Inside-out promises
Before you buy a business, you know very little about it. You might have done a lot of research. You might have asked many questions. You might know about the industry. But how can you trust the answers given to you by the owner, to questions about stocks, tax, contracts, staff and many other detailed matters which make such a difference to the value of the business once you have your feet under the desk?
The answer is that you can’t. That is where warranties come in.
How warranties work in practice
The first matter to consider is the back-to-front way in which lawyers pull out information from a seller.
Most legal agreements consist in a number of points of agreement or obligation or rights. A business purchase agreement is different. The agreement is commonly drawn by the buyer. He sets out what he wants and presents his draft agreement to the seller.
The agreement first covers the mechanics of the deal - what is being sold, where it is, how it is to be transferred, and so on. Then it moves on to the warranties.
The warranties are not so much the sting in the tail as half the wasp. Many solicitors and buyers will deliberately insist on a seller giving warranties he obviously cannot support, then sue for the return of much of the purchase price a few months after the sale has been completed.
We say that not as a recommendation but to illustrate the power of warranties.
Warranties work as follows.
I am a seller. You, the buyer, produce an agreement. In that agreement, you suggest that I should warrant (promise) as facts, say sixty matters about my business.
Examples might be:
None of the employees has given or received notice terminating his employment or will be entitled to give notice as a result of the terms of the agreement.
The seller has obtained all necessary licences and consents for the proper carrying on of the business and the operation of the website and is not in breach of any of their terms or conditions.
The business and the assets are and have at all material times been adequately covered against accident, damage, injury, third party loss, loss of profits and other risks normally covered by insurance.
The seller has not manufactured or sold products which were or are or will become in any material respect faulty or defective or which did not or do not comply in any material respect with any warranties or representations expressly or impliedly made by the seller or with all applicable regulations, standards and requirements.
So I have your list of 60 relevant statements. I do not have to cross them out, re-word them or negotiate them.
Instead, I write a letter of disclosure. In that letter I list all the warranties I cannot accept and for each, I disclose exactly why I cannot agree. The main agreement is worded so that I must accept all the warranties 'subject to the disclosures'. It is obviously very important that I disclose carefully because you could sue me if my disclosures are not complete.
Example disclosures to the above warranties, might reveal:
A change of ownership of the business entitles the marketing director to terminate his employment on six months’ notice.
There is no formal licence agreement covering the photographic images on the website.
You should rely on the details and policy schedules already provided. They show the limits of insurance cover.
The seller knows of no fault or defect or non-compliance but cannot warrant that there is none.
Those replies provide crucially important information to you. You may wish to reduce the price on the table, or to talk to my marketing director or check the insurance policies - or all of these.
Warranties and the letter of disclosure are handled and ultimately agreed by negotiation in advance of completion of the deal. At completion, the final version of the letter of disclosure is handed over to you with the other contract documents.
A clever seller will use the letter of disclosure to qualify some warranties so as to make them true, without giving exact information. The most common way to do this is to say the warranty is true 'to the best of my knowledge and belief'. In that way, before you can sue me, you must prove not merely that the warranty has been breached, but that I knew it was wrong when I completed the deal.
In response (before the seller has the opportunity to reply in this way), the business sale agreement might state:
Where any warranty refers to the knowledge, information or belief of the seller, he undertakes that it has made full enquiry into the subject matter of the warranty.
That makes escape for the seller less easy and forces the seller to give a true and complete picture.
You may find aspects of this illustration to be immoral. That may be. But the world is full of pleasant people who would happily make money at your expense, one way or another. If everyone was fair and honest, we would not need many laws at all.
Warranties - seller's strategy
The task of the seller is essentially to provide full and truthful information and to avoid being tripped up in the process.
The task of the buyer is to ask for the warranties, then to assess the response that comes in the disclosures. Sometimes the buyer will reduce the price offered when he sees the true position.
The disclosures provide a wonderful opportunity to rationalise a price reduction.
As a seller, you have a number of ways to deal with the sting from the warranties:
You be the one to produce the draft sale agreement and remove the most difficult warranties before you send it to the buyer.
When you receive the draft agreement, you must seek the deletion of any warranties that are either outrageous or inappropriate. You may need to be firm.
In your draft disclosure letter, which will be sent to the buyer with your amendments to the draft agreement, you should provide clear and open disclosure to the warranty statements.
Consider the breadth of each warranty. It may be appropriate to give a similar warranty, but worded to apply to a narrower set of circumstances.
Even where you answer the warranty in some way, there is still a strong case for qualifying absolute warranties, with words like 'to the best of the sellers knowledge' or 'so far as the sellers investigation has revealed'.
At all costs avoid the easy way out of leaving the warranties as they are. It is odds on that your buyer, who was so friendly at the time of the sale, will discover something he did not expect and will come back for some of his money.
Protect yourself fairly but firmly
Without warranties, the weight of advantage in the transaction is very firmly with the seller. He has the knowledge. The buyer has none. If the seller refuses to deal with warranties, abandon the purchase because he must be trying to hide something.
However, if your warranties are all absolute in matters where it is unreasonable to expect the seller to be able to give such an adamant response, it will be he, not you, who walks away from the deal.
Set out the warranties according to the transaction. Do not include ones that are irrelevant, such as those about spare parts when the business is an accountant's practice. If your seller is not represented by a solicitor, you may have to explain the disclosure principle to him.
If the seller is represented by a solicitor, you will have to decide whether this creates an unlevel playing field. A solicitor has one obligation only: to look after his client. Many solicitors are quite happy to turn a blind eye to truth, to exaggerate, to frighten you. They will give you marginally honest information with responses like 'We have deleted a number of warranties that we trust you will agree are wholly inappropriate'. For this you should read 'We have deleted all the items which might trip up our client'. So play hardball.
Some solicitors acting for a buyer will see the provision of warranties as an opportunity to go back to the seller later for damages for breach of warranty, possibly under the threat of complete rescission of the contract. Sellers should be aware of this since it underlines the importance not only of the contract itself, but of the work that must be done in preparation for the sale and in connection with the letter of disclosure.
Finally, remember that any legal agreement is only as strong as the person behind it. If your seller is a limited company, you are advised to obtain guarantees. There is nothing like a personal guarantee to focus someone's attention - ask any bank!
The usual provision is for two executive directors or shareholders to act as guarantors. If only one guarantor is proposed, consider insisting on a guarantee also from that person's spouse or life partner. In the more relaxed atmosphere that now surrounds bankruptcy, it is comparatively easy for your seller to pass his assets to his spouse and leave you with no effective cause of action against him. If they are both guarantors, there is no escape.
Further information and documents
Net Lawman offers a number of business purchase and sale agreements covering all but the largest deals. These include a full list of possible warranties.
If you are buying all the shares in a company, you will need a company sale agreement.
Next, you might be interested in reading about the information you will need to find out before buying a business.