Limits of liability in M&A transactions
Introduction to liability limits in M&A transactions
One of the main concerns for both buyers and sellers in M&A and corporate acquisition transactions is defining the temporal and monetary limits within which the seller will be liable for any damages or contingencies arising from events prior to the transaction.
The establishment of these limits is one of the most contentious aspects and often becomes the cornerstone of negotiations.
The seller will naturally seek to make such time and financial limits as short and low as possible, whereas the buyer will pursue the opposite — to maximise both the duration and amount of potential liability (and, consequently, compensation).
To address these issues, it is customary to include in M&A transaction agreements clauses that allocate the risk of potential latent liabilities between buyer and seller. These clauses are typically complemented by temporal and quantitative limitations (both minimum and maximum).
Quantitative limits in M&A transactions
Maximum liability cap
In share purchase agreements within complex M&A transactions, it is common to include a “cap” — that is, a maximum amount for which the seller shall be liable to the buyer (and, where applicable, to the target company) for any damages arising from its prior management.
This cap is usually set as a percentage of the total consideration received by the seller as a result of the sale. Depending on the nature of the transaction, this limit may range between 20% and 100% of the purchase price, or even higher.
Thus, regardless of the amount of damage suffered by the buyer or the company as a result of latent liabilities or contingencies attributable to the seller, the latter’s liability shall be limited to the pre-agreed cap.
Franchise, basket, or deductible
In addition to setting a maximum liability limit, it is also common for the seller to introduce minimum thresholds (minimis) establishing indemnification thresholds — that is, from what amount the seller becomes liable.
The minimis requires that the aggregate amount of damages exceed a minimum before the buyer may bring a claim against the seller. This limitation can be structured in several ways:
- Tipping basket: A minimum liability threshold is set, and once exceeded, the seller indemnifies all losses from the first euro (or pound). Example: In a tipping basket of €50,000 with total damages of €51,000, the buyer cannot claim until the threshold is reached, but once it is, the seller is liable for the full €51,000.
Deductible: The seller is only liable for the excess above the agreed threshold. Example: In the same scenario, the seller would only compensate €1,000 (the excess over €50,000).
- Hybrid schemes: The seller assumes part of the damage below the basket threshold and 100% of the excess. Example: With a 50% basket and 100% of the excess, the seller would pay €26,000 (50% of €50,000 plus €1,000).
- Mini basket: This clause establishes that each individual claim counted towards the basket must exceed a minimum amount (e.g., claims under €500 or €1,000 are disregarded).
Each mechanism serves a different purpose:
- The tipping basket benefits the buyer.
- The deductible and mini basket favour the seller.
- Hybrid schemes aim to balance liability between the parties.
These quantitative mechanisms are essential tools for balancing the interests of both parties in domestic and international M&A transactions.
Temporal limits in M&A transactions
In addition to defining the amount of potential liability, it is crucial to determine the time period during which the seller will remain liable.
In M&A transactions, two main types of time limits are commonly established, depending on the type of claim:
- For administrative claims (tax, social security, etc.), the limitation period usually mirrors the statutory limitation period, sometimes extended by several months.
- For third-party claims (suppliers, clients, etc.), time limits typically range from 12 to 48 months.
Indemnities in M&A transactions
There are exceptions to the above limitations.
It is common for contracts to exclude certain damages or contingencies — particularly those identified during the due diligence process — due to their materiality or likelihood of occurrence.
In many cases, such exceptions are documented in a side letter (a non-public document) stating that specific contingencies will not be subject to temporal or monetary limits, or will have separate thresholds, generally more favourable to the buyer.
Indemnities in M&A transactions play a key role in protecting the buyer from foreseeable damages, safeguarding its position against identified risks.
Other protective mechanisms in M&A transactions
In addition to liability limits and indemnities, share purchase agreements often include set-off mechanisms, allowing the buyer to deduct from future payments to the seller (for example, from an earn-out or deferred payment) any amounts corresponding to indemnity claims.
Other common protection mechanisms include:
Both instruments serve to manage and secure the parties’ liability for potential future contingencies.
Conclusion
Negotiating liability limits in an M&A transaction is a critical exercise in risk allocation between buyer and seller.
The mechanisms discussed — quantitative limits such as the cap and various types of baskets, along with temporal limits — are not merely legal clauses but strategic negotiation tools aimed at balancing certainty and protection.
Indemnities and additional instruments such as W&I insurance and escrow accounts add sophistication and predictability, reducing risk and facilitating the successful completion of transactions.
A carefully structured approach to these elements is essential to achieving robust and sustainable agreements in any M&A operation.
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