M&A & exit
Indemnification
Seller's contractual promise to compensate buyer for losses from breaches of reps, warranties, or covenants.
Definition
Indemnification in M&A is the seller's contractual promise to compensate the buyer for losses arising from breaches of the seller's representations, warranties, or covenants in the Share Purchase Agreement (SPA). The indemnification framework specifies which losses are recoverable, how recovery is calculated, the limits on recovery (caps, baskets, survival periods), and the mechanics for claims. It is the primary risk-allocation tool in M&A.
Same concept, different references
| Canada (common law) | Indemnification, contractual |
|---|---|
| Quebec (Civil Code) | Indemnité, art. 1373+ CCQ |
| US (state law) | Indemnification, governed by SPA and state contract law |
| Director indemnity | CBCA s. 124 — distinct corporate indemnification rules |
Indemnification framework components
A typical SPA indemnification section includes several interconnected provisions:
- Covered breaches: which categories of reps and warranties are subject to indemnification (general reps, fundamental reps, tax reps, etc.)
- Survival periods: how long after closing the reps are 'live' — typically 12-24 months for general reps, 6 years for fundamental reps (capital structure, title to shares), longer for tax matters
- De minimis threshold: minimum claim size before any claim counts (e.g., $25,000 — claims below ignored)
- Basket (deductible): aggregate amount of small claims before any indemnity is paid (e.g., $250K - $500K)
- Cap: maximum cumulative indemnity (e.g., 10-20% of purchase price for general reps; 100% for fundamental reps)
- Mechanics: notice procedures, dispute resolution, escrow agent role, R&W insurance interaction
Caps and baskets in practice
Two parameters drive the economic exposure of the indemnity:
- Tipping basket: once cumulative claims exceed the basket threshold, the entire amount is recoverable (i.e., basket is a deductible until tripped, then full)
- Real basket: only the amount above the basket is recoverable (basket is a true deductible)
- Tipping basket is more common — once $500K of claims are accumulated, all the claims (including the $499K accumulated) are paid
- Cap: typical mid-market cap of 10-15% of purchase price; larger deals trend lower (5-10%); deals with R&W insurance trend even lower (1-3% as a 'tail' beyond insurance)
Fundamental reps vs general reps
The SPA categorizes representations by importance:
- Fundamental reps: corporate existence, authority to enter agreement, title to shares, capitalization. Survive 6 years; cap is 100% of purchase price
- Tax reps: 6+ year survival; cap usually 100% of purchase price
- General reps: business operations, contracts, IP, employees. Survive 12-24 months; cap of 10-20% of purchase price
- Specific reps: particular high-risk areas (environmental, employment, regulatory) — survive longer, sometimes separate cap
In Octelligence
Indemnification framed by the corporate record.
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