Functional Insurance

• Often, an indemnification clause, functionally, does what insurance does. The mechanism by which the "insurance" takes place is different, but the clause may redirect potential perils from one party to another in a strategic way. One party may pay the other party to be absolved of potential perils, making it even more like insurance. Just as insurance is often involved in complex transactions, so is indemnification -- but indemnification is easier to implement. For example, it can be as simple as a single sentence in a purchase contract.
  
  

Affects Value

• When you think about buying something, a simple transaction may come to mind -- an object such as a car, or a service such as tax preparation. Sometimes, though, acquisitions are conceptually more complex. For example, if we buy a business, in a sense, we're being an annuity -- a recurring income stream. We may also be buying potential liability. The market value of isolating and eliminating a particular peril can be negotiated. If you buy a boat manufacturer, once you buy the company, a past customer may sue the company. It's hard to know the risk of this happening, or the potential cost if it does. If the seller indemnifies you from such perils, you should expect to pay less for the company, because an unknown risk has been removed.
  
  

A Major Negotiating Point

• Indemnification can be a major negotiating point in the sale of a business. For example, imagine a small business that's involved in a lawsuit. The book value of the business is $5 million and it's being sued for $5 million. It's difficult to know the value of the company without knowing the outcome of the lawsuit. A $5 million judgment may bring the company's value to zero. This exemplifies the tremendous impact some perils can have and the value of eliminating the peril through indemnification.
  
  

Past and Future Liability

• Acquisition indemnity, in the case of selling a business, for example, may divide potential liability based on timelines. For example, a seller may agree to indemnify a buyer for any lawsuits claiming damages resulting from products manufactured while she was managing the company but limit the indemnification to exclude any new products manufactured under the care of the new owners. Particularly in complex transactions, such as acquiring a business, indemnity can be an effective way of engineering risk, liability and value.