A Founder's Guide to Reps and Warranties in an Acquisition

What Are Reps & Warranties, in Plain English?

When you sell your company, the buyer needs to know what they are actually buying. They’ve done due diligence, but they can’t uncover everything. Reps and warranties are the bridge over that information gap.

Think of them as a set of legally binding statements you, the seller, make to the buyer about the state of your business. They are the backbone of the purchase agreement and the primary way risk is allocated between you and your acquirer.

Representations are statements of past or present fact. Example: "The company is in compliance with all applicable laws." · Warranties are promises that a fact will remain true in the future. Example: "The seller warrants that they will assist in transitioning key customer relationships for three months post-closing."

In practice, the terms are often used together ("reps and warranties") and serve one primary purpose: to give the buyer a legal remedy if you've told them something that turns out to be untrue. Getting this wrong can turn a successful exit into a multi-year nightmare of lawsuits and clawbacks.

Why This Isn't Just "Lawyer Stuff"

As a founder, it's tempting to tune out during the reps and warranties negotiation and let the lawyers handle it. This is a massive mistake. The details decided here directly impact how much of the purchase price you actually get to keep.

If a rep you made turns out to be false, the buyer will suffer damages. For example, if you claimed to own all your IP, but a former contractor later proves they own a key component, the buyer will have to spend money to fix it. They will then come to you for that money.

The reps and warranties section, and the related indemnification terms, dictate exactly how, when, and how much they can recover from you. This is your money on the line.

The Core Components of an M&A Deal Structure

The negotiation isn't about whether to have reps, but about how to qualify them and what happens if one is breached. The key levers you'll negotiate are the "Three Baskets": the Basket, the Cap, and the Escrow/Holdback, plus the Survival Period.

Key Categories of Reps You'll Be Asked to Make

You won’t be making vague statements. The buyer will present a purchase agreement with dozens of specific reps. They typically fall into these categories:

Fundamental Reps

These are the absolute basics about your company's existence. Breaches here are considered catastrophic, so your liability is highest.

Organization: The company is a duly organized corporation in good standing. · Capitalization: The cap table is accurate. All issued shares, options, and other securities are listed. There are no other "phantom equity" claims. · Authority: The company and its shareholders have the right to sign and execute the agreement. · Taxes: The company has filed all its tax returns and paid all taxes due.

Financial and Operational Reps

Financial Statements: The financials you provided are accurate and prepared according to standard accounting principles. · No Undisclosed Liabilities: There are no hidden debts or obligations beyond what's on the balance sheet. · Material Contracts: You have provided all significant contracts, and they are in full force and effect. There are no breaches on your end or the other party's. · Compliance with Laws: The business has not violated any laws, regulations, or permits. This includes industry-specific rules (like HIPAA) and general employment laws. · Litigation: There are no pending or threatened lawsuits against the company.

IP & Technology Reps

For a tech startup, this section is paramount and often heavily negotiated.

IP Ownership: The company legally owns or has valid licenses to all intellectual property used in the business. All employees and contractors have signed agreements assigning their IP to the company. · No Infringement: The company’s technology does not infringe on the IP rights of any third party. · Open Source Software: You have disclosed all use of open-source software and are compliant with all licenses. (A violation of a "copyleft" license like GPL can be a deal-killer). · Data Privacy & Security: The company complies with all relevant privacy laws (like GDPR or CCPA) and has taken reasonable steps to protect its systems from cybersecurity threats.

The Disclosure Schedules: Your Most Important Document

You will never be able to make every rep with 100% accuracy. No business is perfect. That's what the disclosure schedules are for.

The disclosure schedules are a separate document attached to the purchase agreement where you list every exception to the reps. For every rep that isn't perfectly true, you write a disclosure explaining the real situation.

Example: The purchase agreement contains a rep stating: "The company is not a party to any pending or threatened litigation." However, a former employee has threatened a wrongful termination suit.

Your Disclosure: On Schedule 4.12 (Litigation), you would write: "The Company has received a demand letter dated October 15, 2023, from counsel for former employee Jane Doe, alleging wrongful termination and seeking damages of $50,000. The Company disputes these claims."

By disclosing the issue, you have shifted the risk for that specific item to the buyer. They cannot later claim you breached the litigation rep, because you told them about the threatened suit. The golden rule is: disclose, disclose, disclose. Hiding a problem is the fastest way to commit fraud and face unlimited liability.

How Indemnification Works: The Financial Stakes

Indemnification is the legal mechanism for how the buyer gets paid back for a breach. These are the terms you must negotiate carefully.

1. The Survival Period

This is the time limit for the buyer to make a claim. After this period, your reps expire.

General Reps: Typically survive for 12-18 months post-closing. This is long enough for most operational issues to surface. · Tax and Environmental Reps: Survive for the statute of limitations, often 6-7 years . · Fundamental Reps: Can survive indefinitely or for a very long period (e.g., 10+ years).

2. The Basket (The "Deductible")

The buyer can't come after you for every tiny issue. The "basket" is a threshold that must be met before they can make a claim. A typical basket is 0.5% to 1% of the purchase price.

Tipping Basket: Once damages exceed the threshold, the buyer can recover the full amount of the damages, from dollar one. · True Deductible: The buyer can only recover the amount of damages in excess of the threshold. (This is better for you).

3. The Cap (The Liability Limit)

This is the most important number. The cap is the maximum amount you and other shareholders can possibly lose from a breach of general reps. A market-standard cap is 10-15% of the purchase price .

Crucially, the cap for fundamental reps is often much higher—typically 100% of the purchase price . This is why it's so important that your cap table and corporate authority are perfect.

4. The Escrow / Holdback

To ensure money is available to pay claims, the buyer will "hold back" a portion of the purchase price in an escrow account. The escrow amount usually matches the general cap ( 10-15% of the purchase price ) and is held for the duration of the general survival period ( 12-18 months ).

R&W Insurance: The Modern Alternative to Escrow

In recent years, Rep & Warranty Insurance (RWI) has become a popular way to deal with this risk, even in smaller deals ($20M+). Instead of a large seller escrow, the buyer purchases an insurance policy that covers damages from a breach.

This is a huge win for founders. The policy cost is shared between buyer and seller, but it means:

You get more cash at closing. The escrow can be dramatically reduced (e.g., from 10% of the price down to 0.5-1%) or eliminated entirely. · You get a cleaner exit. The buyer makes claims against the insurance policy, not directly against you.

If you are entering an M&A process, you should immediately ask your lawyer if RWI is a viable option for your deal.

Common Founder Mistakes and How to Avoid Them

Under-Disclosing: You get nervous that revealing a problem will hurt the valuation or kill the deal. You hide it. Don't. The problem will almost certainly be discovered later, and what was a simple breach of contract will now be fraud, with unlimited liability. · Not Preparing Your Data Room: You can't make accurate reps if your documents are a mess. Start organizing key contracts, employee agreements, and corporate records long before you have a buyer. · Ignoring IP Cleanliness: You never had a formal process for open-source license scanning or ensuring all contractors signed IP assignment agreements. This can create huge, expensive problems during diligence that must be fixed before closing. · Accepting Non-Market Terms: A buyer, especially a large corporate one, might present an initial draft with a 25% cap, a 36-month survival period, and no basket. You need to know that this is not market and push back forcefully with your lawyer's help.

How to Apply This Next Week

Selling your company is a future goal, but the work to ensure a clean exit starts now.

Run an IP Audit: Use a tool like FOSSA or Snyk to scan your codebase for open-source licenses. Identify any copyleft (GPL, AGPL) licenses and see if you can replace that code. · Check Your Contracts: Make a list of your top 10 customers and top 5 vendors. Review their contracts for any change-of-control clauses, assignment limitations, or unusual termination rights. · Verify IP Assignments: Go through your employee and contractor history. Do you have a signed IP assignment agreement from every single person who ever wrote code or contributed to the product? If not, go get them signed now. · Model Your Cap Table: Ensure your cap table is 100% accurate, including all options (issued and unissued), warrants, and SAFEs/notes. Get this validated by your lawyer.