facts and information that support the Buyer’s purchase of the company. Typically, both sides of an M&A deal are concerned with:
Breaches of representations or warranties,
Noncompliance with covenants,
Nonperformance of obligations, and
Pre-closing liabilities and debts.
As one can imagine, a company’s history can be quite involved and complex, often leading to indemnification provisions of M&A agreements leaning far more heavily on the Seller than the Buyer. Another reality is that the Buyer will likely have fewer areas of exposure because (1) it is making fewer representations and warranties than a Seller, (2) it has fewer covenants to comply with post-closing, (3) its main obligation is to deliver the purchase price (this largely occurs at closing), and (4) a Buyer’s pre-closing liabilities usually do not cause a Seller to incur post-closing liability.
With this basic framework in mind, let’s explore how both the Buyer and Seller should approach indemnification in M&A transactions.
A Buyer (and the investors) have an interest in ensuring that the original purchase price will retain its value after closing. Indemnifications are a way to mitigate some of the more common risks that lead to decreased value in an M&A transaction. Based on this presumption, the Buyer should consider the following as it pertains to the indemnification provision of the agreement:
Are there specific types of claims where the indemnification should not be limited by time?
Is there an escrow involved that should be tied to the expiration of indemnity?
How can the Buyer avoid nuisance / non-material claims?
Can the inclusion of baskets or hurdles (to be discussed in detail in a future post) help provide additional assurances?
On the other hand, a Seller must be diligent in the specific representations, warranties, and certifications made in the agreement. As such, some things that a Seller may consider with regard to indemnification:
To what extent should shareholders be liable for any potential claim?
What is a reasonable time for the indemnification to be effective?
Is it reasonable to limit liability to the purchase price?
Should the Seller’s key stakeholders be personally subject to indemnifications?
Be sure to check back next week when we will explore indemnification as it relates to Corporate Officers and Directors. Also, in the coming weeks, we will delve further into indemnification in the M&A setting, considering caps, baskets, exclusive remedies and other legal facets tied to indemnification.
*This blog provides general information for educational purposes only. It is not intended to constitute specific legal advice and does not create an attorney-client relationship.*