Indemnification
Contractual obligation by one party to compensate another for losses arising from specified events or breaches.
Indemnification is a contractual provision in which one party (the indemnitor) agrees to compensate another party (the indemnitee) for losses, damages, costs, and expenses arising from specified events—most commonly breaches of representations and warranties, pre-closing liabilities, fraud, or specific known risks disclosed in the agreement. Indemnification provisions are among the most heavily negotiated provisions in M&A, financing, and commercial agreements.
In M&A transactions, indemnification provisions specify: what triggers an obligation (breach of reps/warranties, pre-closing taxes, specific liabilities), the deductible structure (retention or 'basket'—the minimum loss threshold before indemnification kicks in), the cap on maximum liability (often 10–20% of purchase price for general indemnities), survival periods (how long after closing claims can be made), and the remedy (cash payment, escrow release).
Baskets come in two types: a 'tipping basket' (once losses exceed the threshold, the full amount from dollar one is recoverable) vs. a 'deductible basket' (only losses above the threshold are recoverable). Sellers prefer deductible baskets; buyers prefer tipping baskets.
Escrow holdbacks—typically 5–10% of purchase price held in escrow for 12–18 months—provide a funded source for buyer indemnification claims without requiring sellers to return already-distributed proceeds. Representations and Warranties Insurance increasingly replaces escrow holdbacks by having an insurer bear the risk.
Commercial agreements (software licenses, service agreements, vendor contracts) also contain indemnification provisions, most commonly covering IP infringement claims (vendor indemnifies customer against third-party patent suits) and gross negligence or willful misconduct.
FAQs
What is a basket and a cap in M&A indemnification?
A basket is the minimum loss threshold that must be reached before indemnification obligations arise—functioning like a deductible. It prevents costly litigation over trivial claims. A tipping basket means once the threshold is crossed, the full amount from dollar one is recoverable; a deductible basket means only losses above the threshold are compensable. A cap is the maximum aggregate indemnification liability, typically expressed as a percentage of the purchase price. Together, basket and cap define the 'indemnification corridor' within which the indemnitor's financial exposure lies.
Can indemnification obligations survive after the agreement terminates?
Yes—indemnification obligations in purchase agreements survive the closing of the transaction for the agreed survival period, even though the main agreement is 'completed' at closing. This is the purpose of survival periods: they define how long the indemnification obligations remain enforceable. Some indemnification obligations (tax indemnities, fraud, and fundamental representation breaches) often survive for the full statute of limitations period or indefinitely because the potential severity and latency of such claims justifies extended protection for buyers.
What is a specific indemnity versus a general indemnity?
A general indemnity covers breaches of any representation or warranty in the agreement, subject to the basket and cap. A specific (or targeted) indemnity covers a known, specifically identified risk that is disclosed in the diligence process but is too risky to handle solely through representations. For example, a company with pending litigation, a known environmental remediation issue, or uncertain tax positions might give a specific indemnity covering those items—often with no basket (dollar-one coverage) and no cap (or a higher cap than the general indemnity), reflecting the higher certainty and severity of the known risk.
Related Terms
Representations and Warranties
Contractual statements of fact in a purchase agreement that allocate risk between buyer and seller.
Due Diligence
Systematic investigation of a business or investment to verify facts and identify material risks before closing.
Earnout
Contingent payment mechanism tying part of the acquisition price to the target's future financial performance.
Term Sheet
Non-binding document outlining the key terms of a proposed investment or acquisition deal.
