Why Indemnification Is Important In Stock Purchase Agreements?

By - August 29, 2024 - Uncategorized

Stock purchase agreements (SPAs), also called share purchase agreements, are crucial documents involved in the process of buying or selling a business. Within the agreement, indemnification provisions can be included to protect the buyer and the seller from unforeseen liabilities and to help the transaction go smoothly. Let’s take a closer look at what indemnifications are and why they’re so important in a stock purchase agreement.

What Is Indemnity and Why Is It Important in Stock Purchase Agreements?

In the context of legal agreements, “indemnity” refers to a contractual obligation in which one party (the indemnitor) agrees to compensate another party (the indemnitee) for specific losses, damages, or liabilities that may arise related to the purchase agreement. By outlining the responsibilities and liabilities of the buyer and seller, indemnification provisions help everyone involved understand and manage risk, as well as set a plan in place for any potential issues that may arise in the future.

Indemnification provisions are especially helpful for the buyer, who relies on representations and warranties made by the seller to better understand the business’s financial status, legal compliance, tax compliance, and other significant aspects of the company. The provisions ensure that if any of the information given to the buyer is inaccurate, the buyer can seek compensation.

Types of Indemnification Provisions

There are a variety of indemnification provisions, including clauses for breaches, assumed liabilities, and mutual clauses that protect the buyer and the seller.  

Seller Indemnification for Breach of Contract

In this provision, the seller offers indemnity, or protection, to the buyer in the event that the seller breaches the contract, and it results in losses. This also includes inaccuracies in the warranties and representations that the seller makes about the company, such as the company’s finances, operations, and/or legal compliance. This clause is helpful because it protects the buyer from unexpected liabilities and holds the seller responsible for providing accurate information. 

Buyer Indemnification for Assumed Liabilities

A buyer may choose to indemnify, or protect, the seller from specific liabilities that the buyer takes on when they purchase a business. These liabilities typically include specific debts or obligations of the business. The buyer, rather than the seller, is then responsible for any claims or losses related to these assumed liabilities. This clause is important because it clarifies who is responsible for which liabilities. This protects the seller from future claims related to the liabilities that the buyer assumes.

Mutual Indemnification Clauses

In transactions where buyers and sellers both make representations and warranties, they may choose to include mutual indemnification clauses. These clauses protect both the buyer and the seller, as both parties must indemnify the other for breaches of their respective warranties and representations. Mutual indemnity is helpful because it creates a more balanced approach to risk management and offers both parties protection from potential breaches.

Key Elements of Clauses: Information for Each Party

Indemnity clauses include information that helps buyers and sellers understand their risks and protections. The clause should address a few key points to make sure it’s clear and can be easily enforced.

• Scope: This clearly states what is covered under the provision, including specific types of losses, liabilities, and damage. Relevant exclusions should also be mentioned. 
• Survival period of obligations: Clauses that indemnify buyers or sellers typically do not last forever. The purchase agreement should specify how long the clauses will remain in effect.
• Limitations and caps on liability: A stock/share purchase agreement may place a cap on liability, limiting the financial exposure of the indemnitor. These limitations can make liabilities more predictable for both parties when buying or selling a business.

Benefits for Buyers

After purchasing a company, buyers may face risks and liabilities that they were not expecting. Having the right provisions in place to address these unknown issues ahead of time helps protect buyers from unforeseen circumstances. For example, if someone purchases a company and later learns that the seller did not honestly represent the business’s financial condition, or learns that the company does not comply with the necessary laws and regulations when the seller said it does, the seller is responsible for covering the buyer’s losses. These clauses help keep sellers honest, and give buyers a way to seek compensation if the sellers are not honest.

Benefits for Sellers

Although buyers are usually the ones protected under these clauses in an agreement, sellers may benefit as well. Sellers can negotiate the terms of the provisions, allowing them to set caps on their liability and ensure their exposure to claims has a set end date following the completion of the sale. These terms help sellers define their responsibilities and make sure their obligations are both reasonable and manageable. 

Common Negotiation Points

Negotiating the terms of provisions that indemnify buyers or sellers can be intense. Before entering into negotiations, it’s helpful to consider some of the key discussion points that may arise. 

• Determining the survival period for indemnities: Obligations will only remain in effect for a set period of time, and buyers and sellers must agree on this time frame. Buyers often prefer longer periods to ensure future liabilities are covered, while sellers typically prefer shorter periods to limit their liability. 
• Setting liability caps and thresholds: It’s common to set caps on liability for buyers and sellers. This provides clarity and protection for both parties, as well as helps prevent disproportionately large claims.
• Agreeing on dispute resolution mechanisms: Even with protections in place, disputes may still come up. That’s why it’s helpful to agree ahead of time how both parties will work together to resolve disputes. This predetermined process may include mechanisms like mediation, arbitration, or litigation.

Contact Stevens Law

Indemnities are crucial components of stock purchase and sale agreements. By clearly outlining the terms of the agreement, buyers and sellers can complete the business transaction with the coverage necessary to help both parties mitigate risk while understanding their post-transaction obligations. When it’s time to draft the agreement, consider consulting an experienced business lawyer who can work with your best interests in mind. 

At Stevens Law, we have years of experience helping businesses of all sizes in mergers and acquisitions, commercial real estate, real estate syndication, and more. Whether you’re purchasing a company, selling one, or merging two together, our attorneys can help you understand what to expect, assist with contracts and documents (including drafting a purchase agreement), and guide you through the legal process. 

To learn more about our services, fill out our online contact form or give us a call at (614) 826-3100.