Investors such as business angels and VC providers require founders to provide guarantee declarations as part of investment agreements. These relate to legal, commercial and tax matters, such as the proper incorporation of the company, the existence and encumbrance-free status of the shares, or the accuracy and completeness of submitted documents. The background to this is that the investor, as purchaser of shares, can never obtain absolute certainty in all legally relevant details, even after careful review during the due diligence process, and therefore wants to limit their examination effort and reduce their risk through guarantees in the investment agreement.
Founders, however, must exercise caution – on the one hand because they are generally required to be liable for the guarantees they provide regardless of fault, and on the other hand because personal liability is regularly demanded of them. If a guaranteed circumstance proves to be incorrect, it is not the company (which is usually the reference point of the guarantees) but the founders who are liable and personally stand with their private assets for the restoration of the guaranteed state or for claims for damages. Depending on the size of the company and the significance of the guarantee provision breached, amounts running into millions can quickly accumulate. Anyone who does not want to face claims that jeopardise their existence should therefore be very careful about what they want and are able to guarantee, and how these guarantees are structured.
Problematic and less problematic guarantee provisions
In principle, so-called "title guarantees" ("title warranties") are less concerning. These concern matters such as the company having been properly incorporated as the legal entity of the business, the share capital having been paid in, the shares existing and not being encumbered by third-party rights, etc. Founders can reasonably be expected, as careful businesspeople, to have done their "homework" and to be willing to stand behind the accuracy of this information.
The situation is different with guarantees relating to the underlying business plan, operational business or, for example, intellectual property rights ("IP rights"). Example – business plan: even with a sincere conviction in one's business idea, it would be negligent for a founder to guarantee that their business plan is "correct" and that the expectations set out in it will be met. After all, the economic situation can change unexpectedly or the company's business partners may in turn breach their contractual obligations, with the result that the projections from the business plan become void through no fault of the founder.
The same applies to the annual balance sheet or the existence of IP rights. It is hardly ever entirely possible to rule out that an error has crept in, or that third parties suddenly assert conflicting rights (patents, trademarks or similar). Founders would need the knowledge and skills of an auditor or a specialised attorney to be able to positively confirm that annual accounts are "correct" or that, for example, a name right exists. With a carelessly worded and given guarantee, the guarantor is nonetheless personally liable regardless of their own fault. It is of no help to them if they invoke the fact that they did not know and could not have known about the incorrectness of the guaranteed circumstance, and they may pay dearly for such carelessness.
Formulating guarantees in investment agreements carefully and limiting legal consequences
Reputable investors will generally only demand from founders such guarantees as founders can actually comply with; nevertheless, in order to limit the financial risks for founders, certain approaches are available that can defuse overly far-reaching guarantee provisions. This begins with the formulation of specific guarantee clauses. Instead of guaranteeing the correctness of a business plan, for example, it can also be worded such that it was prepared taking into account all known circumstances with the care of a prudent businessman. In general, wherever possible, guarantee provisions should not be based on actual circumstances but on the positive knowledge of the guarantor or on what a prudent businessman ought to know (legally: constructive knowledge). A founder should therefore, for example, not guarantee that no court proceedings are "pending" against the company, but rather that no pending proceedings are known to them. A lawsuit is "pending" as soon as the plaintiff has deposited it in the court's mailbox. If the founder's company is the defendant, they would only learn of this when the claim is served, meaning that at the time of giving such a guarantee they cannot necessarily know about "pending" proceedings.
In addition, restrictions can also be introduced on the side of the legal consequences (i.e. what is to occur if a guarantee provision is breached), which reduce the risk for the guarantor. Since there are hardly any mandatory statutory rules in this area, the determination of the legal consequences lies essentially in the hands of the contracting parties and can be structured almost as desired. For example, allowances can be defined for de minimis breaches, maximum liability amounts and exclusions, or the possibility of fulfilling damages claims by transferring shares. It is also quite common and appropriate to the interests of both parties, for example, to limit the guarantor's liability in amount to the investor's investment amount. It is also important to agree that, in addition to the guarantees, the application of statutory warranty law is excluded. Otherwise the founder risks being held liable in this way despite having carefully avoided a guarantee provision.
Finally, the limitation period for guarantee claims should also be considered and regulated contractually. Here, a limitation period of one to two years is generally considered appropriate. For certain guarantees, however, such as complex corporate and tax matters that by their nature only produce effects with a certain delay, longer periods may in individual cases also be worth considering.
Conclusion
Even if certain guarantees will hardly be negotiable away, the resulting risk for the guarantor can be sensibly limited through a considered choice of words in the contract formulation and a balanced limitation of the legal consequences in the event of a guarantee breach, so that the legitimate interests of both parties can be safeguarded. As experts in corporate law and contract drafting, we are happy to assist you if, as a founder or investor, you need help with guarantee provisions in investment agreements.
