Warranty

What is a warranty?

Warranty (German: Garantie) denotes, in a company purchase or investment agreement, the statement of a contracting party that certain facts about the company or the shares sold are true at a specified point in time. The party stands behind every deviation under the rules of the contract, even without fault. Comparable is the written promise in the purchase of a used car that the vehicle is accident-free: if accident damage later comes to light, the seller must answer for it, even if the seller knew nothing about it.

In a share deal, the purchase of the shares in a company instead of individual assets, the company purchase agreement is usually called a share purchase agreement (SPA). The warrantors are the sellers, in funding rounds the company and often the founders. The buyer examines the catalogue in due diligence, the investigation of the company before signing the contract. The seller qualifies it by the disclosure schedule (disclosure schedule), in which known deviations are listed.

Independent guarantee instead of statutory warranty rights

In a share deal, shares are bought as rights; Section 453(1) of the German Civil Code (BGB) applies the provisions on the sale of goods to them accordingly. The statutory rights in respect of defects under Section 437 BGB fit an ongoing business poorly, however: rescission, for example, is hardly feasible once the acquirer has already integrated the company. The statutory limitation period of two years (Section 438(1) no. 3 BGB) likewise does not suit tax risks, which often become visible only years later.

Contract practice therefore replaces these rules with independent guarantee promises based on freedom of contract (Section 311(1) BGB). The consequences of a deviation then arise solely from the contract. The background is Section 444 BGB: under it, a seller cannot rely on an exclusion or limitation of liability to the extent that the seller has given a guarantee as to quality. According to the prevailing view, this does not cover limits that form part of the content of the guarantee from the outset. The contracts nevertheless regularly clarify that no guarantees of quality within the meaning of Sections 443 and 444 BGB are given.

At the same time, the parties largely exclude the statutory claims. This concerns above all the rights in respect of defects, liability for breaches of duty in contract negotiations (Sections 280 and 311(2) BGB) and adjustment for disruption of the basis of the transaction (Section 313 BGB). Liability for intent and fraud, that is, for knowingly concealing or misrepresenting facts, can neither be excluded in advance nor limited by a liability cap.

Structure of the warranty catalogue

Title warranties

Title warranties (fundamental warranties) concern the legal foundations of the transaction. These include the valid existence of the company, the full payment of contributions and the seller's ownership of the shares. Further title warranties concern the freedom of the shares from third-party rights, such as pledges, and the seller's power to dispose of them. The list of shareholders in the commercial register does not replace these warranties. Good-faith acquisition under Section 16(3) of the German Limited Liability Companies Act (GmbHG) applies only under narrow conditions and, according to a widespread view, protects neither the existence of the share nor its freedom from encumbrances.

Business warranties

Business warranties describe the state of the company. Statements are usual on annual financial statements, material contracts, intellectual property rights and software, employment relationships, litigation, permits, data protection, grants and taxes, and on the conduct of business in the ordinary course since the last balance sheet date. For technology companies, rights in the source code and the use of open-source software are added.

The balance sheet warranty is negotiated intensively. In its objective form, the seller warrants that the annual financial statements give a true and fair view of the net assets, financial position and results of operations (Section 264(2) of the German Commercial Code, HGB). In its subjective form, the seller warrants only that the statements were prepared in accordance with the principles of proper accounting, that is, the recognised accounting rules, and to the best of its knowledge. The difference decides who bears the risk of undetected valuation errors: in the objective form the seller, in the subjective form largely the buyer.

Consequences of a breach of warranty

If a warranty is untrue, a warranty claim arises. Under the usual structure, the buyer must give written notice of it and quantify it within a period from knowledge. First, the buyer can demand that the seller produce the warranted state. If that does not succeed, the seller owes damages in money, at the buyer's choice to the buyer itself or to the company. The contracts often deviate here from Sections 249 et seq. BGB: lost profit, consequential losses, internal administrative costs and a calculation of loss by way of the valuation multiple are often excluded. If the purchase price was set at ten times annual earnings, for example, a permanently lower result of EUR 50,000 could otherwise be claimed as a loss of EUR 500,000.

Provisions in the balance sheet at the reporting date, purchase price adjustments and insurance payments are usually credited, so that the same disadvantage is not compensated twice. In terms of amount, the contracts limit liability in three tiers: a de minimis threshold for small individual claims, a threshold amount for the total of all claims (basket) and a cap.

The contract also regulates limitation, after the expiry of which claims can no longer be enforced. For business warranties, 12 to 24 months after closing (the transfer of shares and purchase price) are common. The period is usually meant to cover at least one set of annual financial statements under the new owner. Title warranties often become time-barred only after five to ten years, tax warranties often six months after the relevant tax assessments have become final, that is, can no longer be challenged. Limits are set by Section 202 BGB: for liability for intent, limitation cannot be eased in advance and generally cannot be made harder beyond 30 years from the start of the statutory limitation period.

Buyer's knowledge and disclosure

Under Section 442(1) BGB, the buyer loses its rights if it knows of the defect at the conclusion of the contract. Whether this applies to independent guarantees is not clear; company purchase agreements therefore regulate the question expressly. Buyers prefer a clause under which their knowledge is irrelevant (pro-sandbagging), sellers the opposite. Many contracts choose a middle way: claims are excluded only for circumstances disclosed so that an expert buyer could recognise their nature and significance. Counting as sources are the disclosure schedule and the data room, that is, the collection of documents made available for the review.

Warranties are generally given at signing and repeated at closing. The contract regulates whether the seller may supplement the disclosure schedule in the meantime. At closing, the seller often confirms that the warranties remain correct in a separate statement (bring-down certificate).

Warranties in the funding round

In the participation agreement of a funding round, the warranty catalogue is usually slimmer. If the company pays investors who became shareholders with the capital increase, capital maintenance applies. Assets required to maintain the share capital may not flow to shareholders (Section 30(1) GmbHG). Breaches of warranty are therefore usually compensated in shares: the investors take additional shares at nominal value, that is, without a premium. Their percentage then corresponds to a valuation reduced by the loss. The founders' personal liability is usually limited to a fixed amount, which does not apply in cases of intent.

Practical example: warranty on software rights in a company sale

A software company with annual revenue of around EUR 6 million is sold to a strategic acquirer. The draft contract contains the warranty that the company has all the rights in the software used that are necessary for its business operations. In preparing the disclosure schedule, it emerges that an important module comes from a freelance developer with whom there is no written agreement on rights of use.

The legal position is uncertain. The special rule for programs created by employees (Section 69b of the German Copyright Act, UrhG) does not apply to freelancers. Without an express agreement, the scope of the rights of use depends on the purpose of the contract (Section 31(5) UrhG). It can fall short of what an acquirer needs, for example the right to modify the code or to license it to third parties.

• Subsequent grant of rights: Before signing, the company agrees with the developer exclusive, unrestricted rights of use against a one-off payment (IP assignment). The problem is thereby removed, and the warranty can be given without qualification.
• Disclosure: The facts are included in the disclosure schedule. Liability under the warranty is then excluded, and the buyer will demand an indemnity, a purchase price reduction or a condition to closing.
• No action: The warranty is untrue. Because the seller knows the circumstance, the accusation of fraud is added, against which no contractual liability limit protects.

The first solution costs a one-off payment but is usually the cheapest, because it affects neither the purchase price nor the liability limitation; the third is the most expensive.

Distinctions: warranty, indemnity, covenants and W&I insurance

• Indemnity (indemnification): is not tied to a warranted state but to the occurrence of a particular risk, and covers precisely known circumstances as well.
• Covenants: oblige a party to do or refrain from doing something, for example to continue the business in the ordinary course until closing. Warranties, by contrast, describe facts at a point in time.
• Warranty insurance (W&I insurance): covers losses from breaches of warranty and replaces the seller's liability in whole or in part, but not the warranties themselves.

Common mistakes

• No reconciliation with the data room. Anyone who signs the catalogue without checking each statement against the documents gives warranties whose untruth they could have recognised.
• Forward-looking warranties. A warranty on planning figures makes the seller the insurer of the business plan. At most, an assurance that the planning was prepared with care is defensible.
• Blanket disclosure. Buyers often reject the clause that the entire data room is deemed disclosed. Specific disclosure for each warranty is more robust.
• Uniform limitation period. A single period for all warranties does justice neither to tax risks nor to title questions.

Frequently asked questions

Is a warranty a contractual guarantee or statutory liability for defects?

In a company purchase, a contractual guarantee (Garantie). Statutory liability for defects (Gewährleistung) is the seller's liability for defects under the law (Sections 434 et seq. BGB) and applies without special agreement. A warranty, by contrast, is a contractual promise to answer for a particular state; the purchase agreements largely exclude statutory liability for defects alongside. In consumer business, warranty usually means the manufacturer's guarantee.

What is the difference between representations and warranties?

In German law there is none. In the US market, a representation is a statement of fact whose untruth can give rise to claims for misrepresentation, whereas a warranty is a contractual promise to stand behind it. German contracts combine both as independent guarantees.

Is the seller liable for circumstances the buyer knew from due diligence?

That depends on the knowledge clause. It is common that only properly disclosed circumstances exclude the claim. For known risks that the buyer does not want to take on, an indemnity is agreed.

What does "to the best of knowledge" mean in a warranty?

The warranty applies only to circumstances that were known to the persons named in the contract or, depending on the wording, ought to have been known on due inquiry. Unknown risks are borne by the buyer to that extent. If there is no exhaustive list of these persons, it is unclear in a dispute what knowledge of employees is attributable to the seller.

The Roemer Capital view

In a sale process, we reconcile the warranty catalogue early with the data room, which is ready with us within 24 hours. We assign each warranty to the documents that support it and mark where a disclosure, a remedy before signing or a separate rule becomes necessary. In this way gaps such as missing grants of rights can be closed before they weigh on the purchase price.

Warranties and the disclosure schedule are drafted by the client's law firm. We calculate what knowledge qualifiers, thresholds and limitation periods mean for the liability risk of each individual seller.