The sale is not the end of your exposure

When you sell your business, the buyer will ask you to confirm and guarantee that certain things about it are true. For example: the accounts are accurate, nobody is suing the company, and the main contracts are in order. These confirmations are called ‘warranties’. One important document in this process is the disclosure letter.

If one of those confirmations turns out to be wrong, the buyer can make a warranty claim against you. You may have to pay the buyer compensation, even months after you have handed over the business. The disclosure letter is one of the main ways you can protect yourself.

What a disclosure letter does

A disclosure letter is a document you give the buyer when the sale agreement is signed. It lists anything that makes a warranty untrue or incomplete. If you explain a problem clearly enough for a sensible buyer to understand it, the buyer cannot make a warranty claim for it later.

Think of each warranty as a statement the buyer is asking you to confirm is true (for example, ‘there are no disputes with customers’). The disclosure letter is your chance to set out any exceptions (for example, ‘except for the dispute with Client ABC as described below’).

The more accurate and specific your explanation in the letter, the better informed the buyer is. Therefore, there is less room for a warranty claim.

Due diligence, the data room and your disclosure letter

Before buying, the buyer will investigate your business. This is called due diligence. The buyer’s advisers will check things like your contracts, accounts, employees, property and any disputes.

To do this, they will usually send you a due diligence request list setting out the documents and information they want to see. You respond by uploading the documents and your written answers to a data room. This is a secure online folder the buyer and its advisers can access.

What the buyer’s advisers find in due diligence shapes the negotiation. If they identify a problem, the buyer may ask for a lower price. In addition, they could ask for a specific indemnity (a separate promise to cover that risk), a holdback on part of the price until the issue is resolved, or for you to fix the problem before the sale completes.

But due diligence has its limits, particularly as much of what the buyer sees comes from you. As a consequence, the buyer will ask you for warranties in the sale agreement to make you stand behind the information you provided during the due diligence process. If a warranty turns out to be untrue, the buyer may be able to claim compensation from you. This is where the disclosure letter helps you limit your exposure after the sale.

It does so by listing the exceptions to those warranties, including problems the buyer already knows about. This is important because the buyer knowing about a problem does not necessarily restrict it from making a warranty claim later.

Whether information provided to the buyer in the data room or otherwise counts as disclosed depends on what your sale agreement says. Do not assume that an issue flagged to the buyer outside of the disclosure letter protects you from a warranty claim.

Disclose properly: general, specific and fair

Disclosure comes in two forms. A general disclosure qualifies all warranties and usually covers matters such as information available from public sources. A specific disclosure is made against one particular warranty.

The sale agreement should also set a disclosure standard. This establishes how much detail a disclosure must contain for the buyer to lose its right to make a warranty claim against you. The standard is negotiated and can range from a light test, such as the matter being reasonably apparent from the documents provided, through ‘fairly disclosed’ (enough detail for a reasonable buyer to identify the nature and scope of the matter), to a strict test requiring it to be set out fully, clearly and accurately within the disclosure letter.

Early involvement from your solicitor can help you get the best result when negotiating these disclosure practicalities.

Three further points:

  • Disclosure does not cover fraud. If a seller deliberately hides something from the buyer, the letter will not be protection enough.
  • Indemnities usually sit outside the disclosure letter. If the buyer spots a risk in due diligence, it may ask for a specific indemnity, and disclosing the issue will not usually affect the indemnity.
  • Timing matters. If there is a gap between signing the sale agreement and completing the sale, agree whether you can update the letter for new events, and what the buyer can do if you do.

Other protections to negotiate

The disclosure letter works alongside limits written into the sale agreement itself. Ask your solicitor about each of these:

  • De minimis: claims below a set value cannot be brought at all.
  • Basket or threshold: claims must reach a certain total before any can be pursued, and sometimes only the excess is recoverable.
  • Cap: your overall liability is limited to a maximum amount.
  • Time limits: warranty claims must be notified within a fixed period, with tax claims commonly allowed longer.
  • Several liability: if there are multiple sellers, each is liable only for their own share, not for each other’s.
  • Buyer’s knowledge: a term stopping the buyer from claiming for something it already knew about. Buyers often push back on this.
  • Retention or escrow: if part of the price is held back, negotiate its size and how and when it is released.

Before you sign: a seller’s checklist

☐  Instruct a solicitor early, before the agreement is drafted

☐  Review your own business before the buyer does, so you find any problems first

☐  Go through every warranty with the directors and senior managers, and note anything that is not strictly true

☐  Disclose specifically against the relevant warranty, with enough detail to be understood

☐  Keep the data room indexed, accurate and complete, and archive a copy at signing

☐  Make sure your written answers to the buyer’s questions are accurate and consistent with the letter

☐  Do not leave out anything you know about, even if it is embarrassing

☐  Agree in writing whether the data room and your written answers to the buyer’s questions count as disclosed, and the rules on updating the letter

☐  Negotiate the caps, thresholds, time limits and several liability

Plan the disclosure from day one

A well-organised data room and a good disclosure letter are built over weeks, not rushed at the last minute before due diligence starts or the night before signing. If you are thinking of selling, get advice early. Prepare a robust data room while you are still driving the process and treat the letter as part of your negotiating position, not just more paperwork.

Still concerned about warranties, find out about warranty and indemnity insurance and if this is your first transaction read our SME Guide to Buying and Selling a Business