Warranties and indemnities are, after price and payment terms, the main point of contention during negotiations. But what can all be covered by warranties and indemnities.
In the letter of intent, warranties are usually phrased in general terms. Later in the process, when the buyer has conducted due diligence, he has a much better idea of the risks. Only then are final warranties and indemnities negotiated.
To prevent the buyer from claiming every little thing, a "no whining" limit is often set. The parties agree that a claim may only be made if an individual breach exceeds, say, 5,000 euros and if the total of the breaches exceeds 20,000 euros.
Research duty
Incidentally, the inclusion of warranties does not mean that the buyer can sit idle during due diligence, quite the contrary. Legally, the buyer has a duty to investigate: if the buyer learns - or could have learned - during the acquisition due diligence that there is or is likely to be a breach of the warranties, then he cannot invoke them later. If the buyer encounters a concrete risk, a warranty is not sufficient; he will then have to include an indemnity in the contract.
Difference between guarantees and indemnifications
Guarantees are status descriptive and say something about the state of the business at the time of delivery, such as "there are no legal proceedings pending" or "the balance sheet items give a true and fair view of reality." so a guarantee never contains a promise for the future, such as "employee x will not leave within a year. If the buyer wants to hedge against such calamities, he includes indemnities in the contract. These provide that he will be indemnified if a certain event occurs.
The following items are often covered by warranties and indemnities:
- Balance sheet guarantees
- Tax claims
- Turnover guarantees
- Debtor guarantees
- Staff
- Buyer obligations
We explain them briefly below:
#1 Balance sheet guarantees
Standard in a share purchase agreement is the inclusion of a balance sheet guarantee. This guarantees that the balance sheet value of machinery, inventory, accounts receivable balance and the like accurately reflect reality. If after the takeover it turns out that the stock was far too high on the balance sheet - for example because of obsolete stock - a breach of the guarantee arises
Good to know: differences on the balance sheet are settled one-to-one. If the difference amounts to 50,000 euros, then the seller will also have to indemnify the buyer for 50,000 euros, obviously taking into account the conditions that have been agreed around the claims.
#2 Tax claims
The buyer will also want to be safeguarded against possible claims from the tax authorities. After all, the buyer has no desire to wind up with after-tax assessments of corporate income tax, payroll tax or other taxes related to the period before him.
Good to know: audits from the tax authorities generally go back a maximum of five years, which is why the buyer often demands a five-year term for such indemnifications. For a seller, this is rather long; it is not a pleasant prospect to have another bill from the tax authorities plopping on the mat in four and a half years. A seller will want to keep the warranty period as short as possible. this is typically a point for negotiation.
#3 Turnover guarantees
Parties can also agree on a "revenue guarantee"; effectively, this is an indemnification. This comes into play particularly if the buyer is afraid that important customers will leave after the acquisition. The seller will be reluctant to agree to this because such a guarantee is rather risky. The agreement could be that the seller guarantees revenue of five million and that he will compensate the buyer in the event of lower revenue.
Good to know: such guarantees in the loss and profit sphere are not compensated one-to-one, but corrected for taxes, purchases and expenses incurred. For example, a revenue loss of one million corresponds to a net loss of profit of 150,000 euros. The seller will then reimburse this amount. A turnover guarantee usually runs no longer than one year.
#4 Guarantees for debtors
Debtors are an important balance sheet item, for which the buyer would like a guarantee. often the seller has made a provision for bad debts. If the accounts receivable amount to 200,000 euros on the balance sheet and the provision is 20,000 euros, there is only a breach if more than 20,000 euros of the accounts receivable turn out to be uncollectible. The parties can also agree that the seller will take over the unpaid portion of the debtors from the buyer at face value and then try to collect them himself
#5 Warranties regarding personnel
Every company has staff members who are crucial to its operations. If key people leave after the acquisition, the business immediately becomes less attractive to the buyer. A buyer wants to be compensated for that. You can agree that the purchase price will drop by a certain amount if the manager leaves within a year. Few sellers will agree to this because it is beyond their control.
#6 Obligations for the buyer
If the seller has awarded the deal to the buyer at an attractive price, he does not want the buyer to resell the business within a year to a strategic buyer for a lot of money. The parties can agree that selling within a certain time period is not allowed or that the seller shares in the excess proceeds from selling within that time period.
This is called a non-embarrassment clause. Parties can also make non-financial agreements, such as the continuation of the company name or not firing certain staff members within a certain period of time after the transaction.
Collateral
Often a breach of warranties and indemnities leads to financial compensation by the seller. But then, of course, that money must be there. To prevent the buyer from missing the boat, he will demand securities from you. There are various possibilities for this.
- Deferred payment
The buyer does not have to pay part of the purchase price until later, so he can offset any claims against the payment terms. for the seller, this is not very attractive. It exposes him to the risk that the buyer is unable or unwilling (in the event of a dispute) to pay the remaining installments.
- The provision of a bank guarantee
The seller does not have to grant a deferral of payment, while the buyer still has the assurance that the money will be available if he makes a claim.
- Escrow account
Another possibility is that part of the purchase price is deposited in a blocked bank account of a bank or notary, also called escrow. It is important that the parties make clear agreements on how long the money will remain parked and under what conditions a party may dispose of the money,
