Representations and Warranties: The Seller's Binding Promises About the Business
Representations and warranties ("reps and warranties") are the factual statements a seller makes about the business in the purchase agreement. They're legally binding: if any statement turns out to be false — either because the seller knew and didn't disclose it, or simply because the facts were wrong — the buyer has a right to seek indemnification (compensation) from the seller.
Reps and warranties are the primary mechanism by which buyers protect themselves after closing against problems that existed before closing. They're the contractual backbone of every acquisition.
What Reps and Warranties Cover
A comprehensive purchase agreement includes reps and warranties covering:
- Financial statements — that the financials are accurate, prepared in accordance with accounting standards, and not misleading
- Taxes — that all taxes have been paid, returns filed, and no open audits or disputes exist
- Legal and litigation — that no lawsuits, claims, or regulatory proceedings are pending or threatened
- Assets — that the seller owns the assets being sold, free of liens (other than disclosed ones)
- Contracts — that all material contracts are in force, valid, and have been disclosed
- Employees — that all employment agreements, benefits, and labor matters are disclosed and compliant
- Environmental — that no hazardous materials or environmental violations exist on owned or leased property
- Permits and licenses — that all required permits are current and in good standing
- Intellectual property — that IP is owned by the company, not infringing, and not subject to third-party claims
- No material adverse change — that since a defined date, nothing has materially harmed the business
Indemnification: What Happens When a Rep Is False
When a warranty is breached — meaning a representation turns out to be untrue — the buyer can make an indemnification claim against the seller. The seller must compensate the buyer for losses caused by the breach, up to negotiated limits.
Key indemnification parameters (all negotiable):
- Basket (deductible) — the minimum threshold before claims can be made (typically 0.5%–1% of purchase price)
- Cap — the maximum total indemnification seller must pay (typically 10%–20% of purchase price for general reps)
- Survival period — how long after closing the buyer can make claims (typically 12–24 months for general reps; longer for tax, environmental, and fundamental reps)
Seller Disclosure Schedules
Sellers qualify their reps through disclosure schedules — lists of known exceptions attached to the purchase agreement. A seller who discloses a pending lawsuit in the schedules isn't breaching the "no litigation" warranty; they've carved it out. Buyers must read disclosure schedules carefully — they define the actual scope of protection.
Escrow and Holdbacks
Because reps and warranties only have value if the seller has money to pay claims, buyers often negotiate a holdback or escrow — typically 10–15% of the purchase price held in escrow for 12–24 months as a source of funds for indemnification claims. Without this, the buyer's only recourse for a breach is suing the seller, which is slow, expensive, and depends on the seller having assets.
Related Terms
- Due diligence — where reps are verified before closing
- Earnout — a separate but related post-closing protection mechanism
- No-shop clause — another LOI provision that precedes reps negotiation