Protecting Your Business: Understanding Warranties and Indemnities
Behind every deal lies the question: what if something goes wrong? Buyers want certainty, sellers want a clean exit: warranties and indemnities are the levers that help bridge that divide. From litigation risk to undisclosed liabilities, these contractual promises shape the fairness and viability of any transaction. Forsters’ Corporate team explores how they work in practice, and why they remain central to business sales of every size.
Setting up and running your own business is an amazing achievement. It requires vision, creativity, motivation and stamina. On occasion, it can even bring you fame, riches and fortune. But it can also result in reams of paperwork and cause sleepless nights. And as someone once said to me about children “It doesn’t get easier, it just changes”, so the same can be said for your business throughout its lifecycle. From setting up to exit, it will force you to consider issues that you might not previously have known anything about and it will need you to make many decisions, sometimes very quickly. What it certainly is not is mundane.
We’ve considered the main aspects of the lifecycle of a business from the beginning and you now want to sell…
Understanding warranties and indemnities
When buying or selling a company, warranties and indemnities are essential to manage risk. They help mitigate against the let the buyer beware principle (caveat emptor) and enable the buyer to find out more about the company it’s acquiring.
But what’s the difference between a warranty and an indemnity and how do they work?
What’s a warranty?
A warranty is a contractual statement of fact usually made by the seller(s) to the buyer regarding the condition of the target company or business, for example, the seller(s) might warrant that the target company isn’t involved in any litigation as at the date of the purchase agreement. If a warranty turns out to be untrue, the buyer can bring a breach of contract claim against the seller(s). If the claim is successful, the seller(s) will have to pay damages to the buyer. The amount of damages awarded will typically be the difference between the value of the shares had the warranty been true and their actual value (subject to rules on mitigation and remoteness).
The scope of the warranties will depend on several factors, including the bargaining position of the parties, the terms of the deal, and the nature of the business. Common areas for warranties to cover include ownership (of the shares), legal compliance, accounts, litigation, employment, and intellectual property.
What’s an indemnity?
An indemnity is a promise (usually given by the seller(s)) to reimburse the buyer for a specific loss, often on a pound-for-pound basis. So, taking our litigation example again, if a third party has brought a litigation claim against the target company which the target company is likely to lose, the buyer might insist that an indemnity in respect of that specific litigation claim be included in the purchase agreement. The seller(s) will then have to reimburse the buyer for any loss suffered by the target company in relation to the claim once the sale of the target company has completed.
Who gives warranties and indemnities?
Warranties and indemnities are usually given by the seller(s). In group structures, the parent company may also provide the warranties and indemnities (or a guarantee to stand behind the warranties and indemnities that are given).
Exceptions where the seller(s) may be unwilling to give warranties and indemnities include:
passive shareholders who have nothing to do with the business and have a small shareholding (e.g. family members who have been given shares but have no day-to-day running of the company)
private equity firms (it’s common practice on an exit for private equity firms not to give any warranties)
employee shareholders (i.e. non-managers) who have limited knowledge of the business.
Why include warranties and indemnities?
Warranties
Warranties are crucial to a buyer because there are no statutory or common law protections regarding the nature or extent of the assets or liabilities being acquired; the principle of caveat emptor (let the buyer beware) applies. Having the seller(s) give promises about the target company and its business gives comfort to the buyer as to what exactly it’s buying.
In addition, where a warranty would be untrue, the seller(s) can disclose against that warranty. So, in our litigation warranty example above, if the target company is actually involved in litigation, the warranty will be included in the purchase agreement, but the seller(s) will disclose the details of any litigation in which the target company is involved to the buyer. This enables the buyer to find out information about the target company and business which may be additional to anything discovered during the due diligence exercise. From the seller(s) point of view, it means that the buyer will be unable to bring a successful claim for breach of the warranty, as it had knowledge of the true state of affairs. Any matters to be disclosed are usually included in a separate document, the disclosure letter.
Indemnities
Indemnities protect the buyer financially in the event that specific losses or losses which are of particular concern to the buyer arise post-sale. (Other options may also be available to the buyer if it becomes aware of any specific issues before completion of the sale, for example, it may try to negotiate a lower purchase price, change the transaction to an asset deal or even walk away.)
How can a seller protect itself against a warranty or indemnity claim?
To manage the liability risk of the seller(s) when giving warranties, the parties will usually include caps on liability in the purchase agreement (e.g. they might agree that the seller(s) will only be liable up to a maximum amount equal to the purchase price). Minimum thresholds may also be included (e.g. a claim can’t be brought by the buyer unless it has a value of more than £x) to prevent the buyer bringing “nuisance” claims. Other seller protections may also be included but these are outside the scope of this article. Whether the caps and thresholds will apply to indemnities will be a matter for negotiation between the parties.
Where there is more than one seller, they will need to decide how any liability will be shared between them.
Insurance can also be taken out to cover off warranty and indemnity risks. This is outside the scope of this article but if you would like to discuss further, please get in touch with a member of the Forsters’ Corporate team.
Conclusion
In summary, warranties and indemnities are fundamental mechanisms for allocating risk in corporate transactions.
While warranties encourage transparency and enable the buyer to sue the seller(s) for breach of contract if they turn out to be untrue, indemnities offer targeted financial protection for known risks.
The strategic use of both tools (alongside robust disclosure processes and carefully negotiated contractual limitations) enables parties to strike a fair balance between protection and commercial pragmatism. For sellers, thoughtful drafting and liability management are key to limiting exposure, while buyers must ensure that the warranties are wide enough to be of actual use and that the contractual framework provides sufficient remedies for potential losses.
Lianne Baker, Knowledge Development Lawyer, Corporate | Forsters Law
