Indemnification Agreements

April 13, 2006

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Many business owners harbor a misconception concerning pre-formation contracts, which potentially could lead to one of the contract exceptions to limited liability.

Commonly, when a pre-formation contract exists, the entity, upon coming into being legally, will agree to adopt the contract and release the owner from personal liability on the contract. Unfortunately, this "release" does not actually release the owner from liability.

This type of agreement, commonly called an indemnification agreement, makes the entity liable on the contract in addition to the owner personally. In a small business, the owner who has made the mistake of signing a pre-formation contract may actually be better off if he does not use this type of agreement. Why now make the business also liable on the contract and expose the business's assets to liability, in addition to the owner's personal assets?

However, this type of agreement may have some value, especially in a larger business with multiple owners. While the agreement does not release the owner from liability, it does mean that, if the owner is called on to personally honor the contract, the owner then can seek reimbursement from the business. In a larger, more complex business, this advantage probably outweighs the cost of exposing the business's assets to liability, at least from the perspective of the individual owner in question.