Quick answer: Representations and warranties are the seller’s written statements about the company, such as the accuracy of its financial statements and its title to what is being sold. Indemnification is the seller’s promise to reimburse the buyer if those statements prove false. Baskets, caps, survival periods and an escrow set how much a buyer can recover, for how long and from what source, and each of those limits is negotiated.
Key points
- A representation is a statement of fact about the business, and indemnification is the remedy if the statement is wrong, so the two have to be read together.
- Knowledge and materiality qualifiers decide how much risk a representation really places on the seller, often more than the wording of the statement itself.
- Baskets, caps and survival periods set the size and the window of the seller’s exposure, and they move risk between the parties without changing the headline price.
- An escrow is a part of the price held back to pay claims, so its size, whether it is the buyer’s only source of recovery and its release terms decide how much of the proceeds is certain at closing.
- Anything the seller discloses against a representation generally cannot support a claim, which makes the disclosure schedule the seller’s main protection.
What representations and warranties do in a purchase agreement
A representation is a statement of fact about the company that the seller makes in the purchase agreement, such as that the financial statements are accurate or that the seller owns the shares it is selling. The warranty is the promise behind the statement. Agreements draft them together, and the practical consequence is the same for both: if a statement is untrue, the buyer may recover its loss through the indemnification provision. The guide to purchase agreement terms covers the whole contract. This page goes deeper on the terms that allocate risk.
Representations do two jobs. They force the seller to put every exception on the record, because a statement that cannot be made without qualification has to be qualified on a disclosure schedule. They also give the buyer a route to recover if a statement turns out to be wrong after closing. Buyers test the statements in diligence, and the agreement repeats them at signing and again at closing. Repeating them at closing is called bringing them down, and a seller should ask what could happen between signing and closing that would make any statement false.
The statements buyers ask for and the qualifiers that narrow them
Buyers start with a long list and sellers narrow it. The groups below appear in purchase agreements for operating companies, with what each protects and the qualifier a seller often requests.
| Representation | What the buyer is protecting | Qualifier a seller often requests |
|---|---|---|
| Authority and title | The seller can sign and owns what is being sold | None, because these are usually treated as fundamental |
| Financial statements | Reported results fairly reflect the business | Limit to the periods and statements actually delivered |
| Undisclosed liabilities | No obligations sit outside the balance sheet | Limit to liabilities that are material or required to be recorded |
| Taxes | Returns were filed and amounts due were paid | Materiality, and knowledge for audits and claims |
| Contracts and customers | Major contracts are valid and no counterparty has given notice to leave | Knowledge, for what customers intend to do |
| Employees, intellectual property and compliance | Workers are correctly classified, the company owns or can use its intellectual property, permits are in place | Knowledge for infringement and threatened claims |
Knowledge. A statement made to the seller’s knowledge is breached only if the seller knew the fact. The definition decides how much that protects. It names the people whose knowledge counts and says whether it means actual awareness or what a reasonable inquiry would have revealed. Sellers want a short list of people and actual knowledge. Buyers want more managers and a duty to inquire.
Materiality. A statement qualified by materiality is breached only if the problem is significant. A material adverse effect qualifier sets a higher bar, because it asks whether the problem changes the business as a whole. Buyers answer with a materiality scrape, which ignores the qualifiers when deciding whether there was a breach, when measuring the loss, or both. A scrape in both places removes most of the protection the qualifiers gave the seller.
Flat statements. A statement with no qualifier is flat. A flat statement about something the seller controls, such as title to its shares, is normal. A flat statement about something outside the seller’s control, such as whether a customer will renew, asks the seller to insure the buyer against the future.
Disclosure schedules, data rooms and sandbagging
The disclosure schedule lists the exceptions to each representation. An exception listed against a statement generally means that item does not breach the statement, so the schedule is the seller’s main protection and deserves the same care as the price. The schedule is built from the facts the buyer tests in diligence, and a problem that appears in the data room should appear on the schedule too. Three drafting points decide how much protection it gives.
- Specific or general. A buyer wants each exception tied to the statement it qualifies. A seller wants an item disclosed once to qualify every statement it touches.
- The data room. Sellers often ask that everything in the data room count as disclosed. Buyers usually resist, because that would let a problem sit unnoticed in a folder.
- Updates before closing. The agreement should say whether the seller can update the schedule between signing and closing, and whether an update cures the breach or only gives the buyer a right to walk away.
A sandbagging clause answers a different question: whether a buyer that learned of a problem before closing can still recover for it. A pro-sandbagging clause says yes. An anti-sandbagging clause says no. Silence leaves the point to be argued after a loss has occurred, when neither side is inclined to compromise.
Baskets, caps, survival periods and other limits on recovery
Each term below limits what the seller can owe. Together they decide whether a representation is a real exposure or a modest one.
- Basket. The amount of losses the buyer absorbs before the seller pays. A deductible basket leaves the first slice with the buyer. A tipping basket, also called a first-dollar basket, makes the seller pay from the first dollar once the threshold is passed. A per-claim minimum keeps small items from being added up toward either.
- Cap. The ceiling on what the seller owes for breaches of general representations. It is often set at or near the indemnity escrow, which makes the escrow the buyer’s only recourse for those claims.
- Survival period. How long a representation can support a claim. The buyer must give written notice before it ends. General representations usually expire first, and tax and fundamental representations usually last longer.
- Fundamental representations. The statements the deal rests on, such as organization, authority, title and broker fees, and sometimes taxes. They survive longer and are usually subject to a higher cap, which can reach the full price.
- Exclusive remedy. A clause making indemnification the buyer’s only remedy after closing, other than for fraud and a few named items. It keeps the seller from facing claims outside the negotiated limits, so the carve-outs are worth reading closely.
- Definition of losses. Whether losses include lost profits, diminution in value or a multiple of earnings is one of the costlier points in a draft. If a recurring earnings shortfall can be multiplied by the multiple the buyer paid, a modest breach can become a large claim.
- Offsets and mitigation. Sellers ask that insurance proceeds and tax benefits reduce the loss, and that the buyer take reasonable steps to limit it.
- Several liability. With more than one seller, several liability makes each owner liable only for its own share. Joint liability lets the buyer collect the whole loss from any one of them.
How an indemnity escrow or holdback works
An escrow is a part of the purchase price that the buyer deposits with a neutral escrow agent at closing, to be paid out under the agreement. A holdback has a similar effect, but the buyer keeps the money and owes it to the seller later. The difference is credit risk. An escrow agent holds cash that neither party can take alone, while a holdback is only as safe as the buyer’s promise to pay.
A deal often has more than one pool. An adjustment escrow covers the working capital true-up described in the guide to the working capital peg. An indemnity escrow covers claims under the general representations. A special escrow can cover a known matter, such as a pending dispute, that the seller has disclosed but the buyer will not price.
Release follows the dates in the agreement. At each date the agent pays the seller what remains, less the amount of any claims still pending. Sellers should check whether release is in stages or all at once, whether pending claims are held at the buyer’s estimate or at a figure the seller can contest, and whether the buyer can also set off claims against an earnout or seller note. The earnout guide explains why a set-off right turns deferred payments into security for the seller’s promises. Because the escrow comes out of the check at closing, it appears as a deduction in the bridge from enterprise value to cash received, although it is not lost. When escrowed amounts are taxed is a question for the seller’s CPA before signing.
How one claim moves from notice to payment
The sequence below is the usual path of a claim under the general representations.
- Discovery. The buyer finds a problem after closing, often when it closes its first books or when a customer, employee or agency raises it.
- Notice. The buyer sends written notice within the survival period, naming the representation, the facts and an estimate of the loss. A late notice, or one without the required detail, can lose the claim.
- Response. The seller has a set period to accept or dispute. Silence is often treated as acceptance, so the seller or its representative needs a way to see notices when they arrive.
- Third-party claims. When the loss comes from a claim by an outsider, the agreement says who controls the defense, who pays for it and whether the buyer can settle without the seller’s consent.
- Resolution. The parties agree, or a dispute clause sends the question to negotiation, mediation, arbitration or a named court.
- Payment. The loss is paid from the indemnity escrow first and then, if the cap allows, by the seller directly or by set-off.
- Release. When the survival period ends, the remaining escrow, less pending claims, goes to the seller.
Illustrative example: One claim under two basket types
A buyer pays $20,000,000 for a company. At closing $1,000,000 goes into an indemnity escrow. The cap on general representations equals the escrow, the basket is $200,000, and claims under $25,000 do not count toward it. After closing the buyer finds an unrecorded customer rebate obligation of $450,000, accrued liabilities of $150,000 that were missing from the closing balance sheet, and a $10,000 invoicing error. The invoicing error is below the per-claim minimum and is ignored, so the counted claims total $600,000.
| Item | Deductible basket | Tipping basket |
|---|---|---|
| Counted claims | $600,000 | $600,000 |
| Absorbed by the buyer | $200,000 | $0 |
| Paid by the seller from the escrow | $400,000 | $600,000 |
| Escrow released at the end of the survival period | $600,000 | $400,000 |
The basket type moves $200,000 between the parties on identical facts. If counted claims had been $150,000, neither basket would have paid anything. Because the cap equals the escrow, no claim under the general representations could cost the seller more than $1,000,000 here, although fundamental representations and fraud sit outside that cap. The numbers are invented to show the mechanics and are not benchmarks.
Points to settle with the seller’s attorney
The limits are easiest to change in the first draft, before the buyer has spent time and money on the deal. These are the questions to put to the seller’s attorney when it arrives.
- Which statements are flat, which carry knowledge or materiality qualifiers, and whose knowledge counts?
- Is there a materiality scrape, and does it apply to breach, to loss or to both?
- Is the basket a deductible or a tipping basket, and is there a per-claim minimum?
- Is the cap equal to the escrow, and is the escrow the only source for general claims?
- Which statements are fundamental, how long do they survive and what is their cap?
- Does the data room count as disclosure, and can the schedule be updated before closing?
- Does the agreement address sandbagging, and are several sellers liable only for their own shares?
- Would the buyer’s representations and warranties insurance replace part of the escrow, and what would remain with the seller?
These terms are negotiated while diligence is still running, which is why the seller’s attorney needs the draft early. The guide to how to sell a business shows where this stage falls among the others. This guide is general education and not legal advice.
Frequently asked questions
What is the difference between a representation and a warranty?
A representation says something is true when the agreement is signed or closed. A warranty is the promise that it is true, with a remedy if it is not. Purchase agreements usually draft the two together and treat them alike, and the practical remedy for a false statement is the indemnification provision.
What is a basket in a purchase agreement?
A basket is a threshold of losses the buyer must absorb before the seller owes anything. With a deductible basket the seller pays only the losses above the threshold. With a tipping basket the seller pays from the first dollar once losses pass it. A per-claim minimum can also keep small claims from counting toward either.
Can a seller lose more than the escrow?
Sometimes. The agreement can make the escrow the buyer’s only source for general representations, but fundamental representations and fraud are often carved out of that limit, and the buyer may recover directly from the seller or by set-off against deferred payments. The cap and the sources of recovery should be read closely before signing.
What happens if the buyer knew about a problem before closing?
It depends on whether the agreement has a sandbagging clause. A pro-sandbagging clause lets the buyer recover even if it knew of the breach. An anti-sandbagging clause bars the claim. Some agreements say nothing, which leaves the point to be argued. A problem disclosed on the schedule avoids the question for that item.
Thinking about a sale or an acquisition?
The Impetus Group provides sell-side and buy-side M&A advisory, from preparation and buyer outreach to negotiation and closing. A transactional valuation is often the first step, scoped and priced separately.
Related guides
- The Purchase Agreement: Key Terms Sellers Should Understand Before Signing: The purchase agreement is the binding contract in a business sale. See its key terms, from price adjustments to indemnification, and the questions to ask counsel.
- Representations and Warranties Insurance: How R&W Policies Work in a Business Sale: R&W insurance pays the buyer for breaches of the seller’s representations. See how underwriting, retention and exclusions work and what changes for sellers.
- Earnouts Explained: How Contingent Consideration Works in a Sale: An earnout ties part of the purchase price to future results. Learn how earnouts are structured, why buyers propose them and how sellers can value the risk.
- From Enterprise Value to Equity Value: What the Owner Receives: Enterprise value is the price of the business. Equity value is what owners receive after debt, debt-like items, cash and working capital. See the bridge.
- How Long Does It Take to Sell a Business? Phase by Phase: How long a business sale takes depends on its slowest phase. See what controls each stage, where delays occur and what shortens the path.
- Buyer Outreach in a Sale Process: Reaching Buyers Without Breaking Confidentiality: How a confidential sale reaches buyers: blind teasers, NDAs, call sequencing, contact logs, broad versus targeted outreach and what to do if word leaks.
This guide is general education. It is not a valuation opinion, appraisal, investment advice, or legal or tax advice. How these guides are made.