Indemnity vs. Damages: Simplified for Founders and Entrepreneurs

Contracts can be tricky to navigate, especially when terms like "indemnity" and "damages" appear. While both aim to provide financial remedies, they serve different purposes and operate under distinct legal principles. In addition to these differences, there are several other practical distinctions between indemnity and damages, which we will cover separately. For now, we focus on the core differences to provide clarity without overwhelming the reader.

At Legally Wired, we offer insights that look beyond the basics of the law. Each article concludes with actionable insights to help you assess potential risks and practical ways to reduce them, empowering you to make informed, proactive choices for your business

Indemnity: Shifting Risks Proactively

Indemnity in a contract is like a financial safety net. It’s a promise from one party to compensate the other for specific risks or losses agreed upon in the contract. On the other hand, damages are a legal right to compensation when someone breaks the contract, covering direct losses caused by that breach. While both indemnity and damages aim to make up for losses for breach of a contract, indemnity is more flexible and can cover broader situations.

For example, with indemnity, you can define specific risks you want protection against. Importantly. This makes indemnity a powerful tool, as  it can cover not just breaches of the contract but also claims from third parties connected to the agreement.

This ability to claim compensation for third-party claims makes indemnity a game changer, as it lets you shift potential risks or liabilities onto the other party in advance. Think of it as a proactive way to manage financial risks in a contract.

Business Case: A SaaS Startup and Its Client

Imagine you own a SaaS startup providing logistics management software to a retail client, RetailPro and both of you choose to enter into a contract, where you agree to license your core SaaS application. The client (Retailpro) is worried about the risk of third-party lawsuits against itself, if your software accidentally infringes on another company's intellectual property (IP). To address this, you include an indemnity clause in the contract, which is likely to read as follows

“The Service Provider (i.e., you the startup) shall indemnify and hold harmless the Client (i.e., Retailpro), its officers, employees, and agents, from and against all claims, liabilities, damages, costs, and expenses (including reasonable attorney fees) arising out of or related to any third-party claims alleging that the Service Provider's software infringes upon or violates any intellectual property rights. This indemnity obligation shall not apply if such claims arise from modifications to the software made by the Client without the Service Provider's authorization.”

What happen when InnovSoft, a third - party sues RetailPro for IP infringement

Indemnity Example: A third party, InnovSoft, sues RetailPro, claiming your software infringes on its patent. RetailPro promptly invokes the indemnity clause and requests you, the SaaS provider, to cover their legal costs, settlement fees, and related expenses. RetailPro does not need to prove a breach of contract (e.g., that your SaaS product violated their rights) or prove that you incurred losses to make this claim. Simply because you agreed to the indemnity clause, your financial responsibility begins as soon as there is a claim against RetailPro, such as receiving a legal notice.

It’s important to note that even if InnovSoft’s claim is entirely false, and your software does not infringe any patents, you are still liable for RetailPro’s legal costs, including lawyer fees and court expenses. This obligation exists because of the broad indemnity clause you agreed to.

Key Insight:

This scenario demonstrates why startups must carefully draft indemnity clauses. Broadly worded clauses can expose you to significant financial risks. To protect yourself, you should ensure the indemnity clause clearly defines the events and circumstances that trigger your obligations. Narrow and precise language can prevent unwarranted liabilities while keeping the agreement fair.

If the same software is found to infringe on IP, but there is no indemnity clause, RetailPro’s only other option would be to first prove that your failure to ensure non-infringement constitutes a breach of contract. This can happen only if the contract has language (usually in the form of a representation) stipulating that the SaaS product does not infringe on any third party IP.

Assuming such language exists, RetailPro can claim damages only after proving that your SaaS product definitely was in breach of third party IP, which means that costs are incurred before you can recover from the Service Provider.

Key Insight:

Without indemnity, RetailPro’s ability to recover costs is more limited and dependent on successfully proving that you had breached the contract and the breach caused them losses. If you look at the example here RetailPro enjoys meaningful remedy only when they have an indemnity obligation.

Damages: Compensating for Breaches

Damages are awarded to compensate one party for actual losses caused by the other party’s breach of contract. The goal is to restore the injured party to the position they would have been in if the breach hadn’t occurred.

Business Case: Delivery Delay

You run an e-commerce startup, FastKart, and contract with a logistics provider, ShipEase, to deliver products to your customers. The contract includes both indemnity and damages clauses.

• Damages Example: ShipEase fails to deliver products on time, causing FastKart to lose a major client and suffer $50,000 in lost revenue. To claim damages, FastKart must prove ShipEase breached the delivery timeline, quantify the financial loss, and show that it was directly caused by the breach. Once proven, FastKart can recover compensation for these actual losses.

• Indemnity Example: Separately, if a third-party customer sues FastKart for undelivered goods due to ShipEase’s failure, the indemnity clause would shift the risk to ShipEase. FastKart would not need to prove a breach—the indemnity clause ensures ShipEase covers the lawsuit costs, even if the breach itself is disputed.

Key Difference between Indemnity and Damages: Indemnity protects the Indemnitor by allowing immediate financial recovery for third-party claims, while damages require proof of breach and can only cover direct losses.

What Happens When a Contract Includes Both Indemnity and Damages?

Many contracts include indemnity provision for breach of contract and for third party claims. However, the beneficiary of the right to indemnity for breach of contracts is able to negotiate for it only for breach of key clauses - you can expect to face resistance to include the entire contract under the purview of indemnity, for obvious reasons. Separately, damages as a remedy is available under the law for breach of contracts. Here’s how they might work together in practice:

Scenario: SaaS Provider and Third-Party Claims

Imagine a SaaS provider contracts with a retail company, RetailWorld, to deliver a customer-facing platform. The contract includes:

• Indemnity Clause: The SaaS provider indemnifies RetailWorld for any third-party claims related to data breaches caused by the platform. The SaaS provider also agrees to indemnify RetailWorld if it fails to meet the agreed uptime levels.

• The SaaS provider amongst other obligations under the contract has also agreed to ensure timely removal of reported bugs (to note the contract does not have indemnity for this breach) 

How They Work Together:

Third-Party Claim (Indemnity Applies):

• A third party, DataSecure Inc., sues RetailWorld, claiming that the SaaS platform caused a data breach involving customer information.

• RetailWorld invokes the indemnity clause, and the SaaS provider covers all legal fees, settlements, and other related costs. RetailWorld doesn’t need to prove a breach of contract—the indemnity clause shifts the financial responsibility to the SaaS provider.

  
  

Failure of Uptime Levels (Indemnity Applies):

• Separately, the platform experiences extended downtime, violating the service level agreement (SLA) and causing RetailWorld to lose $100,000 in sales during the downtime. Additionally, RetailKart reports that there is a drop in the number of transactions on the Platform immediately following the downtime which has caused a loss of revenue amounting to $400,000. 

• RetailWorld claims indemnity for the financial losses for the losses directly corresponding to the downtime AND for the loss of revenue thereafter. 

Failure to remove reported bugs in the software (Damages Apply)

• The SaaS provider breaches its obligation to remove reported bugs which impacts the user experience on the platform. RetailKart claims that this breach is solely responsible for losing customers on account of poor user experience and the progressive loss of revenue amounts to $800,000. 

• RetailWorld claims damages for loss of revenue, in this case RetailWorld will have to prove that there has been a breach of contract and that the claims of loss of revenue is directly connected to the said breach.

Why Both Are Useful:

• Indemnity: Covers risks that might arise from third party claims and also from breach of identified obligations (e.g., third-party lawsuits).

• Damages: Compensates for direct losses caused by a breach (e.g., failure to meet obligations).

Practical Differences Between Indemnity and Damages

While indemnity and damages are complementary tools, their practical differences often influence how businesses negotiate contracts. Here are some additional points to consider:

Foreseeability

• Indemnity clauses often cover a broader range of risks, including unforeseeable losses. For instance, if a third-party claim arises unexpectedly, the indemnity clause ensures financial protection.

• Damages, by contrast, are generally limited to losses that were foreseeable at the time of contract formation.

  
  

  Third-Party Involvement:

  
  

• Indemnity is particularly valuable in scenarios involving third-party claims, as it allows the indemnitee to recover costs without needing to prove fault.

  
  

• Damages are usually focused on direct harm caused by one party to the other, without involving third parties.

  
  

  Burden of Proof:

  
  

• With indemnity, the indemnitee often does not need to prove a breach, only that the triggering event occurred.

• With damages, the injured party must demonstrate not only the breach but also causation and the extent of their losses.

  
  

  Scope of Coverage:

  
  

• Indemnity clauses can include indirect and consequential losses (e.g., reputational damage or regulatory fines).

• Damages are typically confined to direct and quantifiable losses.

  
  

  Legal Costs and Timing:

  
  

• Indemnity allows quicker access to compensation for costs such as legal fees in third-party claims, reducing financial strain on the indemnitee.

  
  

• Damages, however, often require a lengthy legal process to establish fault and assess losses, which can delay recovery.

  
  

Comparing Indemnity and Damages

Aspect	Indemnity	Damages
Nature	Proactive risk-shifting	Reactive compensation for actual losses
Trigger	Specific event (e.g., third-party claim)	Breach of contract
Scope	Broad (can include third-party claims and indirect losses)	Narrow (foreseeable and direct losses only)
Mitigation Duty	Generally not required	Required
Purpose	To allocate risks in advance	To compensate for harm caused by a breach

Why These Differences Matter for Founders

Understanding indemnity and damages can help you:

Negotiate Better Contracts: Avoid overbroad indemnity clauses that could expose your business to unlimited liability.

Protect Your Business: Ensure damages clauses fairly compensate you for actual losses without excessive penalties.

Allocate Risks Strategically: Use indemnity to protect against high-risk events, such as third-party claims or regulatory fines.

Save Costs: Anticipating these distinctions allows you to better budget for potential liabilities and incorporate them into pricing or service terms.

Tip: Work with a lawyer to draft contracts that balance risks and responsibilities effectively.

Conclusion: Choosing the Right Remedy

Indemnity and damages are essential tools in contract law, but they serve different purposes. Indemnity shifts specific risks in advance, while damages provide compensation for breaches. Understanding these differences helps you:

• Protect your startup from unforeseen liabilities.

• Negotiate fair terms in agreements.

• Strengthen your legal position in disputes.

By including clear indemnity and damages clauses in your contracts, you can safeguard your business and focus on growth without unnecessary legal risks.