Wednesday, January 21, 2009

Private Equity and VC Funds Should Review Their Indemnification Agreements

Private equity and VC firms usually appoint representatives to serve on the board of directors of their portfolio companies. These directors provide strategic guidance and expertise. Typically, they would receive two layers of protection from personal liability for their services to the company by signing indemnification agreements with both the company and the PE/VC fund.

While indemnification agreements protect the director against personal liability, they do not usually specify the priority of the director’s indemnification rights. That is, the agreements do not specify whether the company or the PE/VC fund should be tapped first for indemnification. Many PE/VC funds assume that the indemnification they are providing is second in line to that provided by the company. However, in the recent case of Levy v. HLI Operating Company, the court allowed a board member to seek indemnification from the private equity fund without first seeking it from the company. The court suggested that the private equity fund pursue a contribution action against the company.

Although the Levy case was in the Delaware state courts and involved a Delaware corporation, the underlying legal concepts may well apply with equal force to contracts and cases under the laws of other states.

This decision highlights the importance of carefully managing multiple indemnification agreements. When creating layers of indemnification protection, it is important to designate who will be the primary source of payment for directors’ out-of-pocket expenses. It could be either the company or the PE/VC fund, depending on the circumstances. For example, when a PE fund wholly owns its portfolio company, it may be irrelevant which entity provides the first indemnification. On the other hand, a VC fund would be very concerned about this issue since it typically only holds a minority position in a company. By designating the desired result ahead of time, no one will receive a nasty and costly shock if it does not come out the way they had assumed.

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Dividends and Preferences by Hank Heyming is licensed under a Creative Commons Attribution 3.0 United States License.