Holly founded ExitPromise.com as well as StartupPromise.com and so far has answered more than 3,000 questions asked by business owners about starting, growing and selling a business.
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The “indemnification basket” is one of the most important deal terms found in the Letter of Intent and ultimately in the Purchase Agreement and is often misunderstood by both the buyer and seller of a business.
Buyers want the basket to be as low as possible and Sellers want it to be as high as possible. Baskets may be one of two types: a deductible basket or a tipping basket. Understanding the specific way a basket works, as negotiated and defined in a purchase agreement, will prevent you from leaving money on the table when it’s time to sell your business.
Before we address when the indemnification clause should be negotiated, let’s clarify what exactly the indemnification is and why it’s important to both buyers and sellers.
Indemnification Basket Definition
When you sell a business, typically you will find language in the Stock or Asset Purchase Agreement that defines exactly what the Seller and the Buyer agree to do or guarantee as part of the transaction. In other words, each may agree to make the other party not responsible. The term used to identify this particular form of guarantee is indemnification.
To indemnify another party in the sale or purchase of a business means the party being indemnified is not responsible.
Often the language in a Stock or Asset Purchase Agreement related to the indemnification clause in the sale of a business is hotly debated by the buyer’s and seller’s respective legal counsels.
The reason for this elevated attention to the indemnification language has to do with post-closing liabilities. If one party in the transaction indemnifies the other with regard to a specific matter and that matter triggers a financial loss after the acquisition or sale has closed, then the party who indemnified the other may be held financially responsible up to the amount of the loss sustained.
Because the legal and financial ramifications may be extensive, it’s advisable to insist that legal counsel clearly spells out for the seller or buyer the potential risks associated with an indemnification clause in the sale of a business.
When Should Indemnification Be Negotiated?
If you are the business owner selling your business, this term should be negotiated when the Letter of Intent (LOI) is contemplated. Subsequent to the buyer’s due diligence and as you get close to the finalization of the deal, it becomes much more difficult to keep the basket as a layer of protection, unless it has been negotiated in the LOI.
And if you are the party buying a business, it is a good idea to keep the basket as low as possible and not part of the Letter of Intent (LOI) so you have something to negotiate with later in the acquisition process.
The basket term defined in the purchase agreement addresses materiality with regard to post closing indemnification for the representations and warranties made by the seller. It is intended to reduce risk and can make the task of completing a deal manageable. Just as no two deals are alike, it is true that no two baskets are alike. The basket varies in form (deductible vs. tipping) and size, so it is important to understand and define this term carefully in the purchase agreement.
Deductible vs. Tipping Indemnification Baskets
The basket concept in the sale of a business is similar to the concept of a deductible in an insurance policy. Just as an insurance company defines a deductible in its insurance policy, the basket specified in the purchase agreement of a business defines the dollar amount of post closing claims from the buyer which must be exceeded before the buyer may pursue a refund for the claim from the seller.
Baskets are needed by both parties to establish a threshold for which a buyer may pursue indemnification for a breach in the seller’s representations and warranties made in the purchase agreement.
A buyer may pursue indemnification claims when defined as a deductible basket only when such claims in total exceed the basket (or floor) amount. And only the excess is subject to repayment by the seller.
Alternatively, a buyer may pursue indemnification claims when defined as a tipping basket once claims from the buyer reach the basket amount defined and then repayment by the seller will include the total of all claims.
For example, if claims from the buyer are $400,000 and the purchase agreement defines the basket as a deductible basket in the amount of $100,000, the seller will be responsible to repay to the buyer the excess $300,000.
If in this example, the basket is defined in the purchase agreement as a tipping basket, the total amount of claims $400,000, would be subject to repayment.
Carefully defining the type and amount of indemnification basket is always recommended so you don’t unintentionally leave money on the table.
I have a question regarding a seller note as part of an acquisition. For a forgivable/contingent seller note, in which the (annual) note payment to the seller is contingent on meeting certain revenue hurdles, how does the IRS treat the forgiven portion – is it considered as cancellation of debt income for the buyer? (So, for instance if the note is set up such that there is a seller note with a maximum $30K annual payment; in which payment is subject to seller getting paid 10% of the revenue in excess of the revenue hurdle of $1MM. If for one year the Revenue turns out to be $1.2MM, the seller will be paid $20K and the balance ($30K-$20K) = $10K will be forgiven. Will this forgiven $10K be considered COD income under IRS rules?
Hi Manish,
First, let’s consider the contingency aspect of your question:
Typically, the scenario for a contingent payment to the seller, based on the post-closing revenue you’ve described, is part of an Earn Out Payment agreement or clause in the business’ purchase agreement. I don’t believe I have ever found an earn out agreement embedded into a Seller’s Note Payable (agreement).
An Earn Out agreement (or clause) is meant to address a purchase price contingent arrangement where a Seller’s Note Payable agreement is a form of financing between the seller and the buyer. I don’t recommend blending the two!
Next, consider a seller’s note:
Seller’s Notes are typically reported on a seller’s tax return under the Installment Method of Taxation — this spreads out the tax due on the sale over the duration of the payments received from the buyer. And only the actual amount of money received from the buyer is reported as income. If the Installment Method of Taxation is used by the seller, the Cancellation of Debt won’t apply because the buyer never truly incurred the debt if they didn’t pay the buyer under a contingency arrangement.
Does this help?
Thank you Holly, I appreciate the detailed response and the explanation regarding the Installment Method of Taxation vis-a-vis the Seller note and the Earn Out – I am not that familiar with the Installment Method concept – and your write-up is certainly very useful to shed some light for me on it.
What I’ve been trying to find more information on is what I have understood to be a forgivable promissory note, and that this type of structure of a seller note – i.e. a forgivable/contingent promissory note – can be SBA 7a compliant (whereas an earn-out is not). So, I just want to add this context to the discussion.
I am still trying to learn more on this subject, and while exploring this structure I ran into the issue of COD income – whether it is applicable or not for the Buyer.
And given there is the mix of SBA and IRS issues, I am still trying to navigate through this, I am still unsure what the fully right questions to ask are!