If you are selling shares in a private company, the buyer will almost always seek warranties. In this context, a warranty is a promise you make about the thing you are selling.
Warranties in a share sale agreement generally relate to one of three things:
- The person selling the shares;
- The shares themselves; or
- The company in which the shares are issued.
It is the third type of warranty above that gives rise to the most discussion. Examples of this type of warranty are that:
- The company’s books are in order;
- The company has paid or provisioned for all taxes;
- The company owns all of its assets, including intellectual property;
- The company’s contracts with third parties are binding; and
- The company is not in dispute and is not aware of any dispute.
In most cases, you are likely to be comfortable with these sorts of warranties being requested by the seller. However, there are a number of things you should do to minimise the risk of future claims.
1. Read the warranties very, very carefully.
At first glance, many warranties may appear fairly harmless. As always, the devil is in the detail and every word is important. If you’re not sure what a warranty means, or what effect it might have, seek advice.
2. Limit the scope of the warranties wherever possible.
Warranties are usually prepared from a template document used by the buyer’s lawyer. Consequently, many warranties that appear in the first draft of the agreement may not be relevant, or even appropriate, to your circumstances and the company in which the shares are being issued. If this is the case, you should request that those warranties be removed.
3. Be clear about the time the warranty is given.
Warranties relate to a certain state of affairs at a particular point in time. Usually, the warranty is given as 'at the date of the agreement'. Sometimes they will be given as 'at the agreement date', and as 'at completion', if they are two separate dates.
Warranties should rarely, if ever, relate to future matters. In many cases it will be appropriate for you to include an express disclaimer in the agreement that any forecasts you may have given are non-binding and should not give rise to a breach. Although sellers will require you to provide accurate information about the company’s past and present affairs, they cannot expect you to give firm guarantees about what will happen in the future. The risk of the business is something that goes with ownership of the shares.
4. Limit the time in which claims can be made.
Sale agreements usually prescribe a specific time in which claims can be made. If your agreement doesn’t, you should insist on one. The idea is to give you certainty that, after the agreed timeframe has passed, the purchasor can no longer bring a claim against you.
Obviously the buyer will want this period to be as long as possible, and you will want the opposite. Sometimes there are different periods for different types of warranty; for example, 6 months for warranties relating to tax and title, and 2 years for everything else.
It is rare for a warranty period to be less than 6 months or longer than 4 years. Most of the time, the period is between 12 and 24 months.
5. Avoid absolute warranties where possible.
There is a big difference between a warranty that is given ‘to the best of the seller’s knowledge’, and one that is not.
An absolute warranty is one where a breach will arise regardless of whether you knew, or could have known, of the breach at the time the warranty is given.
There are a number of warranties where the buyer will expect the warranties to be absolute. Warranties relating to ownership are an example. However there will be other warranties where it would be unreasonable to expect you, as the seller, to have absolute confidence in the position, or to carry the risk of a breach. For example, the buyer might want a warranty that no material customer intends to cease doing business with the company. You might consider qualifying this kind of warranty so that it is made only 'to the best of your knowledge'.
6. Include caps on your liability.
You should seek to limit the amount you will have to pay in the event a warranty is breached, and usually the seller will accept this.
A common cap is the amount the buyer is required to pay for the shares, on the basis that the seller should not have to pay more for a breach of warranty than the amount they received for their shares.
Sometimes the seller will be able to negotiate a lower cap. For example, where there is a breach of warranty, it may be unreasonable for the buyer to claim 100% of the purchase price and also retain ownership of the shares.
7. Qualify the warranties for disclosure material.
As part of the due diligence process, you will normally provide the buyer with various items of information about you and your company. This information should be complete, so that the buyer is on notice of anything that could potentially affect the value of the company.
The warranties in the sale agreement should be qualified by reference to the disclosure material. That is because, with few exceptions, the buyer should not be able to make a claim for breach of warranty in respect of matters of which it is already aware.
8. Include a threshold for making a claim.
Most agreements will contain a minimum amount, below which a claim for breach of warranty cannot be made. The idea is to ensure that claims for breach of warranty are only made where there is a serious issue.
An appropriate value for this threshold will depend on the nature and value of the business being sold. Buyers will be reluctant to agree to a threshold that is unreasonably low.
Often there will be two different thresholds. The first relates to the value of an individual claim, and the second relates to the aggregate value of all claims. For example, it may be that the buyer should not be able to make a claim unless the value of the claim is over $[x] and the value of all claims (in aggregate) is over $[y].
9. Avoid or qualify indemnities for breach of warranty.
Some share sale agreements will require the seller to indemnify the buyer for a breach of warranty. Two practical consequences of these indemnities, in comparison with a normal claim for a breach of warranty, are as follows:
- they can increase the amount of compensation that the seller might be liable to pay in the event of a breach, beyond the normal measure; and
- they can prevent the seller's liability being reduced by reason of any failure by the buyer to mitigate its loss.
For these reasons, sellers ought to avoid giving indemnities wherever possible. Where they cannot be avoided, the seller should seek to qualify and cap those warranties so that they do not materially increase the seller's exposure under the agreement.
10. Make sure you understand what you're signing.
This last tip is an obvious but nonetheless important one.
Although your lawyers will be responsible for negotiating and drafting the agreement, ultimately you will need to make sure that you are comfortable with the scope of the warranties and that you understand what will happen if there is a breach.
