Privately held businesses are rarely bought or sold “as is.” Buyers of most businesses usually expect the sellers to make a comprehensive set of “representations” or “reps.” In other words, statements about the business that the sellers promise are true. These representations often serve two purposes: first to prompt a seller to make disclosure in a document called the “Disclosure Schedule” if a representation is untrue, and the other is to allocate the involved risks between buyer and seller if the representation turns out to be untrue.

Buyers of privately held businesses therefore expect some kind of protection, usually in the form of a refund of purchase price, if those representations, as modified by the seller’s Disclosure Schedule, turn out to be false. Buyers also often expect protection against being obligated to cover unpaid pre-sale taxes or sellers’ transaction expenses, which, absent some protection, are typically obligations that remain with the business post-sale.

Sometimes there are known issues specific to the business such as an ongoing lawsuit that the buyer wants to be protected from. All these protections are usually found in a section of the definitive agreement called “Indemnification.” Lawyers often call this collection of protections an “indemnification package,” and we typically use quite a bit of jargon in discussing these terms.

To help you get up to speed, here are eleven of the most common aspects of an indemnification package, with jargon-busting explanations.

1. “Rep and Warranty Insurance” or “RWI”

Rather than trying to recover damages from the sellers, the parties can purchase insurance that kicks in if the representations turn out to be untrue. The parties will agree on who covers the premium (cost) of the insurance and while it is often shared, occasionally buyers will pay the entire cost. The policies usually have a “retention” or “deductible” which, just like standard insurance, is an amount that needs to be met in damages before the insurance kicks in.

Again, this is often shared, but can also be borne solely by the buyer. However, keep in mind that this insurance is intended to cover “breaches” or “inaccuracies” in the representations, and generally will not cover other indemnity matters such as transaction expenses, known issues like active litigation, and fraud.

2. “Fundamental Rep”

The buyers will usually designate a certain set of representations as “fundamental.” These are most commonly representations about capitalization (who owns the business), who has authority to sell the business, conflicts that might prevent the sale, and whether or not there are any brokers involved who should earn a fee. As the name suggests, these are statements made by the sellers that, if false, have the capacity to completely undermine the deal, rather that statements that would simply make the business less valuable. Fundamental reps are usually subject to longer survival periods (see below), higher caps (see below), and other enhanced protections. As such, the parties often negotiate as to which reps will be designated as fundamental. Reps that are not designated as such are often referred to as “non-fundamental” or “general” reps.

3. “Specific Indemnities”

These are usually protections focused on specific aspects of the business or known issues. Most commonly captured is ongoing litigation. Similar to fundamental reps, these will often have longer survival periods, higher caps and other protections.

4. “Survival”

Just like most warranties, the protections in an indemnification package will only survive for a set period of time, after which, even if the representation was false at the time the deal closed, the buyer will be out of luck. Most commonly, fundamental reps (see above), or representations regarding compliance with certain laws like tax law or employee benefits laws, will have a longer survival period than other reps. There are a few deal surveys published each year that give an indication of what is market standard at any given time.

5. “Cap”

The “cap” is the maximum damages that a person can seek to recover, either in the aggregate or from any one party. For fundamental reps, the purchaser can usually recover up to the purchase price. This can make sense because, as discussed above, a breach here may mean that the whole deal has been undermined. For reps other than fundamental reps, the cap is usually a percentage of the purchase price and is, at its core, a way that the parties share risk between themselves. Specific reps and tax reps may also have different caps. Overall, the higher the cap the more risk lies on the seller-side and, vice versa, the lower the cap, the more risk lies on the purchaser-side.

6. “Deductible” or “True Deductible”

Whether or not there is representation and warranty insurance, the purchaser will usually agree that it will bear a certain portion of damages before it can make a claim against the seller(s). Practically speaking, it would not be cost effective to make a claim for each minor issue, so again, this is another method of shifting risk between the parties: only when the aggregate value of all claims exceeds some materiality threshold will the buyer make claims. For a deductible, the seller(s) will only pay damages that exceed the deductible. For example, with a deductible of $80,000, if the purchaser has a $100,000 claim, the seller will only pay $20,000.

Note that RWI will usually have a deductible, often confusingly called a “retention.” As described above, the parties will agree on who will cover the amount until the retention is met.

7. “Tipping Basket” or “From the First Dollar”

Similar to a deductible, this is also a baseline threshold for damages where sellers will not pay damages until a certain materiality threshold is met. However, unlike a deductible, once the threshold is met, the seller will pay all the damages, even those below the threshold. For example, with a basket of $80,000, if the purchaser has a $100,000 claim, the seller will now pay $100,000 as the damages exceeded the threshold.

Sellers might also introduce a “De Minimus Basket” or “Mini Basket.” This is a method of preventing a buyer from making a claim for a number of small amounts that could, in the aggregate, exceed the deductible but are, in fact, only fairly minor breaches of the reps. These are often combined with “materiality scrapes,” as discussed below.

An important caveat is that the terms used for tipping baskets and true deductibles are mixed and matched depending on the drafter. The key is to look at how the limit is described. A true deductible usually includes language that states that only damages “that exceed” the limit are recoverable. In contrast, a tipping basket usually states that damages are recoverable “from the first dollar.”

8. “Escrow”

In this context, an escrow means an amount of the proceeds of sale that is kept in an escrow account with a third party to cover indemnification claims. This gives the purchaser security that, if they have a claim, it will be easy and cost-effective to recover. The escrow amount is usually negotiated as a percentage of the purchase price. Parties will sometimes also negotiate how long the escrow is held – but most often this is the survival period of the general reps (see above).

9. “Holdback”

In contrast to an escrow, the purchaser may ask for a holdback. Exactly as it sounds, the purchaser holds back a portion of the purchase price rather then pay it to the seller(s) at closing. A holdback is considered more favorable to the purchaser as it gives the purchaser more upfront power to retain funds.

10. “Sandbagging”

A purchaser “sandbags” a seller when a purchaser knows that a rep is false when the seller makes the rep but does not reveal this and instead waits for the deal to close and then makes a claim. Much is written about whether or not sandbagging is, in fact, allowable but parties will sometimes still include a clause that allows or prohibits sandbagging. The latter approach called an “anti-sandbagging clause.”

11. “Materiality Scrape”

Since the representations can be a significant source of liability for a seller, it is not unusual for seller’s counsel to ask for materiality qualifiers to soften the reps. An example may be that the seller has complied with the law “in all material respects.” While buyers may be willing to accept such qualifiers in some circumstances, such as for the purpose of reducing the seller’s burden when preparing the “Disclosure Schedule” (a materiality qualifier eliminate any obligation of seller to disclose immaterial matters) many buyers are not willing to reduce their recovery if the rep is only false in immaterial ways.

Many buyers will in fact argue that eliminating the “noise” is the purpose of a deductible or basket, and therefore having a materiality qualifier has the buyer doubling up on its exposure to immaterial matters. One solution, and often used when there is representation and warranty insurance, is a “materiality scrape.” This would be a provision saying that either for the purpose of determining whether a representation was breached, or in calculating the damages for such a breach, or both, any materiality qualifiers in that representation would be ignored.

Again, this allows sellers to only disclose “material” issues, but the buyer to be covered for all issues, even if the seller thought they were immaterial. To avoid buyers making a plethora of de minimis claims and therefore exceeding the basket, when buyers propose a materiality scrape seller counsel will sometimes ask for a “mini basket” in return.  

Conclusion

At Procopio, we aim to give our clients a nuanced and practical perspective of the deal on the table. By understanding the indemnification package that is on offer, we empower the business teams we work with to drive value and reduce risk. We’ve tried to explain some of the jargon you may hear when you try to sell your business, but nothing will replace the guidance of a qualified M&A attorney translating this sometimes foreign language on your behalf!