Reps, Warranties and Indemnification in a Small Business Sale: Caps, Baskets and Survival Explained

What are representations, warranties and indemnification in a business sale?

A representation is a statement of fact made to induce the buyer to sign, such as "the Company has filed all tax returns required by law." A warranty is a promise that the fact is true. In practice deal lawyers use the phrase "reps and warranties" as a single concept: the seller's factual promises about the business, as of signing and usually again as of closing.

Reps do two jobs. Before closing, they force disclosure: the seller lists exceptions on disclosure schedules (for example, "except for the pending claim described in Schedule 4.7"), which is often how a buyer learns about problems. After closing, an inaccurate rep becomes the basis for an indemnity claim.

Which reps matter most when buying a small business?

Long-form agreements can contain dozens of reps. For a small, owner-run business, these usually carry the most money:

• Financial statements: the profit and loss statements and balance sheets provided are accurate and prepared consistently.
• Taxes: all returns are filed and taxes paid, including sales tax and payroll tax, which are common sources of successor claims.
• No undisclosed liabilities: there are no debts beyond those shown or listed.
• Material contracts: key customer, supplier and lease agreements are in force, not in default and listed in a schedule.
• Employees: workers are properly classified and paid, with no pending wage claims.
• Compliance and permits: the business holds the licenses it needs and is not violating any law.
• Litigation: no pending or threatened lawsuits beyond those disclosed.
• Title and condition of assets: the seller owns the assets free of liens and the equipment is in working order.
• Customers: no major customer has said it will leave or reduce its business.
• Indemnification is a promise to pay the other party's losses if a rep is inaccurate, a covenant is breached, or an excluded liability surfaces. In a business sale the seller indemnifies the buyer for these, and the buyer usually indemnifies the seller for liabilities it assumed and its own breaches.
• Most purchase agreements make indemnification the exclusive remedy for breaches of the agreement, with an exception for fraud. Industry studies of private-company deals have found exclusive-remedy language in the large majority of agreements. That means the indemnity terms are not an extra protection on top of a lawsuit; they are usually the whole of what the buyer can recover.

What are indemnity caps, baskets and survival periods?

Four numbers decide what an indemnity is worth. Market data comes mostly from studies of larger private-company deals, such as SRS Acquiom's annual deal terms studies, which have reported median caps of roughly 10% of the price, baskets of around 0.5% to 1% and general survival periods of 12 to 18 months. Small business deals vary more, so treat these as reference points, not rules.

What are fundamental reps and fraud carve-outs?

Agreements usually separate "fundamental" reps from the rest: the seller's authority to sell, ownership of the shares or assets, capitalization and often taxes. These go to whether the buyer got what it paid for, so they typically survive longer (sometimes until the statute of limitations runs) and are capped at the full purchase price rather than the general cap.

Fraud is normally carved out of the cap, basket and survival limits. Sellers should make sure "fraud" is defined narrowly (intentional misrepresentation of a fact in the agreement) so it does not swallow the limits; buyers should make sure the carve-out exists at all.

How long survival can last depends on state law. Delaware, for example, allows parties to a written contract involving at least $100,000 to agree a claims period of up to 20 years under 10 Del. C. section 8106(c). Other states have their own limitation rules, so check the governing law clause.

How do knowledge qualifiers and disclosure schedules change the risk?

Small words in the reps move risk. "To Seller's knowledge, there are no pending claims" protects the seller from claims it did not know about; without the qualifier, the seller is responsible even for surprises. Buyers should insist that "knowledge" is defined to include what the seller should have known after reasonable inquiry of named managers.

Materiality qualifiers ("no material violations") work the same way. Buyers often ask for a "materiality scrape," which ignores those qualifiers when calculating losses, so small breaches still count toward the basket.

Disclosure schedules are where sellers protect themselves. Anything properly disclosed is usually an exception to the rep and cannot support a claim. Sellers should disclose generously and specifically; buyers should read every schedule and refuse vague entries such as "matters disclosed in due diligence."

Can a buyer claim for a problem it knew about before closing?

This is called sandbagging, and the answer depends on the contract and the governing law. In Arwood v. AW Site Services (2022), the Delaware Court of Chancery described Delaware as a pro-sandbagging jurisdiction: absent contrary language, a buyer can recover for a breached rep even if it knew of the breach before closing, because a contract claim does not require reliance. New York courts have reached a similar result in some cases, such as CBS Inc. v. Ziff-Davis (1990), with limits where the seller disclosed the problem.

Because state law varies and is not always settled, do not rely on the default. Sellers should ask for an anti-sandbagging clause; buyers should ask for an express pro-sandbagging clause stating that rights are unaffected by any investigation or knowledge.

How should escrow, setoff and insurance back up the indemnity?

An indemnity is only as good as the seller's ability to pay. A seller who has spent or distributed the proceeds is a poor source of recovery, so buyers usually want part of the price held in escrow with a third-party agent, or held back by the buyer, for the length of the general survival period. Where there is a seller note or earnout, buyers often also want a right of setoff against those payments.

Representation and warranty insurance, which replaces much of the seller's indemnity with an insurance policy, is now common in mid-market deals but less so in small ones, where premiums and minimum policy sizes can make it uneconomic. Ask a broker if your deal is large enough to price it.

A worked example: what an indemnity is really worth

A buyer pays $1,000,000 for a plumbing company. The agreement has a $10,000 deductible basket, a $100,000 cap, a 12-month survival period and $75,000 held in escrow for a year. Fourteen months after closing, the state assesses $40,000 of unpaid payroll tax from the seller's ownership.

If tax reps survive only as long as the general reps, the claim is out of time and the buyer recovers nothing. If tax reps survive until the statute of limitations runs (a common ask), the buyer recovers $30,000 after the deductible, or the full $40,000 if the basket tips or tax claims are excluded from it. By then the escrow may already have been released, so the buyer must collect from the seller directly. The same clause read from the seller's side shows why sellers resist long tax survival and fight for a deductible basket.

Negotiation checklist for buyers and sellers

The Business Purchase analyzer turns the cap, basket and survival terms in your draft into dollars and dates as an automated review, weighted for your side of the deal. Use it with this checklist, and bring a deal attorney in before you sign if the amounts are significant.

• Buyer: is there an escrow or holdback, and does it last as long as the general survival period?
• Buyer: is the basket a tipping basket, and is the threshold realistic for the deal size?
• Buyer: do tax and fundamental reps survive longer and carry a higher cap?
• Buyer: is there a materiality scrape and a defined knowledge standard?
• Seller: is the cap a fixed dollar amount, and is indemnification the exclusive remedy except for fraud?
• Seller: is fraud defined narrowly?
• Seller: are disclosure schedules complete and specific?
• Seller: is setoff against a seller note or earnout limited to resolved claims?
• Both: are notice requirements and claim procedures clear, including deadlines and how disputes are resolved?