Traps to Avoid When Selling a Business

Traps to Avoid When Selling a Business: Indemnification Provisions

Sellers often do not carefully consider how the indemnification provisions in a purchase agreement may impact them after the sale of their business. To avoid this and other traps, it is imperative to have an experienced business lawyer (not just your broker) review the purchase and sale contract before you sign.

Negotiating the sale of a business can be a long and arduous process. Once approaching the finish line, many business owners are eager to sign on the dotted line. While the eagerness is understandable, failing to fully appreciate your ongoing legal obligations can come back to bite you. 

Obligations Under an Indemnification Provision

Other than the provisions involving the business purchase price and payment terms, indemnification provisions are among the most important. From the seller’s perspective, the indemnification provisions should be drawn as narrowly as possible so as to avoid significant legal liability after the closing.

In basic terms, an indemnification provision shifts the liability for identified post-sale costs or losses from the buyer to the seller. In most cases, the losses covered by the indemnification provision must be related in some to way to representations, warranties, or other seller obligations established in the purchase agreement. In other cases, the buyer may require the seller to indemnify specific losses, such as those related to environmental contamination, tax obligations, or outstanding legal claims.

Limiting the Seller’s Post-Sale Liability

Because indemnification is closely related to the seller’s representations and warranties, it is imperative to review these contract provisions very carefully. Whenever possible, sellers should seek to address potential liabilities prior to putting the business up for sale, which can limit the representations and warranties a buyer may require.

Because violations of the seller’s representations and warranties can trigger indemnification, the disclosure of any adverse material facts should also be thoroughly documented during the negotiation process and acknowledged in writing by the buyer. Doing so helps address the threat of a buyer suing the seller for breach of warranties and representations when the adverse facts result in business costs or losses after the sale closes. For instance, the seller may disclose that a certain employee has raised an internal sexual harassment complaint. Unless the seller has agreed to indemnify the buyer for the claim, the buyer can’t hold the seller accountable if the worker later files a lawsuit.

As highlighted in a prior post, sellers can also limit their post-sale liability for minor losses and set a cap on their indemnification obligation. A “basket” sets a monetary threshold that must be exceeded for indemnification to kick in. Meanwhile, a “cap” limits the total amount of money that must be paid under the indemnification provision in the event of a breach.

Sellers should also try to limit the “survival period” for bringing claims for breach of the contract representations and warranties. Under New Jersey’s statute of limitations for breaches of contract, an aggrieved party typically has six years to bring a claim. However, sellers can often negotiate a much shorter survival period of 12-18 months in the purchase and sale agreement.

As highlighted above, there are several opportunities for sellers to limit their post-sale liability. When negotiating indemnification provisions, it is imperative to have a skilled negotiator in your corner.

Are you currently in the process of selling a business? Would you like to discuss the matter further? If so, please contact me, Dan Brecher, at 201-806-3364.