While pursuing the upside of a growth stage company, it’s easy to forget to hedge against downside risks. Corporate officers and directors can face immense financial liabilities if sued in connection with their service to the corporate entity. With this in mind, the prudent officer/ director will ensure entitlement to indemnification for legal expenses AND advancement of funds to cover their defense.
What is Indemnification? Advancement?
So, what exactly is advancement and how is that different from Indemnification? Although the terms are often used interchangeably, there is a difference. Indemnification refers to the ultimate obligation of the corporate entity to pay, among other things, the legal costs of a proceeding involving a director/officer. Advancement is the obligation of the corporate entity to pay those costs as they are incurred.
Whether or not you are entitled to indemnification or advancement is governed by state law. In Delaware, for instance, corporate entities have great flexibility in their ability to indemnify officers. While there are some mandatory indemnification obligations by statute, most authority is permissive, which means it has to be drafted into documents in order to apply. Officers and directors who have not ensured adequate indemnification AND advancement rights have been created might find themselves depleting their own personal savings to pay for the costs of litigation. Worse yet, if those individuals don’t have adequate funds to defend themselves, they might not be able to defend themselves at all. Knowing these risks, the next question is what potential officers and directors should do to ensure that personal assets are protected from litigation costs associated with the duties performed in their corporate capacity.
As a first step, officers and directors should check whether their entity’s corporate documents provide for indemnification and advancement. With appropriate planning, these provisions may have been included in the certificate of incorporation, and/or bylaws. However, even if these provisions exist, in many situations, directors and officers who rely exclusively on these provisions may not be fully protected. It is for this reason that we recommend an Indemnification Agreement. An Indemnification Agreement provides broader and more thorough protections for officers and directors than those contained in corporate documents. For instance, the types of expenses to be advanced can be drafted much more broadly to ensure there is no arguing over whether or not particular expenses or types of proceedings will be covered. It can clarify the time frame for indemnification to make sure the entity does not drag its feet. It can give the indemnified director or officer more choices in connection with his or her defense, and ensure legal fees are covered if he or she has to sue to enforce indemnification provisions. An additional, yet critical feature of the Indemnification Agreement is that it can mandate adequate insurance to ensure the entity is able to live up to its indemnification and advancement obligations. These are just some of the higher priority provisions that your agreement should begin to address.
So, as you are considering your role in your new business endeavor, whether you are starting it yourself or joining an existing organization, don’t forget to add indemnification and advancement protections to your “to-do” list. You hope you’ll never need it, but if you do, no doubt you’ll give yourself a pat on the back for having the foresight to focus on this important legal protection.