101: How To Negotiate Indemnities In Your Series A Investment Docs

Indemnity provisions?

Entrepreneurs raising their initial rounds of investment (often in India) are often confronted with indemnity provisions in shareholder agreements that provide for personal liability. I have written previously on why I fundamentally disagree with having these provisions in shareholders arragements. Unfortunately, you may still see this popping up when you go on to raise money, and it is often hidden away in terribly boring legal jargon that competes with other provisions to make a careful reading of your contract a challenge to staying up and staying interested. If you do manage to read carefully though (or if someone explains to you) you will probably sit up wide awake. Here’s how it usually looks like –

“Indemnification: The Company and Promoters shall jointly and severally indemnify, defend and hold harmless the Series A Investor and their Affiliates, and their respective directors, officers, representatives, employees and agents (collectively, the “Series A Indemnified Persons”) from and against any and all incurred by the Series A Indemnified Persons, as a result of, arising directly or indirectly from, or in connection with or relating to:

(a) any matter inconsistent with, or any breach or inaccuracy of any representation, covenant or agreement made;

(b) any failure to perform (whether in whole or part) any obligation required to be performed by any of them pursuant to this Agreement;

(c) any existing or potential legal issues against either or both of the Promoters or the Company, in respect of any specific arrangements or obligations relating to any or all of the Promoters’ previous employments, engagements and businesses, or otherwise;

(d) all responsibilities and liabilities (actual, contingent or otherwise) prior to the Series A Closing Date or Taxes prior to the Closing Date; or

(e) gross negligence, fraud or misconduct by the Promoters.”

What does this jargon mean?

It means that if any of the matters specified in (a) – (e) were to occur, the promoters may be personally liable to make up and pay out losses to the investors in the the company. Seems fair? Maybe, but it can be fairly onerous. Indemnity provisions like the one above are usually followed by “gross-up” provisions and the liability is framed as “joint and several”. This in layman’s terms means that the investors can require that the promoter to make good to the investors losses suffered by the company as well as the investors. This can be tough if enforced – assume a situation where a Series A investment of USD 1 – 5 million is being made in your company and any of (a) – (e) occur, this would effectively result in your having to make good the extent of the losses suffered by the investors, which may be USD 0 – 5 million or more. No matter how culpable you are – the size of the potential loss ay result in your insolvency or in other words – you may just end up completely broke. In most jurisdictions, there is no bar on executing a decree against the promoters personal assets and filing for insolvency if these assets are insufficient to pay out the investors. While in practice this may not happen, the position still remains that there is no legal bar on the investors enforcing pre-agreed indemnity provisions.

How do you negotiate this?

There are several options if you wish to negotiate indemnity provisions and to remove, restrict or contain your personal exposure to investments made in your company. Lets run through each of them below, starting from the best case and moving on to other points of consideration:

1) Remove promoter liability altogether:

This is certainly the optimal outcome. You insist on removing promoter liability from the indemnity provisions and clearly argue that you (your kids, spouse or parents) do not intend to undertake personal exposure in the fundraise irrespective of your commitment or lack of it to the investment or the spirit of the transaction. For more arguments on why this may be morally justified and technically not that unsound for an investor to agree to, read here.

By doing do, the liability would be limited to that which can be undertaken by the company, i.e., liability would be limited to amounts that the company is in a position to pay. While this may result in indirect loss for the promoters and does not completely compensate the investors in indirect terms, it still offers some comfort to investors. Watch out for gross-up provisions that require a promoter to make good to the company if a company is paying out. If the liability is being restricted to the company, it must be so.

2) Introduce a liability cap:

If the investor insists on having some sort of personal liability, it may make sense to introduce a cap on the amount of damages that you can personally be held liable for. For instance, while you may not be able to satisfy open-ended claims for damages or damages equalling a substantial portion of the investment, you can probably accept a risk you can afford. The liability cap should ideally be a clear dollar/rupee amount so as to be enforceable and to provide sufficient clarity at the time of enforcement, if ever.

3) Negotiate the grounds under which indemnity obligations arise:

In the indemnity provision provided above, it appears that paragraphs (c), (d) and (e) may be to a certain extent reasonable. Paragraphs (c) and (d) relate to matters prior to the investors having invested in the company and therefore the investors may not want to take a financial loss on these unless specifically disclosed and agreed upon prior to the investment. Paragraph (e) relates to fairly serious matters that may result in penalties, personal liability and potential criminal proceedings even in the absence of the investors specifically providing them in the agreement. This being said, paragraph (a) and (b) may be extremely onerous on the promoters who may not be able to control every aspect of having agreed to these matters.

For instance paragraph (a) refers to representations and warranties, these may be difficult to back with personal indemnities given the extensive representations that are usually provided in the shareholders agreement. You will find these representations tagged into a separate schedule to the agreement and you might want to review them in detail. Given that it can be a fairly elongated laundry list, you might want to wish to consider deleting them altogether or at least limiting your liability to only a few of them, ie., you take liability only on representations that you can stand behind in all circumstances and where you have absolute certainty. For instance, you could be in a position to represent that your company is duly incorporated or that you are not prohibited from entering into the investment transaction. On the other hand, it may be difficult for you to say for certain whether all tax and regulatory compliance have been undertaken or your books have been audited in accordance with sound financial principles. Carving out specific representations that you back may help manage the risk of personal liability.

Similar principles apply to paragraph (b) that relates to complying with the terms of the shareholders agreement. If you are not able to insist on removing paragraph (b) altogether you can request that you must be responsible only for matters that are completely in your control and where there is no risk of claims due to alternate interpretations or a technical/procedural breach of the agreement. For instance, that you will not sell your shares to any person within a prescribed lock-in period or deprive the investors of their rights on liquidation. However, you must insist on excluding all other provisions. Provisions that are less difficult to accurately monitor such as for instance – compliance with applicable law or payment of applicable taxes from time to time, should ideally have no place in the indemnity provisions.

Bonus point of note: As a matter of strategy, it is best to include each head of indemnity specifically rather than exclude specific items. That is to say, you insist that representations, warranties and covenants that you stand behind must be specifically listed out.

4) Introduce a “de-minimis” provision:

If the indemnity is open ended, as long as any of (a) – (e) occur, the promoter may be liable to make good. In the ‘laundry list’ of representations and within the extensive terms of a shareholders agreement, there may be matters that result in a small amount of potential liabilities or losses that are indeterminate at this stage but which may aggregate over time to a substantial amount from a promoter’s perspective. For instance, there may be a potential dispute with an employee that may result in litigation, or a tax return that has not been completed that may give rise to fines. While these issues may be a part and parcel of the business, they may be marginal enough in the larger context of the investment and result in unnecessary burden on the promoters at the time of raising the investment to disclose each of these, discuss with the investors and to assess what the promoters should and should not be liable for. The best way out of this is to have what lawyers call a “de-minimis” provision which says that the promoters and the company will not be liable to the investors unless the aggregate sum of all claims in (a) – (e) in any financial year exceed a certain amount. This would also simplify a review of the representation and warranties to identify and disclose to the investors only substantial risks that the company / promoters see in the business and to ensure the parties do not get lost in detail.

Thoughts to end

While it’s all in a good day’s work to negotiate indemnity provisions for lawyers and investors, please keep in mind that sophisticated early stage investors do not typically insist on extensive indemnity provisions of this kind and even if they do, they are willing to talk about it. Fear typically has no place in high risk early stage investments and the ability of most promoters to back these provisions is limited. If any part of them are retained, the intention is usually to bring some seriousness into the agreements and ensure that there is “skin-in-the-game” as far as the promoters are concerned. Beyond that it makes little sense for the investors to retain them and being open to negotiations may provide much comfort to promoters who may be wary of personal liability.

Hope you found this useful, and best of luck with closing your investment!

[Suhas is founder of Innove Law.]