How does indemnification work in an acquisition?

Takeaway: Indemnification in startup acquisitions is a crucial risk-allocation mechanism where the seller promises to compensate the buyer for certain losses due to breaches of the representations and warranties. Understanding its nuances - including indemnification caps, escrow accounts, basket clauses, and exceptions - is key to protecting your interests in an acquisition deal.

Indemnification in startup acquisitions is a critical part of the contractual agreement that can impact the success of a deal and the financial outcomes for all parties involved. In essence, indemnification is a promise made by the seller to compensate the buyer for certain losses that may occur after the acquisition.

Indemnification provisions are triggered when there's a breach of the representations and warranties made by the seller in the acquisition agreement. These representations and warranties are factual assertions the seller makes about the company, its financials, and its operations. If these assertions are later found to be untrue, the buyer may incur financial losses. In such cases, the indemnification provisions stipulate that the seller compensates the buyer for these losses.

Typically, an acquisition agreement will set an indemnification cap, which is the maximum amount the seller can be obliged to pay for any claims made by the buyer (other than claims arising from fraud). Additionally, there's often a "basket" or "deductible" clause, which is a minimum threshold of losses the buyer must incur before they can make a claim. This prevents the buyer from making small claims that could constantly burden the seller.

In some cases, a portion of the purchase price is held in an escrow account for a certain period after the acquisition (the indemnity period). This money is used to satisfy any indemnification claims made by the buyer. Any amount remaining after all indemnification claims are settled is then released to the seller.

Indemnification is not absolute. There are often certain exceptions and carve-outs in the agreement. These exceptions vary from deal to deal and specify circumstances under which the seller would not be responsible for compensating the buyer.

Lastly, it's important to remember that while indemnification is a vital risk-allocation mechanism in acquisitions, it is a complex legal concept that requires careful consideration and expert advice. Working with experienced legal and financial advisors is crucial to understand and negotiate indemnification provisions that protect your interests in an acquisition.