Indemnification and Limitations of Liability: The Core Risk Allocation in any Commercial Contract
Takeaway: The indemnification and limitation of liability clauses are the most heavily negotiated terms in any major contract; they work together to define who pays for what when something goes wrong.
When you sign a commercial contract, you are not just agreeing on a price and a service; you are entering into a complex legal relationship that allocates risk between you and your customer. Of all the dense legal language in a Master Service Agreement, two clauses do the most work in defining this risk allocation: Indemnification and Limitation of Liability.
These two provisions are deeply intertwined and are often the subject of intense negotiation between lawyers. Understanding how they work is critical for any founder who is signing a major customer or partnership agreement.
Indemnification: "I'll Cover Your Legal Bills"
Indemnification is a promise by one party (the "indemnitor") to pay the costs, including legal fees and damages, of the other party (the "indemnitee") if a specific type of third-party lawsuit arises.
The Most Common Use Case (IP Indemnity): As a startup selling software, the most important indemnity you will provide is the intellectual property indemnity. You will promise your customer that if they get sued by a third party who claims that their use of your software infringes on that third party's patent or copyright, you will step in and pay for the customer's legal defense and any resulting damages. This is a standard and reasonable request from a customer; they need to know that you will stand behind your product.
Limitation of Liability (LoL): "The Financial Cap"
While you may agree to indemnify your customer for certain risks, your company cannot accept unlimited liability. The Limitation of Liability (LoL) clause is the most important provision for protecting your company. It places a cap on the total amount of damages that you can be liable for under the agreement.
The LoL is typically broken into several parts:
The General "Cap": This is the main liability cap for most breaches of the contract (like a failure of your service). A standard, market-rate cap is the total amount of fees paid by the customer in the preceding 12 months. This ensures that your total liability to a customer is tied to the economic value of that customer relationship.
The "Super Cap": Some agreements will have a higher "super cap" (e.g., 2x or 3x the annual fees) for breaches of more critical obligations, like your confidentiality duties.
The "Uncapped" Carve-Outs: This is the most heavily negotiated part. The customer will demand that certain "critical" breaches be completely excluded from the liability cap, meaning your liability would be unlimited. The standard and most important carve-out is for your IP indemnification obligations. Most customers will demand that your promise to protect them from IP infringement lawsuits be uncapped.
The negotiation over these two clauses is a complex dance. Your goal is to provide a reasonable indemnity to give your customer confidence, while ensuring your own financial exposure is limited by a strong and clearly defined liability cap.
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.