Warranty and indemnity clause: what you are really guaranteeing

What the warranty covers, and what it does not

The warranty and indemnity clause is an undertaking by the seller to compensate the buyer if a liability whose origin predates the sale surfaces afterwards, or if an asset turns out to be worth less than what was declared.

It covers: a tax reassessment relating to a prior financial year, an employment tribunal dispute whose facts predate the sale, a customer receivable declared recoverable that has become irrecoverable for a prior cause, overvalued inventory, an unrecorded debt, an environmental dispute linked to past operations.

It does not cover: the loss of a customer after the sale, a fall in margin, a management error by the buyer, a market downturn. In other words, the warranty is not a performance guarantee. A buyer who invokes it for a poor subsequent year has no chance of succeeding, provided the drafting is clean.

This distinction is simple, and yet it reassures most sellers who discover it. What they guarantee is the sincerity of what they said, not the success of the person buying.

The six parameters that determine your exposure

The whole negotiation comes down to these six figures. They are discussed together, because a concession on one is always paid for on another.

Two mechanisms are too often forgotten on the seller's side. The first is the step-down: a cap that decreases every year, for example 20% of the price in the first year, 12% in the second, 6% in the third. The second is the deduction of provisions: if a risk was already provisioned in the accounts, the warranty should only apply to the excess.

How the buyer secures the warranty

A warranty without a recovery mechanism is of little value to the buyer. Three solutions coexist, with very different consequences for you.

Escrow. A fraction of the price is blocked in a third-party account for the duration of the warranty. It is the most frequent solution and the most costly for the seller, since it ties up funds they cannot use. Negotiate a release in tranches rather than all at once at the end of the period.

The first-demand bank guarantee. Your bank undertakes to the buyer on simple demand, under article 2321 of the French Civil Code. You keep the whole of the price, in exchange for an annual fee and, most often, a pledge. The point to watch is the automatic nature of the call: a first-demand guarantee can be triggered without prior discussion.

Warranty and indemnity insurance. An insurer takes on the risk in exchange for a premium, generally expressed as a percentage of the amount covered. Long reserved for large transactions, it is gradually moving down into the SME segment. It allows a clean exit for the seller, which has value for an owner-manager who is retiring or reinvesting immediately.

The representations, where everything is decided

The warranty rests on a list of representations that you sign: the company owns its assets, the accounts are true and fair, there is no ongoing dispute other than those mentioned, the employment contracts are compliant, the operating permits are valid, and so on over several pages.

These representations are the subject of a disclosure schedule. Everything you mention in it is deemed known to the buyer and falls outside the scope of the warranty.

This is the most important point of the whole exercise, and it is counter-intuitive. The seller's reflex is to play down problems so as not to weaken the negotiation. The right reflex is exactly the opposite: nothing you disclose can be held against you afterwards. An ongoing employment tribunal dispute, mentioned and quantified in the schedule, cannot be claimed under the warranty. The same dispute passed over in silence will become a claim, compounded by the accusation of concealment.

The practical rule fits in one sentence: everything that worries you must appear in the schedule.

Reducing your exposure before even negotiating

The best warranty negotiation starts eighteen months earlier, in the keeping of the file.

• Clear the disputes. A dispute settled before the sale falls outside the scope. An ongoing dispute weighs on the cap and on the duration.
• Carry out a preventive employment audit. Fixed-day working arrangements, overtime, collective-agreement classifications, freelancer status. These account for three quarters of the warranty claims we see in service SMEs.
• Record the provisions. A provision that has been booked reduces the warranty by the same amount, and it has already been taken into account in the price.
• Document the intellectual property. Trademarks registered and up to date, assignments of rights signed by contractors, software licences regularised.
• Regularise the agreements with related companies. Rents, services, shareholder current accounts: everything that ties the company to a structure owned by the owner-manager will be examined.

When the warranty is called, the procedure follows a path laid down in the sale agreement. The buyer notifies the claim within a set period, often thirty days from becoming aware of the triggering event. The seller has a period in which to respond. In the event of a tax audit or a dispute with a third party, the sale agreement generally provides that the seller may take part in the defence: without this clause, the buyer can settle quickly with the tax authorities and hand you the bill.

Two useful reflexes for the seller: keep the entire sale file for the whole duration of the warranty, including the due diligence exchanges that prove what was communicated; and respond within the deadlines, even to contest, because silence sometimes amounts to acceptance, depending on the drafting adopted.