An indemnification agreement is a contract in which a company promises to cover the legal costs, judgments and settlements its directors and officers incur when they are sued or investigated because of their role with the company, and usually to advance defense costs as they are incurred. For founders who serve as directors and officers, it turns the protections in the company’s charter and bylaws into a direct contractual right that cannot be taken away later. It works best alongside directors and officers (D&O) insurance, because indemnification is only as good as the company’s ability to pay.
Startups face lawsuits, regulatory inquiries and shareholder disputes more often than founders expect, and claims are usually brought against the individuals running the company as well as the company itself. Here is how indemnification agreements work and what they can and cannot do.
What an Indemnification Agreement Covers
A well-drafted agreement typically addresses:
- Covered proceedings. Threatened or pending lawsuits, arbitrations, investigations and regulatory proceedings brought against the person “by reason of” their service as a director, officer or other agent of the company.
- Covered costs. Attorney’s fees and other expenses, judgments, fines and amounts paid in settlement, subject to the legal limits discussed below.
- Advancement. The company pays defense costs as they are incurred, rather than after the case ends, in exchange for the person’s written undertaking to repay if it is ultimately determined they were not entitled to indemnification. For most individuals, advancement is the most valuable part of the agreement.
- Procedures. Deadlines for the company to pay, presumptions in favor of the indemnitee, who decides entitlement, and the right to recover the costs of enforcing the agreement.
- Insurance and continuity. Commitments to maintain D&O insurance and to keep the protections in place after the person leaves or the company is acquired.
Legal Limits on Indemnification
Indemnification is broad but not unlimited. Most venture-backed startups are Delaware corporations, where Section 145 of the Delaware General Corporation Law sets the framework. California corporations are governed by Corporations Code Section 317, which is similar in structure.
- Good faith requirement. A company may generally indemnify a person only if they acted in good faith and in a manner they reasonably believed to be in, or not opposed to, the company’s best interests, and, in criminal matters, had no reasonable cause to believe their conduct was unlawful.
- Suits brought by or for the company. In derivative suits, indemnification is generally limited to defense expenses. Judgments and settlements paid to the company itself usually cannot be indemnified without court approval, and expenses may be barred if the person is found liable.
- Mandatory indemnification on success. If a director or officer successfully defends a covered claim, on the merits or otherwise, statutes generally require the company to cover their expenses.
- Securities claims. The SEC takes the position that indemnifying directors and officers for liabilities under the Securities Act is against public policy and unenforceable, which matters at an IPO.
Indemnification also covers the person in their corporate role, not their personal obligations. A founder’s own breach of a personal guarantee or a dispute over their individual employment agreement generally falls outside it.
Agreement vs. Charter and Bylaws
Most startup charters and bylaws already provide indemnification. A standalone agreement still adds value because:
- It cannot be changed unilaterally. A later board or new controlling stockholders can amend bylaws; a contract requires the indemnitee’s consent.
- It makes permissive protections mandatory. Statutes permit indemnification in many situations without requiring it. The agreement converts “may” into “will.”
- It adds procedural protections. Payment deadlines, burden-of-proof presumptions and fee-shifting make the rights practical to enforce.
For a California corporation, protections that go beyond Section 317 must be authorized in the articles of incorporation, so the articles and agreement should be drafted together.
Exculpation and D&O Insurance
Exculpation is a related protection. Delaware and California allow a corporation’s charter to eliminate directors’ personal monetary liability for certain breaches of the duty of care, with exceptions for bad faith, intentional misconduct, improper personal benefit and similar conduct. Delaware amended its law in 2022 to allow charters to exculpate certain senior officers as well, though not in claims brought by or on behalf of the company. Exculpation provisions belong in the charter, not an indemnification agreement.
D&O insurance fills the gaps. If the company is insolvent, or indemnification is legally prohibited, as with many derivative settlements, “Side A” coverage can pay on behalf of the individuals directly. Founders should confirm the policy limits, the definition of insured persons and whether coverage continues after an acquisition, often through a “tail” policy.
Who Should Get an Agreement
Venture-backed companies commonly enter into indemnification agreements with every director and with senior officers, usually in connection with a priced round such as a Series A financing. Standard venture forms also address directors designated by investment funds, which typically have their own indemnification from the fund. Those agreements commonly make the company the “indemnitor of first resort,” so the company pays before the fund’s coverage applies. Founders should check that their own agreements are at least as favorable as those given to investor directors.
Agreements for employees and other agents are less common. Bylaws often make indemnification of employees discretionary, so the board can evaluate each situation, for example in employment-related claims. A person who is both an employee and a director should confirm that the agreement covers each of their roles.
The Takeaway
An indemnification agreement gives founders, directors and officers a contractual right to defense costs and protection from personal liability for acting in their corporate roles. It cannot override statutory limits for bad-faith conduct, derivative settlements or Securities Act claims, so pair it with a charter exculpation provision and adequate D&O insurance. Put these protections in place before disputes arise, ideally at formation or the first priced round.
Frequently Asked Questions
Do founders need an indemnification agreement if the bylaws already provide indemnification?
It is still recommended. Bylaws can be amended by a future board or stockholders, while an agreement requires the indemnitee’s consent to change. Agreements also make permissive protections mandatory and add enforcement procedures.
What is advancement of expenses?
Advancement means the company pays legal defense costs as they are incurred instead of reimbursing them after the case ends. The individual signs an undertaking to repay the amounts if it is later determined they were not entitled to indemnification.
Can a company indemnify a founder for anything?
No. Indemnification generally requires that the person acted in good faith and in the company’s best interests. Settlements and judgments in suits brought by or on behalf of the company are restricted, and indemnification for Securities Act liabilities is considered unenforceable by the SEC.
Is D&O insurance still necessary with an indemnification agreement?
Yes. If the company cannot pay because it is insolvent, or indemnification is legally prohibited, D&O insurance can pay on behalf of the directors and officers directly.
How Sutter Law Can Help
We draft indemnification agreements, charter exculpation provisions and board governance documents, and we advise founders in founder disputes where these protections are tested. Learn more about our startup law practice, or contact us for a free consultation.
This article is general information, not legal advice. Reading it does not create an attorney-client relationship.
