Warranties – allocating risk and ensuring transparency

In venture capital transactions, warranties are a fundamental tool for allocating risk and ensuring transparency between the parties. These contractual statements, provided by the company and sometimes the founders, confirm the accuracy of key information about the business. Warranties provide investors with reassurance about the state of the company, while creating a framework for addressing any misrepresentations or unforeseen risks.

In the UK, it is increasingly common for founders to limit or avoid personal liability for warranties, reflecting a shift towards protecting founders' personal financial position. Where founders do give warranties, their liability is often capped at a multiple of their salary, with 1x being standard in many deals. 

This article in our ‘Anatomy of a term sheet’ series explores the role of warranties in venture capital term sheets, their practical application, and how they can be structured to align the interests of founders and investors.

What are warranties?

Warranties are legally binding statements about the company’s condition, operations, and compliance. They cover a wide range of topics and are designed to give investors confidence in their decision to invest. If a warranty turns out to be untrue, it may trigger a claim for damages or other remedies.

Warranties are typically included in the investment agreement or subscription agreement and are supported by a disclosure letter, where the company outlines any exceptions or qualifications to the warranties provided.

Common warranties in venture capital transactions

Warranties vary depending on the size and stage of the company, but common categories include:

Corporate matters

• The company is duly incorporated and validly existing.
• The company has the necessary authority to enter into the transaction.

Financial position

• The financial accounts fairly represent the company’s position and are prepared in accordance with applicable standards.
• No undisclosed liabilities exist.

Intellectual property

• The company owns or has valid licences for all intellectual property necessary for its business.
• No third-party claims have been made regarding the company’s IP.

Contracts and commitments

• All material contracts are valid and enforceable.
• The company is not in breach of any key agreements.

Employees and founders

• The company has complied with all employment laws and regulations.
• No disputes with employees or founders exist.

Compliance and litigation

• The company has complied with all applicable laws and regulations.
• There are no ongoing or threatened legal proceedings.

Ownership and capitalisation

• The company’s share capital is accurately described, and there are no undisclosed rights to acquire shares.
• All share issuances have been properly authorised.

Role of the disclosure letter

The disclosure letter is a key document in conjunction with warranties. It allows the company to disclose specific facts or circumstances that might otherwise breach a warranty. For example, if a warranty states that "the company has no outstanding litigation," but a minor claim is ongoing, this can be disclosed to investors, preventing a warranty breach.

The disclosure letter acts as a safeguard for founders, ensuring that they can qualify warranties where necessary, while giving investors full visibility of the company’s position.

Investor protections and warranty limitations

Investor protections

Warranties are a critical part of the investor’s risk management strategy. They serve to:

• Ensure transparency: provide a full and accurate picture of the company’s position.
• Allocate risk: allow investors to seek remedies for material misstatements or omissions.
• Encourage due diligence: motivate the company to thoroughly disclose risks and liabilities.

Warranty limitations

To balance the protection provided to investors, warranties often include limitations to prevent excessive liability for founders and the company:

• Caps on founder liability: in the UK founder liability is often capped at 1x their annual salary to reflect their limited financial resources and incentivise participation in the business.
• Time limits: claims under warranties must be brought within a specified period, typically 12–24 months post-completion.
• Knowledge qualifications: some warranties are qualified by the knowledge of the founders, limiting liability for unknown issues.
• Excluded matters: warranties do not cover issues disclosed in the disclosure letter.

Increasingly, founders are not required to give warranties personally, with the company taking responsibility instead. This reflects market practice aimed at reducing founders' personal risk.

Negotiating warranties: practical considerations

Tailoring to the stage of the company

• Early-stage companies may require more limited warranties, reflecting their evolving nature and lack of operational history.
• Later-stage companies or those in regulated industries may need more comprehensive warranties.

Balancing breadth and specificity

• Investors often seek broad warranties for maximum protection, while founders aim to narrow them to avoid undue exposure.
• Specific warranties (e.g., regarding key contracts or intellectual property) can strike a balance.

Aligning with due diligence

• Warranties should reflect the findings of the due diligence process. Investors may seek additional warranties to address specific risks identified during diligence.

Minimising founders’ exposure

• Founders should negotiate to avoid giving warranties personally where possible. Where they are required, liability caps should be linked to 1x their annual salary and should not expose personal assets beyond this amount.

Analysis: founders’ perspective vs investors’ perspective

In summary

Warranties are a critical tool for ensuring transparency and allocating risk in venture capital deals. For founders, they represent a commitment to disclose key information about the business, though UK practice increasingly limits their personal liability. 

For investors, they provide reassurance and remedies in the event of misrepresentation. By negotiating warranties thoughtfully and using the disclosure letter effectively, both parties can align their interests and create a foundation for trust and growth.

Read the next article in our ‘Anatomy of a term sheet’ series, where we’ll explore monitoring and arrangement fees, examining how these provisions reflect the costs of investment and investor oversight. 

If you're navigating the complexities of venture capital term sheets or preparing your business for investment, our experienced team is here to help. Get in touch to discuss how we can support you in securing the right deal for your business.