Indemnification Obligation Limits in Stock Purchase Agreements
In an earlier post, stock purchase agreements were addressed, with brief mention of principal clauses including indemnification provisions. This post will focus directly on the utility of indemnification obligation limits in stock purchase agreements. The indemnification obligations imposed on stockholders of the target company are typically subject to either a threshold, deductible, or cap. A threshold means the buyer has to withhold indemnification claims until it has actual indemnifiable losses equal to or above the threshold amount, and then it receives full compensation for all losses incurred. A deductible is more favorable to target stockholders, forcing the buyer to absorb a stated floor of indemnifiable losses, only receiving compensation for those indemnifiable losses exceeding that amount.
The decision whether to impose thresholds or deductibles can substantially affect the deal value, and thus is a point heavily negotiated in any M&A transaction. Other value-altering terms may be negotiated as well, beyond just the threshold and deductible amounts, which might vary substantially depending on the deal size. A target company may seek to impose a “noise level” in which any individual claim for indemnity must have losses exceeding a stated amount in order to be recovered by the buyer. These clauses have obvious downstream effects on the ability of a buyer to reach deductible or threshold amounts through aggregation of multiple claims.
In addition, the total possible indemnification liability of the target stockholders will usually be capped at an amount negotiated with the buyer. That amount may be as high as the entire value of the deal, or much smaller, depending on several factors and market conditions. Deals may even include separate caps for individual stockholders of the target company, limiting that stockholder’s indemnification obligations to the amount of transaction proceeds the stockholder receives in connection with the deal. These individual caps are a sort of safety valve for stockholders to placate fears that indemnity might lead to a net loss on the deal.
Institutions seeking to circumscribe their potential indemnification liability with even greater certainty and precision may resort to other even more creative methods. One such method is limiting a buyer’s remedy for indemnification to funds placed in escrow, effectively limiting the total potential liability of target stockholders. Any imposed caps are in turn usually subject to carve-outs for certain losses arising from breaches of fundamental representations and warranties, or fraud and willful misconduct by the target and target stockholders; these carve-outs are subject to heavy negotiations as well, which should now come as no surprise to anyone with some exposure to basic deal making.