What are seller warranties

Even though the potential buyer of your company will demand that he gets to do a so called due diligence where he investigates the company in depth before deciding to buy, you will still be the one who has the most information about the company. Therefore, the buyer will typically request that you, as part of the final share purchase agreement, give him a long list of warranties as regards the shape of the company and its operations for a historical period leading up to the closing date.

These warranties can address everything from the accounting being correct and done in accordance with applicable laws and regulation, that the company owns all of its intellectual property and that it is not infringing on others intellectual property, that employment matters having been addressed in accordance with laws and regulation and without any pending claims or disputes, to taxes have been reported and paid in a timely manner.

The consequences of you signing such warranties will be that if, once the buyer has taken over the company, something comes up that is not in line with the warranties you have provided, then he or she can turn to you with a claim for damages. This means that after the deal is done, and you have sold the company and have gotten the money in the bank, there can still be a risk that you end up needing to cover costs due to the (far reaching) warranties you have committed to.

So here are the 5 top ways to limit the risk for you as a seller;

1. Absolute or qualified warranties

Fundamentally, you are free to agree on whichever structure and wording in relation to the warranties that gets the deal done.

This means that the warranties can be absolute - e.g. stating that all taxes have been duly paid, or qualified - e.g. with wording such as “to the best of the seller's knowledge” all taxes have been duly paid.

And why is the difference so important to limit your exposure for claims from the seller? Well, if the warranty is absolute, any issue arising that contradicts the statement will basically mean that you can be held accountable for a breach of that warranty. But if it is qualified and you signed the warranty while honestly not being aware of any circumstances contradicting it, then the buyer will not be entitled to claim damages from you.

Another common qualification relates to information disclosed to the buyer. If you have provided information in a data room, in management sessions, in Q&A etc. that contradicts any of the warranties, you are usually (but not always) off the hook.

So what to do as a seller? Try to qualify the warranties with both references to the seller's actual knowledge and with carve-outs for details that have been (fairly) disclosed during the due diligence process or in other communications with the buyer. Of course, how far you can push your position in this regard depends on your bargaining positions – and also, to some degree, on what is actually fair and how comfortable you are in general with providing warranties in relation to your business. (Do note that issues caused by gross negligence or willful misconduct are often not possible to disclaim from, so be mindful of that.)

2. Time limits

The right for the buyer to make claims against you as a seller due to a warranty breach will be restricted to a certain time period after the deal has closed. Either this will follow from general statutes of limitations, or some other timeframe agreed between the buyer and the seller. And why is this? Because at some stage, you should be entitled to regard the full purchase price as “yours”.

Practically, this means that the buyer has no right to direct claims against you in relation to any issues that he discovers after the stated time period has ended – even if something was wrong with the company (although if the seller has e.g. acted fraudulently, agreed time limits will typically be thrown out the window).

Hence, as a seller you should (i) ensure that the warranties are subject to reasonable time limits and (ii) see if you can segment the warranties into different time limits based on the type of issue they cover in order to, overall, shorten the time period under which the buyer has a right to throw claims your way.

Typically a seller will be expected to commit to longer time limits for so-called “fundamental warranties” - i.e. warranties that addresses more fundamental issues for the deal at hand, such as the fact that you own the shares you are selling, and that you are entitled to sell them without any restrictions.

For the non-fundamental warranties, you can typically argue for (much) shorter durations. These warranties, generally related to the company's business operations (and therefore called “business warranties”), are harder for you to have full control over and that therefore comprise the larger part of a seller's risk exposure. Business warranties can cover issues such as that the company owns all intellectual property that it utilizes and needs for its business, that no key employees have given notice of termination, and that none of your most important customers have terminated their contracts.

Warranties concerning tax are often treated as a category of their own, with the duration corresponding to the period before the tax authority becomes time-barred from making reassessments.

Importantly, the concept of fundamental warranties, business warranties and tax warranties are contractual concepts. As such it will be up to you and the buyer to agree on what goes into each bucket – and also if you want to segment the warranties in more than two (or three) buckets in relation to the time period under which they remain in force. So if a buyer tries to expand the fundamental warranties beyond what you find reasonable, make sure to push back on it.

So what would constitute reasonable time periods? As warranties are contractual, you are of course free to negotiate. But to give some guidance, more typical time periods will be from 12 months on business warranties (with up to 24 months being far from uncommon), and up to 10 years on fundamental warranties. Also, as mentioned tax warranties are typically linked to statutory time limits, with approx. 6 years being common.

3. De minimis and baskets

In order to protect you as a seller from the buyer “running after you” with every problem or “defect” that he finds after taking over the business, most share purchase agreements will also, in addition to the time periods stated under 2 above, stipulate economically quantifiable thresholds as regards when the warranties may be invoked - so-called “de minimis” amounts. It is also common to agree that no compensation will be paid out until the total sum of these claims have reached a certain amount, which is referred to as the “basket”.

These thresholds look at the economic damage that the breach of warranty has entailed for the buyer. Only if the total amount of "valid" damage reaches or exceeds the agreed threshold may the buyer be entitled to direct claims towards you for reimbursement.

For example the share purchase agreement could state that the damage must, in an individual case, be at least USD 2,500 in order to count as "valid" losses (the de minimis), and that the buyer will not be entitled to compensation unless the total amount of such "valid" losses meeting the de minimis amount exceeds USD 10,000 (the basket). Whether the buyer gets compensated for the full amount (through a "tipping basket") or only for amounts exceeding USD 10,000 is also a matter for negotiation. So what if the buyer suffers a thousand losses of USD 100 each? In that case, the de minimis is not met at all, and the buyer is not entitled to compensation.

So what to do as a seller? Make sure that the share purchase agreement includes de minimis and basket provisions, and try to make the numbers as high as possible. Typically they will relate to the overall purchase price (expressed as a percentage) in order to make sure that they are reasonable.

4. Obligation to minimize losses?

Given that the warranties mean that you, as a seller, may need to assume the financial burden for issues arising after you have surrendered the control over the company to the buyer, even if they only relate to events occurring prior to closing it is still reasonable for you to demand that the buyer takes actions to limit the damages (otherwise he might not care given that it is you - and not he - who will take the financial hit).

As an example, the seller has warranted that the company owns all the IP that it utilizes, and a third party files a law suit against the company for IP infringement some time after closing. Assume that the damages could, in full, be avoided if the company responded and provided documentation that would prove its innocence in time. Without any obligations for the buyer to minimize the damages, he might simply not make a reasonable effort to avoid the damages. To the contrary, the buyer may be incentivized to take a very friendly position towards such third party for completely unrelated reasons. But, if there are obligations in the share purchase agreement to take reasonable actions to minimize the damages, such regulation should help to ensure that the buyer does in fact do what he can to help avoid damages for warranty breaches.

5. Limitation of liability

A limitation of liability is a cap on how much damage you will be liable to pay under the agreement. It can also limit your liability in other ways, such as in relation to what types of damages you must cover (typically in relation to the distinction between "direct" and "indirect" damages). As a seller this is an important clause to include as it will limit your risk exposure significantly.

The scope and size of the limitation of liability is, same as for the other terms discussed herein, subject to negotiation. As a seller you may anchor your limitation to for example 20% of the purchase price. You may also limit the types of damages that will be covered, for stating that no loss of profits (i.e. indirect damages) will be covered.

As a seller, you should expect to cover up to the full purchase price for breaches of fundamental warranties. If you e.g. ultimately did not have the right to sell the shares, and the buyer will be left with nothing, it makes sense that the buyer gets its money back. But for other warranties, aim for a low (but reasonable) amount. And make sure that the limitations are clearly expressed as total maximums!

Examples

As to put the above in context, say that you sold your company to a buyer for USD 500,000. In the share purchase agreement, you warranted that the company has complied with all data protection regulations for the last three years leading up to the transaction. 16 months after the buyer took control over the company, the company is subject to an investigation by the authorities and fined USD 100,000.

a)       If the contract stipulates a limitation of liability for you as a seller in relation to business warranties (into which category this kind of issue would almost always fall) of 10% of the purchase price, that will mean that you are only obliged to pay damages of USD 50,000 for the breach of warranties and that the buyer is stuck with the bill for the residual USD 50,000.

b)      If the contract stipulates a warranty period of 12 months, that would mean that you will need to pay 0 USD since the warranty breach was discovered after 16 months, so the buyer is stuck with the full bill of USD 100,000.

Note that both examples assume that you were not acting in bad faith, as in case of deceitful actions from a seller's side will almost always mean that the buyer can come after you for a longer period and for a higher amount than the agreed limitations.

End note

How you regulate the warranties is highly important for you to minimize your risk exposure after closing the deal. So you can sleep better at night.

Note that none of this is legal advice, and only general knowledge sharing. If you have further questions or whish help in a transaction please feel free to contact us at kat@stgcommerciallaw.com

London, 2024-07-01

Author; Kat Strandberg