Reps, Warranties, and Indemnification in a Purchase Agreement
| John M. McCormick | business, Mergers & Acquisitions
Quick Answer
Representations and warranties are the seller's statements of fact about the business in the purchase agreement, such as the accuracy of its financial statements, ownership of its assets, and absence of undisclosed lawsuits. Indemnification is the promise to pay for losses if those statements turn out to be wrong. The most negotiated terms are survival periods, baskets, caps, fundamental representations, knowledge and materiality qualifiers, and escrows or holdbacks.
This article is part of our Legal Guide to Buying or Selling a Business.
These provisions are where most of the risk in a purchase agreement is allocated. They are dense and technical, and small wording changes can shift significant money between buyer and seller after closing.
What Are Representations and Warranties?
Representations and warranties are factual statements, usually made by the seller, about the business as of signing and closing. Common examples include:
- The seller has authority to sell, and the company is properly organized
- The seller owns the shares or assets free of liens
- The financial statements are accurate
- There are no undisclosed liabilities, lawsuits, or tax problems
- Material contracts are valid and not in default
- The business complies with applicable laws and holds required licenses
- Employees are properly classified and paid
Exceptions are listed on disclosure schedules. A thorough disclosure schedule protects the seller: a known issue that is properly disclosed generally cannot later be the basis of a claim for breach.
What Is Indemnification?
Indemnification is the contractual remedy. If a representation is inaccurate, or if a specific liability the parties identified comes due, the indemnifying party compensates the other for resulting losses, subject to the limits negotiated in the agreement.
Key Indemnification Terms
| Term | What It Means | Why It Matters |
|---|---|---|
| Survival period | How long after closing a claim can be made | Shorter periods favor sellers; certain representations often survive longer |
| Basket | A threshold of losses before indemnity applies; can be a deductible or a first-dollar threshold | Keeps small claims out and defines whether recovery starts at the first dollar |
| Cap | The maximum total indemnity exposure | Often negotiated as a portion of the purchase price for general representations |
| Fundamental representations | Core statements such as ownership, authority, and capitalization | Typically excluded from the basket, with a higher cap and longer survival |
| Knowledge qualifier | Limits a representation to what the seller actually knows | Shifts the risk of unknown problems to the buyer |
| Materiality scrape | Ignores materiality qualifiers when calculating breach or losses | Can significantly expand seller exposure |
| Escrow or holdback | A portion of the price set aside to secure indemnity | Gives the buyer a practical source of recovery |
| Set-off | Lets the buyer reduce seller note or earnout payments for claims | Sellers should require a final determination before set-off applies |
What Sellers Should Focus On
Sellers should aim for a reasonable cap, a meaningful basket, limited survival, knowledge qualifiers where appropriate, a narrow definition of losses, and a provision making indemnification the exclusive remedy after closing, with fraud as the usual exception. When there are several sellers, each should push for several (not joint) liability, so one seller is not responsible for another's share.
What Buyers Should Focus On
Buyers want broad representations, a strong disclosure process, a reliable source of recovery such as an escrow or set-off right against a seller note, and specific indemnities for known issues found in due diligence. Buyers should also confirm that the seller will have the financial ability to pay a claim after receiving the proceeds.
What About Representation and Warranty Insurance?
Representation and warranty insurance can shift some indemnity risk to an insurer. It is more common in larger transactions because of premiums, retentions, and underwriting requirements. For smaller deals, escrows, holdbacks, and set-off rights remain the usual tools.
Attorney Insight
The fight over indemnification is really a fight over who bears the risk of the unknown. I encourage sellers to disclose aggressively and buyers to diligence thoroughly. When both happen, the indemnity section stops being a battleground and the deal closes with fewer surprises later.
Frequently Asked Questions
What is the difference between a representation and a warranty?
In practice the terms are used together. Traditionally, a representation is a statement of fact that induces the deal, and a warranty is a promise that the fact is true. Most modern agreements treat them as a single concept.
Can a buyer sue for a breach outside the indemnity provisions?
Many agreements make indemnification the exclusive remedy, typically with exceptions for fraud. Whether that limit applies depends on the agreement's language and applicable state law.
Does a seller remain liable after closing?
For the survival periods and up to the caps set in the agreement, subject to any exceptions such as fraud.
Continue Reading
- The Legal Guide to Buying or Selling a Business (start here)
- Asset Purchase vs. Stock Purchase: Choosing the Right Deal Structure
- Letters of Intent in Business Acquisitions: What Is Binding and What Is Not
- Legal Due Diligence Checklist for Buying a Business
- Earnouts and Seller Financing: Bridging a Valuation Gap
- Buying a Business With an SBA Loan: The Legal Steps
- How to Prepare Your Business for Sale: A Legal Checklist
- Non-Competes, Employees, and Key Contracts in a Business Sale
- Buying or Selling a Business in Virginia
- Buying or Selling a Business in North Carolina
Talk With an M&A Attorney Before You Sign
McCormick Law & Consulting represents buyers and sellers in business acquisitions, primarily in Virginia and North Carolina and in transactions that cross state lines. The transactions in which we have represented a party total hundreds of millions of dollars in combined deal value, a measure of the size of those deals, not of amounts recovered or earned for clients. We have formed roughly a thousand new business entities and currently represent hundreds of businesses, so we approach every deal from the operating side as well as the legal side. Every transaction is different, and the size or outcome of past deals does not predict the result in yours.
With offices in Norfolk, Virginia and Raleigh, North Carolina, we handle most of our transactions in those two states and also assist clients with multistate transactions. If you are buying or selling a business, a short call early in the process can save time, money, and leverage later. Learn more about our mergers and acquisitions practice.
This article provides general information only. It is not legal, tax, or financial advice and does not create an attorney-client relationship. Laws differ by state and change over time. Our attorneys are licensed in Virginia and North Carolina. We assist clients with business transactions involving multiple states. For matters involving the law of a state where we are not licensed, we associate with appropriately licensed counsel or otherwise proceed only as permitted by applicable law.