Venture Capital Deals in IT: Indemnification

We continue the series of articles on the instruments of venture capital deals in IT under the English law. Today, we will look at the indemnification – a mechanism of compensation for losses.

Who does indemnify, who is indemnified and why?

Indemnification means that a party compensates the other party for losses incurred by the other party in connection with certain events. In venture capital deals, this mechanism is essential for investors to protect themselves against losses (damages, liabilities) that they may incur when investing in a startup and transfer the risk of such losses to founders in advance. 

Indemnification is primarily used in conjunction with representations and warranties: i.e., founders undertake to indemnify the investor for the losses incurred by the investor in the event of a breach of representations and warranties given by founders in transaction documents. However, the instrument is applicable in other cases as well: e.g., when entering a target company, the investor may appoint a representative in the target’s board of directors and request for indemnification – in this case, the target should indemnify the investor for the losses that its representative may incur while holding the office of a board member. 

What do you need to take into account when negotiating indemnification?

When negotiating indemnification clauses, it is advisable to pay close attention to the indemnification limits. The limits may be quantitative: a minimum threshold (where indemnification amount cannot be claimed in each particular case unless the total aggregate amount of losses reaches X) and a maximum threshold (e.g., limiting compensatory amount to the aggregate investment amount or to the founders’ stock value). Indemnification may also have time limits. However, generally, such limits do not apply to the losses arising out of the breaches of fundamental representations and warranties, as well as fraud, misconduct or gross negligence of the founders and the target company (e.g., setting up a competing company without the investor’s knowledge, conducting business and undertaking business opportunities through it).

As the subject of indemnification (what falls under the losses, damages, liabilities, etc.) and the triggers for indemnification are often specified broadly in the deal documents, it is desirable for founders to have the indemnification obligations limited. For example, the deal documents may provide for that:

• founders do not indemnify the investor to the extent the losses are caused by fraud or willful misconduct of the investor;
• founders don’t indemnify the investor to the extent the losses arise from circumstances, which have been known to the investor;
• the investor undertakes the duty to mitigate (reduce) losses to the extent possible;•    if the same circumstance gives the investor the right to claim indemnification under several provisions in the investment agreement, the indemnification will apply in full but only once (not for each such provision).

Indemnify, defend and hold harmless – what is the difference?

Transaction documents may contain the provision “Company (Founders) shall indemnify, defend and hold harmless Investor”. As three terms are similar, there may be confusion in the contents of each and, as a result, incomplete understanding of how the instrument will work when a trigger for indemnification occurs. Let’s look at these terms in detail:

1. “Indemnify” refers to the obligation to pay or compensate the investor for losses or legal liabilities; 
2. “Defend” refers to the obligation to undertake settlement of a dispute brought against the investor, including obtaining legal advice, engaging an attorney, paying legal fees, etc.;
3. “Hold harmless” is similar to “indemnify”, however, the founders (target company) not only undertake the risk by accepting responsibility for the investor’s losses and legal liabilities, but also undertake to refrain from transferring the risk further to the investor (i.e., undertake not to “bother” the investor at any time, even if the founders themselves incur losses, by accepting the investor’s actual and potential losses).

Indemnification, as a risk transfer mechanism, allows the parties to determine in advance who is liable for the losses and to what extent. It is advisable to be very careful when negotiating this instrument in the transaction documents with a view to reasonably define the triggers for the risk transfer between the investor and the founders, while preserving the balance of interests.