In an acquisition, particularly an equity acquisition, a buyer must perform extensive due diligence on the target company to understand, as thoroughly as possible, the risks associated with the acquisition. In most cases, however, the buyer cannot fully evaluate or even identify all sources of risk that it will assume post-closing. To address these uncertainties and allocate these potential risks, the buyer and seller negotiate indemnification provisions that set forth the scope of each party’s obligation to reimburse the other party for certain losses associated with the acquisition that may arise following closing. This blog, Part 2 in a 5-part series, discusses common indemnification provisions in purchase agreements and how they affect a buyer’s ability to recover for losses post-closing. Visit this link to access Part 1 in the series “Purchase Agreement Components, Part 1: Options for Forms of Purchase Price Consideration in Acquisition Agreements.”
Types of Representations and Warranties
A primary source of indemnification in a purchase agreement arises from a breach of a representation or warranty of the seller. The buyer relies on disclosures, representations, and warranties that the seller makes in the purchase agreement regarding the status, history, and operation of the target company and its business, including the accuracy of its financial statements and tax returns, any current and past litigation involving the target company, and the ownership of the target company’s assets and equity.
Typically, the purchase agreement assigns particular representations and warranties to one of two categories: (1) Fundamental Representations and (2) General Representations. Fundamental Representations include representations and warranties regarding the basic characteristics of the transactions and that, if that particular representation or warranty were not true, the buyer would not have proceeded with the transaction. Fundamental Representations typically include the ownership of the equity and capitalization of the target company, the target company’s ownership of its assets, due organization of the target company, and due authorization of the transaction under applicable state law. Representations and warranties that are not identified as Fundamental Representations in the purchase agreement are General Representations. A seller’s breach of any of these representations or warranties will provide the buyer with a basis to seek indemnification under the purchase agreement, and the extent of indemnification will depend on whether the breach pertains to a Fundamental or General Representation.
Even if the buyer has a claim for indemnification due to a breach of a representation or warranty, recovery of losses will likely be subject to an indemnification basket or deductible. In order to recover for losses under the purchase agreement, the aggregate of the buyer’s losses must exceed a certain amount, which is referred to as a “basket.” Baskets in lower middle market deals without indemnity insurance typically range from 0.5% to 1% of the total purchase price and vary depending upon whether the basket is a true deductible basket or a tipping basket. A true deductible basket permits the buyer to recover only the amount of losses that exceeds the basket amount; a tipping basket, on the other hand, permits the buyer to recover all of its losses once its losses exceed the basket. For example, if the acquisition agreement provides for a $50,000 basket and the buyer has $60,000 in losses, the buyer can recover only $10,000 of those losses with a true deductible basket, but can recover all $60,000 in losses with a tipping basket.
Indemnification for breaches of representations and warranties is also typically subject to maximum amounts, or caps, which usually vary depending on the type of representation or warranty that is breached. Because Fundamental Representations are vital to the transaction, the buyer can typically recover for losses up to the purchase price paid in the acquisition, and in some cases, recovery for losses related to Fundamental Representations may be uncapped. General Representations typically have the lowest cap, and a cap of 10% to 20% of the purchase is common in lower middle market deals without indemnity insurance, although a higher cap may be negotiated depending on the size of the transaction and the extent of potential risks.
In addition to caps on the amounts that the buyer can recover, representations and warranties are subject to survival periods, and the buyer will be unable to cover for claims that arise following the end of the applicable survival period. Fundamental Representations often have a survival period in excess of 5 years following closing and may survive indefinitely. General Representations usually survive for 12 to 24 months following closing, with 15 to 18 months being the most common survival range.
 Occasionally parties may negotiate a third category of representations that falls in a middle ground between “general” and “fundamental” and is subject to mid-length survival periods (often a statute of limitations) and a cap between the caps on “general” and “fundamental” representations.