For many sellers of businesses, particularly sellers of family-owned or other privately-held businesses, the sale of the business might be their first experience in dealing with a complex purchase and sale agreement. This article is a basic overview of issues sellers should consider in negotiating the indemnification provisions in such an agreement.

When a business is sold, seller makes representations and warranties to buyer regarding the business. For example, seller may represent that “there are no lawsuits pending or threatened against the business.” Other topics typically covered include ownership of assets, the accuracy of the business’ financial records, the business’s compliance with laws, and payment of taxes by the business. 

Indemnity involves an agreement by one party to secure the other party against loss. Indemnity provisions in a purchase and sale contract provide that seller will reimburse buyer for any losses suffered by buyer if a representation or warranty is not true. For example, if there is a pending lawsuit, seller would have to cover buyer’s losses related to that lawsuit.

If seller is unable to make a clean representation, then seller provides a schedule of items that are exceptions to the representation. Using the “no litigation” representation above as an example, the representation would be modified to read “except as set forth on the attached Litigation Schedule, there are no lawsuits pending or threatened against the business.” Seller would then list on the Litigation Schedule all lawsuits pending against the business. Because the lawsuits are listed on the Litigation Schedule, seller will not be in breach of the representation and warranty.

However, listing an exception to a representation on an exception schedule does not terminate the negotiations regarding which party should bear the risk of loss associated with that item. A typical indemnification provision will provide for line item indemnification for certain items listed on the various exception schedules if the parties negotiate that seller should rightfully bear the risk of loss associated with the listed items.

The proper allocation of risk between buyer and seller is the primary negotiation point with respect to drafting indemnification provisions in a purchase and sale contract. Sellers will often try to include qualifiers in the representations and warranties in order to shift some of the risk to buyer. Two typical qualifications are knowledge (i.e., “to seller’s knowledge, there is no pending or threatened litigation against the business”) and materiality (i.e., “there is no material litigation pending or threatened against the business”). The effects of these qualifiers are that buyer bears the risk, respectively, of items of which seller was unaware or which are immaterial to the business.

Another typical negotiation point is the existence and size of any cap on the amount of indemnification from seller. If there is a cap on seller’s indemnification obligations, buyer bears the risk of any losses in excess of the cap. The parties may negotiate that specific types of claims, such as fraud or specific items included on the exception schedules, are excluded from the cap and remain seller’s responsibility.

Another typical feature of indemnification provisions is a basket. A basket is a dollar amount of losses that must be suffered by buyer before buyer can seek recovery from seller. Two typical variations are a deductible, where buyer bears the cost of the deductible, and a first dollar basket or “tipping basket,” which provides that once the basket limit has been reached, seller pays all losses, including losses for items in the basket. Certain specific items may be excluded from the basket and remain fully the responsibility of seller.

A seller will not want its indemnity obligations to last indefinitely. Indemnification provisions typically contain a time limit for a buyer to assert indemnification claims. Again, as is typical with most indemnification deal terms, the time period for asserting claims is subject to intense negotiation and specified exceptions.

The indemnification provisions are often the most heavily negotiated provisions of a purchase and sale contract and can spark hours of lively debate amongst the lawyers for buyer and seller. Accordingly, sellers of businesses should make sure that they fully understand how the particular indemnification provisions in any proposed purchase and sale contract operate and give the proper amount of attention to negotiating those provisions.