What Actually are Indemnification Caps? And Why Should Buyers and Sellers Care?

by Joe Delehanty

We have all come across this concept (or is it a term?) before, but now, let’s take the time to really understand this. Over the next few posts in this series, we’ll take a dive into the indemnification pool (pun intended) and break down the useful definitions and considerations to give you enough to have a conversation and lead you into more in-depth research.

In fact, Indemnification Caps (“Caps”) are essential to both buyers and sellers and draw on expertise from litigators and deal lawyers. Are they worth it? You bet, a botched indemnification negotiation could negate the entire value of the deal you just closed. Is it tricky? As you’ll see, the negotiators have their own language.

Let’s start with a broad definition that we can refer back to throughout the series: What is an Indemnification Cap?

An Indemnification Cap is a contractual provision, or more likely, a series of contractual provisions, that limits the damages purchaser could recoup from a seller through indemnification following a private sale or purchase of a company.

Any number of things could happen post-closing, including breaches of reps, warranties, and covenants or something as simple as a burst pipe. The client will call, and the attorney’s first move is to look to the agreement: the Caps are key.  

What’s this like in the real world? Let's look at an example to think about this pragmatically:

Let's say you are the pizza baron in your area, and you decide to acquire a smaller, three-location pizza chain to expand your barony. But shortly after the sale goes through, you get sued by a restaurant equipment supplier for having not fully paid for an industrial oven, which was formally an asset of the company you acquired.  Who's liable in this case? Is it you because you now have ownership of the company? Or is it the former owner because they missed the payments and didn’t make you aware? Was it a stock purchase or an asset sale? This is where indemnification caps come in to play.

At the highest level, purchase agreements include indemnification caps encompassing three major considerations: scope, costs and duration (also known as Survival Periods). In other words, who's considered liable for what, for how much, and for how long following closing.

In the example given, it's more than likely the former owner would be liable, but you need to look to the representations, warranties, and possible Caps in the purchase agreement to be sure.

However, you can see how there might be some instances where it could be a bit more complicated. What if the oven stopped working? Or there was a major leak in one of the shops following the sale? Are these even reasonable recoverable losses? How long should the buyer be protected under these provisions? And up to how much money should the seller have to pay?

Of course, buyers and sellers will often have different negotiating positions depending on the type of business involved and what equipment is used. On top of these complicated considerations, you might see other terms thrown around in a typical purchase agreement like, special indemnifications, basketing, scrapes, and anti-sandbagging provisions. We’ll touch all of these in another post. Needless to say, you'll likely want to hire an experienced attorney to help you navigate these issues. Did we mention a purchase agreement can be about 150 pages?

If you're ready to buy or sell your company, give us a call. We'll even read the purchase agreement for you. We can be reached at 317.777.7920. Or, you can email me directly at: joe.delehanty@gutweinlaw.com.