Caps + Baskets
The Anatomy of a Deal Newsletter January 25, 2019
Each month, Eric Duffee looks at a different piece of The Anatomy of a Deal – a series of easy-to-digest articles that break down complicated aspects of business transactions – helping you better understand terms + processes that can shape the direction of your business.
What is it?
Caps and baskets are types of limitations on the Buyer’s ability to recover from the Seller for certain losses, even when the Seller has breached its representations and warranties under the acquisition agreement. Here’s some sample language:
(a) Seller shall not be liable to the Buyer Indemnitees for indemnification for breaches of the Seller’s representations and warranties until the aggregate amount of all Losses in respect of breaches of the Seller’s representations and warranties exceeds [$[NUMBER]/[PERCENTAGE]% of the Purchase Price] (the "Basket"), in which event Seller shall be required to pay or be liable for [all such Losses from the first dollar]/[only those Losses in excess of the Basket.]
(b) The aggregate amount of all Losses for which Seller shall be liable as a result of Seller’s breaches of its representations and warranties shall not exceed [$[NUMBER]/[PERCENTAGE]% of the Purchase Price] (the "Cap").
What does it really mean?
Caps and baskets effectively shift some of the risk of the Seller’s breach of its own representations and warranties to the Buyer. Baskets shift the first $X of liability to the Buyer by making the Buyer responsible for all losses from Seller’s breach of its representations and warranties, up to the specified basket amount. Caps operate on the other end of the spectrum by shifting to the Buyer risk for total losses in excess of $Y. If you think about caps and baskets like an insurance policy, baskets represent the deductible and caps represent the policy limits. The Seller is responsible between the basket amount and the cap amount, with some exceptions.
Some important general observations about caps and baskets:
- They (almost always) only apply to breaches of representations and warranties. The Seller doesn’t get protection from the caps and baskets when the Seller breaches a covenant (e.g., non-competition and confidentiality obligations) nor from unassumed liabilities in an asset sale.
- But they don’t apply to all representations and warranties. Some of the representations and warranties are deemed to be so “fundamental” that the Seller is responsible from the first dollar, without limitation. Common examples of fundamental representations include: (a) legal existence of the Seller, (b) authority of the Seller to do the deal, (c) title to the stock or assets the Buyer is acquiring, and (d) tax liabilities. Other representations and warranties may also be classified as fundamental, depending on the deal and the parties’ negotiating leverage.
- Caps and baskets generally apply against aggregate losses. As such, you add up all of the losses resulting from breaches of the Seller’s non-fundamental representations and warranties in determining when the caps and baskets apply. So when the aggregate losses from all breaches of the Seller’s non-fundamental representations and warranties exceed the basket amount, then the Seller is thereafter responsible to reimburse the Buyer, up to the cap.
- There are different flavors of caps and baskets. Baskets are usually “tipping” or “non-tipping,” referring to what happens when the basket amount is exceeded. A “tipping” basket (illustrated in bold in the sample language in paragraph (a) above) provides that once the $X basket amount is exceeded, the Buyer is then liable for all losses, including the first $X in losses. A “non-tipping” (or true “deductible”) basket (illustrated in italics in the sample language in paragraph (a) above) provides that once the $X basket amount is exceeded, the Seller is only liable for losses in excess of $X. It’s also possible to have a “partially-tipping” basket, which is a hybrid of the two alternatives. Some transactions might also include a “de minimis basket,” which excludes certain small claims from being counted toward the baskets and caps at all. There are usually fewer variations in caps, but sometimes you may see a typical cap for breaches of non-fundamental representations and warranties and another “ultimate cap” for all breaches, including fundamental representations, covenants, and unassumed liabilities.
- The cap and basket amounts are usually tied to the purchase price. While heavily dependent upon the size of the deal and the nature of the acquired business (among other factors), baskets often range between 0.5% and 1% of the purchase price, and caps often range between 5% and 25% of the purchase price. These percentages trend higher as the purchase price goes down, and lower as the purchase price goes up.
- Caps and baskets only apply to unknown liabilities. If the Buyer uncovers liabilities or issues prior to closing, those matters are almost always excluded entirely from the caps and baskets. As such, the Buyer gets first-dollar protection against those liabilities or issues without limitation.
While these observations generally hold true, there are important distinctions that may apply in a particular deal. Caps and baskets—perhaps more so than the typical deal term—are heavily driven by market conditions and the relative negotiating leverage of the parties. The important thing is to recognize that they may apply and to engage experienced advisors to assist in negotiating and advising on these key provisions.
Why Should I Care?
Buyer: A Buyer has great concern about the caps and baskets because they effectively shift risk to the Buyer for the Seller’s breaches of its representations and warranties. While some Buyers will try to resist agreeing to any caps or baskets at all, they will be going against the overwhelming and longstanding position of the M+A market. A better strategy is to be smart about where the caps and baskets apply. In an asset sale, the Buyer achieves this in large part by simply refusing to assume unknown liabilities. In a stock sale, the Buyer can negotiate to expand the universe of fundamental representations and push for “tipping” baskets. Both Buyers and Sellers might also explore representation and warranty insurance, which allows both parties to assign much of the risk to a third party insurer. Even when insurance is in place, the Buyer needs to be aware of the policy exclusions and make certain that it has adequate protection from the Seller for these excluded matters.
Seller: The Seller obviously cares about the caps and baskets because they can increase the probability that the Seller will keep the purchase price. The first key for the Seller is to recognize the importance of negotiating the caps and baskets—as well as the fundamental representations—in the letter of intent. Once the letter of intent is signed, the Seller loses valuable leverage to negotiate a favorable deal. The Seller will also want experienced deal counsel to advise them on the appropriate cap and basket levels, and to limit the potential exclusions from the cap. As with the Buyer, the Seller may also want to explore representation and warranty insurance, though the Buyer and Seller will need to negotiate cost-sharing of the policy premiums and then decide whether it is economically worthwhile to seek outside insurance.
Next Month: Earnouts - Seller and Buyer Beware
Read last month’s piece: Recoverable Losses