Deal Documents

Purchase Agreement Terms: Reps, Baskets, Caps, Escrows

A purchase agreement allocates risk between buyer and seller. Representations and warranties describe the business as of signing and closing; indemnification lets the buyer recover losses if they prove untrue. Baskets set a threshold before claims are paid, caps limit total recovery, survival periods limit timing, and escrows or holdbacks secure payment of valid claims.

What do representations and warranties do?

Representations and warranties are statements of fact by the seller about the business, such as the accuracy of financial statements, ownership of assets, absence of undisclosed liabilities, compliance with laws, status of material contracts, tax matters, employee benefits, environmental conditions and intellectual property. They serve three purposes. First, they force disclosure, because the seller must list exceptions on disclosure schedules. Second, they set conditions to closing, since the buyer usually need not close if the representations are materially inaccurate. Third, they define the scope of the buyer's post closing recovery through indemnification if a statement proves untrue.

Buyers seek broad representations with few qualifiers. Sellers try to narrow them with knowledge qualifiers, which limit a statement to facts the seller actually knew, and materiality qualifiers, which exclude minor inaccuracies. A materiality scrape is a provision that removes those qualifiers when calculating losses or determining breach for indemnification purposes, and it significantly strengthens the buyer's position. Sellers push back on double scrapes, and the outcome often depends on the overall balance of the indemnity package and whether insurance is in place.

• Fundamental representations: ownership, authority, capitalization, brokers
• Business representations: financial statements, contracts, compliance, litigation, employees
• Tax and environmental representations, often with special survival and cap terms

How does indemnification work?

Indemnification is the seller's contractual promise to compensate the buyer for losses arising from breaches of representations, warranties and covenants, and often for specific known risks identified in diligence, such as pending litigation or pre closing taxes. Indemnification is typically the buyer's exclusive remedy after closing, apart from fraud. The agreement defines what counts as a loss, whether consequential damages or lost profits are recoverable, how third party claims are handled and how indemnity payments interact with insurance and tax benefits.

Specific indemnities for known issues are often more valuable than general representations, because they apply regardless of baskets and sometimes outside the general cap. A buyer who discovers a tax exposure or an environmental problem in diligence should negotiate a dedicated indemnity rather than relying on a representation that the seller can qualify through disclosure. Specific indemnities should define the covered matter precisely, state whether the general cap applies, and set a survival period long enough for the risk to actually materialize, such as the period during which a tax authority can still assess.

What is the difference between a deductible and a tipping basket?

A basket is the threshold losses must exceed before the seller pays indemnification claims. With a deductible basket, the seller pays only losses above the threshold, so the buyer absorbs the first dollars of loss permanently. With a tipping basket, also called a first dollar basket, once losses exceed the threshold the seller pays all losses back to the first dollar. Baskets are usually expressed as a percentage of purchase price and exist to avoid disputes over trivial claims. The basket size and type often move together in negotiation, with sellers accepting a tipping basket in exchange for a higher threshold.

Many agreements also include a de minimis threshold, which excludes individual claims below a set amount from counting toward the basket at all. A combination of a high de minimis and a deductible basket can dramatically reduce the seller's practical exposure, because many small breaches may never be aggregated. Buyers should model expected claim sizes before agreeing to these thresholds. A buyer who expects many small operational issues, such as minor inventory or receivable discrepancies, may prefer a lower de minimis even at the cost of a larger basket. The right combination depends on the business and on what diligence revealed.

How do caps and survival periods limit exposure?

The cap is the maximum the seller must pay for indemnification claims. General representations are often capped at a fraction of the purchase price, while fundamental representations, taxes and fraud are frequently capped at the full purchase price or uncapped. Survival periods define how long after closing the buyer may bring claims. General representations commonly survive for a period long enough to complete at least one full audit cycle under the buyer's ownership, while fundamental and tax representations survive much longer, often until the applicable statute of limitations expires.

Caps and survival interact with escrows. If the escrow is the buyer's sole source of recovery for general representations, the effective cap equals the escrow amount, regardless of a higher contractual cap. Buyers should confirm whether claims above the escrow can be pursued directly against the seller and whether the seller will have assets to pay them. Sellers who have distributed sale proceeds to multiple holders may have little capacity to pay, so the practical value of a cap above the escrow depends on who stands behind the obligation and whether any guarantee from a creditworthy parent or individual is available.

How do escrows, holdbacks and representation insurance fit together?

An escrow sets aside part of the purchase price with a third party agent to secure the seller's indemnity obligations, with release at the end of the survival period less any pending claims. A holdback serves the same function but the buyer keeps the funds. Separate escrows are often created for the working capital adjustment, so ordinary closing true ups do not consume indemnity protection. Escrows give the buyer certainty of recovery and are especially important when sellers are individuals who will distribute proceeds after closing.

Representation and warranty insurance shifts much of the indemnity risk to an insurer. The buyer purchases a policy that pays losses from breaches above a retention, and the seller's indemnity is reduced, sometimes to a small portion of the retention. The insurance changes negotiation dynamics and often allows a cleaner exit for the seller, but policies exclude known issues, certain covenants and specific risks such as underfunded pensions or forward looking statements. Those exclusions still need specific indemnities or price adjustments.

What should a lender review in the purchase agreement?

Acquisition lenders review the purchase agreement because the buyer's indemnity rights are part of the collateral package and part of the credit story. The lender typically takes a collateral assignment of the buyer's rights under the agreement, so indemnity payments can be directed to repay debt if needed. The lender also checks that closing conditions, material adverse effect definitions and termination rights align with financing conditions, that seller notes and earnouts are subordinated, and that the escrow is sized relative to the key risks found in diligence. A weak indemnity package on a business with known tax, litigation or customer concentration issues can change the lender's view of the credit.

Applying baskets, a cap and an escrow to indemnity claims

1. Purchase price is $50,000,000. The basket is 0.75% of price, or $375,000. The general cap is 10%, or $5,000,000, and the indemnity escrow is $2,500,000.
2. Scenario A, deductible basket: valid claims total $900,000. Recovery = $900,000 - $375,000 = $525,000.
3. Scenario A, tipping basket: claims of $900,000 exceed $375,000, so the buyer recovers the full $900,000.
4. Scenario B, deductible basket: claims total $6,500,000. Uncapped recovery would be $6,500,000 - $375,000 = $6,125,000, but the cap limits it to $5,000,000.
5. The escrow funds the first $2,500,000. The remaining $5,000,000 - $2,500,000 = $2,500,000 must be collected directly from the seller, which is only possible if the agreement allows recourse beyond the escrow and the seller retains assets.

How underwriters apply this

• Map each key diligence finding to a specific indemnity, price adjustment or insurance coverage.
• Model recoveries under the actual basket type, de minimis threshold, cap and escrow size.
• Confirm whether the escrow is the sole source of recovery for general representations.
• Take a collateral assignment of the buyer's rights under the purchase agreement.
• Check representation insurance exclusions and ensure excluded risks have another remedy.
• Align the material adverse effect and closing conditions with the financing commitment.

Frequently asked questions

Keep reading

Educational content written by practitioners. Not investment, accounting, legal or tax advice.