How to sell a company - Part 5: Warranties and Indemnities

This is the fifth part in a series of seven blogs that outline the process of the sale of a company – before, during and after the negotiation and signing of the share sale and purchase agreement.

In this Part 5 of the series, we look at what warranties and indemnities are and why it is important that they are considered carefully by both the buyer and the seller in a transaction. Follow the links to read Part 4: The Consideration and Part 6: Signing the Transaction Documents.

Warranties and indemnities are a common feature of share purchase agreements and are forms of contractual protection. On a share purchase, warranties are particularly important as the buyer is acquiring an entity with all its assets, rights, and liabilities. So, as well as getting the benefit of all of the assets, the buyer is also taking on all of the target company's existing liabilities and commitments.

The law provides no statutory or common law protection for the buyer as to the nature or extent of the company assets and liabilities it is acquiring - a buyer will therefore look to protect their position and warranties and indemnities are a tool that can achieve this. 

What are warranties?

Warranties are contractual statements which take the form of assurances from the seller to the buyer as to the condition of the target company.

Warranties serve two main purposes which are:

1. to provide the buyer with a remedy if the statements made later prove to be incorrect, resulting in the target company being of less value than if the warranty were true; and
2. to encourage the seller to disclose known issues to the buyer, which will assist the buyer in evaluating the transaction.

How can liability be limited?

It is common practice for the seller to seek to limit their liability under warranties and these limitations tend to come under four categories: awareness, disclosure, time limits and financial limits.

• Awareness: the seller (also known as the "warrantor") may qualify a warranty as to their awareness, stating that the warranty is true and accurate "so far as the seller is aware". This does not absolve the warrantor from making 'reasonable' enquiries about the warranty it is giving, but it may help to limit their liability. A buyer will often reject these statements, as the warrantor "ought to know" about the company it is selling.

• Disclosure: making disclosures against warranties is one of the principal ways in which warrantors will seek to limit their exposure to warranty claims. Where known issues are properly disclosed to the buyer in advance, this will remove their ability to make any claim in relation to those issues.

• Time limits: the warrantor should always seek to limit the time period during which any claim can be made. This will commonly be between one and two years for non-tax warranties. As HMRC can re-open tax affairs of a company up to six years after the end of an accounting period, a limitation period of six or seven years is often agreed for tax matters.

• Financial limits: in addition to an overall limit on the value of any claims, which may be an amount up to the total consideration paid or a percentage of it, common financial limits on specific claims are:
  • a minimum limit for individual claims – the buyer cannot claim for breach of any warranty unless it exceeds a certain amount; and
  • a minimum limit for aggregate claims – the buyer cannot claim for a breach unless the aggregate value of multiple warranty claims exceeds a certain threshold amount.

What to look for as a buyer

As a buyer, you will be looking to secure the maximum comfort for yourself as possible, this will likely be done by having a broad range of warranties with a view to apportioning as much risk as possible to the seller and to elicit as much information about the target company as possible.

A buyer will also seek to reduce the limitations (set out above) as much as possible, to increase the value and chances of success for any potential claim.

What to think about as a seller

Conversely, as the seller you will be looking to reduce the scope of the warranties given as far as possible and will want to include the strongest limitation provisions that you can negotiate.

Particular types of warranty that sellers should resist include forward looking warranties – these relate to matters that are out-with the warrantor's control.  For example, a warranty stating that IT Systems will not need replaced or upgraded within two years of completion, and "sweeper" warranties where sellers are asked to warrant that they have provided all relevant information about the target company to the buyer, as this can override the other warranties and create uncertainty should a claim ever need to be made (or defended).

The difference between a warranty and an indemnity

An indemnity is a promise to reimburse the buyer on a "pound for pound" basis in respect of a particular type of liability should it arise. This is distinct from a warranty, where a buyer must prove its loss by demonstrating a reduction in the value of the asset (in this case the shares in the target company) that it has bought and can only make a claim on that basis.

Indemnities are therefore a more certain means of being able to make a claim, and are used for more specific matters, such as environmental issues, unresolved litigation, and tax liabilities (tax indemnities are normally included in a share purchase agreement as standard).

Unlike warranties, indemnities should not be qualified by disclosures and will probably not be subject to an obligation on the buyer to mitigate its loss.

How Brodies can help

Negotiating warranties and indemnities will inevitably form a major part of negotiations in relation to a transaction. If you require any assistance in drafting or negotiating warranties and indemnities, please do not hesitate to get in contact with a member of the Brodies Corporate Team listed below, or your usual Brodies contact, who will be happy to guide you.

View our downloadable guide, "Taking the blinkers off when selling your business", by Neil Ritchie, Director of Personal Tax, on what to watch out for from a personal perspective when selling your business.