Representations and Warranties in a Business Purchase Agreement
What sellers promise in the purchase agreement, how disclosure schedules protect you, and how to limit your exposure after the sale closes.
Words by
Matan Michael
Most owners expect the purchase agreement to be about price and timing. A large part of it is a list of statements you make about the business, each one a promise that it is true as of the closing date. Lawyers call them representations and warranties. After closing, the buyer can come back to you if a statement turns out to be wrong, so this section of the agreement stays with you long after the money has arrived.
What the section is for
A buyer cannot see everything inside a business before buying it. Due diligence catches a lot, and some things are only known to the owner. The representations shift the risk of the unknown. If you state that the company has paid all its payroll taxes and it has not, the buyer has a claim against you for the loss, whether or not you knew. In that sense the section works as a form of insurance written by the seller for the buyer, with the seller's own money behind it.
A representation is a statement of fact about the present or the past, such as the financial statements are accurate or no lawsuit is pending. A warranty is a promise that something will be true, or that the buyer will be made whole if it is not. In most agreements the two are bundled together and treated alike, and you will rarely hear a negotiation turn on the difference.
The sale also includes covenants, which are promises about conduct, such as continuing to run the business normally between signing and closing, and conditions that must be met before either side has to close. Representations are separate from both. They describe the state of the business, and the buyer relies on them in agreeing to pay the price.
The statements you will be asked to make
Every agreement is a little different, and the list for a small business sale usually includes the same families of statements. You will be asked to confirm that the company is properly organized and in good standing, and that you have the authority to sell. You will be asked to confirm that you own the assets being sold and that nothing is pledged against them except what you have disclosed. You will be asked to confirm that the financial statements and tax returns you gave the buyer are accurate and were prepared in the usual way.
There will be statements about taxes, covering whether returns were filed and taxes paid. There will be statements about contracts, saying that the important ones are valid and that neither side is in default. There will be statements about employees, including that wages are paid and no claims are pending. About litigation, that none is threatened. About compliance, that the business holds the licenses and permits it needs and operates within them. About inventory and equipment, that they are in working condition and fit for use. About customers and suppliers, that none of the major ones has given notice that it is leaving. In a business with real property, intellectual property, or environmental exposure, there are further sections on those.
Several agreements also include a catch-all that says nothing you provided to the buyer is misleading or omits something needed to make it not misleading. This one is broad and deserves attention. It can turn a small gap in an unrelated schedule into a claim.
Knowledge qualifiers and why the words matter
Read how each statement is worded. A flat statement that the company has no pending claims is stronger than one that says to the seller's knowledge there are none. The first makes you responsible for a claim you never heard of. The second limits you to what you knew, or in some agreements what you should have known after reasonable inquiry. Sellers should ask for knowledge qualifiers wherever the subject is something the seller cannot fully control, such as the behavior of employees or the actions of regulators.
Materiality is a second set of words. A statement that the company is in compliance with all laws is hard to give truthfully, since small businesses almost always have some minor lapse. A statement that it is in compliance in all material respects is a more reasonable promise. Where a representation refers to every contract, ask whether it should refer only to material contracts and define what counts. A threshold by dollar amount is common, and your advisor can propose one that fits the size of your business.
A buyer will push back on many of these edits and may agree to some. Expect the draft to arrive from the buyer's lawyer written broadly. The first draft is an opening position, and you are expected to respond with changes. Our post on letters of intent explains why settling the major points early, before the draft arrives, saves legal cost and argument later.
Disclosure schedules are your protection
The most useful tool a seller has is the disclosure schedule. It is a set of documents attached to the agreement that lists the exceptions to your statements. If you represent that the company has no litigation except as listed in the schedule, and the schedule lists the matter, you are covered for that matter. A fact that is properly disclosed cannot be the basis for a claim that the statement was wrong.
This makes the schedules worth a good deal of effort. Go through each representation and ask whether anything you know makes it untrue, or even doubtful. A customer dispute that was settled last year, a warranty claim that is still being discussed, a license renewal that is late, an employee who has threatened to sue, an unwritten agreement with a supplier. All of these belong on the schedule. It is better to over-disclose than to leave something out, because the cost of a long schedule is a mild annoyance and the cost of an omission can be a claim.
Describe each item fully and give it more than a short title. A line that says a dispute exists with a vendor may not be enough if the buyer later argues that the dispute was larger than it sounded. A paragraph with the dates, the amount in question and the current status is safer. Your lawyer will help with the language, but the facts must come from you, so start gathering them early. This is the same material a buyer's diligence will find, and the work you did for getting financials ready will be useful again here.
How long the promises last and how much you can owe
An agreement should say how long the representations survive after closing, and how much the seller can be required to pay. Most agreements set a survival period of a year or two for general statements, with longer periods for tax and organizational matters. Without a limit, a claim could in theory be raised at any point, so this is a point to settle.
Most also set a cap, which is the maximum the seller pays for breaches in total, often a fraction of the price. A basket or deductible sets a minimum, so the buyer cannot claim for trivial items. A tipping basket allows recovery from the first dollar once the threshold is passed, and a true deductible allows recovery only above it. The difference matters and is easy to overlook. The agreement may also carve out some items from the cap, commonly fraud, taxes and ownership of the assets, and for these the seller may be responsible without limit.
Part of the price is often held in escrow to cover claims during the survival period. If the buyer makes no claim, the escrow is released to you. Our post on earnouts, holdbacks and working capital goes through how holdbacks behave, and it is useful to understand because the amount held and the length of time both come out of your proceeds. The details here are a matter of negotiation and your attorney confirms what works best under your state's rules.
If the seller is an entity and the owner has personal exposure through guarantees, ask your attorney how the structure affects you. In a sale of assets the company makes the representations, and you may still sign a personal guarantee of them. The asset sale versus stock sale post shows how structure changes who stands behind the promises.
Keeping the promises true between signing and closing
The representations are given at signing and usually repeated at closing. If something changes in between, such as a key employee quitting, a customer leaving or a claim arriving, the statements may no longer be correct. The agreement should have a mechanism for updating the schedules and say what the buyer can do when something new comes up, including whether it can refuse to close. Tell your advisor and your lawyer promptly about any change. An owner who sits on bad news until closing day loses credibility and, depending on the wording, may lose the protection of the schedule.
Some buyers purchase a representations and warranties insurance policy, which pays the buyer for certain losses and reduces the amount they look to the seller for. It is more common in larger deals and the cost makes it rare in the smallest ones. If a buyer offers it, ask what it covers and whether the insurer can pursue you afterward.
What to do before you receive a draft
Write down every fact about the business that you would not want to see in a lawsuit, then check whether it is documented. Make sure your tax filings, payroll deposits and license renewals are current. Gather your contracts and check each for defaults. Ask your attorney, before the draft is written, to explain survival, caps and baskets in your state, and decide the amounts you are comfortable with. Then, when the buyer's draft comes, you will know which promises you can give without a qualifier, which need one, and which should be moved to the schedule.
