When raising investment, businesses often focus on the commercial terms such as valuation, share price and voting rights. But the legal details in funding documentation are just as important. One of the most significant elements is the inclusion of warranties. These assurances can directly affect the liability of founders and the confidence of investors.
This article explains what warranties are, why they matter in funding round negotiations, and how they should be approached in practice.
What Are Warranties?
In a funding round, warranties are contractual statements made by the company and often its founders about the state of the business. They are usually set out in the investment documents and form part of the binding deal between the parties.
Warranties might cover areas such as:
- The accuracy of financial information and projections.
- The ownership of assets, including intellectual property.
- Compliance with employment, tax and regulatory obligations.
- The absence of undisclosed liabilities or disputes.
Investors rely on these assurances when deciding whether to invest. If a warranty proves to be untrue, they may have the right to bring a claim for losses.
Why Investors Want Warranties
For investors, warranties offer a way to manage risk and reduce the chance of discovering major problems after committing funds.
For example, an investor might later discover that the company is facing a tax investigation or does not own the software it relies on. Without warranties, the investor could be left with little protection. With warranties in place, they can pursue compensation or, at the very least, know that such issues should have been disclosed before signing.
The process of giving warranties also improves transparency. Before the documents are signed, the company must reveal any facts that would make a warranty inaccurate. This disclosure process often uncovers risks that may not otherwise have been raised. It can feel uncomfortable for founders, but it allows investors to make informed choices and builds trust.
The Risk for Founders
While warranties benefit investors, they can be a source of risk for founders. In many deals, the company itself gives warranties. However, investors may also expect the founders to give them personally.
This creates personal liability. If a warranty is breached, investors could potentially recover losses from the founders themselves. For someone building an early-stage company, this exposure can be daunting. It also raises practical questions: what happens if the founders do not have the resources to meet a claim?
The key is not to panic but to negotiate sensibly. Most investors understand that bankrupting the founders is not in anyone’s interest. It’s possible to draft warranties in a way that liability is limited and investors are protected, without leaving founders exposed to unlimited risk.
Negotiating the Scope of Warranties
Warranties should always be negotiated. Some of the main points to consider include:
- Who gives the warranties: Founders should try to limit personal warranties to matters only they can truly confirm, such as their ownership of shares. Most business-related warranties should come from the company itself.
- The scope of the wording: Overly broad statements can create unnecessary liability. Warranties should be drafted to reflect the actual state of the business.
- Disclosure: A disclosure letter allows the company to set out exceptions to the warranties. If investors are told about an issue before signing, it cannot later form the basis of a claim.
- Time limits: Liability under warranties usually applies for a fixed period, often 12 to 24 months. Without a time limit, claims could be made years down the line.
- Financial limits: Liability should be capped, either at a percentage of the investment or at a fixed sum. This prevents claims from spiralling out of proportion.
Founders may feel that they are “being difficult” by negotiating these points. But doing so ensures that warranties actually serve their purpose without creating unfair outcomes.
How to Write Warranties
Because warranties carry legal consequences, they need to be written cautiously. A warranty should be specific, accurate and proportionate. Poorly prepared warranties can cause disputes or expose founders to risks they never intended to take on.
Practical points for drafting warranties include:
- Be precise: Warranties should use clear language. Absolute promises should only be made if the business can be certain they are true.
- Focus on material matters: Cover areas that genuinely affect the company’s value, such as ownership of key intellectual property, financial health and major contracts. Avoid cluttering the agreement with trivial points.
- Reflect the company’s stage: Early-stage companies may not have the same level of systems, records or assets as a later-stage business. Warranties should be proportionate.
- Keep them consistent: Warranties should match what is said elsewhere in the documents. If they contradict other clauses, disputes are more likely.
- Support with disclosure: The disclosure process is as important as the warranties themselves. If investors are made aware of issues, those issues should be carved out from liability.
The goal is to strike the right balance: warranties strong enough to give investors confidence, but realistic enough that founders can sign them without fear of disproportionate liability.
Excluding Pre-Contractual Statements
A related issue is how to deal with things said before the agreement is signed. During fundraising, founders will inevitably make statements to attract interest. If those are not carefully managed, they could be treated as binding promises.
To prevent this, investment documents often include:
- Clauses excluding liability for pre-contractual misstatements (except fraud, which cannot be excluded).
- An “entire agreement” clause confirming that only what is written in the contract is binding.
These provisions make it clear that only the written warranties form part of the deal. This protects both sides by drawing a firm line between sales talk and enforceable promises.
Balancing Protection and Liability
The negotiation of warranties should be balanced. Investors want protection against hidden problems, while founders want to avoid personal exposure that could threaten their livelihood.
That balance is usually found through limited but meaningful warranties, supported by disclosure, time limits and financial caps. If both sides approach the process reasonably, warranties can provide reassurance without being a source of conflict.
Why Legal Advice Is Essential
Warranties are a technical area of law, and small changes in wording can have large consequences. For example, a warranty that the company “complies with all laws” is extremely broad. Limiting it to “material laws” or those breaches likely to cause significant harm can make a huge difference.
Founders should always take specialist advice before signing warranties, so they understand exactly what they are agreeing to. Investors should also take advice to ensure the warranties they receive are enforceable and meaningful.
Speak To JPP Law About Funding Round Documentation
If you are preparing for an investment round, you need to understand the warranties you are being asked to give or receive. The corporate team at JPP Law advises both businesses and investors on funding documentation, making sure that warranties and other terms are clear, fair and legally robust.
Contact JPP Law today to discuss your fundraising plans and protect your position in negotiations.
