Venture deals in IT: Representations & warranties

Hi! Let's look at what representations and warranties are.

What are representations and warranties?

Representations & warranties are statements given by the founders about the presence or absence of certain facts relating to a transaction, company (startup) or product (IP). 

In most transaction documents that we have encountered in our practice, representations and warranties were included in same block and were not separated. However, there are some differences between this two instruments.

Thus, warranties are statements made by the founders that guide the investor's decision to invest in the company or not.  If the founders are not willing to confirm and sign off on certain facts, the investor is likely to walk away from the deal. Examples of such fundamental warranties include a statement by the founders that all rights to the IP are legally owned by the company, properly executed.

If it later turns out that some warranties are not true, i.e. the investor was actually misled, the transaction may be cancelled (terminated).

Guarantees, on the other hand, are representations by the founders that certain circumstances relating to the transaction are or will be fulfilled. In other words, guarantees are essentially obligations of the founders, and their breach may also give rise to liability in the form of compensation for damages or payment of penalties (depending on the jurisdiction). If the warranties are breached, the contract is generally not terminated and the transaction is not cancelled.

What are the main representations and warranties?

Usually the list of representations and warranties is prepared by the investor's team following a legal and financial audit of the target company.  

Although the list of representations and warranties is prepared on a deal-by-deal basis, there are blocks that are standard and are actually found in virtually every venture capital deal in IT:

  1. Corporate matters: the target company is duly incorporated, operates in compliance with the laws, the founders have the authority to conclude the transaction (including signing the transaction documents), etc.
  2. Taxes: the target's activities were carried out in compliance with tax legislation (timely payment of taxes, absence of claims from tax authorities, etc.).
  3. Purity of product rights (IP): IP rights are legally owned by the startup, no disputes/potential disputes with 3 persons
  4. Personal data: the company collects and processes personal data in compliance with legal requirements
  5. No disputes with third parties: there are no claims against the company, no legal disputes

What are representations and warranties needed for?

As noted above, in venture capital transactions, the main block of representations and warranties is provided by the founders. The investor, on the other hand, usually gives representations and warranties only on the corporate issues. This is due to the fact that venture capital investments are high-risk: the investor finances a business whose success is impossible to say anything in advance. 

So, firstly, it is important for an investor to have the broadest possible understanding of the business they is investing in, including all its pitfalls. 

Secondly, representations and warranties protect the investor's interests even after entering the transaction: if any of them turn out to be untrue, the founders will be liable to the investors. The liability may range from reimbursement by the founders of losses actually incurred by the investor to the investor's withdrawal from the transaction.

What is a disclosure letter?

Before signing the transaction documents, you should analyse the block of representations and warranties in detail. If you find that any of them are untrue, you should inform the investor.

A Disclosure letter is a document in which founders disclose circumstances and facts that are inconsistent with the representations and warranties listed in the contract.

This document is very important for both the investor and the founders: the investor gets a complete picture about the startup, and the founders remove the risk of discovering false representations/breach of warranties and, consequently, of being held liable.

Thus, representations and warranties are very important tool that largely determines whether a deal will go through. We recommend to analyse the list of representations and warranties very carefully, do not sign anything that is not true, and disclose to the investor immediately if there are any irregularities.