Risks Founders Tend to Overlook in SPA Representations and Warranties
Hello, I'm Noriaki Asato, Representative Attorney at LegalAgent.
In a share purchase agreement (SPA) in an M&A, it is the representations and warranties clause that directly determines the scope of liability borne by a founder who is the seller. Representations and warranties are clauses in which the seller promises that certain facts about the target company and its issued shares are true and accurate, and if there are facts contrary to them, the seller may bear indemnification liability depending on the terms of the contract.
In startup M&A, the founder is often the seller in a personal capacity, and signing without a deep understanding of the reach of the clauses can lead to a situation in which the founder is asked to pay substantial monetary compensation after the sale is complete. Before signing, check the following provisions and the materials supporting them.
- The scope of the representations and warranties (whether they are narrowed to an objective scope that can be investigated or to material matters)
- The specific definitions of the knowledge qualifiers and materiality qualifiers attached to each representation
- The status of the vesting in the company of rights, such as source code and trademarks, from outside contractors and side-job members
- Consistency between the privacy policy and actual data handling, and labor risks relating to the distinction between outsourcing and employment
- The cap on indemnification liability relative to the sale consideration, the survival period, and the thresholds for small claims and cumulative claim amounts (de minimis and basket)
The Risk-Allocation Function of the Representations and Warranties Clause
Because the representations and warranties in an SPA run long in the contract, you may be tempted to give them only a formal check. In practice, however, they are provisions that determine how the seller and buyer will bear the risk if facts about the company, including matters revealed in legal due diligence, turn out to differ from what was explained.
Items such as lawful incorporation procedures, valid issuance of shares, the status of performance of material contracts, whether there are any unpaid taxes and public charges or social insurance premiums, the absence of disputes, the ownership of intellectual property, and the status of legal compliance are listed as matters covered by the warranties. If there is a discrepancy in any of these, the seller may bear indemnification liability if the requirements set out in the contract are met. Because many contracts are designed so that a founder's argument that they did not know the facts will not succeed, check the wording of each clause.
Knowledge Qualifiers and Materiality Qualifiers in Practice
What the seller should consider is attaching knowledge qualifiers and materiality qualifiers. The effect of a knowledge qualifier depends on its definition in the contract. Check whether it is limited to the subjective facts the seller actually knows, or extends to facts the seller could have known through a reasonable investigation, and whose knowledge is covered. A materiality qualifier limits the matters warranted in each clause according to their materiality. Check which qualifier is attached where, such as "material contracts" or "material breach." It does not mean limiting everything to "cases having a material adverse effect on the business." Whereas the buyer will seek broad, unqualified representations and warranties, it would be an excessive burden for the seller to assume unlimited liability even for past events it cannot fully grasp or for trivial formal defects.
It is not uncommon for records and contract documents from the founding period to be incomplete. Rather than unconditionally warranting every past fact, it is important to negotiate clause by clause whether liability can be limited to the scope that can be objectively confirmed or to substantively material matters.
Verifying Intellectual Property and the Development Structure
In a startup SPA, what you particularly want not to overlook are the representations and warranties on intellectual property. The seller may be asked to warrant that the product's source code, registered trademarks, and data held belong entirely to the company.
Where outside contractors or joint research partners were involved in development, determine from the wording whether the clause requires full ownership of the rights by the company or whether it is enough to have obtained the licenses necessary for the business, and check whether rights commensurate with what is warranted are actually secured. If the clause warrants that the rights belong to the company but only a license has been obtained, or if the agreements on the transfer of rights with past developers are ambiguous, the content of the representations and warranties may not match reality. For companies that use generative AI for development or content production, also check the warranties regarding compliance with terms of use and the non-infringement of third parties' intellectual property rights.
Personal Information, Labor, and Tax Risks, and Indemnification Terms
Representations and warranties regarding personal information protection, labor management, and tax treatment are also items that cannot be overlooked. Problems such as a privacy policy that does not reflect reality, insufficient security control measures with contractors, a distinction between outsourcing and employment that diverges from reality, a risk of unpaid wages due to a defective design of fixed overtime pay, or errors in past tax returns become triggers for the buyer to claim damages or a price adjustment after the M&A is executed.
Even if founders are well versed in their company's technology and business, they do not necessarily have a comprehensive grasp of the detailed risks in labor and tax. I think it is desirable to approach the review of the representations and warranties clause with the expertise not only of attorneys but also of tax accountants, labor and social security attorneys, and others.
To prepare for a possible breach of representations and warranties, it is also essential to set a cap on indemnification liability and a limit on the claim period. Negotiate the cap in light of its balance with the sale proceeds, and confirm until when you may receive claims. Also check, following the provisions, whether there are matters to which the exemptions or the cap do not apply. Caps and periods are sometimes divided according to the nature of the risk, such as general matters and fundamental matters, or tax, labor, and intellectual property.
Working With Specialists and Our Support Contact
Indemnification terms should be considered together with the results of the investigation and the terms of the transaction as a whole. To grasp the overall picture and the costs of an SPA, the following may be helpful: SPA (Share Purchase Agreement) Indemnification, Price Adjustment, and Closing, which organizes the contract terms as a whole; What Is Legal Due Diligence? Purpose, Process, Required Materials, and Costs, which explains the steps of the advance investigation; and Attorney Fees for M&A and Items in a Quote, which summarizes guideline attorney fees.
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