How does indemnification work in an acquisition?
Takeaway: Indemnification is the buyer's primary protection against a breach of your reps and warranties; it is a formal legal process that allows them to recover their financial losses by making a claim against the purchase price you received.
In an M&A agreement, the "representations and warranties" are the promises you make, and indemnification is the enforcement mechanism—the "teeth" that give those promises legal and financial power. Indemnification is the legal process that allows the buyer to be "made whole" by seeking monetary damages from you and the other sellers if they discover a problem with the company after the deal has closed.
Understanding how indemnification works is critical because it means that your financial liability does not necessarily end on the closing date. The purchase price you receive is often contingent and at risk for a significant period of time.
The Indemnification Process
The Discovery of a Breach: After the acquisition closes, the buyer may discover an issue that constitutes a breach of one of the reps & warranties you made. For example, they might be hit with a lawsuit that you failed to disclose, or they might discover a major tax liability that was not on the books.
The Claim: The buyer will make a formal indemnity claim, alleging that they have suffered a financial loss as a direct result of your breach.
The Recovery: The indemnification provisions in the merger agreement will outline exactly how the buyer can recover those losses. This almost always involves making a claim against the escrow fund.
The Escrow Fund: The Sellers' "Deductible"
As we've discussed, it is standard practice for a portion of the purchase price (typically 10-15%) to be set aside in an escrow account, managed by a third-party escrow agent, for a period of 12-18 months after closing.
The Buyer's Recourse: This escrow fund is the buyer's primary and often exclusive source of recovery for most indemnity claims. It acts as a sort of "deductible" or "cap" on the sellers' liability.
The Tipping Basket vs. the Deductible: The agreement will specify a "basket," which is a minimum threshold of damages that must be reached before the buyer can make a claim. This can be structured as:
A "Tipping" Basket: Once the total damages exceed the basket amount, the buyer can recover the entire amount of the damages, from the first dollar.
A True "Deductible": The buyer can only recover the damages that are in excess of the basket amount.
Special Indemnities for High-Risk Issues
For certain fundamental or high-risk areas, the buyer will often demand a special indemnity that goes beyond the standard escrow limitations.
What They Are: A special indemnity might cover issues like your compliance with export controls or the ownership of your core intellectual property.
The Terms: For these specific issues, the sellers' liability may not be capped at the escrow amount (it could be up to the full purchase price) and the survival period for making a claim may be much longer.
The indemnification section is one of the most heavily negotiated parts of any M&A agreement. It is the core risk allocation mechanism of the deal, and it is essential to have experienced M&A counsel advising you to ensure the terms are fair and in line with market standards
Disclaimer: This post is for general informational purposes only and does not constitute legal, tax, or financial advice. Reading or relying on this content does not create an attorney–client relationship. Every startup’s situation is unique, and you should consult qualified legal or tax professionals before making decisions that may affect your business.