The Indemnification Cap and Basket: How Advisors Size What Can Come Back After Closing
A seller I worked with agreed to a 40 million dollar price and then spent three weeks negotiating the sentence that mattered more than the price. It said that for eighteen months after closing, the buyer could claim back up to 20 percent of the purchase price for breaches of the seller's representations. Nobody had flagged it at the letter of intent stage, because the LOI said only that the agreement would contain “customary indemnification.” Customary turned out to be a range wide enough to move eight million dollars. The founder had been negotiating the number on the front page while the number in the back of the agreement was quietly deciding how much of it he would keep.
That is the advisor’s blind spot in many lower middle market processes. We are paid to run the price conversation, and the indemnification package gets handed to counsel as legal boilerplate. It is not boilerplate. The basket, the cap, the survival period and the carve-outs together define the maximum amount of the sale proceeds that can come back to the buyer, and how easily. I am not a lawyer and none of this is legal advice; the seller’s attorney drafts and negotiates the language. The advisor’s job is to make sure the economic terms are on the table early, priced like any other term, and understood by the founder before the draft agreement arrives.
Start with the basket, because it decides how small a claim can be and still cost the seller money. A basket is a threshold of losses the buyer must absorb before the seller owes anything. There are two forms and they behave very differently. A deductible basket means the seller pays only for losses above the threshold. A tipping basket, sometimes called a first-dollar basket, means that once losses cross the threshold the seller pays from the first dollar. On a 40 million dollar deal with a threshold of 300,000 dollars and a buyer claim of 400,000 dollars, a deductible leaves the seller owing 100,000 dollars and a tipping basket leaves him owing all 400,000. Same headline number, a 300,000 dollar swing. Ask which form the buyer has in mind at the LOI stage, not at the signing table.
Second, the cap. The cap is the ceiling on the seller’s general indemnity exposure, usually stated as a percentage of the purchase price or as a fixed amount. This is where the advisor should do arithmetic, because the cap interacts with everything else in the deal. If part of the price is an earnout or a seller note, ask whether the buyer can set off a claim against those payments, and whether the cap measures total exposure or only what sits in escrow. A cap equal to the escrow means the escrow is the buyer’s sole source of recovery for ordinary claims. A cap above the escrow means the seller’s other proceeds are exposed, and the founder needs to know that before he spends any of it. I covered one version of this in the post-closing true-up, where the money flows after closing are often larger than founders expect.
Third, survival. Representations do not last forever; each one survives for a stated period, after which the buyer can no longer claim. General representations commonly survive for a fixed term of a year or two, while a short list of fundamental representations, such as authority to sign, ownership of the shares and sometimes taxes, survive much longer or until the statute of limitations runs. Founders tend to hear “eighteen months” and assume everything ends then. Ask for the survival schedule rep by rep. A buyer who proposes that every representation is fundamental has converted a time-limited risk into an open-ended one, and that deserves a price conversation of its own.
Fourth, the carve-outs, which are the places where the cap and the basket stop applying. Fraud is almost always outside the cap, and that is fair. The disagreement is over the definition. A narrow definition covers deliberate, intentional misstatement by the seller. A wide one reaches recklessness or reaches fraud by any person in the company, which can pull an employee’s mistake into the founder’s uncapped personal exposure. Read the definition. The same applies to the fundamental representations and to specific indemnities that a buyer adds for a known problem, such as a pending dispute or a tax position. A specific indemnity can be perfectly reasonable, but it should come with its own cap, its own time limit and a clear way of ending it, or it becomes a permanent lien on the proceeds.
Fifth, understand how this changes when the deal uses a representations and warranties policy. As I wrote in how reps and warranties insurance changes the advisor’s job, insurance can shrink the seller’s exposure to a small retention, which is a very different negotiation from an uninsured deal with a large escrow. But the policy has exclusions, and anything excluded tends to reappear as a seller indemnity. Ask for the list of exclusions early, because a broad exclusions list can bring the old exposure back through the side door.
Sixth, connect the indemnification terms to the disclosure work. The more completely the schedules disclose, the fewer breaches there are to claim. As I argued in the piece on disclosure schedules, that work is the seller’s first line of protection, and the indemnification package is the second. A seller with thin schedules and a generous indemnity is paying twice for the same gap. A seller with thorough schedules can credibly ask for a lower cap and a shorter survival, because the buyer has less to be surprised by.
Seventh, price the package when you compare offers. A bid with a higher headline and a heavy indemnity can be worth less than a lower bid with a clean one, which is the point I made in scoring competing letters of intent. Put each offer through the same questions. What is the basket and is it a deductible? What is the cap and what does it include? What survives and for how long? What is carved out? Then estimate, even roughly, the dollars that could plausibly come back under each package. You will not get a precise number, and you do not need one. You need a consistent way of seeing that two offers with the same headline are not the same offer.
There is a fair answer from the buyer’s side, and an advisor should say it out loud to the founder. The buyer is paying for a business it has examined for a few weeks, and the indemnity is how it protects itself against what it could not see. A seller who resists every protection signals that he is worried about what the diligence will find, and that costs him more than the clause does. The goal is not to win each point. It is to arrive at a package where the amount at risk is sized to the real risk in the business, and where the founder knows that number before he signs.
The founder with the 20 percent proposal ended up at a 10 percent cap equal to the escrow, a deductible basket at roughly three-quarters of one percent of the price, a twelve month general survival, and fundamental representations limited to authority, title and taxes. The buyer gave ground quickly once the seller’s counsel and I showed we had priced each term and could point to the schedules. None of it was dramatic. It came from putting the back of the agreement on the table at the same time as the front. Helping founders see that whole picture early is a large part of the work at Cordis Group.