Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / How the Indemnity Escrow Cap Traps Small Sellers in M&A
Transcript
- Lucas: You sell your business for 12 million dollars. You put 15 percent — one point eight million — into an indemnity escrow. Standard stuff. Then the buyer comes back six months later and says the earnout missed its target by 400 grand, and under the purchase agreement, that triggers a full indemnity review. Suddenly they're claiming a three-point-eight-million-dollar clawback based on the indemnity cap being tied to the full purchase price, and your escrow covers less than half of it. Luna: That happened? That's not a hypothetical. Lucas: That's a real 2023 deal in the B2B SaaS space. The seller, a founder in his late fifties, first-time exit, had a standard R&W policy but zero negotiating room on the indemnity cap structure. The buyer was a well-known pe backed rollup platform. They structured the indemnity cap at 30 percent of the aggregate purchase price — three point six million. But the escrow was only 15 percent. So when the clawback came, the seller had to write a check for two million dollars on top of losing his escrow. Luna: So the cap was basically a ceiling on how much the buyer could demand, but the escrow was just a deposit. The cap didn't protect the seller if the claim exceeded the escrow. Lucas: Exactly. And that's the trap. Most first-time sellers assume the escrow is the limit of their exposure. They hear 'we'll hold back 15 percent for indemnity' and think that's the worst case. But the indemnity cap in the definitive agreement is often set much higher — 20, 30, sometimes 50 percent of the purchase price. And the escrow is just the prefunded portion. If a claim comes in above the escrow, the seller has to pay out of pocket. Luna: Why would a buyer set the cap higher than the escrow? Isn't that asking for trouble? Lucas: It's not trouble for them. It's leverage. The high cap gives them room to go after representations and warranties that might not surface until after the earnout period. And in practice, the buyer uses the threat of a big claim to force a renegotiation on post-close adjustments. The seller, who already emotionally exited, often just settles for a discount on the claim to avoid writing a check. In that SaaS deal, the buyer originally claimed 3.8 million. They settled for 2.1 million — still well above the 1.8 million escrow. Luna: So the cap is a ceiling, the escrow is a floor. And the gap between them is pure exposure. Lucas: That's a great way to put it. And the gap is widest in deals with earnouts, because the earnout period creates a long tail of potential indemnity claims. The buyer can argue that the seller's representations about customer churn, revenue recognition, or product roadmap were inaccurate because the earnout targets weren't met. Suddenly a missed earnout becomes an indemnity event. Luna: What should a seller look for in the cap language? Lucas: Three things. First, the cap should be expressed as a fixed dollar amount — the 'hard dollar cap' — not a percentage of purchase price. Because if the purchase price includes an earnout or a note, the percentage can balloon. If the deal is 10 million cash plus 5 million earnout, a 30 percent cap on aggregate purchase price is 4.5 million, not 3 million. Second, the cap should be no higher than the escrow amount, or at least tied to it. Some sophisticated sellers negotiate a sliding-scale cap where the maximum exposure decreases as revenue milestones are hit. Luna: And the third? Lucas: The cap should apply per-claim, not just in aggregate. If the buyer can bring multiple small claims that each fall under a per-claim deductible, but the aggregate cap is high, they can nibble away at the escrow. A 'basket' — usually 0.5 to 1 percent of purchase price — should be a true deductible, meaning the buyer absorbs the first X dollars, not just a threshold above which they can claim everything below it. Luna: Let's be real — how often do first-time sellers actually negotiate these terms? Lucas: Rarely. Most are so focused on the headline price and the earnout structure that they treat the indemnity section as boilerplate. They might bring in a lawyer, but the buyer's counsel has done this a hundred times. The seller's lawyer might flag the cap as 'market,' which is true — it is market. But market for a PE buyer is designed to protect the buyer. The seller needs to understand that the cap is a risk allocation tool, not a formality. Luna: What about R&W insurance? Doesn't that cap the seller's exposure? Lucas: R&W insurance typically covers breaches of representations and warranties, but it has exclusions — known breaches, forward-looking statements, and often earnout-related claims. In that SaaS deal, the buyer's claim was framed partly as a breach of the representation about revenue recognition methodology. The insurer pushed back, and the seller ended up self-funding the settlement. R&W insurance can help, but it's not a substitute for negotiating the cap down. Luna: So the seller needs to treat the cap like a dollar amount they might actually have to pay. Not a theoretical ceiling. Lucas: Right. And there's a specific countermove that works well in middle-market deals: tie the cap to a percentage of the cash consideration only, excluding earnout and seller notes. If the deal is 8 million cash and 4 million earnout, the cap should be, say, 15 percent of 8 million — one point two million — not 15 percent of 12 million. And then set the escrow equal to that cap. Now the seller's exposure is fully prefunded. No surprise checks. Luna: But the buyer will push back. They'll say they need the higher cap to protect against latent defects. Lucas: They will. And the seller can concede on the survival period instead. Let the representations survive for 24 months instead of 18, or extend the indemnity tail for specific items like tax or title. That gives the buyer time to discover issues without giving them a blank check. The key is to decouple the cap from the survival period. Most buyers focus on survival, and sellers focus on cap. If you give on survival, you can often get the cap down. Luna: That's a concrete trade-off. I like that. Lucas: One more thing: the cap should explicitly exclude fraud. If the seller commits fraud, they should be on the hook for the full loss. But the cap should also state that no other claim can exceed the cap, regardless of theory — including negligent misrepresentation. Otherwise, the buyer can reframe a breach of contract as misrepresentation to sidestep the cap. Luna: I've seen that exact move. The buyer's lawyer sends a letter saying 'we're not suing for breach, we're suing for negligent misrepresentation.' And suddenly the cap doesn't apply. Lucas: So the seller's agreement needs to define the cap as the maximum aggregate liability for any and all claims, except fraud. That's a single sentence that can save millions. In that SaaS deal, the cap language read 'the indemnifying party's liability shall not exceed 30 percent of the aggregate consideration.' It didn't say 'for any and all claims.' The buyer's lawyer argued that the cap applied only to claims under the indemnification section, not to claims for misrepresentation under common law. They ended up settling, but it cost the seller hundreds of thousands in legal fees to even get to that point. Luna: So the lesson is: the cap is not a cap unless it says 'any and all claims.' Period. Lucas: Exactly. And that's the kind of detail that separates a good deal from a nightmare. If you're selling your business, you need a lawyer who has been on the seller side of middle-market M&A, not someone who mostly does public company work. The public company cap dynamics are completely different. Luna: Speaking of useful details — if today's episode helped you think about your own deal terms, I'll say what I always say. These shows stay ad-free because listeners who find value in them sometimes support the network. Buy me a coffee dot com slash fexingo. It's a simple way to keep this kind of specific, no-fluff content coming. Lucas: I appreciate that, Luna. And it's true — we don't have a corporate sponsor telling us what to cover. Every episode comes from actual questions operators send us. So if this one saved you a headache down the road, that's exactly the point. Luna: Alright. Back to the cap. Lucas, what's the one thing a seller can do tomorrow to check if they're exposed? Lucas: Pull out the draft definitive agreement and find the section titled 'Indemnification' or 'Survival and Indemnification.' Look for the subsection that says 'Limitation on Liability' or 'Cap.' See if it ties the cap to the purchase price or to a fixed dollar amount. If it's a percentage, calculate that number and compare it to your escrow. If the cap is more than 1.5 times your escrow, you have gap exposure. Then call your lawyer and ask: 'Does this cap apply to all claims, or only indemnification claims?' If they hesitate, you have your answer. Luna: That's a homework assignment I'd actually do. Thanks, Lucas. Lucas: Next time, we'll look at the flip side: how buyers use the same indemnity cap to protect themselves from seller fraud, and why a well-written cap actually helps both sides close faster.