Selling a Small Business
By: Clay Brock
In the legal documents for a small business acquisition, a seller will make certain representations and warranties (defined on our website) regarding the business. For instance, he might represent that the business’s inventory is of merchantable and usable condition. If it turns out that some of the inventory is obsolete, the buyer might have a claim against the seller. Baskets and caps establish limits on the amount a buyer can claim against a seller for certain claims of indemnification.
An indemnification ‘cap’ limits the overall liability of the seller to some dollar amount. Typically, small market transactions have caps equal to 50% of the purchase price. These caps also usually exclude certain key representations and warranties (i.e. the cap does not apply) such as ownership, authority to enter into the sale transaction, etc.
A ‘basket’ establishes a threshold under which the buyer cannot make a claim against the seller. In small market transactions the basket amount is usually 0.5% of the purchase price and the basket is a ‘first-dollar’ basket. In the case of a transaction with $5 million purchase price this means the basket would be $25,000. In this case, if there were claims totaling $20,000, the buyer could not make a claim against the seller because the $25,000 threshold had not yet been reached. But if the claims totaled $30,000 the buyer could make a claim from the ‘first-dollar:’ that is for the entire $30,000.
Baskets and caps are just one part of the definitive legal agreements that formally document a transaction, but they’re useful to understand.