Buying a business? Manage your risk with seller warranties!

Your decision to buy a business and your negotiations with the seller over the price and other terms and conditions of the purchase will be influenced by information provided by the seller.  For example, the seller is likely to provide you with financial statements of the business.  The seller may also be willing to share internal forecasts and budgets.  Other information and documents relevant to the business may be disclosed by the seller as part of your and your advisers’ due diligence investigations of the financial, operational and legal aspects of the business.

It is, of course, prudent for the purchaser to check the information the seller provides for accuracy and (in relation to any forecasts and budgets provided by the seller) reasonableness.  For instance, this could be done by a review or audit of the financial statements (where they are unaudited special purpose accounts) and, if possible, independent verification by searching public records and registers.  However, budgetary and time constraints and the nature of much of the information provided by the seller will rarely allow you to undertake a complete investigation of all aspects of the target business, and to independently verify all information provided by the seller.

This is why it is common for the purchaser to require the seller to provide warranties about the business in the contract for the sale and purchase of the business.  The warranties will generally be about specific aspects of the business and may be used to confirm information provided by the seller.  If the warranties are later proved to be incorrect, or misleading (depending on the wording of the warranty provisions in the contract), the purchaser will be entitled to recover any resulting loss from the seller.

The following are some key points about seller’s warranties from the purchaser’s perspective:

Warranty limitations: The seller is likely to want to limit their exposure under the warranties.  One common limitation is to seek to exclude warranty claims based on information or matters which the seller disclosed to the purchaser before the sale and purchase contract was signed (the principle being that if the seller has disclosed a risk to you before you legally committed to the purchase, you should not be able to sue them for any loss if that risk later eventuates).

Although that is not generally unreasonable, if you are prepared to accept a limitation based on seller disclosure, the extent of the limitation should be clearly stated in the contract.  For example, you may want to stipulate that only full and fair disclosure of a matter which may give rise to a future warranty claim, or only full and fair disclosure against specified warranties (in a disclosure letter or similar document given by the seller before the contract is signed), will limit your right to claim under the warranties.  Otherwise, the seller may argue that a general and non-specific disclosure of information during due diligence (which may have been insufficient to enable you to identify a risk of a warranty breach) will preclude you from making a warranty claim afterwards.

Other common limitations include a monetary cap on the seller’s liability for warranty claims and a time limit within which the purchaser is allowed to bring a claim for breach of warranty.

Co-warrantors: If the seller is a company, the sale proceeds may, a short time after the sale of the business completes/settles, be distributed to the company’s shareholders, leaving no more than a shell company with no, or no substantial assets.  That would make a later warranty claim by the purchaser against the seller company fruitless.  Therefore, you may want someone of some financial substance, in addition to the seller company, to give the warranties under the sale contract.  That will often mean the directors of the seller company being required to give warranties jointly and severally with the company.

Hold-back of funds/escrow: Even so, there may be no opportunity for the purchaser to assess the financial standing of the directors or other co-warrantors when entering into the sale contract, in particular, their financial standing in the future when a warranty claim may need to be made.  To ensure that there will be some funds readily available to meet a claim later on, you may try to negotiate for some of the sale price to be held back at completion/settlement, or placed in escrow (i.e., held by a third party stakeholder or your lawyer in trust), for part or all of the warranty period.

If you have any questions on seller warranties, or any other legal aspect of buying or selling a business, please do not hesitate to get in touch with one of the Sierra Legal team.