Indemnification Caps and Baskets in Private Company M&A Transactions: What’s market?

M&A Practice Brief  

By: Alexander J. Wilson and David P. Creekman

In negotiating the terms for the acquisition of a privately held company, one of the most important considerations is the scope of the selling party’s indemnification obligations to the buyer. Most transactions of this type provide that, with a few exceptions (such as in the case of fraud), the indemnification provisions included in the purchase agreement will serve as the buyer’s sole recourse to recover from the seller for any losses or damages suffered by the buyer as a result of the transaction. As a result, it is important for both buyers and sellers to understand the most common terms and conditions of indemnification provisions. Two such terms are commonly referred to as “caps” and “baskets.”

What is a Cap?

A “cap” is the upper dollar limit of the seller’s indemnification obligations to the buyer. It is the total amount of losses and damages a buyer is entitled to recover from the seller. In negotiating an indemnification cap, a seller will clearly seek the lowest cap possible, while a buyer will seek a high cap or no cap at all.

Buyers and sellers can negotiate different caps to apply to different types of losses. Purchase agreements often include a negotiated indemnification cap that applies only to losses arising from breaches of the seller’s representations and warranties set forth in the purchase agreement. This general indemnification cap typically does not apply to losses arising from such things as breaches of the seller’s covenants under the purchase agreement, the seller’s tax liabilities, specified indemnification items and fraud committed by the seller. Further, such a cap usually does not apply to certain “fundamental” representations and warranties of the seller, which are those representations and warranties considered by the parties to be critical to the very basis of the transaction (such as the seller’s authority to enter into the transaction and the capitalization of the seller). For those matters to which the general indemnification cap does not apply, either the seller’s liability is uncapped (meaning the buyer can recover from the seller the full amount of its losses) or the purchase agreement contains a second, typically higher cap that applies to these items. Many times, this secondary cap is an amount equal to the purchase price.

What is considered “market” with respect to caps?

The median cap for losses related to general representations and warranties in reported M&A transactions that include a cap is approximately 10% of the total transaction value, but caps range from as low as less than 1% of the total transaction value to 100% of transaction value. Recent market studies show that over half of all reported deals have caps of 10% or less of the total transaction value. The size of the cap often correlates to transaction size: almost 75% of the transactions having a cap in excess of 20% of total transaction value involve a transaction value of less than $75 million. Transactions larger than $100 million have caps that are consistently at or below 10% of the transaction value.

As noted above, indemnification items excluded from the general cap are often subject to a secondary cap that is often equal to the purchase price, though these caps vary in amount as well. In addition, many deals provide that any losses arising out of fraud will not be subject to any cap at all. However, sophisticated sellers, especially venture capital and private equity owners, are increasingly negotiating for an ultimate cap even in the case of fraud.

What is a Basket?

A “basket” (sometimes called a “deductible”) is a threshold amount of losses and damages that a buyer must incur before it is entitled to any indemnification from the seller. In M&A terminology, a basket is often referred to as either a “tipping basket” or a “true deductible.” A tipping basket provides that once the buyer has incurred losses equal to the agreed amount, the buyer is entitled to full recovery of all losses, from the first dollar of losses. For example, assuming a transaction provided for a $50,000 tipping basket, if the buyer suffered $40,000 of losses, it would not be entitled to any recovery, but, after incurring an additional $10,000 of losses, the buyer would be entitled to recover all $50,000 of losses. A true deductible works similarly to a deductible on an insurance policy in that it provides for recovery only to the extent that losses exceed the deductible. Again assuming a $50,000 basket (set up as a true deductible), if the buyer suffered $50,000 of losses, it would not be entitled to any recovery, and, if the buyer incurred $80,000 of losses, it would be entitled to recover only the amount above the deductible, or $30,000. Thus, a true deductible is the more favorable formulation for a seller and a tipping basket is more beneficial to a buyer. Often, negotiating which type of basket will apply in a given deal goes hand in hand with agreeing on the amount of the basket.

In a small percentage of reported transactions, the parties agree upon a hybrid formulation, called a “partially tipping basket,” which combines a tipping basket with a true deductible. Under this approach, the buyer will be able to recover some but not all of the losses equal to the basket amount. For example, the parties might provide a basket of $50,000 and a true deductible of $25,000. The buyer may not recover any losses until it has incurred at least $50,000 in losses, and then it will be entitled to recover only losses in excess of $25,000.

What is considered “market” with respect to baskets?

For transactions having a value in excess of $10 million, a true deductible is the most common type of basket, appearing in more than 60% of all reported transactions of that size. The second most commonly used basket is the tipping basket. The hybrid approach is found in only a small percentage of reported transactions of this size, and a few deals have no basket at all. The amount of the basket is 0.5% or less of total transaction value in a majority of deals of this size and between 0.5% and 1.0% of transaction value in about one-third of such deals.

In smaller deals (under $10 million), market reports show that almost 70% of the reported transactions have a tipping basket or no basket. In deals of this size, the basket amount is typically higher as a percentage of deal value than in larger transactions, but the absolute dollar value of the basket is lower than in larger deals.

Conclusion

Understanding the impact of caps and baskets on indemnification liability in private M&A transactions is important for both buyers and sellers. These terms will impact the amount that a buyer may recover in the event it incurs losses in connection with the transaction, and allow a seller to limit its potential post-closing liability. When negotiating these terms, it is helpful to understand what is typically seen in the M&A market and how transaction size can affect the size of a basket or cap. Ultimately, however, the most important factors determining where these terms will come out will be the respective bargaining power of the parties, advice of counsel, negotiation of other risk-sharing provisions, and the relative importance of these particular points to the parties.

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Alex Wilson and David Creekman are attorneys in the M&A practice group of Wyrick Robbins Yates & Ponton LLP, which represents clients across a broad range of industries in connection with their significant corporate transactions. The group publishes Practice Briefs periodically as a service to clients and friends. The purpose of this Practice Brief is to provide general information, and it is not intended to provide, and should not be relied upon as, legal advice.