Cap and Basket Indemnification in Purchase Agreements

When selling or buying a business, understanding the terms in the purchase agreement is crucial for both parties. One such important concept is the “cap” and “basket” indemnification. A basic understanding of cap and basket indemnification is outlined below. Generally speaking, these provisions are critical to understanding the relationship between the buyer’s diligence and new ownership responsibilities versus the seller’s disclosure and indemnification responsibilities.

What Are Cap and Basket Indemnification?

Cap - The “cap” refers to the maximum amount that the seller can be responsible for in indemnity claims. It sets a limit on the seller’s liability.

Why It’s Important:

• For the Buyer: It sets a maximum expectation on how much can be claimed from the seller allowing both parties to get a sense of the deal behind the deal.
• For the Seller: It limits their liability, preventing them from potentially unlimited losses outstripping the original purchase price.

Basket - The “basket” refers to a threshold that must be met before the basket is full and buyer can make an indemnity claim against the seller. This can be employed for indemnification purposes either as a deductible amount or to require an indemnity from the first dollar as further discussed below.

Why It’s Important:

• For the Buyer: Each basket sets a limit below which minor claims are disregarded, focusing on more substantial matters.
• For the Seller: Each basket protects the seller from a flood of trivial claims that might otherwise be costly and time-consuming.

Types of Baskets:

There are two primary types of baskets used in purchase agreements:

1. Deductible Basket: In the deductible context, like a typical insurance policy, only the amounts over the threshold can be claimed by the buyer.
2. Tipping Basket: In this case, if the claims for which indemnification is sought exceed the basket amount, then the entire amount becomes claimable from the first dollar, not just the excess over the basket’s threshold.

Takeaway:

The cap and basket indemnification provisions are vital components of purchase agreements that balance the interests of both the buyer and the seller. These structures promote fairness by protecting the seller from insignificant claims while ensuring that the buyer has recourse for material issues in the context of the transaction negotiation.

It is essential for both parties to negotiate these provisions diligently, understanding their impact and implications.

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