Right alongside key factors like deal structure, working capital adjustments, and escrows and earn-outs, the legal team at Morse lists indemnification provisions among the top 10 most vital issues in an M&A (mergers and acquisitions) transaction. Just as it occurs elsewhere, indemnity provisions in M&A are all about creating a cohesive plan to bear the burden when liability occurs — but as always, their application in the world of mergers and acquisitions comes with a fair share of unique wrinkles that can alter the core makeup of just about any M&A deal.
Indemnification: The Basics
Indemnification clauses are widely used outside of the world of mergers and acquisitions; understanding the basics of indemnity is key to contextualizing the concept for M&A purposes. So let’s conceptualize a scenario.
Say that a service business chooses a tech startup’s new app to charge their customers for a subscription on their mobile devices. Over time, it’s revealed that an error causes the app to withdraw more than the agreed-upon subscription fee from customers’ bank accounts each month. It’s clear that money will have to be refunded, and it’s possible that damages may need to be paid. But the natural question is: Which party — the service business or the tech startup — is responsible for carrying that burden? That’s the question the indemnification clause aims to answer.
As attorney Mohsen Parsa puts it, “Indemnification clauses are clauses in contracts that set out to protect one party from liability if a third party or third entity is harmed in any way. It’s a clause that contractually obligates one party to compensate another party for losses or damages that have occurred or could occur in the future.”
Indemnification Clauses in M&A
Because M&A intrinsically involves the union of two parties, the indemnification clause is absolutely crucial in this arena. In M&A agreements, it’s typical for sellers to minimize the future liabilities of sold assets and for buyers to minimize liabilities for issues that arose under previous owners or damages that occur from unclear negotiations, as the law firm Arnold & Porter notes.
Foundationally, indemnification in M&A agreements contain much of the same legal language as they might elsewhere. For instance, the language of an indemnification clause may simply aim to make injured parties financially whole again, or it may imply responsibility for defending against lawsuits. Likewise, the clause will most certainly establish how the indemnity might be funded, and it will likely establish if there’s a minimum claim amount that must be met before the acquirer can seek indemnification (i.e., compensation from harm or loss).
Other factors in an indemnification clause may be more specific to M&As, however. In M&A agreements, a portion of the purchase price of an acquisition is commonly placed in a third party escrow, and much of M&A-specific indemnity provisions deal with this escrow, often detailing what types of indemnification claims will be capped at the escrow amount. Some additional questions that an effective indemnification clause might answer include the following:
- Are there specific exceptions to the escrow cap?
- Are claims caused by fraud or intentional bad actors capped at the overall purchase price (rather than adhering to the escrow cap)?
- Similarly, do breaches of intellectual property go beyond escrow?
- What is the specific time period in which parties can make an indemnification claim after closing the deal (known as a “survival period”)?
M&A Indemnification Trends
According to Goulston & Storrs, PC, and the American Bar Association’s Private Target Mergers and Acquisitions Deal Point Studies, indemnity caps saw an uptick directly following the financial recession of 2008, but have since been on the decline. From 2005 to 2017, the mean percentage of the transaction value represented by indemnity caps fell from 17.86% to 12.20%. Representation and warranty insurance, or RWI, has also been a rising trend in the realm of private company M&As. With RWI, a portion of the indemnity risk falls to third-party insurers. Bloomberg Law reports the equitable alternative remedies have become more commonplace since 2018, as well.
CapLinked M&A Solutions
Like any part of an M&A agreement, indemnification clauses are open to negotiation, often tuned down to the hyper-specific events that may invoke them. To avoid being one-sided, that sort of negotiation requires intense collaboration and secure workspaces like virtual data rooms (VDR) that manage crucial documents and data. CapLinked’s VRD spaces are here to help with your M&A contracts, start a free trial today.
Dan Ketchum has been an LA-based freelance writer, consultant and small business owner for over a decade. Along the way, he’s fortunate enough to have collaborated with business brands including Chron.com, Fortune, GoBankingRates.com, Office Depot, The Motley Fool, and more.
Sources
Morse, Barnes-Brown & Pendleton, PC – Top Ten Issues in M&A Transactions
Mohsen Parsa, Inc. – What Is an Indemnification Clause and When Should It Be Included in a Contract?
Mondaq – Arnold & Porter: United States: Basics in M&A: Indemnification Provisions
JD Supra – Trends in M&A Provisions: Indemnity Caps
Goulston & Storrs – Publications: Trends in M&A Provisions: Indemnification as an Exclusive Remedy
