Representations and warranties (“reps & warranties” or R&W) are legal promises made by both buyer and seller. Reps & warranties are a foundational component of any purchase agreement, whether a stock purchase agreement or an asset purchase agreement. Show
Following is a high-level outline of a typical purchase agreement and its various components:
Representations and WarrantiesReps & warranties are nearly always included in the purchase agreement, survive the closing, and serve as the buyer’s basis for future lawsuits (under the “Indemnification” clause). Reps & warranties typically comprise the majority of the content in a purchase agreement and are one of the most hotly negotiated components of the purchase agreement, other than price and terms. This is because reps & warranties define the allocation of risk between the buyer and seller. Definition: A representation is technically the statement of a fact (e.g., the corporation is duly authorized), and a warranty is a promise that a fact will remain true (e.g., seller warrants that the business has operated in compliance with all laws …); however, this distinction has proven unimportant. Reps & warranties are not listed separately in the purchase agreement, but are rather grouped together in one section called “Representations & Warranties.” For example, most agreements state, “The Seller represents and warrants that …” With minor exceptions, the other elements of the purchase agreement (price and terms, conditions, covenants, etc.) have no further implications after closing has taken place. On the other hand, the reps & warranties and related indemnification clauses “survive” the closing and can have implications for both parties for years thereafter. As a result, the reps & warranties are often heavily negotiated, especially when the seller wishes to retire and avoid any lingering obligations that may conflict with their peace of mind. Most reps & warranties are worded similarly from deal to deal and exclusions are then documented in the disclosure schedules for the business based on several factors, such as the size of the business, the complexity and type of business, the structure of the transaction (asset vs. stock deal), and specific risks that may be present in the business. In practice, this means that the buyer’s attorney usually prepares the purchase agreement, which includes a standard list of reps & warranties, and the seller’s attorney is then obligated to list any exceptions in the disclosure schedules. For example, a manufacturing company may have more representations concerning environmental and employee concerns (union, benefits, etc.), while a technology company may have more R&Ws regarding intellectual property. How Reps & Warranties Can Speed Up Due DiligenceDue diligence can expose problems in the business that will subsequently be addressed through drafting tighter representations based on what was uncovered during the due diligence process. However, due diligence is unlikely to reveal every problem concerning the business. In other words, R&Ws are drafted to protect the buyer from what they may have missed during due diligence and what a seller may have intentionally withheld. The buyer’s decision to buy the business is based on a combination of the due diligence they performed and the extent of the protections afforded to them in the purchase agreement in the form of representations & warranties. Protections Afforded to the Buyer in the Purchase AgreementThe following protections are instituted in most transactions to protect the buyer from material misrepresentations or fraud:
The Many Purposes of Reps & WarrantiesRepresentations are engineered to require the seller to provide full disclosure to the buyer — in other words, they force the seller to disclose material issues regarding the business. They also serve as a mechanism for allocating risk between the parties for events that are uncovered after the closing. For example, if a customer sues the business for an event that happened prior to closing, the reps & warranties would serve to allocate the risk of such events between the buyer and the seller. The R&Ws would define who would be responsible for such an event, for how long, and to what extent. Unknown risks are inherent in any business, and the R&Ws seek to allocate both known and unknown risks between the parties. In a buyer’s market, the role of reps & warranties in risk allocation strongly favor buyers, and vice versa. R&Ws also serve as a condition to closing — if the representations and warranties are not true as of the closing date, the buyer may refuse to close. Negotiating Reps & WarrantiesNegotiating the reps & warranties should not be done in isolation but should instead be considered in concert with the following components of the overall deal structure:
IntroductionThe scene is like a living, breathing postcard from paradise. Clear skies, white-sand beaches, warm ocean breezes. And, look! There’s you: tanned and rested, John Grisham legal thriller in one hand, pina colada in the other. In one sense, it took a lifetime to get here. You spent decades building your company and a grueling 12 months to get it sold. But you did it, and now you’re reaping the rewards. You’ve heard about former life-long business owners who found it impossible to relax after successfully exiting the fray. But that’s not you. There are going to be plenty more postcards like this one. Life is good. Then the phone rings and life is about to get a little less good. It seems there is a problem with your financial statements. The buyer of your business discovered that the numbers are not compliant with GAAP and that EBITDA was overstated as a result. Not a big deal, you think … your deal closed six months ago, and it’s the buyer’s problem now. The buyer is demanding a reduction in the $2 million purchase price. But, hey, the deal is already closed! You call your attorney in a fit of fury. Your attorney asks if you remember signing a representation or warranty stating that your financials were prepared in accordance with GAAP. Your response: “What’s a representation or warranty?” Welcome to the world of reps & warranties, where in extreme instances a misrepresentation – inadvertent or otherwise – about the company you’re selling (or have already sold) could put the kibosh on the deal or a major drain on your bank account. The account where you keep the proceeds from the sale. Let the headaches and lawsuits commence. As you’ll read below, reps & warranties typically make up the bulk of the content in a purchase agreement and are one of the most hotly negotiated components. That’s why I have devoted more than 50 pages to the topic here, and that’s why you should pay attention. In addition to the accuracy of financial statements, reps & warranties can address the legality of the business, tax audits, the status of customer contracts, environmental liability, employee benefits, the status of inventory, and more. In the article that follows, we’ll touch on everything you need to know about reps & warranties and how they can impact a business sale from both the buyer’s and seller’s perspectives. After all, we wouldn’t want to spoil your day at the beach. The Letter of Intent (LOI)Unfortunately, the full reps & warranties are documented only in the purchase agreement and not the letter of intent (LOI). As a result, sellers do not have the opportunity to see the reps & warranties that a buyer may be proposing in the LOI. Sellers sometimes counter this by asking the buyer to mark up a draft purchase agreement when evaluating a buyer’s LOI; however, this is customarily only done in larger transactions (generally, nine-figure transactions). The breadth and depth of the R&Ws are also based on facts discovered during due diligence, and the substance of the R&Ws may change based on what is uncovered during due diligence. As a result, the reps & warranties are not drafted until much later in the process. In effect, this results in two stages of negotiations — once when the LOI is hammered out, and again when the purchase agreement is negotiated. This is why R&Ws are so hotly negotiated — the parties have already struck a deal, but now they must negotiate a second time. Negotiating the Purchase AgreementIn most transactions, the buyer’s attorney prepares the purchase agreement, and the seller’s counsel responds by marking up the agreement. When drafting the R&Ws, the buyer’s attorney normally focuses on the likelihood and amount of potential exposure. The scope of the negotiations is based on the aggressiveness of the buyer’s attorney’s initial draft and the bargaining positions (e.g., alternatives) of each party. This is why buyers often aim for a long exclusivity period — doing so reduces the seller’s bargaining power later in the process when the purchase agreement and R&Ws are being negotiated. Consider a scenario in which the seller takes the business off the market after having spent tens of thousands of dollars conducting due diligence (e.g., fees paid to attorneys and accountants), after making a significant emotional investment in the transaction, and after having put all other potential buyers on hold for several months. Because the seller’s negotiating position has been weakened, the buyer may be able to negotiate much more stringent terms in the purchase agreement as a result. The seller should carefully read through the representations and should not blindly sign them as if they were boilerplate — they’re not. If the seller is not 100% certain regarding a representation, that representation should contain a knowledge qualifier such as “to the best of the Seller’s knowledge” or “to Seller’s knowledge.” At the same time, exclusions can be documented in the disclosure schedules. Breaching a rep or warranty can have disastrous effects on either party and should therefore not be taken lightly. Seller’s vs. Buyer’s RepresentationsThe purchase agreement contains significantly more representations concerning the seller because the buyer has much more to lose than the seller does. The seller is primarily concerned about receiving payment — the buyer’s representations are therefore primarily about access to capital and authority to purchase the business. On the other hand, the buyer is concerned about dozens of aspects of the business and its operations. Here’s a list of sample representations a seller might be asked to make:
Expanding the Scope of Reps & WarrantiesNormally, the buyer seeks to obtain protection from as many parties as possible (all shareholders, key managers, etc.) and protection that is as broad as possible (e.g., all information the seller has provided is accurate). Not only must the topic of an individual representation be considered, but the collective scope of all R&WS must also be considered. When attempting to expand the scope to third parties, negotiations may become contentious as a breach can have major financial implications for such a party. The Use of Reps & Warranties in Public vs. Private TransactionsTransactions involving publicly traded companies also include reps & warranties, but they become ineffective at closing (i.e., they don’t survive closing).
What Happens if Reps & Warranties are Breached? The Basics of IndemnificationThis section of the purchase agreement addresses what will happen if a representation or warranty is breached. In most cases, an indemnity offers a party the right to recover losses and legal expenses. Indemnification is also a hotly negotiated component of the purchase agreement. The indemnification is normally subject to limitations, such as minimum thresholds that must be triggered (similar to an insurance deductible, called a basket) and the maximum limit of indemnification (a cap). Indemnification can also be limited by knowledge qualifiers (e.g., to the best of seller’s knowledge vs. to seller’s knowledge), materiality qualifiers, and survival periods (e.g., the R&Ws normally expire after 18 to 24 months). These collectively serve to limit the seller’s exposure level and further serve to allocate risk between the parties beyond the specific language provided in each individual representation. An escrow of 10% to 15% of the purchase price is normally withheld from the seller’s proceeds to fund any indemnification claims. Reps & warranties work like an insurance policy. There are exclusions, or events that the policy does not cover. There is also a deductible (basket) and a maximum payout amount cap. The seller’s goal is to limit their exposure through the following:
Negotiating Deal Structure and R&WsDeal StructuringNegotiating reps & warranties cannot be done in isolation because they are one of many pieces that constitute the overall transaction structure. The trade-offs and tensions can be summarized as follows: Seller’s Objectives:
Buyer’s Objectives:
All of these components should be taken into consideration on a collective basis during negotiations. When negotiating, concessions should not be made in isolation. For example, if the buyer proposes a lower purchase price, then the seller may concede but may request more cash down at closing or reduce the size of the earnout. Or, if the seller insists on providing minimal representations to a buyer, the buyer may concede but may tighten up other elements of the deal structure, such as escrows, knowledge qualifiers, or thresholds. The more assurances the seller is willing to provide to the buyer, the lower the risk for the buyer and the higher the purchase price the buyer can potentially afford to pay given the amount of risk they are assuming. Risk and return are directly related. The higher the risk, the lower the return — and vice versa. By lowering the risk for the buyer, the seller can potentially realize a higher purchase price. The most fiercely debated elements of the transaction are:
NegotiatingThe scope of the reps & warranties is different from transaction to transaction. For example, a stock sale may contain a different scope of R&Ws than an asset sale. Likewise, a buyer who is intimately familiar with an industry and is, therefore, more confident in their ability to conduct due diligence, may demand a lesser scope than a buyer who is not familiar with the industry. As a result, no two negotiations are alike. The scope of the negotiations over the reps & warranties is dependent on the following:
The seller can therefore minimize the potential scope of reps & warranties by:
If the seller operates a basic retail or service business, the R&Ws likely won’t be very broad in scope. However, if it is a risky or complicated business, the seller can expect the buyer to demand much more stringent reps & warranties. For example, if the seller’s business handles hazardous materials, the buyer will request stringent representations addressing potential environmental concerns, worker’s compensation claims (from the workers handling the hazardous materials), etc. Comparing OffersUnfortunately, letters of intent don’t include the full reps & warranties, so the scope of the R&Ws will not be able to be assessed until later in the transaction. LOIs often contain language that the purchase agreement will include “representations, warranties, and indemnification that are customary for a transaction of this size and type.” But customary based on whose definition? Some LOIs will include specifics regarding more contentious issues, such as the amount of earnouts and escrows. Less frequently, the LOI may include information regarding thresholds (caps, baskets, etc.). Timing & Due Diligence When negotiating an LOI, the buyer has not yet performed due diligence and has limited information on the business; therefore, the buyer is not in a position to know exactly what reps & warranties they will request from the seller. Only after the buyer has conducted due diligence will they be in a position to pin down the specifics. Ideally, the purchase agreement should be prepared in tandem with the due diligence process so the parties can negotiate the language as soon as possible in the transaction. Sunk Cost Principle Some buyers attempt to use time to their advantage and will wear down a seller using the “sunk cost” principle. The buyer figures that the more time and money they can get the seller to invest in the negotiations (i.e., sunk costs), the more likely the seller will give in on major deal points later in the transaction (to recover the sunk costs). This strategy can be countered by including milestones in the LOI, such as dates for completion of due diligence and preparation or signing of the purchase agreement. The Shifting Dynamics of Leverage Throughout the Life of the Transaction Sellers should also be aware that they have the most leverage early in the transaction, before the LOI is signed. Once the LOI is signed, the seller loses leverage and is subject to the buyer’s timetable. Most LOIs contain an exclusivity clause and require that the seller take the business off the market and cease negotiations with other parties, which further weakens the seller’s negotiating posture. For this reason, sellers should carefully negotiate all the terms of the LOI. If the seller has never sold a business before, it’s critical that they hire an experienced professional to handle the negotiations on their behalf. The more buyers with whom a seller is negotiating, the stronger the seller’s negotiating posture will be. If the seller is negotiating with multiple parties, it may be suitable to move to a much more detailed LOI and outline in detail the components of the purchase price, such as price, terms, escrows, caps, baskets, survival periods, earnouts, allocation of the purchase price, etc. This will help a seller evaluate offers as opposed to blindly accepting an LOI with vague terms only for it to blow up later in the process. Which offer would you accept? Offer 1
Offer 2
Trick question! You can’t decide. You don’t have enough information to make a decision. We would have the following questions before we could evaluate either offer:
Unfortunately, we are approached all the time by sellers who have an offer in hand with terms similar to one of the offers above. It’s common for sellers to only focus on the price. Yes, the language in the LOI might look impressive — but 90% of it may be boilerplate, and the terms may be vague enough that the buyer can rewrite them later. When a seller receives an LOI, it’s critical to pin down the buyer on all the key terms of the transaction, otherwise, there is a good chance that the unwritten terms will not be favorable for the seller when they are finalized in the purchase agreement. It’s also critical that reps & warranties are negotiated collectively with the other components of the deal structure. In other words, don’t negotiate R&Ws in isolation. Impact of Market Conditions on the Scope of R&WsThe current state of M&A activity and the extent to which it is a seller’s or buyer’s market heavily influences the scope of R&Ws. Market conditions impact not only the price of companies but also the terms of the transactions — and may dictate the prevailing definition or notion of what may be considered “reasonable” or “fair.” For example, in a seller’s market, sellers can expect to sign reps & warranties that are far less broad in scope than in a buyer’s market. In 2009, sellers had to agree to extremely restrictive language in both LOIs and purchase agreements. Once the buyer’s market gained traction several years later, the scope of these restrictions loosened up. Market conditions can influence the following:
Tips for Negotiating Reps & WarrantiesHere are some tips for negotiating representations and warranties:Understand the Purpose of Reps & WarrantiesThe parties must recognize that no business is perfect. There are bound to be a variety of problems in any business, no matter how meticulously the business has been operated. For example, few businesses are in compliance with literally every law. Reps & warranties are not intended to insulate the buyer from every imaginable problem that can arise. The purpose of reps & warranties is to protect the buyer from undisclosed, material risks that occur outside the ordinary course of running the business. Past Events OnlyRepresentations should primarily cover past events. They should not be designed to provide the buyer with assurance regarding the future. Operating a business involves numerous risks, so the buyer should assume the normal risks and not attempt to mitigate future risks that occur in the ordinary course of business. Maintain an Excellent RelationshipThe seller should attempt to maintain an excellent working relationship with the buyer after the closing. The transaction must be win-win for both parties. If the buyer later suffers from buyer’s remorse, they will have sufficient opportunities to obtain revenge on the seller through numerous protections afforded to the buyer in the purchase agreement. Such protections include escrows, post-closing purchase price adjustments (e.g., working capital adjustment), inventory adjustments, collection of accounts receivable, reps & warranties, earnouts, bonuses, etc. The best antidote for disputes is prevention. How does that work? By maintaining an excellent working relationship with the buyer — not just professionally, but personally as well. If you are “friends” with the buyer, it’s easier to work out problems. Be Prepared to Give in, at TimesBe prepared to negotiate and occasionally give in on some points. The parties must weigh the cost of a dispute vs. the potential benefits to be gained. Disputes are expensive and time-consuming, and even if you win, you lose. No deal is perfect, and you can reasonably expect to encounter at least one substantial dispute in nearly every transaction. For immaterial matters, it may be most prudent to simply split the difference. Make Concessions KnownNever make a silent concession — in other words, the seller should never give the buyer something without the buyer becoming aware of it. For example, if the seller counts the inventory and it is $204,000, but the seller only plans to charge the buyer $200,000 for the inventory, the seller should let the buyer know. The more concessions that are made, the more likely the other party will be to concede on minor points, but only if they know about the concessions. Analyze Indemnity Provisions Using a MatrixUse a matrix to analyze indemnification provisions. These provisions can be complex, and it’s best to separate the legal language from the economic parameters. Extract the economic parameters of the provision and map it out on a spreadsheet. This helps organize and analyze the terms of indemnification and facilitates making tradeoffs. Representations & Warranties Matrix Representation Survival Period Basket (% of Purchase Price) Cap (% of Purchase Price) Environmental Unlimited 1% 20% Tax Unlimited None 20% All Other 18 Months 1% 20% Returns 24 Months 1% 20% Accounts Receivable 12 Months None 20% Product Liability 36 Months 1% 20% Title & Organization Unlimited None 100% Non-Assumed Obligations Forever None 100% Understand Underlying MotivationsBuyers propose specific reps & warranties for a reason. The seller needs to find out these reasons and address the concerns directly. Often, the problem can be resolved through other creative measures, or the buyer may have a misunderstanding of the underlying risk the representation is intended to address. This can open a dialogue to educate the buyer on the risk and other methods for mitigating it. Beware of Financial RepresentationsBe very careful when there is a financial representation, such as: “Purchase Price is based on EBITDA for the most current year of $5.2 million … continued to a separate representation … and the financial statements have been prepared in accordance with Generally Accepted Accounting Principles.” This is a potential landmine for a seller and is tantamount to giving the buyer a blank check. If the seller’s financial statements are not prepared in accordance with GAAP (most aren’t), the seller has essentially given the buyer carte blanche to later negotiate the purchase price. Before signing representations concerning accounting or financial matters, have a CPA review them to ensure they are accurate. Here are Some Ways the Seller Can Reduce the Potential Exposure of Reps & Warranties:Reps & Warranties InsuranceInsurance is available to sellers to minimize the potential liability of R&W breaches. The price is normally 4% to 8% of the coverage amount and depends on the scope of the reps & warranties, the industry the business operates in, the deductible, and the term of the coverage. This type of insurance has become commonplace in private middle-market M&A transactions but does not cover fraud or gross negligence. Knowledge QualifiersLimiting the reps & warranties based on the seller’s knowledge is an effective strategy for reducing the seller’s exposure and can place the burden of proof on the buyer to prove that the seller did not have knowledge of the information. Knowledge qualifiers can also be limited to certain parties. For example, a representation can be limited exclusively to the knowledge of the seller, or it could apply to the seller’s management team. Most sellers should attempt to limit knowledge solely to their own knowledge, as broadening the scope of liabilities of knowledge to third parties can increase the amount of risk. Sample knowledge qualifiers include:
Materiality QualifiersMateriality can be addressed either in individual reps & warranties or collectively in the indemnification section. More commonly, materiality is addressed in the indemnification section by the use of baskets and other thresholds. Most agreements specify that only material breaches will be subject to indemnification. The level of materiality is usually defined by providing for a specified basket, or deductible. In most transactions, the amount of the deductible, or basket, is 0.50% to 0.75% of the purchase price. For example, in a $10 million transaction, a claim must exceed $50,000 to $75,000 before it is subject to an indemnification claim. Survival PeriodsReps & warranties are almost always limited to a specified time period, also called a survival period. Survival periods may differ depending on the type of representation. For example, R&Ws regarding tax and environmental concerns may be for longer periods or may even be perpetual (no time limit) in certain cases. Nonetheless, survival periods can also serve to limit a seller’s level of exposure. Right of OffsetIndemnification claims can also be offset by unpaid amounts of the purchase price. For example, if the buyer has been late on the seller note, any indemnification claims could be subtracted from the outstanding balance. Buyer InsuranceA seller can require that the buyer insure against any risks that are potentially insurable. The seller can also maintain their existing policies if the policies are made on a claims basis vs. an occurrence basis. The indemnification should be net of any insurance reimbursements. The seller should be sure to request that the insurer waive any subrogation rights they may have if they aren’t the named party in the policy. This prevents the insurer from coming after the seller in the event of a loss since the seller is not the named policyholder. Indemnification CapsSellers can cap their total exposure to breaches of reps & warranties. Caps, or limits, are generally 10% to 20% of the purchase price, but may be higher for specific types of claims, such as environmental claims. Shareholder LiabilityThe parties to the indemnification can either be the selling entity or the individual shareholders. In most cases, the selling entity ceases to exist, and the buyer requests that all operating shareholders sign the purchase agreement. A selling shareholder must personally sign the purchase agreement in order to be subject to being required to indemnify the buyer. Multiple Parties: If multiple shareholders exist, they should not agree to “joint and several liability.” If joint (together as a whole) and several (individual) liability exists, the shareholders can be held liable either together as a whole (joint) or individually (several). In other words, a 10% minority partner could be potentially liable for the entire amount of the claim. Or a 60% majority partner could be held liable for the entire claim, and the 60% partner would then have to chase down the minority partners for reimbursement. If multiple shareholders exist, the seller should attempt to limit indemnification on a pro-rata basis (each shareholder pays their share of the award), as opposed to “joint and several.” Hiring a Team to Negotiate R&WsTips for Hiring Advisors to Help Negotiate the Purchase AgreementWhen hiring a professional advisor, the number one thing you should look for is real-world experience buying and selling companies. Negotiating the purchase agreement for the sale of a middle-market business is a complex undertaking, and by no means should you risk your hard-earned money to pay an advisor to learn on the job. When hiring an accountant or attorney, look for experience. Don’t be shy when inquiring about qualifications. Ask how many M&A transactions they have worked on in the last three years and their role in each transaction. Ask what role they envision themselves playing in your situation — some advisors prefer to be in the background while others prefer to be on the firing line. The reps & warranties can have significant implications for several years following the closing. In some instances, the liability a seller may incur in reps & warranties can be perpetual, such as in the case of environmental issues, the payment of taxes, or for employment-related matters. For buyers, one word in the agreement can make the difference between a million-dollar recovery of damages and no recovery at all. Both parties should be sure their advisors are familiar with all aspects of the purchase agreement, especially the reps & warranties. Balance risks vs. rewards. Attorneys and accountants are conservative by nature. Find an advisor whose appetite for risk matches your own. Some advisors are excessively risk-averse. Likewise, some business owners are also risk-averse. You want an advisor whose risk profile matches your own. Help your advisors understand your business from both an operational and a financial standpoint. Tell your CPA or attorney what your primary concerns are and work with your advisor to meet your needs before becoming buried in legal or financial jargon. Don’t lose sight of your objectives. Once your advisor understands your business and aspirations, you can work together to create package proposals that meet the buyer’s needs while also addressing the needs of your business. Balance your advisor’s experience and judgment with your own objectives. Experienced accountants and attorneys will know what is customary and reasonable and what is not. The American Bar Association (ABA) compiles surveys from attorneys in the trenches based on what is currently considered reasonable in an industry. For example, the ABA study might indicate that 34% of M&A transactions under $10 million in purchase price include an earnout, or that the average escrow is for 18% of the purchase price. The ABA’s studies are highly detailed and contain specifics on every critical element of a purchase agreement. An experienced advisor can spot when the opposing party is making an unreasonable request and will be able to couple your objectives with current standards of reasonableness. A good advisor will tell you when to fight and when to acquiesce. Know the role of your accountant or attorney based on your experience level. If you have never sold a business, be prepared for your advisor to play an instrumental role in the process. On the other hand, seasoned business owners will require less guidance from their advisors. Your attorney will play a key role in negotiating the purchase agreement. But it’s your accountant who will take the lead in financial due diligence and examining the financial and tax implications of the purchase agreement, and negotiating any R&Ws that relate to the financial aspects of your business. Your accountant or CPA may examine the financial implications of reps & warranties, such as a representation that relates to:
Finally, ask your advisors to conduct pre-sale due diligence. This involves conducting due diligence before you put your business on the market and will allow you to identify and resolve potential problems before you begin the sale process. Doing so may lessen the scope of the reps & warranties. The M&A Advisor or Investment BankerBoth your attorney and your M&A advisor will play instrumental roles in the negotiation of reps & warranties. Your M&A advisor will negotiate with the buyer regarding the high-level elements of the transaction and how the various components of the transaction work together to form the overall deal structure. Experienced investment bankers treat negotiations as a win-win proposition as opposed to stating a position and firmly holding one’s ground. An experienced intermediary can be invaluable in uncovering a buyer’s true concerns and creatively structuring a transaction to meet both parties’ needs. Most M&A firms will ask the seller for indemnification against any legal actions that may occur as the result of inaccurate information or material misrepresentation. Many buyers will enjoin the M&A advisor in any suit and will cast a wide net over anyone that was involved in the transaction. Since the seller will receive roughly 95% of the proceeds of the transaction and will be the source of all the information, M&A advisors argue that they should not be responsible if the information is inaccurate. Without such an indemnification, the M&A advisor would be required to verify every bit of information that passed through their hands. Such a requirement would be burdensome and unnecessarily hamper the process. Such a request is reasonable; however, the degree to which the seller indemnifies the advisor against gross negligence is debatable. In our opinion, the advisor should not be indemnified from acts of fraud or gross negligence, although the M&A advisor should be indemnified from any problems that stem from a source of inaccurate information. Opening up the investment banker to liability for inaccurate information will cause them to second-guess the business owner in an endless number of situations and would add a significant cost and time delay to the process, and their fees would need to be commensurately increased to account for the inflated risk. Other SpecialistsDepending on the nature of your business and industry, other specialists may be employed during the process. Their level of involvement will impact the scope of reps & warranties. In some cases, retaining experts in advance can mitigate risk for the buyer, and the buyer may, in turn, reduce the scope of the reps & warranties.
Asset vs. Stock SaleA question in every transaction is whether the transaction should be structured as an asset sale or a stock sale. The form of the transaction has a significant impact on the scope of the reps & warranties. Reps & warranties are much broader in scope for a stock sale than an asset sale. Asset SaleMost buyers prefer an asset deal due to the lower level of risk. In a stock sale, the buyer is inheriting all of the seller’s liabilities (called contingent or unknown liabilities) whereas in an asset sale, the buyer is only inheriting those liabilities the buyer is explicitly agreeing to assume in the purchase agreement, along with successor liabilities, which the parties cannot avoid regardless of the form of the transaction. As a result, the reps & warranties can be less in scope in an asset sale than in a stock sale. Stock SaleIf a buyer acquires the stock, the buyer is inheriting all of the liabilities of the seller. As a result, reps & warranties in stock deals are more comprehensive than in asset deals. Many larger transactions are structured as stock deals. In stock deals, the seller will make additional representations regarding the capitalization and liabilities the buyer will be inheriting. Successor LiabilityRegardless of the transaction structure, there is a possibility of successor liability. This can be mitigated to a certain extent with thorough reps & warranties, an escrow, and other protective measures; however, the risk can never be completely eliminated. In certain matters, successor liability can never be eliminated, such as for tax or environmental issues. In other matters, such as employee issues, successor liability can be mitigated by reducing the possibility of being labeled a “continuation” if the sale is an asset sale. The business is considered a successor, or continuation, if the product lines, employees, and other aspects of the business are substantially similar both before and after the closing. In other words, if the business is essentially the same, the courts may characterize the business as a “mere continuation” and impose successor liability. This happens in most M&A transactions, meaning that successor liability exists in most M&A transactions. As a result, many of the reps & warranties are designed to address these potential areas of liability. Here are some tips for reducing successor liability:
Funding Breaches Through EscrowThe majority of M&A transactions include some form of holdback, also called an escrow. In a holdback, a portion of the purchase price, normally 10% to 20%, is held by a third party (escrow) for a period of time, normally 12 to 24 months, and is used to satisfy any indemnification claims in the purchase agreement. If there are no claims, the money is released to the seller once the time period expires. Why is an Escrow Necessary?Escrows give the buyer assurance that money will be available to cover their expenses (from litigation, losses, etc.) if any of the seller’s representations or warranties later prove to be untrue or for other breaches in the purchase agreement. For example, let’s examine the sale of a manufacturing plant that includes expensive machinery. The seller may have represented that the machinery is operable and in good repair. If a piece of machinery breaks after the closing, and the seller determines that there was deferred maintenance on the machine and the problem was concealed by the seller, the buyer will file a claim to seek reimbursement for the machine. The holdback goes into an escrow account with a neutral third-party escrow agent. The funds are governed according to an escrow agreement. In most cases, the funds may only be released upon the mutual consent of the buyer and seller. If there are no claims, the money is released to the seller once the escrow period expires. Are there alternatives to escrow?Yes, most M&A transactions include some form of deferred payment, and nearly any deferred payment can also function as a form of escrow. Here are several alternatives to escrow:
Sellers are likely to resist a right of offset against guaranteed, deferred payments (e.g., promissory note and consulting or employment agreements) because such an arrangement affords the buyer a significant amount of leverage since the buyer “controls” the money. Allowing the buyer to simply withhold payments may afford the buyer too much power, and sellers may justifiably prefer an escrow. What Are the Major Terms of the Escrow Agreement?The parties should consider the following as terms of the escrow agreement:
How Are Disputes Normally Handled?Disputes regarding the purchase agreement will be governed by the terms of the purchase agreement in conjunction with the terms of the escrow agreement. In some cases, supplemental agreements (e.g., a non-competition agreement) may have separate dispute mechanisms. Most disputes will be governed according to the terms laid out in the “Indemnification” section of the agreement. There is no such thing as a “standard” indemnification provision. Indemnification language may be strongly debated by both buyer and seller. In most cases, if a buyer discovers a problem or a breach, the buyer must notify the seller, and the seller may be given time to resolve the problem (i.e., “right to cure”), contest the damage, or choose to reimburse the buyer. If the parties cannot resolve the issue, then the money will remain in escrow while the parties attempt to reach a resolution. A final question to consider is whether the escrow should be the buyer’s exclusive remedy or whether the buyer may be afforded additional remedies. Limitations to Reps & WarrantiesLimitations to reps & warranties can be broken down into the following four categories:
Knowledge QualifiersOne of the simplest ways to limit the scope of a representation or warranty is through a knowledge qualifier. A knowledge qualifier limits the seller’s exposure based on the seller’s “knowledge” of a representation. For example, if a seller states that the business’s financial statements have been prepared in accordance with Generally Accepted Accounting Principles (GAAP), and the buyer later determines that the financial statements have not complied with GAAP, the seller may not be held liable. But, the degree to which the seller is held liable depends on the parties’ exact definition of “knowledge.” The seller may not have knowledge regarding every aspect of the business. This is all the more true when the seller is an absentee owner. Sellers may therefore become rightfully nervous if they are required to make representations regarding aspects of the business of which they may be unaware. For example, an absentee owner may not be aware if all equipment is operational. The reps & warranties are therefore often limited based on the seller’s knowledge (as knowledge is defined in the purchase agreement) of that specific representation or warranty. Sample In-line Knowledge Qualifiers include:
These statements may precede the reps & warranties section in a purchase agreement. For example, “To the best of Seller’s knowledge, the Seller represents and warrants that …”. In this case, the definition of knowledge is included in the statement itself, as opposed to being defined separately in the ”Definitions” section. Sample Definitions of Knowledge include:
In some purchase agreements, “Knowledge” is separately defined and included in the “Definitions” section of the purchase agreement, and the term “Knowledge” is then capitalized throughout the agreement to refer to its definition in the “Definitions” section of the agreement. The precise definition of knowledge, as defined in the agreement, will have significant implications for both parties. In the absence of any knowledge qualifier, the seller could be 100% responsible for any representation and warranties in the purchase agreement, regardless of whether the seller knew it was true or not. Limiting the definition of knowledge can dramatically alter the dynamics and can force the onus on the buyer to prove that the seller knew the representation was false at the time it was made. It can also significantly limit the buyer’s indemnification rights by shifting unknown risks to the buyer. The buyer will attempt to expand the definition of knowledge to include “constructive” knowledge, which includes information that should have been known after reasonable or due inquiry, or that should be known based on the seller’s role in the business (e.g., a CEO will be presumed to have a different level of knowledge than that of a CTO or CMO). Regardless, the parties should remember that uncertainty will always be present, regardless of the parties’ desire. Reps & warranties are not solely a test of integrity but are rather primarily a legal mechanism for allocating risk. Careful consideration should be given if the seller is an absentee owner and has little knowledge of the business. In such cases, the definition of knowledge should suit the circumstances, but the seller should bear in mind that knowledge qualifiers are also a risk allocation tool, and the seller may be required to make representations regarding areas of the business of which they are not knowledgeable. In other circumstances, such as a management buy-out (MBO), the buyer(s) may have more knowledge regarding the operations than the seller. In this case, management may be willing to accept more risk; however, this may be limited depending on the demands of external financing sources, such as banks or private equity firms. Whose Knowledge? Finally, the agreement should specify to whose knowledge the reps & warranties are subject. Are the reps & warranties based solely on the seller’s knowledge, or is the knowledge of officers or other employees also included in the definition? If third parties are to be included in the definition, then the seller must be willing to bear the risk of depending on the knowledge of those third parties. In some circumstances, officers or key employees are asked to sign a certificate in which they individually certify knowledge of reps & warranties that are applicable to their roles. For example, a CFO may be required to sign a certificate relating to any financial representations. SurvivalReps & warranties are almost always limited in time. Without a survival provision, it is not clear if they survive at all, or they may be subject to the statute of limitations relative to the specific breach (e.g., environmental, tax, etc.). Once the time period elapses, the seller may no longer be held liable to the buyer for a breach, except in certain circumstances, such as a purposeful or willful breach or fraud. Most buyers prefer to operate the business for at least a full year, or business cycle, to identify any potential breaches. As a result, the average life of representations ranges from 18 to 24 months. Example: “The reps & warranties of the Seller shall survive for a period of 18 months beyond the Closing.” Survival periods may also differ, depending on the type and nature of the representation. For example:
Why don’t reps & warranties for publicly held firms survive the closing? There are two primary reasons:
Baskets (Minimum)Reps & warranties are almost always subject to a basket, or a minimum threshold that must be met before the seller becomes liable. This operates similarly to an insurance deductible. The indemnification section of the purchase agreement defines what happens in the event of a dispute. Within the indemnification section is a clause addressing the basket (sometimes called “Limitations on Amount”). The seller is not liable for claims until the basket, or deductible, is exceeded. The basket sets the minimum loss the buyer must bear before the seller can be held liable. Example: Most M&A transactions include a basket of 0.75% of the purchase price. In a $10 million transaction, a 0.75% basket would be $75,000. The seller would not be liable to the buyer until the cumulative amount of the claims exceed $75,000. The basket has several purposes:
Sample language: “Seller shall not indemnify Buyer until the aggregate amount of all indemnity claims against Buyer exceeds the Basket, which is $50,000.” “Seller shall have no liability until the total of all damages exceeds $100,000, and then only for the amount by which such damages exceed $100,000. However, this Section will not apply to claims under Section x and xx (e.g., tax, environmental, etc.), or to any breach of which Seller had knowledge prior to the date the representations were made, or for any intentional breach of any covenant or obligation. Seller and shareholders will be jointly and severally liable for all damages with respect to such breaches.” “Neither Seller nor Buyer shall be liable to the other for any indemnification until the aggregate amount of Damages due to an Indemnified Party exceeds One Hundred Thousand Dollars ($100,000) (the “Basket”). Once the Basket has been exceeded, the Indemnified Party shall be entitled to indemnification for all Damages, including the amount up to the Basket and any amount in excess. This provision shall not apply to any Damages suffered, sustained, incurred, or paid by an Indemnified Party related to taxes or assessments by any governmental authority, or to any claim of actual fraud or intentional misrepresentation relating to a breach of any representation or warranty in this Agreement.” Tipping vs. Non-Tipping Basket
Sharing the Deductible Some agreements require the parties to split losses up to the deductible amount. For example, if there were a $100,000 deductible and a $101,000 loss, the buyer would be required to pay $50,000 and the seller $51,000. This provision requires the buyer to absorb a significant portion of any losses and therefore motivates the buyer to be thorough in their due diligence to mitigate potential losses. This also motivates the seller to help mitigate smaller losses on behalf of the buyer. This mitigates, to some extent, the motivation of a buyer to “tip” a tipping basket, so they are reimbursed for the “deductible.” Size The average basket size is 0.75% of the total purchase price. Buyers will obviously argue for the lowest basket possible, while sellers will seek a higher basket amount. Certain reps & warranties are often not subject to the basket, such as those relating to employees, environmental, organizational, title to assets, or tax issues, as specified in the language below. “This Section will not apply to claims under Section x and xx (e.g., tax, environmental, etc.) …” The basket may also be voided if the seller commits a willful breach, or it may be limited based on the seller’s knowledge (as it’s defined in the agreement); however, most sellers contest this language since determining “willful” is subjective and subject to costly disputes. Example: “This Section will not apply to any breach of which Seller had knowledge prior to the date the representations were made, or for any intentional breach of any covenant or obligation.” Caps (Maximum)A cap is the maximum amount of liability a seller can incur to the buyer. Caps average 10% to 20% of the purchase price of the business for most transactions. Once the cap is exceeded, the seller is no longer liable to the buyer for damages, with minor exceptions (fraud, etc.). Caps can be higher, or even unlimited, for the following reps & warranties:
Example: “The aggregate amount of damages that may be recovered by the Buyer arising out of or in connection with the breach of any of these representations and warranties shall not exceed $35,000.” General GuidelinesFollowing is a chart of general guidelines for baskets, caps, and survival periods. General Indemnity Provision Guidelines for Baskets, Caps, and Survival Periods Basket Cap (% of Purchase Price) Survival Period Title to Assets None 100% Unlimited Taxes None 100% Unlimited Organization None 100% Unlimited Employee, ERISA 0.75% to 1.0% 20% 24 to 36 Months IP 0.75% to 1.0% 20% 24 to 36 Months Environmental 0.75% to 1.0% 10% to 100% 24 to 36 Months All Other 0.75% to 1.0% 10% to 20% 18 to 24 Months Indemnification & RemediesWhen a problem arises after the closing, the parties look to the “Indemnification” and “General” sections of the purchase agreement to determine how the dispute will be handled. The ‘Indemnification’ section usually addresses the following:
The ‘General Provisions’ section of the purchase agreement usually addresses the following:
Notice that there is some overlap between the indemnification provisions and the general provisions in the purchase agreement. In some purchase agreements, these sections may be combined. Other times, they remain separate. This underscores the need for the buyer and the seller to hire experienced attorneys to represent them, and the need to rely on their guidance in negotiating the terms of the reps & warranties and related indemnification and other clauses that govern how disputes will be handled. IndemnificationThe indemnification clause requires the parties to indemnify one another for breaches of representations, warranties and covenants, and other types of claims that may arise after the closing, such as those related to tax, environmental, or employee issues. The indemnification clause (sometimes called “hold harmless”) functions similarly to an insurance policy and requires the breaching party to reimburse the other party for all expenses resulting from a breach. The value of the indemnification depends on the financial strength and creditworthiness of the party providing the indemnification. In most M&A transactions, 10% to 20% of the purchase price is withheld by a third party in an escrow account to fulfill any post-closing indemnification obligations, which mitigates any impact of a less-than-creditworthy seller. Indemnification rights are much more specific than the general legal rights included in most contracts. The indemnification provisions include specific rules governing the level of involvement the parties may have in defending suits or other claims, and other options that are rarely afforded to the parties under other general legal rights in most purchase agreements. The indemnification can be limited by:
Examples of potential disputes include:
The Language Should be Custom-Tailored The indemnification language should be custom-tailored to the unique characteristics and circumstances of the business and the specific risks identified during due diligence. The relationship between time and dollar limits should also be taken into consideration. Businesses in certain industries may be better served by higher dollar limits and shorter time limits, and vice versa. Who is Providing Indemnification? It’s important to consider who specifically is providing the indemnification. If there are multiple shareholders of the selling company, are all shareholders indemnifying the buyer, or only the majority shareholders? Or is the selling entity indemnifying the buyer? In most cases, the majority selling shareholders are required to personally indemnify the buyer. To be obligated under the indemnification clause, a selling shareholder must sign the purchase agreement directly or through a “joinder.” This is often the case because the selling entity normally ceases to exist after the closing date. If it does exist, the proceeds from the sale are normally distributed to the shareholders and the selling entity is left with little assets with which to fund a potential indemnification claim. It’s difficult for the buyer to have to chase down multiple shareholders, which is why escrows are so prevalent. If there are multiple selling shareholders, the sellers should also attempt to limit their liability to “several” (separate) liability, as opposed to “joint and several” liability. Indemnification Procedures and Specifics The indemnification clause should also address the following:
Buyer’s Indemnification The buyer also normally agrees to indemnify the seller. Common areas include the buyer’s covenant (promise) to offer employment and certain benefits to the seller’s key people. The buyer may also indemnify the seller regarding environmental liabilities or accounts payable. Following is sample language: The Buyer covenants and agrees to indemnify, defend, protect, and hold harmless the Shareholders, the Seller, and any of the Seller’s officers, directors, stockholders, representatives, affiliates, assigns, successors in interest, and current and former employees, each only in their respective capacities as such, from, against, and in respect of: (a) any and all Damages sustained, incurred, or paid by Seller or any other Seller Indemnified Party in connection with, resulting from, or arising out of, either directly or indirectly:
(b) any and all Damages incident to any of the foregoing or to the enforcement of this Section. Sample Indemnification Language Each of the Sellers and the Shareholders, jointly and severally, covenants and agrees to indemnify, defend, protect, and hold harmless the Buyer and any of the Buyer’s officers, directors, stockholders, representatives, affiliates, assigns, successors in interest, and current and former employees, each only in their respective capacities as such (collectively, the “Buyer Indemnified Parties”), from, against, and in respect of:
Notice Procedure; Claims: If the Indemnifying Party, within a reasonable time after receipt of such Claim Notice, fails to assume the defense of any Third-Party Claim, the Indemnified Party shall (upon further notice to the Indemnifying Party) have the right to undertake the defense, compromise, or settlement of the Third-Party Claim, at the expense and for the account and risk of the Indemnifying Party. Here is a simple abbreviated indemnification language: “Seller will indemnify, defend, and save Buyer harmless from and against any financial loss, legal liability, damage, or expense arising from any breach of the above representations and warranties.” Process OverviewThis section describes how reps & warranties fit into the overall process of selling or buying a business. Shifting Positions Of PowerWhen buying or selling a business, it’s important to understand the shifting positions of power between the buyer and seller as the transaction progresses. Naturally, both buyer and seller will push for concessions when they are in the greatest positions of power and try to limit concessions when they are in a weaker negotiating position. The seller has the greatest leverage early in the process. However, this leverage instantly shifts to the buyer the moment a letter of intent (LOI) is signed. Before an LOI is signed, the seller is free to negotiate with multiple parties, but once the LOI is signed, the seller is limited to exclusively negotiating with one buyer (assuming the LOI contains a “no-shop” clause, which most do). This obligation for the seller to exclusively negotiate with the buyer dramatically reduces the seller’s leverage from the LOI all the way to the closing. NDAA buyer has limited information on a company prior to signing a confidentiality, or non-disclosure agreement (NDA). Once a buyer signs an NDA, they are typically granted access to the seller’s Confidential Information Memorandum (CIM). Most NDAs include a clause that limits the seller’s representations to those explicitly outlined in the purchase agreement. Others may include a clause that generically addresses the reliability of the information the seller provides to the buyer and limits specific representations to those contained in a purchase agreement, such as this one: “You understand that the Seller has included in the Confidential Information materials which the Company believes to be reliable for the purpose of your evaluation, but you acknowledge that neither the Company nor any of its respective agents, representatives, or employees make any representation or warranty, either express or implied, as to the accuracy or completeness of the information. The only representations or warranties for which the Company is responsible are those set forth in any definitive acquisition that the Company may execute.” Term SheetOccasionally, the buyer may submit a term sheet to the seller prior to submitting an LOI. The purpose of the term sheet is to focus the parties on the material terms of the transaction as opposed to focusing on the precise legal language contained in a typical letter of intent. This saves the parties time by ensuring they agree on the material terms before they invest a substantial amount of time negotiating the exact language of the LOI. The term sheet may include a broad reference to the representations and warranties that will be included in the purchase agreement, such as in the following example. “The purchase transaction contemplated under these proposed terms is subject to the following conditions: Negotiation and execution of a definitive agreement setting forth representations and warranties of the two entities, covenants, and any other provisions customary in transactions of this nature.” Letter of IntentOnce a buyer is prepared to make an offer, the buyer will submit an LOI. Most sellers are in a rush to sign the LOI and move on with the transaction, as they impatiently eye the end-zone. “Just a few more yards to go,” they think. Not so fast. When accepting an LOI, you are still on your 30-yard line, meaning there are 70 more yards to go. Once the LOI is signed, the arduous process of due diligence begins. Unfortunately, most sellers are woefully unprepared for just how grueling the remaining 70 yards can be. The process from signing the LOI to closing can take several months or more, and less than half of companies make it all the way to the endzone. This is the most critical stage of the process for the seller. The seller’s leverage instantly evaporates the moment the LOI is signed. Unfortunately, many sellers are excited and impatient at this stage and prefer to blindly sign the LOI while overlooking other crucial terms once they agree on a price. Caution is advised. The LOI contains critical provisions that will govern the dynamics of the relationship between the parties all the way until closing. In most cases, the majority of the terms in the LOI are non-binding, with the exception of a few clauses, such as confidentiality and exclusivity. Most LOIs also state that the parties will begin preparing the purchase agreement within a certain timeframe, and also stipulate that the purchase agreement will contain representations, warranties, covenants, and indemnification obligation language customary for a transaction of the size and type being contemplated. The LOI never includes the full scope of the reps & warranties, but the parties may choose to document any potentially contentious R&Ws in the LOI in an attempt to avoid these becoming deal breakers later on. It’s helpful if your attorney has access to the M&A Deal Points Studies, published by the American Bar Association, to give you an idea of what is considered customary for a transaction of your size and type. It’s best to negotiate contentious issues during the LOI stage, as opposed to delaying their negotiation until later in the transaction. If an M&A advisor suspects that certain issues may become contentious later in the transaction, they will work to negotiate comprehensive language addressing these potential issues upfront before the LOI is signed. It’s better to negotiate these issues early on and potentially risk losing the buyer than to spend tens of thousands of dollars and several months negotiating with a buyer only to be hit with a last-minute deal-killer. If these issues are held until later, the buyer will have significant negotiating leverage over the seller, and it’s likely the seller will simply cave in to the buyer’s demands, even if they are unreasonable. Here is sample language that may be included in the LOI that addresses reps & warranties, which may be contained in a definitive agreement: “The Purchaser will prepare and deliver to the Seller within 10 days of the conclusion of Purchaser’s Due Diligence Review a definitive Purchase Agreement (the “Purchase Agreement”). The Purchase Agreement will contain terms and conditions customary in transactions of this type (including standard representations, warranties, covenants, and indemnifications), or which are reasonably necessary as a result of the Due Diligence Review. Representations regarding the Company will, for most items, survive closing for three years, and for other items, including without limitation environmental, taxes, ERISA, and title, the survival shall be for longer periods (and in some cases indefinite).” Following is sample language that may be included in the LOI that addresses reps & warranties made in the LOI: “Seller’s acknowledgment of and agreement with the terms and conditions set forth in this Letter also constitute a representation and warranty that Seller has not entered into any executory agreements or accepted any commitments concerning any of the foregoing transactions. Seller hereby agrees to indemnify and hold harmless Purchaser from and against any and all losses, claims, damages, liabilities (or actions or proceedings commenced or threatened in respect thereof), and expenses that arise out of, result from, or in any way relate to the breach of the foregoing representation and warranty. The obligations of Company and Seller under this paragraph will survive any termination of this Letter and will be effective regardless of whether a definitive agreement is executed.” Components of a Term Sheet: The purchase transaction contemplated under these proposed terms is subject to the following conditions: Negotiation and execution of a definitive agreement setting forth representations and warranties of the two entities, covenants, and any other provisions customary in transactions of this nature. Due DiligenceThe outcome of due diligence will determine the scope of the reps & warranties that the buyer proposes. The extent of the buyer’s due diligence also depends on the scope of the representations the seller is willing to provide to the buyer. The buyer’s due diligence may be less thorough if the seller is willing to provide more extensive reps & warranties. However, reps & warranties should not be viewed as a substitute for thorough due diligence. Likewise, thorough due diligence should not be viewed as a substitute for thorough reps & warranties. The two should work hand in hand. The parties should also bear in mind that due diligence will never uncover every problem in a business. There is always the possibility that something may slip through the cracks during the due diligence process. Buyers rely on reps & warranties to offer them protection for issues they may not uncover during due diligence. Due diligence should also be mutual. Not only should due diligence be performed on the seller, but the seller should also perform due diligence on the buyer, especially if the seller is carrying a note or accepting the buyer’s stock as a form of consideration. The scope of due diligence and the reps & warranties is driven by the type and size of the business. An industrial business will require an entirely different due diligence and R&Ws framework than a technology business. Regardless, due diligence and the reps & warranties should work in concert with one another. Drafting the Purchase AgreementThe buyer’s attorney normally begins drafting the purchase agreement once the due diligence process begins. The reps & warranties contained in the purchase agreement are normally worded in the affirmative and exceptions to the R&Ws are then detailed in the disclosure schedules. Because it’s customary for the buyer to prepare the purchase agreement, the buyer’s first draft sets the tone of the negotiations. If the first draft is heavily weighted in the buyer’s favor, you can expect negotiations to be contentious and lengthy. On the other hand, a “fair” first draft is more likely to speed up the process and facilitate smoother negotiations. The buyer’s first draft of the purchase agreement (and therefore the reps & warranties) also functions as a disclosure tool. If the buyer is unsure regarding any aspects of the business, a representation covering that area will force the seller to disclose any exceptions to the representation. The purchase agreement can also be thought of as a tool for allocating risk between buyer and seller. Some sellers may also attempt to control the pace of the negotiations by withholding the disclosure schedules until the last minute. This strategy can work either way — either in the seller’s favor or against — and should be carefully considered before implementing it. The Purchase Agreement and Its ComponentsThe final document signed at closing is called the Purchase Agreement, but may also be called:
The structure of the purchase agreement will vary primarily depending on whether the form of the transaction is an asset or a stock sale. Most purchase agreements for lower middle-market transactions range in length from 20 to 50 pages, excluding the schedules and exhibits. The purchase agreement contains the following primary clauses or sections:
The purchase agreement may also contain the following exhibits:
Parties to the Purchase Agreement Whoever signs the agreement is a party to the agreement. If the seller signs the agreement in the capacity of an officer of the corporation, then in most cases, the seller cannot be held personally liable for breaches of the agreement. The selling entity ceases to exist in most cases after the closing. That’s why most buyers either require that the majority shareholders of the selling entity sign the purchase agreement as individuals (not as officers of the corporation) or that a portion of the purchase price be set aside in an escrow account to fund indemnification obligations. Alternatively, the shareholders can sign a joinder agreement, which binds them to the purchase agreement. Covenants Covenants are promises to do — or not to do — something and are seldom a contentious issue in purchase agreements. Covenants in a purchase agreement define the obligations of the parties between signing and closing, and sometimes also after the closing. Some purchase agreements intermingle the covenants with the reps & warranties. However, we recommend separating them to keep the agreement clear. Sample language: “Until closing, Seller will operate the business in the normal manner and will use its best efforts to maintain the goodwill of suppliers, customers, the landlord, and others having business relationships with Seller.” As noted above, covenants can either be affirmative — a promise to do something, or negative — a promise not to do something. The most significant covenant requires the seller to operate the business as usual prior to closing. This requires the seller to not make any material changes to the business prior to closing without the buyer’s approval. Such changes could include purchasing new equipment, hiring new staff, or changing compensation arrangements with employees. Pre-closing covenants are necessary only if the purchase agreement is signed prior to the closing. In this situation, the pre-closing covenants define how the business will be operated during the period of time between signing the purchase agreement and the closing. If signing and closing occur simultaneously, then pre-closing covenants are usually unnecessary; however, the parties may include post-closing covenants, especially if the seller is carrying a note. Pre-closing covenants often require the parties to use their best efforts to obtain required consents or to cause the transaction to close, require the seller to provide information to the buyer during due diligence, or may preclude the seller from negotiating with other parties (an example of a negative covenant). Post-closing covenants often require the buyer to offer employment to a certain number of the seller’s employees and provide certain benefits to those employees, or may require the seller to assist in collecting any outstanding accounts receivable. The only covenants that survive the closing are post-closing covenants. Conditions Conditions are requirements that must be met before the parties are obligated to close on the transaction, and are included in a purchase agreement if it is signed before the closing. Conditions are also commonly called “contingencies.” Once the conditions are met, the closing can occur. The “conditions” section is also sometimes called “termination.” The conditions section typically lists a series of conditions that must be satisfied before the closing can occur. Conditions do not survive the closing. Reps & warranties, on the other hand, do survive the closing. This is an important distinction for the parties as the reps & warranties section of the purchase agreement continues to be an important element of the purchase agreement for a couple of years after the closing (or whatever the survival period is, typically 18 to 24 months), whereas most other sections of the purchase agreement have no further implications once the closing has occurred. A breach of a condition relieves the parties from the obligation to close and is unlikely to provide the parties with the option to initiate a lawsuit, whereas a breach of a representation or warranty provides the parties multiple remedies, as outlined in the indemnification section of the agreement. The sole remedy for a breach of a condition in most cases is simply the right to walk away from the transaction, also called a “termination right.” While termination fees are common in M&A transactions involving publicly traded firms, they are rare in the middle market. The rules and processes are significantly different for private and public firms. One important condition to closing is for the reps & warranties to be materially accurate. Thus, each representation functions as a condition to closing. This throws a curveball into the mix in terms of timing. The purchase agreement often contains a condition that the R&Ws must be accurate prior to closing. However, an important question is if the R&Ws are accurate if the seller discloses an exception in the disclosure schedules. But I digress. While such unknowns are common in M&A transactions, the parties must continue marching toward the finish line despite the existence of such grey areas. Successfully completing a middle-market M&A transaction requires a good deal of faith on both sides and not every potentiality can be neatly buttoned up in the agreements. In fact, the attempt to document every eventuality will only slow the transaction and lower the likelihood of a closing. Time kills deals. Either you waste time bickering over minutiae, or you speedily march toward the closing, balancing the need for clear documentation and good faith. An experienced advisor can provide guidance on when to proceed based on faith, and when faith is best put into writing. The second question is what happens if the buyer is aware of a breach prior to closing but chooses to close despite the breach. For example, if the seller represents that the inventory is all salable, but the buyer discovers that a portion of the inventory is not salable, yet decides to close anyway, can the buyer close and then later sue the seller for breach of representation? While the purchase agreement would govern such a scenario, in most situations, the buyer would be contractually precluded from proceeding with the closing and then later suing the seller for a breach of the reps & warranties discovered prior to closing. Most sellers prefer that buyers have a right to terminate the transaction only if material inaccuracies exist in the R&Ws. Buyers prefer broader rights — even for immaterial inaccuracies in the R&Ws, for example. The closing is also conditioned on the covenants. If the seller does not operate the business in the ordinary course, the buyer may have a walk-away right. Important announcement — the party is starting — it’s getting really exciting. Now turn your head upside down and see if you can read the preceding three paragraphs upside down. I’ll wait. Here’s the bottom line: let your attorney do what they do best while you focus on running your business. Keep your hands on the steering wheel while your attorney tinkers with the technicalities. Here are sample conditions to the parties’ obligation to close:
Following is language that requires that the reps & warranties be true as of the closing: “The representations and warranties of the Seller and the Shareholders contained herein or in any Schedule attached hereto shall be true and correct in all material respects at and as of the Closing Date as if made at and as of such time.” When is due diligence over? What if something happens to the business between the signing and the closing? The simple (i.e., affordable), answer is “refer to the purchase agreement.” The complicated (i.e., expensive) answer, and the one most favored by attorneys, is “it depends.” If the purchase agreement has been signed (most aren’t signed before the closing), then the purchase agreement will govern the buyer’s obligation to close, particularly the “conditions precedent to closing.” Most purchase agreements include a “Material Adverse Change/Effect” (MAC/MAE) clause, which outlines conditions under which the buyer may terminate the agreement. The purpose of a MAC clause is to shift risk to the seller for significant downturns, or other calamitous events, that may impact the business between signing and closing. In a nutshell, the buyer will not be obligated to close if any covenants have been breached, the conditions for closing have not been met, or the reps & warranties are untrue as of the closing. The seller should inform the buyer as soon as possible if an event has occurred that makes a representation untrue. Examples include the loss of a major customer or the filing of a lawsuit. Some purchase agreements obligate the buyer to immediately notify the seller if they discover a breach and require the buyer to either terminate the agreement or waive the breach and proceed with the closing. Without such an obligation, the buyer could withhold this information and unload it on the seller at the last minute as a negotiating tactic. The following is such an example: “The Seller shall promptly notify the Buyer in writing of any change in facts and circumstances that could render any of the representations and warranties made herein by the Seller materially inaccurate or misleading.” Sample Termination Language for Seller: This Agreement may be terminated at any time prior to the Closing: by the Seller, if the Buyer (i) fails to perform in any material respect any of its agreements contained herein required to be performed by it on or prior to the Closing Date, (ii) materially breaches any of its representations, warranties, or covenants contained herein, which failure or breach is not cured within 30 days after the Seller has notified the Buyer of its intent to terminate this agreement. Bring-DownA “bring-down” condition requires the parties to reaffirm the reps & warranties at the closing. Normally, both the buyer and seller are required to deliver a bring-down certificate to one another at closing. A bring-down is necessary only if there is a delay between signing the purchase agreement and closing. In other words, the reps & warranties must not only be true as of the date the purchase agreement is signed, but they must remain true (in all material aspects) from the time the purchase agreement was signed through the closing. If there has been a material change in the reps & warranties, the buyer may terminate the transaction if the purchase agreement contains a condition that the reps & warranties are true as of the closing date. The purpose of the bring-down condition is to shift the risk of operating the business prior to closing to the seller. The buyer seeks assurance that the company they are agreeing to purchase will be materially the “same” company at closing. To address materiality, a bring-down condition may include its own materiality limitations that are separate from indemnification limitations. The materiality limitation may be expressed as an actual number, or, more likely, qualitatively, such as: “… except for such inaccuracies that do not and would not reasonably be expected to have, individually or in the aggregate, a material adverse effect.” Materiality can be evaluated either on an individual or a collective basis. In most cases, the reps & warranties must be materially true on an aggregate basis before the closing can occur. For example, several immaterial inaccuracies may constitute materiality on an aggregate basis. “Each of the representations and warranties of the Sellers contained in this Agreement shall be true and correct in all respects (without giving effect to any limitation as to “materiality” or any derivative thereof qualification set forth therein) as of the date hereof and as of the Closing Date as though made on the Closing Date, except for any failures to be so true and correct that, individually or in the aggregate, have not had or would not have a material adverse effect.” Is your head spinning yet? If so, that’s good. This should serve as a wake-up call to rely on the guidance, experience, expertise, judgment, and objectivity of your attorney in such negotiations. While you should understand the high-level mechanics of the transaction, this is a perfect example of issues you should leave to your attorneys to sort out. If your head is spinning now — while you are presumably in a calm, cool state of mind — imagine trying to make sense of this in the whirlwind of one of the largest, most emotionally draining transactions of your life. And THAT is why you should hire the best advisors you can afford. The degree to which the level of inaccuracies of reps & warranties must rise is subjective, regardless of the amount of effort your attorney invests into nailing down the precise language. As in business, there is a degree of uncertainty when selling or buying any company and the only antidote is faith. Even if you lack absolute trust in the other party, you should proceed with a degree of trust and willingness to move forward and be willing to accept a certain amount of risk. Here is a sample clause that addresses materiality: “Each of the Fundamental Representations and Warranties of the Target contained in this Agreement shall be true and correct in all respects, except, in the case of the representations and warranties in Section X, where failure to be true and correct would not result in an increase in the aggregate amount of consideration required to be paid by Buyer under Article X of this Agreement by more than $100,000.” ClosingOnce the closing conditions have been satisfied, the closing can occur. In most cases, the closing is uneventful … an anticlimactic formality … an ordinary occasion … an unforgettable event … a routine affair … a humdrum transaction. The more uneventful, anticlimactic, ordinary, unforgettable, routine, humdrum, the better. For that’s precisely how the closing should be. All problems should have been worked out well in advance of the closing and the closing process should be as uneventful as possible. Post-ClosingOnce the closing has occurred, the parties have a vested interest in working with one another to successfully complete the transition period. The parties are also contractually obligated to fulfill their post-closing covenants to the extent that such obligations exist. They should also be motivated to ensure the reps & warranties remain true after the closing. For example, the seller may have represented that the receivables are collectible. If that’s the case, the seller should assist the buyer in collecting the receivables after the closing and is therefore incentivized to ensure the transition progresses as smoothly as possible. For the seller, the “real closing” has not occurred until the following has transpired:
While the seller may have reason to rejoice at the closing, they should not get too caught up in the celebrations. The seller should not be ready to fully “let go” until the events above have occurred. There generally won’t be a defining moment, but one day you will wake up and realize you have finally completed all of your obligations. Congratulations! When that happens, the largest transaction of your life will be successfully behind you. Sample Representations, Warranties & CovenantsSeller Reps & WarrantiesHere is a general summary (not a complete list) of typical reps & warranties provided by a Seller:
Buyer RepsHere is a general summary (not a complete list) of typical reps & warranties provided by a Buyer:
ConclusionIt was American baseball legend Yogi Berra who coined the phrase, “It ain’t over till it’s over.” To which we would add, “But even then, it may not be over.” That’s certainly the case with reps & warranties, as illustrated by the interrupted vacation example in the introduction above. If you’ve made it this deep into the article, you know that reps & warranties are one of the few elements of a purchase agreement that “survive” the closing and which can come back to bite you in the butt if you’re not careful. The antidote? Be careful. Pay attention. As a seller, you need to meticulously read the representations and, as noted above, not blindly sign them as if they were boilerplate. They’re not. In fact, a breach of a rep or warranty – unwitting or not – can kill a deal at worst or lighten your bank account in less extreme circumstances. Obviously, neither outcome is desirable. It’s my hope that the information in this article will help you avoid the snafus that can arise from a lack of preparation when it comes to dealing with reps & warranties — one of the most important and often overlooked aspects of a deal. Toward that end, I’ll leave you with a high-level synopsis of our discussion — a cheat sheet, if you will. For a broader explanation of any of the major points below, please refer to the article above. R&Ws Recap: Just the Facts, Ma’am*Inspired by Sgt. Joe Friday from the TV show “Dragnet”What follows is the “CliffsNotes” version of the preceding section on reps & warranties. These are the key points, presented in “bullet” format. For a fuller explanation of each category, please refer to the respective sections above. Purposes of Reps & WarrantiesWhy reps & warranties? Think of them as the glue that holds a deal together — or not. Here are the three major purposes of reps & warranties.
Typical Purchase Agreement OutlineHere are the key elements of a purchase agreement.
Negotiating ProcessHere is a summary of how the reps & warranties fit into the negotiation process.
The Parties’ ObjectivesHere is a summary of the buyer’s and seller’s objectives as they relate to the reps & warranties. Not unsurprisingly, the buyer and seller usually have opposite motives. Seller Buyer Purchase Price Maximize Minimize Cash Down Maximize Minimize Taxes Pay Minimum Taxes Maximize Tax-Deductibility Earnouts Minimize Maximize Escrows Minimize Maximize R&Ws Minimize Scope Maximize Scope Indemnification Minimize caps & survival periods Maximize caps & survival periods Scope of NegotiationsHere is a list of the factors that can affect the scope of the negotiations over reps & warranties.
Tips for Negotiating Reps & WarrantiesHow best to work out an agreement on R&Ws? Let us count the ways …
Tips for Limiting the Seller’s ExposureHere are tips and strategies for limiting the seller’s exposure in relation to the reps & warranties. |