What Does Baskets and Caps Mean?
Baskets and caps are typically included with the reps and warranties made by a seller in a purchase and sale agreement. When a seller makes a representation, there is typically an indemnification for the buyer (usually under a your watch, my watch clause) to protect it from such representation being inaccurate.
The baskets and caps clause limits the seller's exposure to this indemnification. The caps concept usually limits, or "caps," the total amount payable under the indemnity. The most common cap used is 50% of the enterprise value, but this cap can be negotiated by both parties. The basket concept establishes a threshold for the indemnification, which means that claims would not be payable unless the threshold, or "basket," is exceeded.
The "first dollar" method usually applies to baskets. This means that if there is a basket of $250,000, any claims up to $250,000 would not be paid. However, if the claims exceed the basket of $250,000, say, the claim is $400,000, then the full amount of $400,000 would be paid (not just the $150,000 in excess of the basket).
Divestopedia Explains Baskets and Caps
Baskets and caps are better understood using an example. One of the key representations a seller makes in a stock purchase agreement relates to liabilities arising from lawsuits.
Suppose a transaction with an enterprise value of $1 million is closed where the seller represents that it does not know of any lawsuits outstanding at closing. The buyer subsequently uncovers that there existed a material litigation pre-transaction which the seller did know/should have known about. The your watch, my watch indemnification clause would kick in, likely allowing the buyer to have a claim against the seller for any costs that resulted from this litigation.
A cap of 50% of the purchase price of $500,000 (50% of the enterprise value) could have been established. This would limit the seller's indemnification exposure to this ceiling amount of $500,000. Furthermore, a basket of, say, $50,000 could have also been put in place. If the costs to resolve the litigation were only $25,000, then the seller would not have to pay anything since this amount would be below the basket. If, on the other hand, the costs were $75,000, this amount would exceed the basket and the seller may be responsible for the full $75,000 (not just the $25,000 above the threshold) based on the "first dollar" requirement.