Definition
Warranties are statements of fact about a business that the seller makes in the purchase agreement, for example that the accounts are accurate or that no litigation is pending. If a warranty proves untrue, the buyer may be able to claim damages, but usually has to show the loss it caused. An indemnity is a promise to reimburse a specific loss, such as the cost of a known tax dispute, usually in full and with a lighter burden of proof. In the US, warranties usually appear as representations and warranties, and indemnities as indemnification.
Worked example
A fictional buyer acquires Glenmoor Garden Centres Ltd, a fictional UK business, for £3,000,000. The share purchase agreement includes:
- a warranty that all VAT returns have been filed correctly
- a specific indemnity for an open employment tribunal claim by a former manager
- a £1,500,000 cap on warranty claims, a two-year time limit and a £10,000 minimum claim
A year later, HMRC finds a £60,000 VAT error, and the buyer claims under the warranty. The tribunal claim settles for £40,000, which the sellers pay under the indemnity.
Why buyers care
Warranties and indemnities allocate the risks you cannot fully check in diligence between you and the seller. They are only as good as the seller's ability to pay, which is why they are often backed by escrow, a holdback or warranty and indemnity insurance.
The seller will usually list exceptions to the warranties in a disclosure letter, and anything fairly disclosed generally cannot be claimed for later. Read the disclosures closely, and take legal advice on caps, time limits and thresholds before you sign.
Due diligence is the investigation a buyer carries out before committing to a purchase, testing the finances, contracts, legal position and operations against what the seller has described.
Escrow is an arrangement in which an independent third party holds money until agreed conditions are met. In a business sale it keeps part of the price available to cover claims after completion.