Cat and mouse warranties
The extent and scope of warranties is one of the trickiest negotiation areas in selling or buying a private company. The buyer wants to make sure that the financial statements were true and fair and it had received all relevant information for his investment decision on closing, while the seller is afraid warranties will allow the buyer to claw back part of the purchase price after the deal. The most important areas to seek warranties are: the valuation of assets, off balance sheet items, related party transactions, pending litigations and potential tax liabilities.
Sellers invariably try to limit the scope of warranties, claiming that the due diligence must have been enough for the buyer to map his risks. After this argument is rejected, the seller seeks to reduce liability to information not included in the data room, which is also resisted by most buyers, who are afraid their auditors were not thorough, or misled by the seller. The next line of defence is to limit the extent that the warranties are backed by a financial security (bank guarantee, payment in escrow), as the chance of proving and recovering funds through the courts is remote for the buyer. Typical proportion of financially secured warranties is between 10 and 30%, and for the total warranty obligation between 50%-100% of the purchase price. Next is to limit the time the warranties may be called. In most cases this ends up between 1 and 3 years, excluding tax liabilities, where most sellers are willing to grant the statutory time limit, which is 6 years in Hungary. The seller will also seek minimum claim limits and restrict the sellers to “third party claims” to remove the buyer’s opportunity to present trifling losses, or to generate claims himself against the company. The seller will also negotiate his right to cure any claims against the company, especially tax claims, which the company may not care to defend, if protected by a warranty.
The final frontier for the seller is to soften-up the text of the representations, limiting it to “the best of his knowledge” and by presenting a disclosure letter before closing, listing the specific exceptions to the representations that it would not warrant.