Limiting Seller Liability in M&A

Why representations and warranties are a critical risk

When you sell a company, it is not just about handing over physical assets. In reality, the buyer is purchasing a package of rights, liabilities, contracts, employees, and legal relationships. For this reason, in the share purchase agreement you typically guarantee dozens of pieces of information about the company—from the state of the accounts and tax matters to the existence of hidden debts or legal disputes.

In legal terms, these guarantees are called representations and warranties (often abbreviated as R&W). Their essence is that the seller promises the buyer: “This information about the company is true. If it later turns out not to be, I will pay you financial compensation."

At first glance, that sounds straightforward. In practice, however, it often gets completely out of control. Sellers usually sign dozens of pages of warranties without a thorough review, without knowing what exactly they are warranting, and—critically—without agreed limits on their liability.

The result? The transaction closes, the buyer owns the company, and then a few months or years later they “happen” to notice something that, under your warranties, should not have existed. They come back to you and ask where their money is. This means you may be liable for matters you may not even have been able to influence—often years after you have sold the company and are no longer receiving any income from it.

Types of warranties for which the seller is liable

Not all warranties are created equal. In a typical share purchase agreement, you will find several categories:

Title warranties

Here, the seller warrants that the shares or ownership interests being sold have good title. This means they are not encumbered by third-party rights (e.g., pledges, easements), that the seller owns them without legal restrictions, and that there are no pledges, easements, or third-party options that could limit their value. Example: “The 100% interest in company X is not encumbered by a bank pledge or any other restriction."

Asset-related warranties

The seller warrants that the company’s assets are in a certain condition, that machinery and equipment are functional, that real estate is free of legal defects, and that it is properly registered in the Czech Land Registry (Czech Cadastre of Real Estate). This is where issues gradually come to light such as: “The engine of the company vehicle is defective” or “The land is not registered in the public register in our company’s name, but in the name of the previous owner from the last decade."

Legal warranties

The seller promises that all contracts with customers and suppliers are valid, that they do not conflict with applicable law, and that there are no court proceedings or arbitrations that could be threatened. At the same time, the seller warrants that intellectual property—patents, trademarks, copyrights—is duly registered and that the company does not infringe any third party’s intellectual property rights.

Financial warranties

Here, the seller warrants that the financial statements are accurate, that the assets reflect the true state of affairs, that the accounts have not been manipulated, that there are no hidden debts, and that all assets shown on the balance sheet are real and belong to the company. It is precisely in this category that problems most often emerge later—the buyer discovers that revenues were lower than reported, or that there is a debt that was not mentioned in the accounts at all.

Tax and legal warranties

The seller warrants that all tax returns have been filed on time and correctly, that there are no unpaid taxes from prior periods, that there are no ongoing tax audits, and that the company has acted in compliance with the law.

Liability limits: basket, cap, and sunset clause

This is where we get to the heart of the issue. Without properly setting limits, the seller would, in theory, be liable for every minor issue that later emerges—forever, or at least for a very long time.

That is why, in professional M&A transactions, three mechanisms are standardly agreed to limit risk: the basket, the cap, and the sunset clause.

Basket – minimum threshold

The basket (also called a deductible) is the minimum amount a claim must reach before the seller’s liability is triggered at all. It is typically set at 0.5% to 1% of the purchase price; in smaller transactions, sometimes as fixed amounts around CZK 50,000–200,000.

Example: If the purchase price is CZK 10 million and the basket is set at CZK 100,000, then: if an issue arises with a value of CZK 50,000, the seller pays nothing. If an issue arises with a value of CZK 150,000, the seller pays CZK 150,000 (or, depending on the type of basket, only the difference of CZK 50,000—see below).

There are two types of basket:

1. True basket (deductible basket) – the seller pays only the amount exceeding the basket. If damages are CZK 150,000 and the basket is CZK 100,000, the seller pays only CZK 50,000.

2. Tipping basket (first dollar) – once total damages reach the basket, the seller pays all damages from the first dollar. If damages are CZK 150,000 and the basket is CZK 100,000, the seller pays the full CZK 150,000.

The seller naturally prefers a true basket (pays less), while the buyer prefers a tipping basket (pays more). In practice, this is often a compromise.

Cap – maximum liability limit

The cap (ceiling) is the maximum amount the seller must pay for all breaches of warranties in aggregate. It is typically set at 10%–50% of the purchase price, depending on the type of transaction and the type of warranties.

Example: If the purchase price is CZK 10 million and the cap is set at 20% (i.e., CZK 2 million), then even if breaches arise with a total value of CZK 5 million, the seller will pay a maximum of CZK 2 million.

The cap often differs depending on the type of warranties:

• General warranties: cap of 10%–20% of the purchase price
• Fundamental warranties: cap of 50%–100% of the purchase price
• Tax warranties: the cap may be even higher, often unlimited

Important: The cap usually does not apply to breaches caused by intentional fraud or knowing misrepresentation. If it is proven that you deliberately misled the buyer, the cap will not apply and you will be liable without limitation.

Sunset clause – time limitation of liability

Without a time limit, the seller would, in theory, be liable forever. That is why sunset clauses are agreed—time periods after which the warranties expire.

Typical setup: general warranties for 12–24 months from completion of the transaction, tax warranties for 3–10 years (in line with the time limit for assessing tax under the Czech Tax Code), legal warranties until the expiry of the limitation period under the Czech Civil Code (typically 3 years, up to a maximum of 10 years). Fundamental (“fundamental”) warranties are often not subject to a sunset at all, or the period is very long.

Example: If the sunset clause is 24 months from closing and the transaction closed on 1 March 2024, the warranties expire on 1 March 2026. If the buyer discovers an issue on 2 March 2026, it is out of time and they cannot bring a claim against you.

Objective vs. subjective warranties – knowledge qualifiers

One of the most important negotiation points is the question: are you liable for what you know, or for everything regardless of your knowledge?

Objective warranty (without a knowledge qualifier)

“The Company has all necessary licences and permits.”

Here you are liable regardless of whether you knew or could have known that a permit was missing. If it is later found that any licence is missing, you pay. This is a very risky position, because you could be liable even for matters you were not aware of and could not have been aware of.

Subjective warranty (with a knowledge qualifier)

“To the Seller’s knowledge, the Company operates in compliance with legal regulations.”

Here you are liable only if you knew or should have known that the Company was not acting in compliance. This is a much safer position. If the issue was hidden and even a reasonable businessperson would not have noticed it, you are not liable.

Practical point: Buyers typically push for objective warranties, sellers for subjective ones. In M&A transactions, a compromise is common – some warranties remain objective (for example, warranties regarding the company’s legal form, title/ownership), while others are qualified by knowledge.

Most common mistakes made by sellers

Mistake 1: Not accounting for multi-year liability

Many sellers think that once they close the transaction, it is over. In reality, liability often continues for years. If you warranted tax matters, you face liability for 3–10 years. If you warranted legal matters, you remain liable until the limitation period expires (often 3–10 years).

Real-life example: The seller warranted that “the company has no tax arrears.” Two years after closing, the Czech tax authority reviewed the period during the seller’s ownership and found CZK 2 million in tax debt. The seller must pay, even though they have not owned the company for two years, because the sunset clause for tax warranties typically runs for three years (or longer if the time limit for assessing tax was extended).

Mistake 2: Signing representations and warranties without review

Many sellers receive a draft share purchase agreement from the buyer’s lawyer and sign it without any meaningful reading. The buyer’s lawyer primarily protects the buyer – not you. The result is that you sign countless warranties that you cannot comply with, or that are drafted extremely to the seller’s disadvantage.

Real-life example: A warranty reads: “There are no potential legal disputes.” This is incredibly broad – if you have a dispute with any employee, with a neighbour, or with anyone else and it later comes to light, you have breached the warranties. A proper lawyer would reject such wording or qualify it by knowledge and a time limit.

Mistake 3: Retaining unlimited risk without a cap

Without a cap, you can theoretically end up with liability exceeding the original purchase price. Say you sold the company for 10 million and, without a cap, you could theoretically pay 20 million on a claim for hidden debts. That is logically unsustainable.

Mistake 4: Not negotiating the escrow holdback at the right level

An escrow holdback is a portion of the purchase price that is not paid out on the closing date, but is held in escrow with a third party (typically a lawyer or a bank) for 12–24 months. If the buyer discovers a breach of warranties, they will draw compensation from the escrow.

If the escrow holdback is too low and a major issue later emerges, the buyer will sue you for the remainder. If the escrow holdback is disproportionately high, you lose a lot of money that could have been paid to you immediately after signing. Typical holdbacks: 10–20% of the purchase price.

Escrow and indemnification – how it works in practice

The practice of selling a company usually works as follows:

1. Signing: Both parties sign the purchase agreement with defined warranties, limits and conditions.

2. Closing: On the closing date, the transfer of the ownership interest/shares to the buyer is completed, the base portion of the purchase price is paid (usually 80–90%), and the escrow portion is deposited with a third party (10–20%).

3. Monitoring period: Over the next 12–24 months, the buyer “checks” the company’s actual condition. They may discover matters they did not know during due diligence.

4. Indemnification claim: If the buyer identifies a breach of warranties, they will send you a formal notice of the issue and the amount they wish to claim.

5. Settlement: If you agree on the amount and it is available in escrow, the money will be deducted from the escrow. If you do not agree, litigation usually follows.

Example: The seller warranted that “the company has no hidden debts exceeding CZK 1 million.” Six months after closing, the buyer discovers an invoice for CZK 1.5 million from a supplier from the previous year that was not recorded in the accounts. The buyer sends a notice and wants to claim CZK 1.5 million. If this is within the cap and the sunset clause has not yet expired, the seller will have to pay from the escrow (or from their own funds if the escrow has been depleted).

Practical negotiation tips

Prepare a list of matters you can genuinely guarantee

Before you start negotiating, sit down honestly and make a list: “What do I really know about my company? What can I guarantee with certainty?” You cannot promise everything the buyer wants. If you say “yes” to warranties you are not sure about, you will pay for it later.

Negotiate by categories

Do not try to negotiate every sentence. Instead, divide the warranties into categories and agree a cap and basket for each category. For example: financial warranties: cap 20%, basket CZK 100,000; legal warranties: cap 30%, basket CZK 50,000; tax warranties: cap without limit, basket CZK 50,000, sunset 5 years.

Disclosure schedule

Prepare a “disclosure schedule” with the buyer – an annex to the share purchase agreement where you clearly specify all exceptions and issues you are aware of. If something is in the disclosure schedule, the buyer cannot later treat it as a breach of warranties. This protects both sides – the buyer knows what to watch out for, and you will not pretend there is no issue.

Qualify warranties by knowledge

Where it makes sense (e.g., for threatened disputes), insist on a “to the seller’s knowledge” or “so far as I am aware” qualifier. This protects you from liability for matters you genuinely could not have known.

Final summary

Representations and warranties are the heart of every share purchase agreement. Put simply: they are your promises to the buyer about the condition of the company. If they are set incorrectly, they can cause you years of problems and financial losses.

It is critical to set three protection mechanisms correctly: the basket – so minor issues do not count, the cap – so your liability has a ceiling, and the sunset clause – so liability ends within a reasonable time.

Even more important is to discuss in detail with a qualified attorney what you are truly guaranteeing and what you are not. We do not recommend taking the signing of a share purchase agreement lightly if you know you do not understand the individual warranties.

The attorneys at ARROWS, a Prague-based law firm, specialise in company sales and in setting the right structure of warranties and liability limits. If you want to ensure that your representations and warranties are not a tool the buyer later uses to put you under pressure, contact us. We will review every sentence of the share purchase agreement and ensure you are liable only for what you can genuinely guarantee. Contact us at consultation@arws.cz.

Read also:

• Reps & Warranties in M&A: How They Protect Buyers and Sellers
• Disclosure Letters in M&A: Structure, Risks and Common Mistakes in Czech Deals
• Pre-Closing Covenants in Share Deals: Seller Obligations and Key Risks
• Managing Seller Risks Between Signing and Closing in Company Sales
• Protecting Equity Value Between SPA Signing and Closing in M&A Deals