Over the years sellers of businesses have often been able to limit their risk of post-closing indemnification claims from the buyer using indemnification caps, deductibles and threshold provisions in purchase agreements.
It is quite common for a buyer to agree to cap the amount of damages it can recover from the seller for the seller’s breach of a purchase agreement.
Our seller was an Akron based private equity firm specializing in investments in distressed or underperforming middle market and mature companies. Through subsidiaries, it owned and operated a chemical division that chiefly sold research and development services to biotech, pharmaceutical, food, flavor, fragrance and specialty chemical customers.
The seller sold the chemical division to the buyer for $27 million; consisting of $8.4 million payable in cash to the seller at closing and an assumption of $18.6 million of seller debt. The buyer also agreed to pay the seller an earnout of $5.5 million if the business hit an earnings target for the first year after the closing.
The buyer and seller’s relationship soured after the closing. The buyer was disappointed with the post-closing performance of the chemical division and the seller did not receive its earnout. They ended up in an Ohio federal district court.
The buyer accused the seller of understating the costs of the business by almost $2 million. Specifically, the seller had represented and warranted that the 2016 business costs were as stated in a schedule attached to the asset purchase agreement. The $27 million purchase price would probably be too high if the chemical division’s 2016 costs were understated by $2 million; given the chemical division’s value was probably based at least in part on a multiple of earnings.
The buyer’s claim then led to a dispute over the amount of the indemnification cap. In other words, what is the seller’s maximum exposure to the buyer for understating the costs of the business?
The indemnification cap provision in the asset purchase agreement capped the seller’s liability for a breach of its representation and warranties to 10% of the “aggregate purchase price actually paid” by the buyer to the seller. The buyer argued that the cap was $2.7 million; arguing that the “aggregate purchase price” was $27 million. The seller disagreed and said that the cap was $840K which is 10% of the $8.4 million aggregate purchase price “actually paid” to the seller; not including the $18.6 million seller debt assumed by the buyer.
The court held that the provision could be read either way and so the dispute must go to trial and not be disposed of in this preliminary proceeding.
This case is referred to Main Market Partners, LLC v. Olon Ricerca Bioscience LLC, Case No. 1:18-CV-916, United States District Court, N.D. Ohio, (April 9, 2019) https://scholar.google.com/scholar_case?case=4976259500205573361&q=%22asset+purchase+agreement%22&hl=en&scisbd=2&as_sdt=2006&as_ylo=2017#r
Indemnification provisions are part of the “boilerplate”. But they are often the first thing that the buyer and seller lawyers look for in the purchase agreement when a post-closing fight breaks out. They are often the first thing that a seller lawyer looks for when reviewing the buyer’ lawyer’s first draft of the purchase agreement.
In 20/20 hindsight, the buyer and seller should have tightened up the cap language. How? One way would be keep it simple and cap it at a specific amount such as $2.7 million.
By John McCauley: I help companies and their lawyers minimize legal risk associated with small U.S. business mergers and acquisitions (transaction value less than $50 million).
Telephone: 714 273-6291
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