The Difference Between a Warranty and an Indemnity

When selling a business, the legal documentation can feel overwhelming. One of the most important parts of a transaction agreement, usually the Share Purchase Agreement (SPA, is the section covering warranties and indemnities. These provisions are designed to allocate risk between buyer and seller after the transaction completes. Although they are often mentioned together, warranties and indemnities serve different purposes and carry different implications for both parties.

Understanding the distinction is important for business owners because these clauses can affect financial exposure long after the sale has completed.

What Is a Warranty?

In the context of mergers and acquisitions, a warranty is a statement of fact made by the seller about the business being sold. Warranties are essentially assurances given to the buyer regarding the condition, history, and legal status of the company.

Common examples of warranties include statements confirming that:

• The company’s financial statements are accurate and fairly presented
• The business complies with relevant laws and regulations
• There are no undisclosed liabilities
• The company owns the assets it claims to own
• There is no ongoing litigation that has not been disclosed

These statements are important because they help the buyer understand the business they are acquiring and assess the risks involved.

If a warranty turns out to be untrue, the buyer may bring a warranty claim against the seller. The buyer must typically demonstrate that the statement was incorrect and that this caused them a financial loss. In most cases, the buyer can recover damages designed to compensate them for the reduction in value of the business caused by the breach.

However, warranty claims are normally subject to a number of limitations negotiated during the transaction. These often include:

• Financial caps limiting the seller’s total liability
• Time limits for bringing claims (often 12–24 months for general warranties)
• Minimum claim thresholds below which claims cannot be made
• Aggregate thresholds before liability arises

These limitations are designed to provide sellers with certainty and prevent minor issues from triggering disproportionate claims after completion.

What Is an Indemnity?

An indemnity is a promise by the seller to reimburse the buyer for a specific identified liability if it arises in the future. While warranties are general statements about the business, indemnities are typically used to address known or identifiable risks that have been uncovered during due diligence.

For example, a buyer might request an indemnity if:

• There is an ongoing tax investigation
• A customer dispute could lead to a future claim
• There are unresolved regulatory issues
• A particular contract contains uncertain obligations

Under an indemnity, the seller agrees to cover losses arising from that specific risk if it materialises.

Indemnities often provide stronger protection for buyers than warranties. In many cases, the buyer can recover losses directly on a pound-for-pound basis without having to demonstrate a reduction in the value of the business. The claim process may also be simpler because the indemnity relates to a specific issue already identified.

Unlike warranty claims, indemnities may not always be subject to the same thresholds or limitations, although the parties often negotiate caps and time limits to manage exposure.

Key Differences Between Warranties and Indemnities

Although both mechanisms deal with post-completion risk, their structure and implications differ in several important ways.

First, warranties relate to the overall condition of the business, whereas indemnities deal with specific risks that have been identified.

Second, the calculation of loss differs. In a warranty claim, damages are usually calculated based on the reduction in value of the business caused by the breach. By contrast, an indemnity typically allows the buyer to recover the actual cost of the liability.

Third, indemnities often provide more straightforward recovery because they are tied to a defined issue. Warranty claims can be more complex because the buyer must demonstrate both breach and financial loss.

Finally, warranty claims are almost always subject to negotiated limitations, while indemnities are often more tightly focused but potentially more onerous for the seller.

Why These Clauses Matter to Sellers

For many business owners, the focus during a transaction is understandably on the headline price. However, the structure of warranties and indemnities can significantly affect the risk profile of the deal.

In some cases, sellers may remain exposed to claims for several years after completion. Understanding the scope of warranties and negotiating appropriate limitations is therefore an important part of protecting the value of the sale.

Many sellers also choose to obtain warranty and indemnity insurance (W&I insurance) in larger transactions. This type of policy allows the buyer to claim against an insurer rather than the seller, reducing the seller’s ongoing liability while still providing protection to the buyer.

The Role of Due Diligence

Due diligence plays a key role in shaping the warranties and indemnities included in a transaction. During this process, the buyer investigates the financial, legal, and operational aspects of the business.

If due diligence reveals potential issues, these may be addressed in different ways:

• By adjusting the purchase price
• By including a specific indemnity
• By disclosing the issue against the relevant warranty

This process helps ensure that both parties have a clear understanding of the risks associated with the business.

Final Thoughts

Warranties and indemnities are fundamental components of most business sale agreements. While they are often discussed together, they perform different functions in allocating risk between buyer and seller.

Warranties provide general assurances about the condition of the business, while indemnities address specific known risks. For sellers, understanding the distinction is important because these clauses can determine the extent of liability after completion.

As with many aspects of M&A transactions, the precise wording and structure of these provisions will be negotiated between the parties. Taking appropriate advice and understanding the implications of these clauses can help ensure that the transaction proceeds smoothly and that both buyer and seller are protected.

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