A Dubai-based tech firm sells for AED 200 million. The deal seems perfect at first. But, months down the line, the buyer uncovers unexpected liabilities—antiquated software systems and unpaid vendor invoices totaling AED 25 million. Without any safeguards in place, the buyer demands the seller pay the full amount. This creates tension and financial stress between both parties. 

This hypothetical scenario highlights one of the biggest challenges in mergers and acquisitions – allocating risks fairly after a deal is closed. How can both parties ensure they are not blindsided by unexpected costs that arise post-closing? How do they manage the financial and reputational risks associated with these unforeseen issues? The answer lies in indemnification caps and baskets, strategic tools that help manage post-closing risks and provide both parties with the necessary protection. 

While indemnification caps limit the seller’s aggregate liability, baskets establish a threshold on claims to ensure cover of serious issues. Whether you’re a buyer looking to protect your investment or a seller aiming for peace of mind, understanding these provisions is key to a smooth transaction. Read on to see how indemnification caps and baskets work in the UAE’s M&A landscape and how they balance risk and responsibility. 

How do Baskets and Caps Work in M&A Transactions?

Indemnification baskets and caps often work hand in hand in M&A deals. The basket acts as a threshold, filtering out smaller claims, while the cap limits the total liability for the seller. This combination ensures that the seller is protected from excessive financial risk while the buyer is still able to recover for major post-closing issues. Together, these provisions create a more balanced, fair, and predictable risk allocation framework that helps avoid conflicts.

In UAE M&A transactions, defining these thresholds and limits enables parties to develop agreements that avoid disputes and provide a clear understanding to all parties involved.

What Are Indemnification Caps And How Do They Work?

In an M&A deal, representations and warranties play a critical role. These statements ensure that the seller’s claims about the company they are selling are accurate as of the closing date. However, should the buyer discover that these representations are false, indemnification will allow the buyer to recover costs from the seller if certain issues arise post-closing. Whilst the seller must pay for these costs, they cannot be expected to pay unlimited amounts for every potential issue. This is why indemnification caps exist and are used.

An indemnification cap sets a ceiling on the total amount a seller is responsible for after the transaction is complete. Essentially, it limits the seller’s liability to a predefined maximum amount, ensuring they’re not exposed to endless financial risk.

For example, let’s say you sell a Dubai-based company for AED 100 million. The buyer discovers that the company has faulty equipment and undisclosed debts amounting to AED 25 million, for which they are seeking recuperation. However, you have negotiated an indemnification cap of AED 20 million. This means that you are only responsible for covering up to AED 20 million, even though the buyer is facing AED 25 million in losses.

Why do buyers and sellers agree on indemnification caps?

• For Sellers: Offers protection from excessive liability, ensuring that the seller isn’t left financially exposed to unforeseen liabilities that could arise long after the deal closes. 
• For Buyers: Ensures they won’t be left vulnerable to massive, unmanageable claims over issues that arise post-closing.

How do indemnification caps in M&A in the UAE work?

M&A deals in Dubai and the UAE generally follow international standards, with both parties carefully negotiating indemnification cap and other terms in order to reach an agreement. Indemnification caps in M&A in the UAE usually range between 30% to 40% of the purchase price, though these amounts can vary depending on the specific circumstances of the deal.

However, some issues may bypass the limits of the indemnification cap. For instance:

• Fraud: If the seller knowingly lies or misrepresents relevant business information, such as hiding major debts, the indemnification cap will not limit the seller’s responsibility.. 
• Taxes: The seller is responsible for paying any outstanding taxes that the company owes in full, regardless of the cap. 
• Issues that come to light during inspection: Certain critical issues that arise during the due diligence process may also be exempt from the cap, such as issues that are considered too risky.

It is important to note that the seller’s liability is not everlasting. Purchase agreements will often mention a survival period, usually lasting one to two years after the deal closes. However, depending on the agreement, for particularly severe issues like tax fraud or disputes over ownership, the survival period can extend longer.

What Are Indemnification Baskets And How Do They Work? 

Indemnification baskets are another limitation to the seller’s liability. While indemnification caps limit how much the seller can be liable for, indemnification baskets address the threshold of claims. Baskets define the minimum threshold of claims a buyer must incur before they can seek compensation from the seller.

There are three types of indemnification baskets common in M&A transactions:

1. Deductible or non-tipping basket: The seller is liable only for losses exceeding the basket threshold. For example, if the basket is AED 500,000, and the buyer suffers a total loss of AED 700,000, the seller will only cover the amount above AED 500,000 — in this case, AED 200,000.
2. Tipping or first dollar basket: The seller is responsible for all of the buyer’s losses, both above and below the threshold. For instance, if the basket is AED 500,000 and the buyer’s loss is AED 700,000, the seller will pay the entire amount of AED 700,000.
3. Partially tipping basket: This combines elements of both tipping and non-tipping baskets. For example, the basket might be AED 500,000 with a deductible of AED 250,000. The buyer cannot recover any losses until they reach the AED 500,000 threshold. But once crossed, they can recover losses exceeding the AED 250,000 deductible. So if the buyer suffers a loss of AED 700,000, they can recover AED 450,000, as the deductible covers the first AED 250,000 (total loss of AED 700,000 minus the AED 250,000 deductible).

Simply put, the basket serves to filter out the small claims, requiring the buyer to reach a certain level of loss before compensation can be demanded from the seller. The threshold ensures that the seller doesn’t face constant claims for minor issues that could be part of normal business operations.

Why do buyers and sellers agree on indemnification baskets?

• For Sellers: Protects sellers from frivolous claims, ensuring that they are not financially burdened by minor issues that arise post-closing.
• For Buyers: Assures buyers of some recourse for major post-closing defects, while sharing responsibilities for minor defects.

How are Indemnification Baskets Used in UAE M&A Deals?

Like caps, indemnification basket provisions are also negotiated to reflect international standards. These baskets undergo rigorous negotiation, with careful consideration given to due diligence, and are tailored to the specifics of the transaction.

In the UAE, indemnification baskets often range from 0.5% to 1% of the purchase price. Therefore, if a business were sold for AED 100 million, the basket amount would range between AED 500,000 and AED 1,000,000. 

For example, you sell a logistics company in Dubai for AED 100 million and the indemnification basket is AED 500,000. The buyer is seeking recuperation for AED 300,000 for vehicle maintenance and AED 700,000 for a legal dispute with an old supplier. Since the AED 300,000 maintenance cost is below the basket threshold, the seller will not be liable to pay. However, the AED 700,000 supplier claim exceeds the threshold, and the seller will be required to pay for it, depending on the type of basket agreed upon. With a deductible basket, the seller will only have to pay AED 200,000 (the amount above AED 500,000). With a tipping basket, the full amount of AED 700,000 must be covered.

Like with indemnification caps, major issues uncovered during due diligence, such as fraud or tax issues, bypass the threshold limitations altogether. Liability under baskets is also time-barred. General claims usually have a survival period of 1–2 years. More serious claims, such as tax disputes, may last longer.

Conclusion

Indemnification caps and baskets are vital in managing risk allocation in M&A transactions. They empower sellers to limit their liability while protecting buyers against significant post-closing issues. These provisions form a foundation for mutual trust and clarity, ensuring that both parties can focus on realizing the deal’s long-term value without unnecessary disputes.

This guide provides sellers and buyers with the knowledge and understanding needed to navigate indemnity caps and baskets. They can now explore incorporating caps and baskets into their M&A agreements, refine risk allocation strategies, and gain a deeper understanding of post-closing liabilities through expert-led audits and due diligence.

United Advocates has established itself as one of Dubai’s premier law firms for mergers and acquisitions. We leverage years of expertise in navigating the UAE’s intricate legal environment, offering services such as:

• Drafting and negotiating caps and baskets to balance liabilities between buyers and sellers.
• Conducting thorough due diligence to identify and address potential risks before closing.
• Structuring agreements with clear indemnification provisions to minimize future conflicts.

Take the next step with confidence. Please contact shoeb@united-advocates.com today to collaborate with the best M&A lawyers in Dubai and ensure your transaction is legally sound and strategically optimized. Let us safeguard your interests every step of the way.