One thing that we can say for sure is, never say never. As with anything else in life, an investment carries both known and unknown risks. A company may have current or historic issues that create liabilities. The company may also have known risks associated with its line of business, and unknown risks associated with outside events it can’t control, such as the behavior of customers or vendors, changes in laws and regulations, and “force majeure” events like wars and pandemics. Venture-backed companies are no exception. Thus, to get investors comfortable with the investment, the parties seek to allocate the risks of investment through negotiation.
What is indemnification?
Indemnification is one way to allocate investment risks among the parties. It is a contractual agreement by a party (the indemnifying party) to cover the liabilities of another party (the indemnified party) associated with certain risks. For example, the company might agree that it will indemnify the investor if there is a patent infringement lawsuit. In US venture capital deals, indemnification is rarely used; investors focus on identifying the risks through due diligence and placing the right bets. On the other hand, in Southeast Asia and India, investors often rely on indemnification to apportion risks and seek downside protection. There is no right or wrong approach. Rather, the prevalence of one approach over another depends on the market norms and the parties’ relative negotiating leverage.
Who indemnifies whom?
In Southeast Asia and India deals, it’s not uncommon for the company to indemnify the investors against breaches of the representations, warranties and covenants contained in the investment documents. Often, the founders are also on the hook as indemnifying parties in their individual capacity. In the most burdensome scenario for the founders, the founders’ indemnification obligations are “joint and several” with the company, meaning that the investor can pursue indemnification claims against any or all of these parties. In other cases, the founders only provide an indemnity to the extent the company fails to do so.
In contrast, rarely do any US deals require the founders to indemnify the investors. This is because, in part, investors in the US take the view that risk of a loss for a venture-backed company would be disproportionately borne by a founder, via an indemnity. This can lead to charged discussions, given the founders are often unlikely to have the assets to backstop the company’s obligations. Also, US investors do not want to be viewed as seeking personal recourse against their founders, given the reputational impact in the market. Given the low likelihood of actually using this tool to protect against risks, it never emerged as a popular term in the US.
Again, different markets have developed in different ways. In Southeast Asia and India, investors take the view that the founders “control” the company and thus should be ultimately responsible for its liabilities. By indemnifying the investors, founders are seen as sending a strong message to the investors that they are dedicated to the growth and integrity of their business. This is a different approach from the US, where investors and founders often view themselves in a joint endeavor, sharing the risks.
Because of this personal liability, it is crucial that founders in particular understand their indemnity obligations and think carefully about which points they want to negotiate. Indemnity provisions are often complex and full of “legalese,” which can make them off-putting for founders; in our experience founders will often view indemnity provisions as “lawyers’ points” and want to agree to them quickly in order to “get the deal done.” However, it is important for founders to make careful and informed decisions about indemnification, because these provisions can impose real liabilities on both their companies and the founders themselves.
Why should you have or not have an indemnification provision?
As an investor, you may want to consider whether indemnification is an appropriate way to protect against investment risks. It is usually most helpful when there are known liabilities or issues which can be quantified. Where there are material known liabilities at the time of investing (e.g. pending litigation or tax claims), you may want to have indemnification against them, even if the company has properly disclosed them.
However, the parties should consider whether certain risks should be considered a cost of conducting the business and whether the company can reasonably prepare for such risks. Some of the foreseeable risks may be borne by the investors, in the form of monetary thresholds that need to be satisfied before making an indemnification claim. Unforeseeable risks may be borne by all parties, on the ground that no party can reasonably predict or prepare for these risks. There are also some kinds of risks that are difficult to quantify in monetary terms. And, as noted above, it’s an imperfect remedy given the natural reluctance of investors to sue founders.
Other points to consider in negotiating an indemnification provision
In negotiating an indemnification provision, the parties should strike a careful balance in the allocation of the risks based on who would be better equipped to address the risks considering knowledge and capacity. In addition to the questions discussed above, you should think about the following questions in negotiating an indemnification provision.
How long should indemnification obligations survive?
In an ideal world for the investors, the indemnification obligations would survive indefinitely. However, the company and its founders would (for good reason) ask for a reasonable limit on the survival period of the indemnification obligations. For instance, while the general representations and warranties may survive for a limited period of time often tracking the statutory limitations period to bring a claim, certain representations and warranties about fundamental company information (e.g. its capital structure) may have a longer survival period.
Should there be any limitations on indemnification?
Depending on the deal circumstances, the parties should consider dollar thresholds for individual and aggregate claims. An indemnification clause might provide that there is no indemnification liability until claims exceed a certain threshold amount. Once the claims are recoverable, they may be recovered from the first dollar, or only for the excess amount above the applicable threshold (similar to a deductible in an insurance policy). Further, the maximum indemnification amount could be capped at the total investment size or some lower amount. These upper and lower limits on indemnity sometimes have exceptions, such as claims based on fraud.
What, if any, steps can the parties take to control and minimize losses?
It may be important for the company to have control over resolving claims that could result in the company having to indemnify the investor, since an indemnified investor may not have an incentive to fight the claim. However, investors may not be comfortable giving the company complete control over these claims. The parties’ exact level of control over these claims is often a negotiated point. In addition, the company may require the investors to take steps to mitigate losses. However, investors would often resist this, as it could be another reason for the company to refuse to pay for the indemnifiable losses. As always, the best way to protect against indemnity liabilities is to disclose all issues at the time of the financing.
The questions above are not an exhaustive list but rather high-level issues to be considered in negotiating an indemnification provision. To bring certainty to the deal, the investors, the company and the founders should carefully negotiate clearly identified rules for risk allocations and consult with counsel in the relevant jurisdiction. However, the parties should always keep in mind that these questions should be considered in light of the broader context of growing the business together as a share enterprise. Each party has a different risk tolerance and each deal has a different mix of what is fair and reasonable under the circumstances.
Last reviewed: March 11, 2022