How to negotiate warranties and indemnities in a business sale

Warranties and indemnities sit at the heart of almost every business sale. They are the mechanism by which risk is allocated between buyer and seller once the deal is done, and the negotiation of them is where many transactions spend a significant proportion of their legal time.

For business owners on either side of a transaction, understanding what warranties and indemnities are, why they matter, and how they are negotiated will make you a more effective participant in the process. This article explains the key concepts in plain terms.

What is a warranty?

A warranty is a statement of fact made by the seller about the business being sold. By giving a warranty, the seller is confirming that a particular state of affairs is true.

Common warranty areas include the accuracy of the financial accounts, the absence of undisclosed litigation, compliance with employment law, and the validity of key contracts.

If a warranty turns out to be untrue and the buyer suffers a financial loss as a result, the buyer can bring a warranty claim against the seller to recover that loss. The sale and purchase agreement (SPA) will set out the conditions under which such a claim can be made, including time limits and minimum claim thresholds.

Warranties are not just protective for buyers. They also benefit sellers. By agreeing a defined and limited set of warranties, the seller contains the scope of their post-completion liability. Everything outside the agreed warranties is generally outside the buyer’s ability to make a claim.

What is an indemnity?

An indemnity is a more direct form of protection. Unlike a warranty, which requires a buyer to prove a loss and establish its connection to a breach, an indemnity is a pound-for-pound commitment: if a specific liability arises, the seller will cover the cost without the need to prove loss.

Indemnities are used where there is a known or specific risk that the buyer wants direct protection against. For example a pending tax enquiry, an unresolved environmental matter, or a specific contractual dispute. They represent a higher level of protection than warranties and are typically harder to negotiate.

How the negotiation works

Sellers want warranties to be as narrow as possible, with qualifications that limit their exposure to matters they were aware of and disclosed. Buyers want warranties to be as wide as possible, covering every material aspect of the business.

In practice, the negotiation involves several key levers:

• Specific indemnities: Where due diligence reveals a particular risk, the parties will negotiate whether it is covered by warranty, a specific indemnity, a price adjustment, or an escrow arrangement.
• Disclosure: Sellers protect themselves against warranty claims by disclosing known issues against the warranties in a disclosure letter. A properly made disclosure limits the seller’s liability for that specific matter. This makes the preparation and negotiation of the disclosure letter a critical part of the transaction.
• Limitations on liability: Sellers will seek to cap their total warranty liability, typically at a percentage of the transaction value, and to impose time limits within which claims must be brought. Buyers will resist limitations that they consider leave them under protected.
• Materiality thresholds: A minimum threshold is usually agreed below which individual claims and the aggregate total of claims cannot be brought, preventing buyers from bringing trivial claims.

Warranty and indemnity insurance

Warranty and indemnity (W&I) insurance has become increasingly common in SME transactions. It allows the buyer to make warranty claims against an insurer rather than directly against the seller, which is attractive to sellers who want a cleaner break after completion and to buyers who are concerned about the seller’s financial standing to meet future claims.

W&I insurance adds cost to a transaction but can genuinely facilitate deals, particularly where the seller wants to distribute sale proceeds quickly and cannot hold funds in reserve against potential claims.

Why experienced advice matters

The negotiation of warranties and indemnities requires experienced corporate lawyers on both sides. Poorly drafted warranties expose sellers to claims they never anticipated. Weak protections leave buyers exposed to liabilities they thought were covered.

Getting the balance right requires legal expertise, commercial judgement, and an understanding of the specific risks in the business being sold.