Legal Issues When Buying a Business: Indemnification Basket

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As discussed in prior installments of this series on buying a business, there are a number important legal issues you need to consider before signing the purchase agreement.  The first installment discussed the role of the Exclusivity Agreement, and the second installment examined the differences between structuring the transaction as stock purchase as opposed to a purchase of assets.  This Part III stays on the theme of key provisions of the purchase agreement by exploring the importance of escrowing a portion of the purchase price to cover any issues that may arise post closing whether the deal is structured as a stock or asset purchase transaction.

 When buying a business, the purchase agreement will include a number of covenants requiring a party to specifically perform certain actions post closing, representations, and indemnifications which may survive the closing of the transaction.  Covenants can include such significant post-closing obligations as assisting the buyer with transition of customers, completing and delivery tax documents, the resolution of outstanding litigation, filing of intellectual properly assignments, and the Seller's completion of items that could not be resolved prior to closing.  Similarly, the purchase agreement will also include representations that survive closing and indemnification rights protecting the Buyer against third party claims arising from pre-closing events (think: environmental representations).  What happens, however, if the Seller fails to perform the post-closing obligations, breaches a representation that survived the closing or a thrid party asserts a claim against the purchased assets giving rise to indemnification rights?  Of course, the Buyer can file a lawsuit to enforce its rights, but resolution of litigation can be very costly and drag out for years.  And, even if the Buyer eventually prevails on the claim, very often the Seller no longer has the financial ability to satisfy the claim.

 The solution to addressing post-closing liabilities is to create a basket of segregated funds to be available for post-closing claims.  In other words, the parties should agree to escrow a reasonable portion of the purchase price for a defined period of time after the closing.  The time period will vary:  of course the Buyer will demand a longer period and the Seller a shorter post-closing escrow, and this will often be an important negotiated aspect of the purchase Agreement.  An alternative to setting up an escrow is simply allowing the Buyer to hold back a portion of the purchase price to cover post-closing claims.  The Buyer would likely prefer a hold back because it will continue to control a portion of the purchase price, but the Seller should require an escrow arrangement rather than leaving part of the purchase price in the hands of the Buyer.  Under the escrow arrangement, a third party ("escrow agent") holds the portion of funds set aside from the purchase price and can only release the escrowed funds in accordance with the provisions of the purchase agreement.

 If the parties agree to include an escrow of funds to cover post-closing claims, they must carefully draft the terms of the escrow and be sure to address:

• The amount of the escrow, which can be further broken down based on the type of claim asserted (for example, the inability to settle an outstanding litigation may allow Buyer to use a defined amount of the escrowed funds to settle the claim).
• The time period for holding the funds in escrow, and even the time period by which certain types of claims must be asserted before they are deemed waived.
• The actual procedure for the Buyer to assert a claim, the notice required to the Seller, and the right of the Seller to dispute the claim.
• How disputes are to be resolved, which can include referral to a mediator or arbitration.
• When the escrow agent is permitted to release all or a portion of the funds to seller or buyer, as applicable.

Both the Buyer and Seller need to pay particular attention as to how post-closing claims are to be handled under the terms of the purchase agreement.  The parties need to set forth clearly what claims can give rise to an obligation on the part of the Seller post-closing and the mechanism for the enforcement of those claims.  The escrow of a portion of the purchase price is a common tool for addressing these issues, but the parties must make sure the purchase agreement clearly spells out when the Buyer can assert a claim against the escrowed funds and the procedures for making post-closing claims.
  Disclaimer: The discussions in this blog do not constitute legal advice nor create any attorney-client relationship.  You are urged to seek the advice of an experienced lawyer who can provide counsel with respect to your corporate/business law matters