Reps and Warranties
The seller's contractual promises about the state of the business, made in the definitive purchase agreement and backed by money held in escrow.
What They Are
Representations and warranties (reps and warranties) are the statements a seller makes in the definitive purchase agreement asserting that the business is what the buyer was told it is. They cover facts such as ownership of assets, accuracy of the financials, payment of taxes, and the absence of undisclosed liabilities or pending lawsuits. Warrillow defines them as
"Promises about the company (e.g., no pending litigation); a serious breach can trigger escrow claims or a lawsuit."
Warrillow, The Art of Selling Your Business, Appendix B
McDannell frames the same provision as part of the purchase agreement and treats it as something to negotiate, not just accept. He describes reps and warranties as the
"Seller's contractual promises about the business's current state; limit liability where possible."
McDannell, Get Acquired, ch. 7
Why They Matter
Reps and warranties are how a buyer transfers risk back to the seller for anything that turns out to be untrue after closing. If a promise is false and the buyer suffers a loss, the seller pays. This is why McDannell stresses honesty throughout diligence: a single caught misstatement destroys trust and invites the buyer to assume the worst about everything else. Clean financials matter for the same reason, because deals most often die in diligence when the numbers do not reconcile, and a number that does not reconcile is a representation a seller may not be able to stand behind.
How They Are Backed: Indemnification and Escrow
A representation is only as good as the recourse behind it. That recourse is indemnification, the purchase-agreement mechanism that allocates post-sale liability. Warrillow ties the two together directly, defining indemnification as
"Compensation for loss or harm; backs the promises (reps and warranties) made in a purchase agreement."
Warrillow, The Art of Selling Your Business, Appendix B
The money usually comes from escrow: a portion of the sale proceeds held back, often by a lawyer, for a period after closing. Burlingham describes the pairing concisely as
"Contractual seller assurances backed by sale proceeds held back (in escrow) pending resolution."
Burlingham, Finish Big, ch. 8
If a buyer brings a valid claim for a breached representation, it is paid first out of escrow. The size of the escrow, how long it is held, and what triggers a payout are all negotiable terms, not fixed rules.
Limiting Exposure
Because reps and warranties expose the seller after the deal is done, the goal on the sell side is to cap and time-limit that exposure. McDannell advises sellers to negotiate
"liability caps, time limits, and clear deposit/breakup-fee terms in the purchase agreement."
McDannell, Get Acquired, ch. 7
The other common limiter is the basket, a loss threshold below which the buyer cannot claim at all. A true deductible pays only the excess over the threshold, while a tipping basket pays the entire loss once the threshold is crossed. Negotiating a high deductible-style basket, a firm liability cap, and a short survival period keeps a seller from being on the hook indefinitely for small or inevitable post-close hiccups.
Further Reading
Sources: McDannell, Get Acquired ch.7; Warrillow, The Art of Selling Your Business Appendix B; Burlingham, Finish Big ch.8