Definition - What does Indemnity mean?
An indemnity is a contractual tool that buyers and sellers use in acquisitions to allocate risk between them. Each party agrees to indemnify the other party for its actions. Indemnification obligations arise when a seller breaches a representation or a warranty that it made to the buyer, or the seller fails to perform a covenant that it promised to perform and the buyer incurs damages as a result.
Divestopedia explains Indemnity
Mergers and acquisitions involve complex business and legal transactions, and indemnification clauses usually entail significant negotiation. Despite conducting due diligence, a buyer needs to protect itself from the risks involved in acquiring a company and, therefore, would require certain indemnifications from the seller. This indemnification provides contractual protection to the buyer if the seller delivers reps and warranties that are inaccurate, which result in additional costs post-transaction.
When negotiating indemnities, the parties must agree on several complicated matters such as who pays for any liabilities arising from the acquisition, how much and how long should funds be held in escrow to satisfy future indemnity claims, and the threshold limit that the buyer must sustain as damages before it can seek indemnification. It is common practice for buyers to retain a part of the purchase price for a certain period of time post-transaction in order to satisfy any indemnification claims.