Articles & Advisories Publication: Farrell Fritz

Selling Your Business: Baskets, Deductibles and Caps, Oh My!

By Lyle C. Mahler

You’re a business owner and have spent years nurturing and growing your business into a valuable asset, and now you have decided it’s finally time to monetize that asset and sell your business. You go about the process of engaging an investment bank or business broker to help you find a suitable buyer. You negotiate a purchase price and the payment terms, and you’re ready to close on the sale of your business. But hold on, your lawyer then begins the process of negotiating the purchase agreement and starts to talk to you about indemnities and terms like “baskets”, “deductibles” and “caps”. Say what? You tell her that you just want to sell your business and get the purchase price … “what’s all this stuff about indemnity and these strange terms??

A concept often little understood by business owners is the indemnity provisions of the purchase and sale agreement.[1]

So why do we need an indemnity provision at all, you ask your lawyer? The Buyer has done his due diligence on my business. I have certified financials, have shown him everything I have in my books and records, and I have allowed him to speak with my employees. What else do they need?

Well, as the Seller, you are going to be asked to make a number of representations and warranties about your business, which serve the purpose of essentially certifying to the Buyer what he has learned during his due diligence of your company. These reps and warranties are used by the Buyer to confirm that the facts about your business, as he understands them, justify the purchase price he is paying. The indemnity provision acts as a means of insurance for the Buyer in the event it turns out that some of the Seller’s representations and warranties are not completely true and correct, and such misrepresentation results in the Buyer incurring unexpected expenses or losses from buying your business or otherwise negatively impacts the value of the business. In such a circumstance the Buyer is going to want restitution.

Well here is where the “fun” begins, IF the Seller is being properly represented, the attorney will negotiate protections and limits on the Seller’s exposure to indemnification claims. The “basket” concept requires that the aggregate amount of losses incurred by the Buyer resulting from inaccuracies in the representations and warranties exceed a specified minimum dollar amount before the Buyer can recover. Buyers will often be receptive to baskets since they don’t want to have to go after Seller for every $10 loss. Buyers, however, will generally push to structure the basket as a “threshold”, meaning once the dollar amount of the basket is reached, the Seller is responsible for the total amount of the losses starting from dollar one! Sellers, on the other hand, will want to structure the basket as a “deductible”, meaning the Seller is only responsible for losses that exceed the basket amount.

Another very important item to address in the negotiation of indemnity provisions is the “indemnity cap”. Why a cap? Well, if you are selling your business for $2 million, you wouldn’t want your buyer to be able to seek indemnity from you for $3 million of losses! That’s not a very good business model.[2] So, the purpose of the cap is to put some limit on the Seller’s post-closing indemnity exposure for breaches of representations and warranties. Obviously, Sellers will want to make the cap as low as possible. Buyers, however, will resist a very low cap and will also try to exclude certain representations and warranties from the cap at all. This tug-of war often results in different tiered caps of varying amounts which cover different types of reps and warranties.

Ultimately, where the parties end up on these points is often the result of some compromise and frequently depends on each party’s relative bargaining power, leverage and the gives and gets each negotiates with respect to other provisions of the purchase agreement.

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[1] While representation and warranty insurance has started to become popular as an alternative or supplement to indemnity provisions, given the inherent cost of obtaining that insurance, it is typically reserved for transactions in excess of $50 million. So for the typical owner in the middle market, they are going to have to learn about, and come to understand, the indemnity provisions of their agreement and their associated terms.

[2] In actuality, it may be proper to exclude certain representations (e.g. capitalization, environmental) and liabilities from the cap.