Deal Hurdle – The Dreaded Indemnity

In representing business owners in purchasing and selling businesses, there is one area that seems to be the sticking point in almost every deal…the dreaded indemnity.

For people that regularly buy or sell businesses an indemnity is just part of the deal.  There is an acceptable framework and they negotiate to get the best deal in light of the particulars of the business involved.  But many owners of large and successful businesses started their business from scratch.  Their business is an integral part of their life and they sell the business upon retirement in the only “M&A deal” they will ever do.  To these sellers the terms of the indemnity can be the biggest hurdle on the way to closing the deal.

The purchase of a business with a purchase price in the millions or tens of millions of dollars, is complex and can involve considerable due diligence and investigation.  It is obviously more complex than the purchase of a used car that you might take to a mechanic for the once over and then buy “as is”.

The value of a business can depend on many factors including the income generated from the business, the value of the asset, and the extent of the liabilities and potential future claims that may be assumed by the buyer.  Even if the buyer does considerable due diligence on the business they are buying, there are material issues that can impact the value of the business that simply cannot be verified before closing.

A typical business purchase agreement is structured to address this uncertainty by describing, in the seller’s representations and warranties, the facts about the business that the buyer is relying on in making its decision to buy the business.  For example that the financial statements that have been provided are true and accurate, that they own all the assets they say they own, that they have complied with all laws, paid their taxes, and have otherwise done everything “right”, or that the seller has disclosed to the buyer if they have not.

The indemnity describes what happens if the representations and warranties are not true.  Many first time sellers generally think… I am selling the business so I don’t have to worry about it anymore.  How long will I have to continue to worry? How much am I at risk? Will the buyer  nitpick every little thing?  Will the joint assets held with my spouse be subject to these claims.  The indemnity section describes precisely those types of details.

An indemnity is often limited in time to provide the buyer a reasonable period to discover any defects in the statements made by the seller but also offers the seller a reasonable end date for potential claims to be brought.

The dollar limit on the amount of the indemnity should be carefully evaluated based on the amount that the value of the business could be deflated if a unverifiable representation of fact turns out to be untrue.  The amount of the indemnity, in my mind, takes the most thought surrounding the unique circumstances of the business being sold.

The issue of nitpicking is addressed in what is called the “basket.”  The amount of the basket describes the dollar threshold of claims under which no claim will be made.  Once the basket is reached, if it is a true basket, only claims above the threshold amount will be subject to reimbursement from the seller.  If it is a tipping basket, once the amount is reached the dollar amount of all claims can be recovered.

The most sensitive issue is whether the owners of the selling business and their spouses will be personally responsible for claims under the indemnity.  Once the assets of a business are sold, the business almost always distributes the proceeds to the owners.  So, from the buyer’s perspective the only way to recover is to have the commitment of the owners, and in Pennsylvania, their spouse too.

If selling your business, or even leaving your business to family members, is part of your retirement plan some thought and planning in advance can help maximize your proceeds and make the transaction go smoothly.

Summary

The purchase or sale of a business is complex.  For many owners of businesses their business is an integral part of their life and they sell the business upon retirement in the only “M&A deal” they will ever do.  To the seller the terms of the indemnity can be the biggest hurdle on the way to closing the deal.   If selling your business, or gifting your business to family members, is part of your retirement plan, thought and planning in advance can help maximize your proceeds and make the transaction go smoothly.


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