Time and money.
Innovative business ventures are often short on both.
So, in the face of competing priorities, it can be tempting to gloss over standard contractual terms—like representations and warranties—with the assumption that they are boiler-plate and relatively unimportant.
“We don't have the time to run this past counsel. We'll make our best guess and move on.”
I think we can all admit in retrospect that we've made more than one important business decision based on less information than we should have.
But when it comes to certain things, like a service or product sales agreement, or a stock purchase, the stakes are simply too high to resort to intuition or an educated guess.
At best, the consequences can amount to costly damages or an order of specific performance. At worst, a stock transaction is declared void and sums of money already spent must be returned. For a young startup, the consequences can be devastating.
In short, representations and warranties are a critical component of every contract that should be reviewed and negotiated with care (and ideally the assistance of experienced counsel).
What are representations and warranties and what do they do?
“Representations” and “warranties” are each distinct and different but are often referred to collectively to indicate the part of a contract that contains the statements of fact and assurances that underpin an agreement.
They are a foundational part of any contract negotiation and serve many important functions, including:
- Transferring risk between the parties to a transaction
- Focusing due diligence efforts
- Informing the assumptions of both parties in determining whether to ultimately consummate the transaction
- Determining what conduct will trigger contractual termination rights
Let's take a look at each more specifically.
Representations are statements of past or present fact made by one party to a contractual negotiation to induce another party to enter into the contract.
For example, a seller might represent that the business has no claims asserted against it or that gross revenues in the last fiscal year reached a certain dollar amount. Based on this information, the seller might decide that the purchase at an agreed-upon price is a good bargain.
However, if the representations of the seller are later found to be false, the buyer might argue that they haven't received the benefit of the bargain that was promised. As a remedy, they can seek money damages or have the contract voided.
A warranty is a promise that a particular fact or assertion is true at the time the contract is made coupled with an indemnification if the assertion is found to be false.
For example, the same seller above might state that there are no claims against it at the time of purchase, but if any such claims are later discovered, the seller will indemnify the buyer from those claims and pay for their defense.
A breach of warranty entitles the injured party to a remedy that gives them the benefit of the bargain that was made, but unlike a breach of representations, the contract remains in place and typically cannot be voided.
Why are representations and warranties critical for life sciences and technology startups?
Cutting-edge technology is unpredictable
Many technology and life sciences companies are delivering products and services that are rendered at the edges of technology development using state-of-the-art techniques and processes that aren't entirely well understood. As a result, the outcomes may be uncertain or cannot be guaranteed.
Synthesizing a protein is a good example. Unlike making a watch or baking a cake—where certain inputs and procedures end with a consistent result—the end product cannot be precisely guaranteed.
Because of this uncertainty, both parties must collaborate closely in developing the contract's specifications. This includes clarifying:
- What the deliverables are in as much detail as possible
- Determining what procedures will be followed
- Specifying what is guaranteed and also what is uncertain
Having a clear understanding of expectations and capabilities and memorializing these in writing can help avoid later disappointments and costly disagreements.
The rewards are big—and so are the risks
Big pharma usually profits much more handsomely than the many smaller intermediary companies who help a drug or device along its path to market. In theory, their outsized profit is well-earned, as they accept the higher level of risk that accompanies selling a product into the marketplace.
But product liability claims are inevitable and plaintiff's lawyers don't limit their list of defendants to just big pharma; they name everyone in the value chain. That's why it's critical for companies involved early in the development process to include specific representations and warranties that indemnify them against future product liability claims.
Thoughtfully crafted representations and warranties can help even the scales to ensure that the risks borne by your company in the development process are commensurate with the relative rewards.
Intellectual property matters
Everything from pacemakers to insulin pumps now relies on software to function properly. Oftentimes, this software is sourced from a third-party vendor or independent contractor. Many companies commonly assume that when a service is rendered in the creation of software, so too are the intellectual property rights to the underlying software.
However, copyright interests in software can only be transferred through a written agreement with the third-party software provider. In other words, an unwary company that contracts for software to incorporate into its products may inadvertently end up with what amounts to only a license to use its accompanying software – unless the ownership rights to the software are clearly transferred in a written agreement with the contractor or vendor. This can lead to the time-consuming and expensive process of getting additional permissions and licensing to create modifications of the software, known as derivative works.
If software is involved in a product development, special care needs to be taken to ensure that the copyright in the software is actually transferred to the contracting party free and clear of any intervening interests.
How technology and life sciences startups can avoid representation and warranty missteps
- Don't overpromise.
The false representations that result in an agreement's unfortunate demise are often made unintentionally; as the saying goes, “the path to ruin is paved with good intentions.”
There are two simple ways to avoid this problem.
First, take time to review and verify all representations and warranties against what you can verify or absolutely know to be true.
Second, some representations and warranties should be qualified as being true “to the best of your knowledge” rather than being absolute. For example, because patent applications are not published in the first 18 months after filing, your technology may infringe the intellectual property of another party without your even knowing it or having the capability to discover as much. In this case, your representation might state: “This technology does not infringe the intellectual property of another to the best of our knowledge.”
Even if unintentional, the repercussions of a material misstatement can be severe. In the case of an offering document in a securities financing, it can give a wary investor grounds to rescind a stock purchase transaction and ask for the investment to be refunded. The consequences for a young startup—or a company of any size or maturity—can be irrecoverable.
2. Understand and disclaim implied warranties.
While the parties to an agreement might clearly understand the expectations explicitly written into their contract, they might fail to appreciate that several unstated and implied warranties may also govern their agreement.
In particular, the Uniform Commercial Code (UCC), as adopted by most states and U.S. jurisdictions, imposes an implied warranty of merchantability and fitness for a particular purpose to the sale of all goods and services. In short, the UCC's warranty of merchantability and fitness guarantees buyers that the product will be of the type typically sold by relevant merchants or providers and that it is fit for the intended purpose and will do what it can be expected to do.
While this warranty makes perfect sense for fruits and microwaves, it doesn't make much sense in technical contracts with detailed descriptions of the services and specifications to be provided. However, in the event of a dispute or litigation, your company can end up burdened with the unnecessary expense of proving the inapplicability of such implied warranties if you don't explicitly disclaim them in your contract.
This risk can easily be remedied by making sure your contract is as specific as possible on the deliverables and expectations of parties and that it also disclaims implied warranties that are not appropriate to the transaction.
3. Engage a trusted advisor.
The path to new medical device and drug development is fraught with risk. But much of this risk can be managed and mitigated with a good prospective planning process—like ensuring that your contracts include representations and warranties that are accurate and appropriate to your agreement. Likewise, some risks can be bargained away in negotiations, while others must simply be accepted and stopgaps like insurance put into place. A trusted legal advisor who is experienced in helping emerging tech and life sciences businesses can be invaluable in navigating this planning process.
If you're still taking shortcuts when it comes to risk and legal, it's time to stop. Making your best guess works fine…until it doesn't. And by then the consequences are usually all too severe.
A small investment in the right counsel can, and often is, the difference between startups that change the world and those who close their doors on the edge of a breakthrough.
Like most startups that are short on time and resources, you might think that having counsel that is as cutting-edge as your technology is out of reach. Crowley Law LLC is here to prove you wrong. Our firm specializes in helping small and midsize technology and life sciences companies navigate the legal and compliance complexities that are unique to a start-up business.