November 1, 2017
Indemnification Baskets in Acquisition Transactions
Some of the most critical aspects of any acquisition transaction are the indemnification provisions. However, it is an aspect of the transaction that is often overlooked by clients. Buyers often conduct exhaustive due diligence on numerous aspects of the seller’s business, but that does not guarantee that there are not any unknown liabilities lurking about or events that have happened prior to closing that will cause problems that do not arise until after closing. Indemnification provisions serve to allocate the risks of known and unknown liabilities between the buyer and the seller.
Generally, seller and buyer agree to indemnify each other for breaches of representations and warranties. Many times, the seller will also indemnify the buyer for certain claims arising after the closing, but which occurred before the closing. Sellers seek to walk away from closing without any continuing responsibility for a business it no longer operates. Buyers want protection from any possible losses or damages that are related to the business before they took over operations.
In many instances, the seller does not wish to deal with indemnifying the buyer for small or insignificant amounts. In those cases, the parties will often negotiate and implement what is known as a basket. A basket provides that the seller’s indemnity obligations do not begin until damages or losses reach a certain dollar amount. There are two distinct types of baskets: the deductible basket and the tipping basket.
With a deductible basket, the buyer can only recover those losses or damages that are in excess of the agreed upon basket amount. For example, if the parties agree upon a deductible basket amount of $100,000, the seller only has to indemnify the buyer for losses or damages that exceed $100,000. The buyer is responsible for the first $100,000 of losses or damages.
With a tipping basket, once losses or damages exceed the agreed upon basket amount, the buyer is indemnified for the full amount of the losses and damages. So if the parties agree upon a tipping basket amount of $100,000, once the losses or damages exceed $100,000 the buyer can recover the full amount of such losses, not just those in excess of $100,000.
As you would expect, sellers like to have a very large basket while buyers often want a very small basket. However, in many cases, during the early stages of the deal neither party is thinking about the indemnification provisions. It’s only after counsel has had the opportunity to discuss how important and impactful these provisions can be that clients take an interest in the indemnification provisions. Baskets are only a small part of what will need to be negotiated when it comes to indemnity obligations. Survival periods, caps, and exceptions, are just a few other aspects of the indemnification provisions that parties should consider when buying or selling a business.