TRC 015: Legals don't have to be scary - Understanding warranties and indemnitiesAug 03, 2023
Read time: 5 mins
You’ve got your term sheet. You’re almost home and dry, money in the bank.
Then the legal documents start to roll in.
It can all seem pretty daunting if you haven’t been through it before.
The number of documents, the unfamiliar terms. As if running a fast growing startup isn’t enough stress for one person!
In reality - a lot of the key terms you see will be recognisable from the term sheet you have just signed.
One thing that we find worries a lot of founders when reviewing these documents is the warranties and indemnities.
It can seem disconcerting if it’s your first time fundraising from VCs or other institutional investors.
Especially as you are trying to get things done quickly to close the investment and get back to running the business.
The reality is, they are a normal part of a contract where you are selling shares in your business.
Here’s the lowdown.
Warranties and indemnities, in essence, are your promises as a seller in the sales agreement.
They help protect the buyer who, under the principle of caveat emptor (buyer beware), lacks statutory or common law protection.
But they also help you define and limit your responsibilities.
Warranties are like your declarations about various aspects of the business, such as
- your capacity to sell
- the accuracy of accounts
- the status of contracts
- intellectual property rights
- litigation, tax, and more.
Should these prove inaccurate post-sale, you could be liable for damages.
Indemnities, however, are promises to cover certain specific liabilities that might arise post-acquisition, like tax or ongoing litigation issues.
Think of indemnities as your commitment to cover specific, identified risks.
Here are some pointers:
- Capacity/authority to sell: Ensure you have clear legal rights to sell the shares.
- Accounts: Be accurate and transparent to avoid later disputes.
- Contracts: Disclose all liabilities or future commitments.
- Licenses/consents: Validate that all necessary licenses or consents are in place (software is an obvious one for startups).
- Litigation: Be open about any ongoing or threatened legal actions.
- IP rights: Confirm your ownership and protection of all intellectual properties.
- Employment: Disclose any potential HR issues, like contracts, disputes, and benefits.
- Taxation: Be open about past and future tax liabilities. R&D tax credits are a key what-out here.
While warranties and indemnities can mitigate risk for the buyer, they should be carefully managed from the seller's perspective.
This is because you can be personally liable if a warranty is breached or an indemnity triggered.
While warranties need the buyer to prove breach and quantifiable loss, indemnities may not require the buyer to mitigate their loss, which is often the case with warranties.
Therefore, it is usually in your best interest as a seller to limit the scope of the warranties and resist granting indemnities where possible.
Should a breach claim arise, the buyer must prove the statement was untrue.
Remember that legal enforcement can be complex, costly and time-consuming, so it's essential to get your warranties and indemnities right.
Don’t skip over the detail, make sure you understand every clause.
Be proactive in limiting your liabilities through:
- financial limitations (the amount you would have to pay)
- time constraints (the time period after the investment in which a claim can be made)
- careful crafting of your statements, or qualifying your awareness of any issues.
However, ensure you're not withholding material information that could lead to a breach.
When providing warranties and indemnities, consider your ability to satisfy any claims.
The reality is, that if you have been upfront and honest about all the items raised, you have little to worry about.
However, it is always a very good idea to have an experienced legal adviser to help you through the negotiation of the documents.
We hope that understanding these things before you start the process will mean that these things are not quite so daunting in the heat of trying to close a round.
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