Filthy McNasty

M&A Monday: Indemnification Caps - A Very Long (and opinionated) Deep Dive Why the “market” cap is wrong for sub-$50m deals, and why Buyer's should be more strategic around caps and baskets As an M&A lawyer for private equity, independent sponsors, and other buyers in the Middle Market and LMM, we argue about Caps and Baskets on almost every deal. Shockingly, deals die over the cap on indemnification. This is an issue that lawyers love to argue about. They routinely bill tens of thousands of dollars going back and forth on why the indemnification cap should be 15% rather than 10% of the purchase price. Two weeks ago, a seller’s lawyer, I will call him Bob, told me our requested cap on indemnity was a “walk-away issue” and a “non-starter.” I told him the cap represented the diligence risk (the business had minimal compliance) and Bob said, it was not market; therefore, he would advise his client to walk. A savvy buyer has to understand indemnification caps and be able to discuss the issue directly with a seller, so that Bob’s alarmism does not kill a good deal. This often comes up at the LOI stage. This is a deep dive on caps. If you want the broader overview of how survival, caps, and baskets fit together, start with my earlier post, Limitation on Seller’s Liability: Survival, Caps, and Baskets. A quick review Unlike buying real estate, a buyer of a business is fully reliant on the seller for accurate due diligence materials. So a good purchase agreement asks the seller to make representations and warranties, which are promises that certain things about the business are true. For example, that the financial statements are correct, that there is no pending litigation, and that no material customers are leaving. After closing, if one of those promises turns out to be incorrect and causes the buyer a loss that relates to the pre-closing period, the buyer can recover that loss. For example, say the seller promised there were no pending lawsuits, but there was one. After closing, the plaintiff files and the matter costs $1 million to resolve. The buyer can recover that loss from the seller. What a cap actually is In private M&A there is traditionally a liability cap on the non-fundamental representations, which are the less core promises. The fundamental reps, like title to the equity and authority, are usually not capped, or are capped at the purchase price. Fraud, covenants, and specific indemnities are also uncapped or capped at the purchase price. (More on that split in the earlier post.) Non-fundamental reps traditionally include financial statements, undisclosed liabilities, material contracts, sufficiency of assets, intellectual property, inventory, insurance, litigation, and compliance with laws. These are promises the seller is making about the condition of the business you are buying. A cap is the maximum the seller will owe if those non-fundamental reps turn out to be wrong. Here is the mechanic. Say the seller gave you financial statements that were incorrect, and that misstatement causes a $2 million loss after closing. If the purchase price is $10 million and the cap is $1 million (10%), the seller is only responsible for up to $1 million, minus any deductible basket. The buyer eats the other $1 million, even though the loss came from the seller’s own misstatement. Fraud and (often) willful misrepresentation are not usually subject to a cap. That is why lawyers fight so hard over the cap. It decides who absorbs a loss caused by a broken promise. Many of us have seen this play out after closing and know it is a real risk. Where should the cap be set? Most lawyers will tell you the “market” cap is somewhere around 10% to 15% of the purchase price. That range applies to traditional deals, meaning deals that do not use representation and warranty insurance (RWI). (see Graphic One: Median and Average Caps) That number holds up across the two leading deal points studies. In SRS Acquiom’s M&A Deal Terms Study, the median cap on non-RWI deals sits right at 10% of transaction value, and has for years, while the average runs higher, around 14% to 15%, because a real share of deals cap well above the median. The ABA Private Target M&A Deal Points Study lines up with it: on traditional, non-insured deals, caps have clustered in the 8% to 12% range. So 10% is a fair description of the middle of the market. What that number does not tell you is where the cap should land on your specific deal. The data moved exactly as I said it would Back when I first wrote about this, the market had been a seller’s market for over a decade, and caps had been grinding down. I predicted that as deal flow slowed and the market turned buyer-friendly, caps would move back up. They have, though you have to look past the median to see it. (see Graphic Two: Cap Trends, 2023 to 2025) The typical deal has not changed. In the SRS Acquiom study, the median cap on a non-RWI deal has held right at 10% of transaction value, 11.8% in 2023 and 10.0% in both 2024 and 2025. What moved is the average, which rose from 13.1% to 15.3% over the same three years. An average that pulls away from a flat median means one thing: a growing share of deals are capping well above the market number. The data bears that out. The share of non-RWI deals capping above 15% of transaction value rose from 13% in 2023 to 21% in 2025, and the share capping above 20% doubled, from 6% to 12%, with some deals capped at the full purchase price. The median is still 10%, but it is no longer the ceiling, and the top of the market is drifting toward the position I take, that a seller should stand behind the reps it made. Why I do not accept the “market” on a small deal A cap shifts all risk of liability above the cap onto the buyer. From a basic fairness perspective, I have never understood why a buyer should absorb a seller’s misrepresentations above some arbitrary line. If someone pays $55 million for a business and it turns out the business was misrepresented so badly that there is a $55 million loss, why should the seller keep any part of the price? Business decline is the risk of buying a business - Seller is never liable for business decline. The seller’s misrepresentation, intentional or not, is not a risk the buyer should have to assume. Last week I suggested a cap of 60% of the purchase price on the non-fundamental reps, and the seller’s lawyer said, on a call with the clients, “Eli is insane. This is the most ridiculous thing I have seen in 20 years.” I responded that if he bought a car that was missing an engine, should the dealership only be responsible for losses up to 10% of the car? This was a business with so many diligence issues, 60% cap was more than appropriate. How did we get here? To understand why caps drifted so low, look at the history. In 2008, caps averaged almost 22%, insurance included, so probably higher without it. Then, for over a decade, low rates and an economic recovery drove a private equity frenzy. Debt was cheap, leverage was plentiful, and it was a perfect seller’s market. Private equity groups fell over each other bidding on targets - I know because I worked on many of those deals for big Private Equity groups. Sellers had the leverage, so they simply demanded that buyers assume more liability, which meant lower caps. The auction process made it worse. On larger deals, the seller drafts the agreement and sends it to interested buyers in a “public-style” posture where the buyer assumes most of the risk. Buyers then compete by asking for lower and lower caps, or tiny caps backed by insurance. That competition drove the market averages down. So how do you actually set the cap? My opening position on a sub-$50 million deal is that the seller’s liability cap should be reflective of how clean the business is. If there is a professional management team and in-house GC responsible for compliance a cap is appropriate; if it is a mess, the cap should be the purchase price - the seller should simply stand behind the reps they made. A seller’s lawyer will tell you that is crazy. It is not. From there, each deal is different, and the cap should reflect the actual risk and liability of the company you are buying. I think through factors like these: How professionalized is the seller, and do they have the controls to reduce post-closing liability? We can never do enough diligence to get fully comfortable assuming all the risk. What is the industry risk? A SaaS business may carry less rep risk than a manufacturer. How forthcoming has the seller been with diligence? A seller who buries the data room is telling you something about the cap. The seller’s best argument, and my answer The weakest seller argument is “it is not market,” and it is also the one I hear most. The strongest version is different, and it is worth reviewing. It goes like this: the buyer has a responsibility to diligence the business. A quality of earnings report and real legal diligence should catch anything that is a meaningful portion of value, and a buyer’s unwillingness to pay for proper diligence should not shift that risk onto the seller. Do all the diligence you want, then take the business “as is”. I agree with the premise and reject the conclusion. The buyer absolutely has to do real diligence, and how much diligence the buyer did should move the cap. But diligence is not omniscience. You can run a full QoE and a careful legal review and still miss a side agreement, an unasserted claim, cash under the table to employees, or a number the seller knew was wrong. Good diligence lowers the residual risk; it does not entitle the seller to keep the purchase price after misrepresenting the business. The cap should reflect the risk that is left after good diligence, not reward the seller for their own misstatement. A word on rep and warranty insurance A fair number of the deals we do are RWI deals, and the dynamic there is different. On an RWI deal the seller’s cap effectively collapses to the policy retention, often around a quarter of one percent of the price, and the insurer stands behind the reps above that. That can be a good outcome. It lets the seller walk away cleaner, and it tends to push both sides toward fuller, more carefully negotiated reps. RWI is not a cure-all, though. Insurance does not cover known or disclosed issues, the retention and the exclusions still matter, and the premium and underwriting add cost and time. Furthermore, making claims against insurers is very challenging and often ends in litigation. There is a longer conversation about where RWI genuinely helps and where it quietly moves risk around, and I will write that one separately. Three closing notes First, you do not have to treat caps as all or nothing. If you are willing to accept a cap generally but are worried about one area, you can make that rep fundamental or give it its own higher cap. For example, you might accept a 10% cap on non-fundamental reps but carve employment classification issues out to an 80% cap. You can get granular on what is capped and what is not. Just be careful about overcomplicating the agreement. Second, as a buyer, I try to put my position in the LOI, which is a cap of the purchase price on all reps. If the seller’s lawyer pushes back hard, I ask to defer the conversation until we are deeper into diligence. By then I can better judge the risk profile of the business and how hard to push. Third, do not let “market” end the conversation. On a small deal, with asymmetric information, a thin cap makes no logical sense. The right cap is the one that fits the risk of the business you are actually buying. As always, DM me with any questions.