Buying a business - the role of warranties and indemnities in protecting a buyer

Posted: 17/03/2023

The negotiation of warranties and indemnities is one of the most important (and time consuming!) aspects of many private company and business acquisitions.

This article is part of a series that provides an overview of the processes and considerations involved when buying a business.

The purpose of a warranty is to provide a buyer with a remedy if statements made about the target company or business prove to be incorrect and result in the value of the shares (or business) acquired being lower than expected. Warranties in this respect act as a potential price adjustment mechanism.

Warranties also encourage a seller to focus on matters relating to the target company or business and, accordingly, they flush out issues when, as part of the disclosure process, a seller informs the buyer of known problems relating to the target company or business. Warranties are not, however, a substitute for thorough financial, commercial and legal due diligence (DD).

To read more about the importance of DD click here.

What are warranties?

Warranties are contractual statements made by a seller (or sellers) that amount to assurances about the condition of the target company or business and, in particular, the existence and level of any liabilities.

Warranties speak at a particular point in time – usually the point at which the acquisition agreement is entered into, though they may also be repeated at the point when the acquisition completes (if later). The warranties must be read in conjunction with another document, known as the ‘disclosure letter’, in which the seller(s) will set out details of any matters of which they are aware, that would constitute breaches of, or exceptions to, the warranties as of the date they are given.

Disclosures made in the disclosure letter operate to qualify the warranties. If a warranty statement turns out to have been untrue when made, the buyer may have a legal remedy against the seller(s), except to the extent that the relevant matter has been disclosed. The warranties are usually set out in a lengthy schedule to the acquisition agreement and their precise scope will be a matter for (sometimes intense) negotiation between the buyer and seller(s) and their respective legal advisers.

Drafts of the disclosure letter will be provided to the buyer before the acquisition agreement is entered into, and, frequently, matters referred to in the various drafts will prompt additional enquiries from the buyer’s legal team. The warranties and disclosure letter will be negotiated in tandem and will overlap with the DD exercise, all of which are likely to be ongoing right up to the point when the acquisition agreement is entered into.

What are indemnities?

Indemnities are contractual promises by the seller(s) to meet a specific potential legal liability which a buyer may incur as a result of an acquisition. An indemnity would entitle the buyer to a payment if the event giving rise to the indemnity occurs. 

A buyer should seek to include indemnity protection in the sale and purchase agreement (SPA) in respect of any liabilities it discovers in DD that have not yet crystallised or are not yet quantifiable. It is customary on a share acquisition for the SPA to make provision for certain tax liabilities to be for the account of the buyer, and others for the seller(s), and for indemnities to be included in this respect (referred to as a ‘tax covenant’).

What is the difference between a warranty and an indemnity?

It is important for parties to be aware of the distinction between a warranty and an indemnity. A warranty is a contractual statement made by the seller(s) regarding the state of the target company or business. An indemnity is a promise made by the seller(s) that they will reimburse the buyer for a specific liability, if the need ever arises. 

A breach of warranty will only give rise to a successful claim if the buyer is able to show that the warranty was untrue, the seller(s) did not make an adequate disclosure in the disclosure letter and, as a consequence of the breach, it has suffered a loss. Additionally, before a buyer can recover for a breach of warranty, it will need to demonstrate that it has mitigated its loss.

An indemnity, however, acts as a promise to reimburse the buyer upon a specific event occurring, so there is no onus on the buyer to show that a breach has arisen nor that it has suffered a loss.

Who gives warranties?

In a share sale, the seller(s) of the target company will usually give warranties to the buyer. There may, however, be exceptions to this practice. For instance, trustee sellers may attempt to argue that they should not give full warranties as they do not have sufficient knowledge of the business of the target company. Likewise, institutional shareholders and persons holding shares who are not involved in the day-to-day running of the business – for example, spouses of director shareholders – may refuse to give warranties. If this position is acceptable to a buyer, it may wish to ensure that any shortfall is covered by those who do give warranties.

It is not usually reasonable to ask a director of the target company who has no shares to give warranties, regardless of whether or not they have detailed knowledge of the business. 

Limitations of warranty liability

If there are a number of sellers, the buyer will usually request that the warranties are given on a ‘joint and several’ basis. This means that the buyer may pursue any one or more of the warrantors in relation to the full amount of a warranty claim. Understandably, individual warrantors will wish to limit their liability to their share of the sale proceeds.

It is common practice for an individual seller’s liability to be limited in this way, although this may be resisted if the sellers are closely connected to each other (for example, spouses). Sellers will also usually benefit from other limitations on warranty liability, such as time limits and an aggregate financial limit capping the sellers’ liability at the actual price paid for the shares or business being acquired. 

Don’t cut corners!

The DD exercise can account for a significant proportion of the professional fees on an acquisition. However, its importance cannot be underestimated. Prospective buyers may be tempted to try to save costs in terms of DD and instead rely on the warranties in the acquisition agreement.

However, this is a very risky and inadvisable strategy for several reasons:

• Bringing a warranty claim can be a costly process, both in terms of legal fees – as well as its own legal costs, a buyer may be ordered to contribute towards a seller’s legal fees in the event that the claim is unsuccessful – and management time; and where there is an ongoing relationship between buyer and seller(s), litigation will not be an attractive option.
• To bring a successful claim, the buyer will need to be able to show that the warranty concerned was untrue and the seller(s) did not make an adequate disclosure against it in the disclosure letter. It will also need to show that as a consequence of the breach of warranty, the buyer has suffered a loss, meaning the company or business being worth less than it would have been had the warranty been true. In practice, this can be difficult to demonstrate and may entail a costly valuation exercise.
• Alongside identifying any issues that might affect the buyer’s decision to go ahead with the acquisition, the price it is willing to pay, and areas where enhanced warranty or indemnity protection may be required, the DD exercise will also identify any third party consents that will be required as part of the acquisition process (for example, from a regulatory body). The understanding of the target business that it provides can be invaluable for the buyer in planning how it will integrate the target into its existing operations. In a business and asset sale context, the DD process should identify which contracts permit assignment (where the counterparty will need to be notified that the assignment has taken place) and those where the third party will need to be approached in advance, and either a new contract negotiated, or the existing one novated.

The timing of these discussions will need to be considered carefully. Sometimes, where a contract is particularly important to the business but the existence of the transaction is commercially sensitive, it may be appropriate for the third party to be approached only after the SPA has been entered into, but for completion of the acquisition to be made conditional on satisfactory contractual arrangements being agreed between the buyer and the third party. Where notification of assignment of contracts is all that is required, this process may be ongoing after completion of the acquisition.

Conclusion

Warranties and indemnities, along with the DD process, serve as important protection mechanisms for a buyer of a business, whether the assets of the business, or the company itself are being sold. Arguably, however, they are particularly critical on a company acquisition, where the buyer will inherit the company’s entire tax history as well as its past, present and future liabilities.

This article is an edited summary from Penningtons Manches Cooper’s Guide to Buying a Business. For a copy of our Guide please click the banner below or get in touch with your usual PMC contact.

Our highly regarded corporate team provides clear, pragmatic and practical advice to businesses large and small from the UK and around the globe on the corporate transactions and the legal issues they face. To find out more about our corporate team please click here.

Return to news headlines