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Three Points About Warranties Every Startup Founder Should Understand

Posted on Oct 28, 2013 by Catriona Brown  | Tags: heads of terms, investment  | 0 Comments

Catriona Brown

In the next in her series of posts (see Part 1 and Part 2) exploring the contents of typical Heads of Terms used by an investor who wants to invest in a startup business, Catriona Brown highlights three points about warranties that every founder should be aware of in advance.

In my last post, I referred to warranties which are “standard” or “customary”. This time the warranties themselves take centre stage in my Heads of Terms in plain English series.

Warranties: What Is Customary?

Typical wording in a set of Heads of Terms might be:

“The Directors and the Company will be expected to give such warranties as would be customary in this type of transaction. Warranties will be given on a joint and several basis.”

There are a few points to note in these two sentences, and they each relate to the investors’ theoretical ability to recover cash from the warrantors in the event of the warranties statements being found to be seriously inaccurate.

1. Both the Directors and the Company are giving the warranties.

The chances are, if you and your fellow founders have poured your life savings into the company, re-mortgaged your flat and then maxed out your credit cards to get your business off the ground and appealing to investors, you will have no cash to pay out for a warranty claim. The Company, on the other hand, may well be starting to generate some cash and would therefore be capable of paying some compensation.

2. The warranties you give are those which would be customary in “this” type of transaction.

Any sensible investor, using sensible investment documentation, and, dare I say, sensible advisors, will be tailoring warranties that you are expected to give in a way that is commensurate with the stage of the business and amount of investment.

What this means is that if you are getting a seed round investment, have just incorporated the company and have never traded, warranties ought to be fairly limited. If, however, you’re about to secure £5million from a VC, and have been out in the world making progress for a few years, you should be prepared to have to give some pretty extensive warranties.

This said, I can’t deny that for “equity type” investments at any level, the warranties may seem pretty extensive to the first time reader. If you check out my previous blog, you will see that one function of warranties is to flush out information not caught at diligence. This is the investors’ check that their cash is going into a company which is in good shape.

3. Warranties will be given on a joint and several basis.

This means that one warrantor can be potentially liable for the liability of the other warrantors (subject to agreed caps), with a legal right to recovery from other warrantors for their pro rata (proportional) share of the claim.

How Likely Are Warranty Claims In Practice?

One thing that these points (particularly the last one) should be viewed against, is (without sounding too much like an episode of Crimewatch) the fact that a warranty claim by investors is extremely rare – they would damage ongoing relations, suck up huge amounts of management time, often bear little fruit, and could be disproportionately expensive. The most important thing, whatever warranties you are being required to give, is to make sure that anything you know about the business, no matter how small, or terrible, that is in any way contrary to a warranty, is fully disclosed by you to the investors in the disclosure letter which you sign up along with the investment agreement.

Next time I’m going to look at what investors mean when they state in Heads of Terms that they will be looking for “investor protections” or “information rights”. Until then, let me know if you’ve any warranty related questions, or indeed any queries about any other Heads of Terms requests.

Catriona Brown

@_CatrionaBrown

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