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M&A Reps & Warranties

Executive Summary

Representations and warranties, often referred to as “reps & warranties” or simply R&W, constitute legally binding commitments made by both the buyer and the seller. They form the bedrock of any purchase agreement, whether it’s a stock purchase agreement or an asset purchase agreement.

Below, you’ll find a concise overview of a typical purchase agreement and its integral components:

  • Key Terms: This section encompasses crucial elements such as the purchase price, terms, and the agreement’s structure (asset or stock).
  • Conditions: These are the prerequisites that must be fulfilled before the closing can occur. Examples include obtaining employment or non-compete agreements from key staff, securing financing, and gaining landlord approval. One common condition is the verification that the reps & warranties remain accurate as of the closing date, aptly known as a “bring-down.”
  • Covenants: Here, the responsibilities of each party between signing the purchase agreement and the closing date are outlined. For instance, the seller may commit to maintaining regular business operations, while the buyer may pledge certain post-closing actions, such as retaining a specific percentage of employees or fulfilling outstanding purchase orders.
  • Reps & Warranties: This section entails promises and disclosures made by each party. These promises act as a form of “warranty” or “insurance” in case a representation turns out to be false later on. Examples include the seller affirming the payment of all outstanding taxes and the absence of ongoing litigation.
  • Disclosure Schedules: Detailed descriptions of exceptions to the reps & warranties are provided here. These schedules and exhibits explicitly address any deviations from the R&Ws. Typically, reps & warranties are stated affirmatively, with exceptions being separately listed in the “Disclosure Schedules.”
  • Indemnification: This pertains to the obligation to cover costs incurred by the other party due to breaches of the contract, such as inaccurate representations or warranties or other violations of the purchase agreement.
  • Miscellaneous: This section covers various aspects, including expenses, notices, jurisdiction, governing law, severability, assignment, and waivers.

Representations and Warranties

Reps & warranties, an integral part of the purchase agreement, extend beyond the closing and form the foundation for potential future legal actions through the “Indemnification” clause. In fact, reps & warranties typically constitute the lion’s share of the purchase agreement’s content and are among the most fiercely negotiated aspects, right up there with price and terms. This is because reps & warranties are the linchpin that defines how risk is apportioned between the buyer and seller.

In technical terms, a representation is essentially a statement of fact (e.g., confirming that the corporation is duly authorized), while a warranty is a promise that a fact will remain true (e.g., the seller warrants that the business will continue to operate in compliance with all applicable laws). However, in practice, the distinction between the two has proven to be relatively unimportant. Instead of being listed separately, reps & warranties are consolidated into one section titled “Representations & Warranties” within the purchase agreement.

Unlike other elements of the purchase agreement, such as price, terms, conditions, and covenants, which often lose significance after the closing, reps & warranties, along with the associated indemnification clauses, “survive” the closing and can have repercussions for both parties for years to come. Consequently, reps & warranties tend to undergo rigorous negotiations, particularly when a seller is eager to retire and seeks to avoid lingering obligations that might impede their peace of mind.

While most reps & warranties follow a similar pattern across deals, exclusions and specifics are typically documented in the disclosure schedules for the business. These variations hinge on factors such as the business’s size, complexity, type, the structure of the transaction (asset vs. stock deal), and any particular risks unique to the business. In practice, the buyer’s attorney usually drafts the purchase agreement, incorporating a standard set of reps & warranties, while the seller’s attorney is tasked with outlining any exceptions in the disclosure schedules.

For instance, a manufacturing company might feature more representations related to environmental and employee matters (such as union and benefits), whereas a technology company may emphasize reps & warranties concerning intellectual property.

How Reps & Warranties Can Speed Up Due Diligence

While due diligence plays a crucial role in uncovering and addressing issues within the business, it’s important to recognize that it may not unveil every potential problem.

In essence, representations and warranties (R&Ws) are crafted to safeguard the buyer against anything that might have escaped their scrutiny during due diligence or that the seller may have intentionally kept hidden. Therefore, the buyer’s decision to acquire the business hinges not only on the findings of their due diligence but also on the level of protection afforded to them through the representations and warranties contained in the purchase agreement.

Protections Afforded to the Buyer in the Purchase Agreement

In the realm of most transactions, a set of robust safeguards is routinely employed to shield the buyer from significant misrepresentations or fraudulent activities:

  • Reps & Warranties
  • Indemnification
  • Escrows or Holdbacks

The Many Purposes of Reps & Warranties

Representations are meticulously designed to compel the seller to offer full and transparent disclosure to the buyer. In essence, they act as a mechanism for the seller to divulge any significant issues pertaining to the business.

Furthermore, these representations function as a means to distribute risk between the parties, particularly concerning events that come to light after the deal is finalized.

Consider this scenario: Suppose a customer files a lawsuit against the business for an incident that occurred before the closing date. In such cases, reps & warranties come into play, defining the responsibility, duration, and extent to which each party would be accountable for such events.

In the world of business, both known and unknown risks are an inherent part of the landscape. Reps & warranties are carefully structured to allocate these risks between the parties involved. The dynamics of this allocation can vary, with the favor tilting towards buyers in a buyer’s market and vice versa.

Moreover, reps & warranties serve as a critical condition for closing. Should it be determined that the representations and warranties are not accurate as of the closing date, the buyer retains the right to decline the closure of the deal.

Negotiating Reps & Warranties

When it comes to negotiating reps & warranties, it’s imperative to view it as an integral part of the broader deal structure. It’s not a standalone component but rather a crucial element that should align seamlessly with the following aspects:

  • Price & Terms
    • Purchase price
    • Consideration (including stock, cash, debt, earnouts, and more)
    • Terms related to any seller note, if applicable
  • Deal Structure
    • Allocation of the price for tax purposes
    • Determination of the deal structure (asset sale vs. stock sale)
  • Protective Mechanisms
    • Implementation of protective mechanisms like escrows or holdbacks
    • Definition of indemnification terms, including caps, baskets, ceilings, and more
  • Miscellaneous
    • Covenants (typically not heavily negotiated)
    • Conditions necessary for closing, such as financing contingencies

Introduction

Picture it: a scene straight out of a paradise postcard. Azure skies, powdery beaches, gentle ocean breezes. And there you are – sun-kissed and rejuvenated, one hand engrossed in a John Grisham legal thriller, the other cradling a refreshing piña colada.

In one sense, it’s been a lifetime in the making. Decades spent nurturing your company, followed by a grueling year-long journey to seal the deal. But you did it, and now, you’re reaping the well-deserved rewards. You’ve heard stories of former lifelong business owners who couldn’t quite unwind after stepping away from the hustle. But that’s not you. There’s a trove of postcards like this in your future. Life is undeniably sweet.

Then, the phone rings, and the sweetness begins to wane. It turns out there’s an issue with your financial statements. The buyer of your business has unearthed discrepancies – your numbers aren’t aligning with GAAP, and EBITDA has been somewhat overstated. You brush it off, after all, the deal closed half a year ago, and it’s the buyer’s predicament now. But lo and behold, the buyer is clamoring for a $2 million price reduction. “The deal is already done!” you retort.

In your exasperation, you dial your attorney. With a hint of exasperation, your attorney asks if you recall signing a representation or warranty that affirmed your financials were prepared in accordance with GAAP. Your response: “What’s a representation or warranty?”

Welcome to the realm of reps & warranties, where even the slightest misrepresentation – intentional or not – about the company you’ve either sold or are in the process of selling could derail the entire deal or become a substantial financial burden. And we’re talking about the account where you’ve stashed the proceeds from the sale. Get ready for a whirlwind of headaches and legal battles.

As you’ll soon discover, reps & warranties typically comprise the lion’s share of content within a purchase agreement and are often the subject of intense negotiation. That’s why this topic warrants over 50 pages of discussion here, and why your attention is paramount.

Beyond financial statement accuracy, reps & warranties can encompass the legality of the business, tax audits, the status of customer contracts, environmental responsibilities, employee benefits, inventory status, and much more.

In the forthcoming article, we’ll delve into all things reps & warranties, unveiling their significance in a business sale from both the buyer’s and seller’s vantage points. After all, we wouldn’t want to spoil your day at the beach.

The Letter of Intent (LOI)

Regrettably, the comprehensive reps & warranties are exclusively detailed within the purchase agreement and not within the letter of intent (LOI). Consequently, sellers may find themselves without insight into the reps & warranties proposed by the buyer in the LOI. Some sellers attempt to address this by requesting the buyer to annotate a draft purchase agreement while evaluating the LOI. However, this practice is typically reserved for larger transactions, usually in the nine-figure range.

Moreover, the scope and intricacy of the R&Ws hinge on the findings unearthed during the due diligence phase. This means that the content and substance of the reps & warranties can undergo alterations based on the discoveries made during this process.

In essence, the reps & warranties aren’t drafted until a later stage in the proceedings. This creates a two-stage negotiation process – first during the negotiation of the LOI and subsequently when hammering out the purchase agreement. It’s precisely this dual negotiation that renders R&Ws a subject of such intense scrutiny; parties have already struck an initial deal, only to find themselves negotiating once more.

Negotiating the Purchase Agreement

In the majority of transactions, the purchase agreement is initiated by the buyer’s attorney, and it’s then the task of the seller’s counsel to respond with their own revisions. During the drafting of the reps & warranties (R&Ws), the buyer’s attorney typically places significant emphasis on assessing the potential risk exposure and its potential financial implications.

The extent of these negotiations is directly influenced by the assertiveness of the buyer’s attorney’s initial draft and the overall bargaining positions of both parties, including their alternatives and leverage. This is precisely why buyers often aim for a prolonged exclusivity period – it strategically diminishes the seller’s negotiating leverage later in the process when the purchase agreement and R&Ws come under scrutiny.

Imagine a scenario where a seller, after investing substantial resources in due diligence (including attorney and accountant fees) and emotional commitment to the transaction, decides to pull the business off the market. This decision, made after putting other potential buyers on hold for months, significantly weakens the seller’s negotiation stance. Consequently, the buyer may manage to secure more stringent terms in the purchase agreement.

Here’s a critical point: sellers should meticulously review the representations rather than blindly endorsing them as boilerplate clauses – because they’re not. If there’s any uncertainty regarding a representation, it’s prudent to include a knowledge qualifier like “to the best of the Seller’s knowledge” or “to Seller’s knowledge.” Additionally, any exceptions or exclusions can be diligently documented in the disclosure schedules. Breaching a representation or warranty can have severe consequences for either party, and should therefore be approached with the utmost care and attention.

Seller’s vs. Buyer’s Representations

The purchase agreement inherently places a greater emphasis on representations pertaining to the seller, primarily because the buyer typically carries a more substantial risk in the transaction. The seller’s primary concern revolves around receiving payment, while the buyer’s representations predominantly revolve around their financial capability and authorization to proceed with the purchase.

Conversely, the buyer is tasked with scrutinizing numerous facets of the business and its operations. Here’s a sample of the representations a seller may be required to provide:

  • The seller is current on all tax payments.
  • No judgments, claims, liens, or legal proceedings are pending against the seller.
  • All information provided to the buyer, including financial data, is accurate.
  • The seller is a corporation in good standing with the necessary authority to engage in the transaction.
  • The assets being sold encompass the entirety of the business assets, are in good condition, and are free from any liens, encumbrances, pledges, or claims.
  • The seller is in compliance with all applicable laws, including licensing, permits, zoning, environmental regulations, and more.
  • The inventory is sufficient, unused, and marketable.
  • The seller is not in default on any contractual obligations.
  • No hazardous substances are utilized in the business.
  • All accounts receivable are legitimate, have arisen in the regular course of business, and are not subject to offsets.
  • There are no undisclosed liabilities, pending legal actions, court orders, or judgments.
  • There are no undisclosed agreements related to employment, consulting, bonuses, or any other arrangements with employees or third parties.
  • The seller has disclosed all material facts that could influence the buyer’s decision to purchase the business.

Expanding the Scope of Reps & Warranties

Typically, the buyer endeavors to secure protection from a multitude of parties involved (including all shareholders, key managers, and more), and they aim for this protection to encompass a wide spectrum (e.g., the accuracy of all information provided by the seller). It’s not just about the individual representations; it’s also about the combined breadth of all R&Ws. When extending the scope to encompass third parties, negotiations can indeed become quite intense, given that a breach in such cases could carry substantial financial repercussions for those involved.

The Use of Reps & Warranties in Public vs. Private Transactions

In transactions involving publicly traded companies, representations and warranties are also present, but they typically cease to have effect after closing (i.e., they don’t survive closing).

This occurs because the selling entity usually dissolves following the closing, making it exceedingly challenging to seek indemnification from a widely dispersed shareholder group (e.g., thousands of individual shareholders from the public who are not direct parties to the purchase agreement).

  • Publicly traded companies are additionally subject to a multitude of Securities and Exchange Commission (SEC) disclosure regulations, and the information they furnish is generally deemed to be more reliable compared to that provided by private entities. Consequently, expansive representations and warranties are not viewed as critically essential as they are in private transactions.
  • For public companies, the seller’s representations are typically minimal, often encompassing statements affirming that the company has fulfilled all requisite filings with the SEC and that these filings adhere to federal securities laws. Occasionally, the buyer may insist on the inclusion of a representation concerning the preparation of financial statements in accordance with Generally Accepted Accounting Principles (GAAP), although this is less customary.

What Happens if Reps & Warranties are Breached? The Basics of Indemnification

This section within the purchase agreement addresses the course of action in case a representation or warranty is breached. In the majority of instances, indemnity provisions grant a party the right to recover losses and associated legal expenses. Indemnification stands as one of the pivotal points of negotiation within the purchase agreement.

Indemnification typically operates within certain constraints, encompassing minimum thresholds that must be met (similar to an insurance deductible, termed a “basket“) and the maximum indemnification limit (referred to as a “cap”). Additionally, indemnification may be subject to qualifiers based on knowledge (e.g., “to the best of the seller’s knowledge” vs. “to seller’s knowledge“), materiality qualifiers, and specified survival periods (usually 18 to 24 months for R&Ws). These collectively serve to confine the extent of the seller’s potential liability and further allocate risk between the involved parties, extending beyond the specifics outlined in individual representations.

It’s customary to withhold approximately 10% to 15% of the purchase price in escrow from the seller’s proceeds to cover any potential indemnification claims.

Think of reps and warranties as akin to an insurance policy. Just like insurance, there are certain exclusions – events that the policy doesn’t cover. Moreover, there’s a deductible (referred to as the “basket”) and a cap on the maximum payout amount. The seller’s primary aim is to prudently mitigate their exposure by:

Tightening the Language:

  • Precision in the wording of each representation separately.
  • Restricting “joint and several” liability.
  • Incorporating knowledge qualifiers (e.g., “to the best of the Seller’s knowledge”).

Reducing Financial Exposure (Money):

  • Elevating the basket (the deductible that must be met before a claim is honored).
  • Lowering the maximum payout (the cap).
  • Trimming down the escrow amount.

Reducing the Length of Exposure (Time):

  • Shortening the survival period.
  • Cutting the duration of the escrow.

Other Measures:

  • Mandating the buyer to self-insure against specific risks.

Negotiating Deal Structure and R&Ws

Deal Structuring

Negotiating reps and warranties cannot exist in a vacuum; they are just one piece of the puzzle in shaping the overall transaction structure. The trade-offs and dynamics can be distilled as follows:

Seller’s Goals:

  • Maximize the purchase price.
  • Receive a substantial cash payment upfront.
  • Minimize tax liabilities.
  • Restrict earnouts and escrows (e.g., contingent payments).
  • Limit the scope and extent of reps and warranties.
  • Weaken indemnification through factors like baskets, caps, and survival periods.

Buyer’s Goals:

  • Minimize the purchase price.
  • Contribute minimal cash at the closing.
  • Maximize the tax benefits of acquired assets (e.g., by enhancing the tax basis).
  • Expand earnouts and escrows.
  • Broaden the scope and reach of reps and warranties.
  • Strengthen indemnification using mechanisms like baskets, caps, and survival periods.

All these components should be considered collectively during negotiations. Concessions should not be made in isolation.

For instance, if the buyer proposes a lower purchase price, the seller may agree but request more cash upfront at closing or reduce the size of the earnout.

Conversely, if the seller insists on providing minimal representations to the buyer, the buyer may concede but tighten other aspects of the deal structure, such as escrows, knowledge qualifiers, or thresholds.

The more assurances the seller offers to the buyer, the lower the risk for the buyer, potentially allowing them to offer a higher purchase price due to the reduced risk. Risk and return go hand in hand: higher risk corresponds to lower return, and vice versa. By mitigating risk for the buyer, the seller has the opportunity to secure a higher purchase price.

The most hotly debated elements of the transaction include:

Price & Terms

  • Purchase price
  • Terms of the seller note
  • Post-closing purchase price adjustments (e.g., working capital adjustment)
  • Escrow: size and length
  • Contingent payments, such as earnouts and escrows
  • Specific terms of employment/consulting agreements

Deal Structure

  • Allocation of purchase price, which affects the tax implications of the transaction

Protective Mechanisms

  • Reps & warranties: survival period, knowledge, materiality qualifiers
  • Indemnification: caps, baskets, survival period

Miscellaneous

  • Conditions to closing, including material adverse change (MAC)

Negotiating

The scope of reps & warranties varies from one transaction to another. For instance, a stock sale may entail a different scope of R&Ws compared to an asset sale. Similarly, a buyer well-versed in an industry and confident in their due diligence capabilities may require a narrower scope than a buyer less familiar with the industry. Consequently, each negotiation is unique.

The scope of negotiations surrounding reps & warranties hinges on various factors:

  • Negotiating Skills: Each party’s ability to negotiate effectively.
  • Bargaining Strength: The respective postures and bargaining power of both parties.
  • Transaction Structure: Whether it’s an asset or stock sale.
  • Financial Capacity: The seller’s financial ability to provide indemnification.
  • Shareholder Structure: If the seller entity will no longer exist post-closing, additional protective measures like escrows may be sought.
  • Buyer’s Knowledge: The buyer’s familiarity with the business and industry.
  • Management Team: If the seller’s management team is involved in the purchase, they may request less stringent R&Ws.
  • Business Nature: The inherent risks associated with the business and its industry.
  • Due Diligence Findings: The extent of issues uncovered during due diligence.
  • Due Diligence Capability: The buyer’s capacity to conduct thorough due diligence.
  • Perception: The buyer’s perception of the seller’s character and the business’s risks.

The seller possesses the means to narrow down the potential scope of reps & warranties through strategic actions:

  • Engage an Expert: Employ a seasoned negotiator, such as an investment banker or M&A advisor, to oversee negotiations.
  • Leverage Market Demand: Opt for an auction-style sale to enhance negotiation leverage. The more prospective buyers engaged, the stronger the seller’s position becomes.
  • Prioritize Due Diligence: Undertake pre-sale due diligence to proactively identify and rectify issues before initiating the sale process.
  • Exhibit Trustworthiness: Maintain unwavering trustworthiness throughout the process by consistently meeting commitments, adhering to schedules, and displaying composure during negotiations. Employ prudent estimations and actions.

In scenarios where the seller operates a straightforward retail or service business, the scope of R&Ws is likely to be relatively narrow. However, if the business carries inherent risks or complexity, expect the buyer to demand more rigorous reps & warranties. For instance, in cases where the seller’s business involves handling hazardous materials, the buyer will seek robust representations covering environmental considerations and potential worker’s compensation claims, particularly for employees exposed to hazardous materials.

Comparing Offers

Regrettably, letters of intent (LOIs) don’t encompass the complete range of reps & warranties, leaving the assessment of their scope until later in the transaction. LOIs frequently contain language indicating that the purchase agreement will feature “representations, warranties, and indemnification customary for a transaction of this size and type.” But what defines customary? Some LOIs delve into specifics on more contentious matters, like the extent of earnouts and escrows. Less often, an LOI might outline information about thresholds (caps, baskets, etc.).

Timing & Due Diligence

During LOI negotiations, the buyer lacks the insights garnered from due diligence and has limited knowledge about the business. Consequently, the exact reps & warranties they’ll request from the seller remain uncertain. Ideally, the purchase agreement should be prepared in tandem with due diligence, allowing the parties to address language specifics at the earliest stage of the transaction.

Sunk Cost Principle

Certain buyers attempt to leverage time to their advantage, employing the “sunk cost” principle. They believe that the more time and resources they can compel the seller to invest in negotiations (i.e., sunk costs), the more likely the seller is to concede on major deal points later in the transaction to recoup their investments. This strategy can be countered by incorporating milestones into the LOI, such as deadlines for completing due diligence and drafting or signing the purchase agreement.

Shifting Leverage Dynamics Throughout the Transaction

Sellers should recognize that they wield the most leverage in the early stages of the transaction, before the LOI is finalized. Once the LOI is inked, the seller’s leverage diminishes, subjecting them to the buyer’s timeline. Most LOIs include an exclusivity clause, mandating that the seller withdraw the business from the market and cease negotiations with other parties, further eroding their negotiating position. Hence, sellers must diligently negotiate all LOI terms. For sellers inexperienced in business sales, engaging a seasoned professional to lead negotiations is crucial.

The more buyers a seller engages with in negotiations, the stronger their position becomes. When dealing with multiple parties, it’s often advisable to transition to a more detailed Letter of Intent (LOI), explicitly outlining the elements of the purchase price. These details encompass aspects like price, terms, escrows, caps, baskets, survival periods, earnouts, and allocation of the purchase price, among others. This strategic move empowers the seller to assess offers thoroughly, rather than blindly accepting an LOI with vague terms that might lead to complications later in the process.

Consider this scenario:

Offer #1

  • Purchase Price: $13 million Payment Terms:
    • $3 million cash at closing
    • $10 million earnout

Offer #2

  • Purchase Price: $10 million Payment Terms:
    • $8 million cash at closing
    • $1,500,000 seller note
    • $500,000 escrow

Trick question! You can’t decide. To evaluate either offer, we need more information:

For Offer #1:

  • What are the earnout terms? Revenue-based? EBITDA-based? Duration?
  • Post-closing control of the business?
  • Allocation details.
  • Extent of R&Ws, indemnification, escrow, etc.

For Offer #2:

  • Seller note terms (duration, interest rate, amortization)?
  • Extent of R&Ws, indemnification, escrow, etc.
  • Allocation specifics.

About the buyer:

  • Buyer’s creditworthiness (crucial for earnouts and seller notes).
  • Buyer’s relevant experience.
  • Exclusivity request?
  • Buyer’s cash availability or LOI contingent on third-party financing?
  • Past successful acquisitions by the buyer.

With answers to these questions, we can make an informed choice.

Timing:

  • Buyer’s due diligence timeframe.
  • Post-due diligence closing timeline.

Escrow:

  • Escrow terms and conditions.
  • Duration of the escrow period.
  • Indemnification limitations (caps, baskets, etc.).

Transaction details:

  • Purchase price allocation.
  • Asset or stock sale structure.
  • Closing conditions.
  • Reps & warranties survival period.
  • Buyer’s request for seller’s continued involvement, with details of the employment agreement.

We frequently encounter sellers with offers that resemble the ones above. Sellers often fixate on the price, but it’s vital to look beyond that. LOI language can appear impressive, yet much of it might be boilerplate with vague terms that favor the buyer in the purchase agreement’s final draft. When you receive an LOI, it’s crucial to clarify all key transaction terms with the buyer. Failing to do so risks unfavorable unwritten terms when the deal is formalized.

Additionally, negotiating reps & warranties should be part of the broader deal structure discussions. Don’t isolate them in negotiations.

Impact of Market Conditions on the Scope of R&Ws

The current landscape of M&A activity significantly shapes the scope of R&Ws, determining whether it’s a seller’s or buyer’s market. Market dynamics not only affect company valuations but also transaction terms, defining what’s considered “reasonable” or “fair.”

For instance, in a seller’s market, R&Ws tend to be narrower in scope compared to a buyer’s market. Back in 2009, sellers had to accept highly restrictive language in both LOIs and purchase agreements. However, as the buyer’s market gained prominence in subsequent years, these restrictions began to ease.

Market conditions hold sway over several critical aspects:

  • Price & Terms
    • EBITDA multiples
    • Terms (including cash down payment and equity rollover)
    • Contingent payments like earnouts
  • LOI Terms
    • Exclusivity periods, notably shorter in a seller’s market
  • Protective Mechanisms
    • Indemnification scope
    • Escrow size (holdback)
    • Indemnification constraints (baskets and caps)

Tips for Negotiating Reps & Warranties

Here are some tips for negotiating representations and warranties:

Understanding the Role of Reps & Warranties

It’s essential for both parties to acknowledge that no business operates flawlessly. In any business, no matter how diligently managed, various issues are bound to arise.

For instance, it’s rare for businesses to be in full compliance with every single law and regulation.

Reps & warranties do not aim to shield the buyer from every conceivable problem that might surface. Instead, their purpose is to safeguard the buyer against undisclosed, substantial risks that deviate from the ordinary course of business operations.

A Focus on Historical Events

Representations should primarily pertain to past events, not future ones. They should not be structured to guarantee the buyer against future risks inherent to routine business operations.

Fostering a Strong Post-Closing Relationship

It’s in the seller’s best interest to maintain a robust working relationship with the buyer after the deal is sealed. The transaction should be mutually beneficial.

In cases where buyer’s remorse arises later on, the buyer possesses various safeguards within the purchase agreement to address concerns. These safeguards encompass escrows, post-closing purchase price adjustments (e.g., working capital adjustment), inventory corrections, accounts receivable management, reps & warranties, earnouts, bonuses, and more.

The most effective approach to averting disputes is through prevention. How does that work? By nurturing not only a professional but also a personal rapport with the buyer. When you share a positive connection with the buyer, it becomes easier to collaboratively address any challenges that may arise.

Be Prepared to Compromise When Necessary

Being prepared to negotiate and occasionally compromise on certain aspects is crucial. Both parties must carefully consider the cost of a dispute in comparison to the potential benefits. Disputes are not only financially draining but also time-consuming, and even if you emerge as the winner, the toll can be substantial.

Recognize that no deal is flawless, and it’s reasonable to anticipate encountering at least one significant dispute in nearly every transaction. For matters of lesser importance, it’s often wisest to find a middle ground.

Transparently Communicate Your Concessions

Never silently concede. In other words, sellers should never offer concessions without ensuring that the other party is aware of them.

For instance, if a seller calculates the inventory at $204,000 but intends to charge the buyer only $200,000 for it, the seller should communicate this to the buyer. The more concessions are openly acknowledged, the more likely it is for both parties to compromise on minor points, provided they are informed of the concessions.

Utilize a Matrix for Analyzing Indemnity Provisions

Consider using a matrix to analyze indemnification provisions. These provisions can be intricate, and it’s beneficial to separate the legal language from the economic aspects.

Extract the economic parameters of the provision and organize them in a spreadsheet. This approach simplifies the assessment of indemnification terms and facilitates the process of making tradeoffs.

Representations & Warranties Matrix
RepresentationSurvival PeriodBasket

(% of Purchase Price)

Cap

(% of Purchase Price)

EnvironmentalUnlimited1%20%
TaxUnlimitedNone20%
All Other18 Months1%20%
Returns24 Months1%20%
Accounts Receivable12 MonthsNone20%
Product Liability36 Months1%20%
Title & OrganizationUnlimitedNone100%
Non-Assumed ObligationsForeverNone100%

Understanding the Underlying Motives

It’s essential for sellers to grasp the motivations behind the specific reps and warranties proposed by buyers. Sellers should inquire about these reasons and directly address any concerns raised. Often, issues can be resolved through creative alternatives, or buyers may have misconceptions about the underlying risks that the representation aims to cover. This provides an opportunity for constructive dialogue to educate the buyer on the risks and alternative risk mitigation strategies.

Exercise Caution with Financial Representations

Exercise extreme caution when encountering financial representations, such as:

“The Purchase Price is based on an EBITDA of $5.2 million for the most recent year… continued as a separate representation… and the financial statements have been prepared in accordance with Generally Accepted Accounting Principles (GAAP).”

This represents a potential pitfall for sellers and is akin to giving the buyer a blank check. If the seller’s financial statements aren’t prepared in compliance with GAAP (which is the case for most), it essentially grants the buyer the authority to renegotiate the purchase price later. Prior to endorsing representations concerning accounting or financial matters, it’s advisable to engage a CPA for a thorough review to ensure their accuracy.

Here are Some Ways the Seller Can Reduce the Potential Exposure of Reps & Warranties:

Reps & Warranties Insurance

Sellers have the option of utilizing insurance to mitigate the potential liability associated with breaches of reps and warranties. The cost typically falls within the range of 4% to 8% of the coverage amount and hinges on various factors, including the extent of reps and warranties, the industry in which the business operates, the deductible, and the coverage term. This insurance has become increasingly common in private middle-market M&A transactions, although it’s essential to note that it doesn’t extend to cover cases of fraud or gross negligence.

Knowledge Qualifiers

Employing knowledge qualifiers as a strategy for limiting reps and warranties based on the seller’s knowledge is an effective way to reduce the seller’s exposure. It also shifts the burden of proof onto the buyer to demonstrate that the seller was unaware of specific information. Knowledge qualifiers can be tailored to apply to specific parties involved.

For instance, a representation can be confined solely to the knowledge of the seller or extended to encompass the seller’s management team. In most cases, sellers should aim to restrict knowledge qualifiers to their own knowledge, as broadening the scope of knowledge liabilities to third parties can amplify risk.

Examples of knowledge qualifiers include:

  • “To the best of Seller’s knowledge” (presumes proactive efforts by the seller to obtain knowledge).
  • “To the Seller’s actual knowledge” (limits knowledge to what the seller possesses, without assuming sufficient inquiry).
  • “To Seller’s knowledge.”

Materiality Qualifiers

Materiality considerations can be addressed either within individual reps and warranties or collectively in the indemnification section. More frequently, materiality is managed in the indemnification section through mechanisms such as baskets and other thresholds. Many agreements specify that only material breaches will trigger indemnification. Typically, the level of materiality is defined by establishing a specific basket or deductible.

In most transactions, the deductible or basket amounts to 0.50% to 0.75% of the purchase price. For example, in a $10 million transaction, a claim must surpass $50,000 to $75,000 before it becomes eligible for an indemnification claim.

Survival Periods

Reps & warranties consistently come with a defined timeframe known as a survival period. The duration of these survival periods can vary, contingent on the nature of the representation.

For instance, representations concerning tax and environmental matters may have lengthier survival periods or even remain in effect perpetually, without any time constraints, in certain instances.

Nonetheless, these survival periods are also instrumental in capping the seller’s potential exposure.

Right of Offset

Offsetting indemnification claims with outstanding amounts of the purchase price is another option.

For instance, if the buyer has delayed payment on the seller note, any indemnification claims could be deducted from the remaining balance.

Buyer Insurance

Sellers possess the authority to demand that buyers secure insurance coverage against insurable risks. Alternatively, sellers can retain their existing policies, particularly those structured on a claims basis as opposed to an occurrence basis. In such cases, indemnification should be calculated net of any insurance reimbursements.

Sellers should also ensure they request that the insurer waive any subrogation rights, provided the seller is not the named party in the policy. This precautionary measure prevents the insurer from pursuing the seller in the event of a loss, given that the seller isn’t the designated policyholder.

Indemnification Caps

Sellers have the option to set limits on their overall liability in the event of breaches of reps & warranties.

These caps, typically ranging from 10% to 20% of the purchase price, might vary for specific claim types, such as environmental claims, where higher caps could apply.

Shareholder Liability

The indemnification can involve either the selling entity or individual shareholders. Often, when the selling entity dissolves post-sale, the buyer requests that all operating shareholders sign the purchase agreement. This means a selling shareholder must personally sign the purchase agreement to become liable for indemnifying the buyer.

Multiple Parties: In cases involving multiple shareholders, it’s crucial to avoid agreeing to “joint and several liability.” With joint and several liability, shareholders can be held accountable either as a collective whole (joint) or individually (several).

To illustrate, a 10% minority partner might potentially be responsible for the entire claim. Similarly, a 60% majority partner could be held entirely liable, subsequently having to pursue reimbursement from the minority partners. When multiple shareholders are involved, sellers should aim to limit indemnification on a pro-rata basis, ensuring each shareholder pays their share of the award, rather than opting for “joint and several” liability.

Hiring a Team to Negotiate R&Ws

Tips for Hiring Advisors to Help Negotiate the Purchase Agreement

When selecting a professional advisor, prioritize real-world experience in buying and selling companies above all else. Negotiating the purchase agreement for a middle-market business is a complex endeavor, and you shouldn’t risk your hard-earned money on an advisor who is learning on the job. Whether hiring an accountant or an attorney, seek experience, and don’t hesitate to ask about qualifications. Inquire about the number of M&A transactions they’ve handled in the last three years and the role they played in each. Clarify their intended role in your situation—some advisors prefer a behind-the-scenes approach, while others thrive on the front lines.

Reps & warranties carry significant implications for several years post-closing. In certain cases, a seller’s liability under reps & warranties can extend indefinitely, particularly for matters like environmental issues, tax payments, or employment-related concerns. For buyers, a single word in the agreement can mean the difference between recovering millions in damages or receiving nothing at all. Both parties should ensure that their advisors possess comprehensive knowledge of the purchase agreement, particularly with regards to reps & warranties.

Balance risk against reward. Attorneys and accountants often lean towards caution by nature. It’s essential to find an advisor whose risk tolerance aligns with your own. Some advisors tend to be overly risk-averse, just as some business owners are. You should seek an advisor whose risk profile matches your own.

Assist your advisors in understanding your business from both operational and financial perspectives. Communicate your primary concerns to your CPA or attorney, and collaborate with them to address your needs without getting bogged down in legal or financial jargon. Keep your objectives in sight. Once your advisor comprehends your business and goals, you can work together to develop proposals that meet the buyer’s requirements while also satisfying your business needs.

Strike a balance between your advisor’s experience and judgment and your own objectives. Seasoned accountants and attorneys are well-versed in what is customary and reasonable in their field and what is not. For instance, based on industry surveys compiled by the American Bar Association (ABA), an experienced advisor can identify when the opposing party is making an unreasonable request. These surveys contain detailed information about critical elements of a purchase agreement. A good advisor will guide you on when to stand your ground and when to make concessions.

Strike a harmonious balance between your advisor’s wealth of experience and your own objectives. Seasoned accountants and attorneys possess a keen understanding of what is customary and reasonable in their field. They draw insights from surveys conducted by organizations like the American Bar Association (ABA), which gauges the prevailing norms within industries. For instance, an ABA study might reveal that 34% of M&A transactions under $10 million involve earnouts, or that the average escrow constitutes 18% of the purchase price. These studies provide comprehensive insights into every critical aspect of a purchase agreement. An experienced advisor can readily identify when the opposing party is making an unreasonable request and align your objectives with the current standards of reasonableness. A valuable advisor knows precisely when to stand firm and when to find common ground.

Understand your accountant’s or attorney’s role based on your own experience level. If you’re new to selling a business, be prepared for your advisor to play a pivotal role in the process. Conversely, seasoned business owners will require less hands-on guidance from their advisors.

Your attorney will spearhead the negotiation of the purchase agreement, whereas your accountant will take the lead in financial due diligence. They’ll scrutinize the financial and tax implications of the purchase agreement and negotiate any reps & warranties pertaining to the financial aspects of your business. Your accountant or CPA may delve into the financial ramifications of reps & warranties related to:

  • Capitalization
  • Financial statements (accuracy, adherence to GAAP, etc.)
  • Taxes and tax returns
  • Books and records
  • Accounts receivable
  • Inventory
  • Employee benefits
  • Employee compensation

Lastly, enlist your advisors to conduct pre-sale due diligence. This proactive approach involves investigating potential issues before listing your business on the market, allowing you to resolve any concerns before initiating the sale process. It’s a strategic move that can help limit the scope of reps & warranties.

The M&A Advisor or Investment Banker

Both your attorney and your M&A advisor will play pivotal roles in negotiating reps & warranties. Your M&A advisor will engage in discussions with the buyer to shape the high-level aspects of the transaction and ensure that all components of the deal structure align harmoniously. Seasoned investment bankers approach negotiations as collaborative endeavors, aiming for mutually beneficial outcomes rather than rigidly defending a position. An experienced intermediary excels at uncovering the buyer’s true concerns and creatively tailoring the transaction to satisfy both parties’ objectives.

Most M&A firms typically request indemnification from the seller against any legal actions arising from inaccurate information or material misrepresentation. Many buyers may involve the M&A advisor in legal proceedings and cast a wide net over anyone involved in the transaction. Given that the seller receives the majority of the transaction proceeds and is the primary source of information, M&A advisors argue that they should not bear responsibility for inaccuracies.

Without such indemnification, M&A advisors would be compelled to meticulously verify every piece of information they handle, which would be onerous and obstructive to the process. While requesting indemnification is reasonable, the extent to which the seller should indemnify the advisor against gross negligence is subject to debate. In our view, advisors should not be shielded from acts of fraud or gross negligence. However, they should be indemnified for issues stemming from inaccuracies in the information provided. Holding investment bankers liable for inaccurate information would lead to unnecessary second-guessing of business owners, increased costs, delays, and necessitate higher fees to accommodate the escalated risk.

Other Specialists

Depending on the nature of your business and industry, the involvement of specialized experts can significantly influence the scope of reps & warranties. The extent of their participation can, in some cases, help mitigate risk for the buyer, leading to potential reductions in the scope of reps & warranties.

  • Environmental Considerations: For businesses dealing with hazardous materials or subject to environmental regulations, hiring an environmental consultant is prudent. Buyers often engage environmental experts when acquiring properties suspected of contamination. Many jurisdictions impose strict liability on past real estate owners for environmental issues, representing substantial exposure. Employing a consultant in advance allows proactive identification and resolution of problems before they become buyer concerns.
  • Employee Benefits: Employee benefits pose a substantial area of risk exposure for buyers. Sellers should collaborate with experts in this realm well in advance of a sale. Ensuring that assets outweigh liabilities in retirement plans and facilitating a seamless transition of benefits, including deferred compensation, profit-sharing, stock options, and health and life insurance, is crucial. In most cases, plans will be terminated, with the seller obligated to fulfill termination requirements, while employees transition to the buyer’s plans.
  • Code Audits: When acquiring a software company, most buyers opt for a third-party code audit to assess the cleanliness and documentation of the software code. A savvy seller should proactively arrange a code audit and code cleanup before listing the company for sale. The audit results and code improvements can then be leveraged during negotiations to provide buyers with confidence in the code’s documentation, accuracy, and organization.

Asset vs. Stock Sale

In every transaction, a fundamental question arises: should it be structured as an asset sale or a stock sale? This choice significantly influences the scope of reps & warranties, with stock sales generally involving broader coverage than asset sales.

Asset Sale

Most buyers favor asset deals due to lower risk. In a stock sale, the buyer assumes all of the seller’s liabilities, including contingent or unknown ones. In contrast, an asset sale only transfers the liabilities explicitly agreed upon in the purchase agreement, along with unavoidable successor liabilities. Consequently, reps & warranties tend to have a narrower scope in asset sales.

Stock Sale

In stock acquisitions, the buyer inherits all of the seller’s liabilities, leading to more comprehensive reps & warranties compared to asset deals. Larger transactions often adopt the stock sale structure. Here, the seller provides additional representations regarding capitalization and assumed liabilities.

Successor Liability

Regardless of the transaction type, successor liability remains a possibility. This risk can be partially mitigated through thorough reps & warranties, escrows, and protective measures, but it can never be entirely eliminated. Certain matters, like tax or environmental issues, inherently carry successor liability. In contrast, in cases like employee matters, successor liability can be reduced by minimizing the perception of being a mere continuation. If the business remains substantially similar before and after the sale, courts may impose successor liability. This scenario is common in most M&A deals, leading to reps & warranties tailored to address potential liability areas.

Here are effective strategies for mitigating successor liability:

  • Thorough Due Diligence: The buyer should conduct comprehensive due diligence, particularly focusing on potential successor liabilities related to environmental, tax, and employment laws.
  • Triangular Acquisition Structure: Consider using a triangular acquisition structure. In this approach, the buyer entity establishes a subsidiary, and the subsidiary either acquires or merges with the target. This setup effectively isolates liabilities within the subsidiary entity.
  • Asset Deal Clarity: In asset deals, make sure to explicitly list the liabilities the buyer is assuming and those the seller retains.
  • Robust Reps & Warranties: Strengthen representations and warranties in the purchase agreement to address potential issues susceptible to successor liability.
  • Indemnification with Reduced Baskets: Include indemnification provisions with reduced baskets specifically for matters related to successor liability.
  • Minimize Business Continuity: To reduce the risk of being labeled a “mere continuation” by a court, minimize the appearance of business continuity.
  • Seller Entity Maintenance: Require the seller to keep their entity open and maintain liability insurance for as long as possible. This is especially crucial in cases like environmental or tax issues, where liability can endure indefinitely. Carefully balance the duration the entity remains open against the potential risks involved.

Funding Breaches Through Escrow

In the realm of M&A transactions, it’s customary to incorporate a holdback, often referred to as an escrow. This mechanism involves reserving a segment of the purchase price, typically around 10% to 20%, within the custody of a neutral third party, the escrow agent. This reserved amount serves as a safeguard, spanning a duration usually lasting 12 to 24 months. Its primary purpose is to cover any indemnification claims specified in the purchase agreement. However, should no claims arise during this timeframe, the reserved funds are then promptly released to the seller.

Why is an Escrow Necessary?

Escrows play a vital role in providing the buyer with peace of mind, ensuring that financial resources are readily available to cover any unforeseen expenses, such as legal proceedings or losses resulting from discrepancies in the seller’s representations or warranties within the purchase agreement.

To illustrate, consider the sale of a manufacturing plant equipped with costly machinery. If the seller had represented that all machinery is fully operational and well-maintained, but a piece of machinery malfunctions shortly after the transaction, revealing undisclosed deferred maintenance, the buyer may initiate a claim to recover the costs associated with repairing or replacing the machinery.

The holdback amount is securely placed in an escrow account, managed by an impartial third-party escrow agent, and governed by a meticulously crafted escrow agreement. Typically, the release of these funds requires mutual consent from both the buyer and seller. In cases where no claims arise, the escrowed funds are eventually disbursed to the seller upon the completion of the agreed-upon escrow period.

Are there alternatives to escrow?

Indeed, most M&A deals incorporate some form of deferred payment, and it’s worth noting that various deferred payment mechanisms can also serve as effective alternatives to traditional escrows. Here are several options to consider:

  • Promissory Note: A well-structured promissory note can explicitly grant the buyer the right to withhold future payments in the event of a breach, often referred to as an “offset.”
  • Earnout: Earnout arrangements, too, can include provisions for a right of offset. However, it’s crucial to evaluate the likelihood of the seller actually receiving earnout payments as these can be contingent on specific performance metrics.
  • Consulting or Employment Agreement: Similar to promissory notes, consulting or employment agreements can incorporate a right of offset. Keep in mind that certain states may have regulations prohibiting setoffs against employment agreements.

It’s worth noting that sellers may be somewhat hesitant to accept a right of offset against guaranteed, deferred payments (such as promissory notes or consulting agreements). This reluctance stems from concerns that granting the buyer the ability to withhold payments could tilt the balance of power significantly in the buyer’s favor. Consequently, sellers may find traditional escrow arrangements to be a more balanced and preferable solution.

What Are the Major Terms of the Escrow Agreement?

Consider the following key aspects when establishing the terms of your escrow agreement:

  • Amount of Funds: Typically, escrows in most transactions range from 10% to 20% of the total purchase price. The size of the escrow should be commensurate with the perceived risks, their potential impact, and whether other deferred payment mechanisms also incorporate a clear right of setoff.
  • Duration: The time period for escrows varies, often spanning 18 to 24 months. However, it’s not uncommon to encounter shorter periods of 12 months or longer ones lasting up to 36 months. Many buyers prefer a full year’s Profit and Loss (P&L) statement to assess the entire accounting period, hence the prevalence of 18-month durations. In most cases, a two-year escrow period proves sufficient for identifying potential risks.
  • Conditions: Your escrow agreement should outline the specific conditions governing the escrow, including control of its release (typically mutual consent) and dispute resolution mechanisms.
  • Interest: Clearly define whether any interest accrued on the escrowed amount should be paid to the buyer, the seller, or shared in a predetermined manner.

How Are Disputes Normally Handled?

Disputes arising from the purchase agreement will be governed by the terms meticulously outlined within the purchase agreement itself, working in conjunction with the stipulations set forth in the escrow agreement. It’s worth noting that in some instances, supplementary agreements, such as non-competition agreements, may entail separate dispute resolution mechanisms.

The focal point for addressing most disputes typically resides within the “Indemnification” section of the agreement. It’s essential to understand that there is no universally standardized indemnification provision. Rather, the language concerning indemnification can become a subject of robust debate between the buyer and the seller.

In the majority of cases, if a buyer identifies a problem or breach, protocol dictates that the buyer must duly notify the seller. Subsequently, the seller might be granted a specific timeframe to rectify the issue (often referred to as the “right to cure”), contest the alleged damages, or opt to reimburse the buyer accordingly. Should resolution efforts falter, the funds will remain securely held in escrow while both parties diligently strive to reach a mutually agreeable resolution.

One pivotal aspect deserving consideration is whether the escrow arrangement should exclusively serve as the buyer’s recourse or whether the buyer should have the option to pursue supplementary remedies.

Limitations to Reps & Warranties

Restrictions on representations and warranties can be categorized into the following four distinct groups:

  • Knowledge Qualifiers: These limitations hinge on defining the extent of the seller’s knowledge pertaining to the specific representation or warranty being provided.
  • Survival Periods: Reps and warranties come with an expiration date, often referred to as a “survival period.”
  • Baskets (Minimums): Sellers are shielded from liability claims until the cumulative amount surpasses a predetermined basket threshold, akin to an insurance deductible.
  • Caps (Maximums): The seller’s liability is capped, signifying that they are only responsible for damages up to a predetermined maximum limit, also known as a cap.

Knowledge Qualifiers

One of the most straightforward methods to narrow down the scope of a representation or warranty is by employing a knowledge qualifier. This qualifier constrains the seller’s potential liability based on what the seller “knows” about a given representation.

For instance, if a seller asserts that the company’s financial statements adhere to Generally Accepted Accounting Principles (GAAP), and the buyer subsequently discovers a deviation from GAAP, the seller’s accountability may be limited. However, the extent of the seller’s liability hinges on the precise definition of “knowledge” as outlined in the purchase agreement.

It’s essential to acknowledge that sellers might not possess knowledge of every facet of the business, especially when the seller is an absentee owner. Therefore, it’s understandable for sellers to be cautious about making representations concerning areas of the business about which they may have limited awareness. To address this, reps and warranties are frequently constrained based on the seller’s knowledge, as per the purchase agreement’s definition.

Sample In-line Knowledge Qualifiers encompass:

  • “To the best of Seller’s knowledge”
  • “To Seller’s actual knowledge”
  • “To Seller’s knowledge”

These statements often precede the reps & warranties section in a purchase agreement. For instance, you might encounter a phrase like, “To the best of Seller’s knowledge, the Seller represents and warrants that…”. In such cases, the definition of knowledge is embedded within the statement itself, rather than being separately outlined in the “Definitions” section.

Here are some examples of definitions of Knowledge:

  • Actual knowledge
  • The best of a party’s knowledge after due and reasonable inquiry
  • Actual knowledge, without any requirement of inquiry or investigation
  • Actual knowledge that would have been obtained after reasonable inquiry
  • Constructive knowledge to the extent such knowledge would have been obtained by due inquiry
  • Actual knowledge of any officer of the company
  • Actual knowledge of the officers and employees listed in Schedule XX

In certain purchase agreements, “Knowledge” is distinctly defined and featured in the “Definitions” section of the purchase agreement. Consequently, the term “Knowledge” is then capitalized throughout the agreement to refer to its defined meaning in the “Definitions” section.

The specific definition of knowledge, as delineated in the agreement, carries significant implications for both parties involved. Without any knowledge qualifier, the seller could potentially bear 100% responsibility for any representations and warranties in the purchase agreement, regardless of whether the seller was aware of their accuracy or not.

By narrowing down the definition of knowledge, the dynamics can undergo a significant shift, potentially placing the burden on the buyer to prove that the seller knew a representation was false at the time it was made. It can also substantially curtail the buyer’s indemnification rights by transferring unknown risks to the buyer.

The buyer will seek to broaden the scope of knowledge to encompass “constructive” knowledge, which includes information that should have been known through reasonable or due inquiry, or that aligns with the seller’s role in the business (e.g., a CEO is presumed to possess a different level of knowledge compared to a CTO or CMO).

Nevertheless, it’s essential for both parties to recognize that uncertainty is an inherent element, irrespective of their preferences. Reps & warranties don’t solely gauge integrity; they primarily serve as a legal mechanism for distributing risk.

Special attention is warranted when the seller is an absentee owner with limited knowledge of the business. In such instances, the definition of knowledge should align with the circumstances. However, sellers should bear in mind that knowledge qualifiers also function as risk allocation tools. Thus, sellers might be compelled to make representations concerning aspects of the business about which they possess limited knowledge.

In contrast, scenarios like a management buy-out (MBO) may grant the buyer(s) greater insights into the operations than the seller. Here, management may be inclined to assume more risk, though external financing sources such as banks or private equity firms could impose constraints on this willingness.

Determining Whose Knowledge Matters

Finally, it’s crucial to outline whose knowledge the reps & warranties are contingent upon in the agreement. Do they rely solely on the seller’s knowledge, or does the definition encompass the insights of officers or other employees?

If third parties are to be incorporated into the definition, the seller must be prepared to assume the risk associated with depending on the knowledge of these external parties. In certain scenarios, officers or key employees may be requested to execute a certificate where they individually affirm their awareness of reps & warranties pertinent to their respective roles. For instance, a CFO might be mandated to sign a certificate pertaining to any financial representations.

Survival

Reps & warranties typically come with a built-in expiration date. Without a specific survival provision, it becomes uncertain whether they persist beyond the deal’s closure, potentially subject to the statute of limitations related to the specific breach, such as environmental or tax issues. Once this defined timeframe concludes, the seller’s liability for any breaches usually expires, with a few exceptions like purposeful or willful breaches or fraud.

Buyers often prefer to run the acquired business for at least a full year, or one business cycle, to uncover any possible breaches. Consequently, the typical lifespan of representations ranges from 18 to 24 months.

For instance: “The reps & warranties of the Seller shall remain in effect for 18 months beyond the Closing.”

However, the duration of survival periods can vary based on the type and nature of the representation. Here are a few examples:

  • Intellectual Property: Can extend up to 36 months.
  • Environmental: May have no time limit.
  • Tax: Unlimited, or the full period of limitation under local, state, or federal law.
  • Employment: ERISA and employment matters can range from two years to unlimited.
  • Organizational & Title: Can be unlimited.
  • Compliance with Laws: Can be unlimited.

Why don’t reps & warranties for publicly held firms survive the closing?

There are two primary reasons:

  • Accuracy of Information: Publicly held firms are obligated to file periodic reports with the Securities and Exchange Commission (SEC). This regulatory requirement instills confidence that public firms adhere to higher standards, rendering their information more reliable compared to private entities.
  • Dispersed Ownership: Publicly held firms have a dispersed ownership structure, making it more challenging to hold individual shareholders accountable in the event of a breach. In public companies, there are fewer available shareholders to indemnify the buyer.

Baskets (Minimum)

Reps & warranties almost always come with a companion – the basket, which acts like a minimum threshold that must be crossed before the seller becomes liable. Think of it as similar to an insurance deductible.

The purchase agreement’s indemnification section lays out the rules in case of a dispute, and within it, you’ll find a clause that defines the basket (sometimes referred to as “Limitations on Amount”). Until the claims breach this threshold, the seller remains shielded from liability. The basket essentially sets the minimum loss that the buyer must absorb before the seller’s responsibility is triggered.

For instance: In most M&A transactions, you’ll encounter a basket set at 0.75% of the purchase price. In a $10 million deal, a 0.75% basket would be equivalent to $75,000. So, the seller wouldn’t be held accountable until the cumulative claims surpassed $75,000.

Here’s why the basket is an integral part of the process:

  • Encouraging Buyer Accountability: Much like an insurance deductible, the basket motivates the buyer to share in the risk. If the basket were set at zero, the buyer might be tempted to submit numerous trivial claims with nothing to lose.
  • Acknowledging Imperfection: It recognizes that no deal is flawless. Parties accept that challenges will surface, agreeing not to escalate issues until they cross a significant threshold. This streamlines the transaction, ensuring that only substantial claims are considered.
  • Enhancing Efficiency: By filtering out minor claims, it streamlines the process, making it more efficient. This allows both parties to focus on the substantial issues at hand.
  • Promoting Diligence: The basket pushes the buyer to conduct thorough due diligence since they have a vested interest in identifying any potential issues before they become material.

Sample Clauses:

  • “Seller’s indemnification obligation to Buyer shall trigger only when the aggregate amount of all indemnity claims against Buyer exceeds the Basket, which is $50,000.”
  • “Seller shall assume liability only after the total damages surpass $100,000, and solely for the amount exceeding $100,000. However, this provision excludes claims under Section x and xx (e.g., tax, environmental, etc.), breaches known to Seller before representation date, or intentional breaches of covenants or obligations. Both Seller and shareholders share joint and several liability for all damages arising from such breaches.”
  • “Neither Seller nor Buyer shall bear liability for indemnification until the cumulative Damages incurred by an Indemnified Party exceed One Hundred Thousand Dollars ($100,000) (the ‘Basket’). After exceeding the Basket, the Indemnified Party is entitled to indemnification for all Damages, encompassing amounts up to the Basket and any excess. This clause does not apply to Damages linked to taxes or governmental authority assessments or claims of deliberate fraud or intentional misrepresentation concerning a representation or warranty breach in this Agreement.”

Tipping vs. Non-Tipping Basket:

Tipping Basket:

  • Under a tipping basket, once the basket is exceeded, the seller must fully reimburse the buyer for all losses.
    • For instance, with a $100,000 basket and a $101,000 claim, the seller would reimburse the buyer $101,000, not just $100,000.

Non-Tipping:

  • With a deductible, or non-tipping basket, the seller only reimburses the buyer for amounts surpassing the basket.
    • In the previous example, with a $100,000 basket and a $101,000 claim, the seller would only reimburse the buyer $1,000.

Sharing the Deductible

In some agreements, both parties are required to share losses up to the deductible amount.

For instance, if a $100,000 deductible is in place, and a loss of $101,000 occurs, the buyer would contribute $50,000, and the seller would contribute $51,000.

This provision necessitates the buyer to shoulder a significant portion of any losses, encouraging thorough due diligence to minimize potential losses. Simultaneously, it incentivizes the seller to help mitigate smaller losses on behalf of the buyer. This approach, to some extent, discourages buyers from exploiting a tipping basket to recover the “deductible.”

Basket Size

The typical basket size is 0.75% of the total purchase price. Naturally, buyers advocate for the lowest possible basket, while sellers aim for a higher amount.

Certain representations and warranties are often exempt from the basket. These typically include matters related to employees, environmental concerns, organizational issues, title to assets, or tax matters, as outlined in the following clause:

“This Section will not apply to claims under Section x and xx (e.g., tax, environmental, etc.) …”

Additionally, the basket may be rendered void if the seller engages in a willful breach, or it may be restricted based on the seller’s knowledge (as defined in the agreement). However, many sellers contest this language, as the determination of “willful” breaches can be subjective and lead 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 represents the maximum level of liability a seller can assume towards the buyer. In the majority of transactions, caps typically range from 10% to 20% of the total purchase price of the business. Once this cap is surpassed, the seller’s responsibility for damages towards the buyer is generally extinguished, with a few minor exceptions (such as cases involving fraud).

For specific representations and warranties, caps can be set higher or left unlimited. These typically include:

  • Intellectual property (IP)
  • Title to assets
  • Employee matters
  • Employee benefits, ERISA
  • Environmental issues
  • Tax matters
  • Organizational issues

For instance: “The total damages recoverable by the Buyer resulting from any breach of these representations and warranties shall not exceed $35,000.”

General Guidelines

Here is a concise reference chart outlining general recommendations for baskets, caps, and survival periods.

General Indemnity Provision Guidelines for Baskets, Caps, and Survival Periods
BasketCap
(% of Purchase Price)
Survival Period
Title to AssetsNone100%Unlimited
TaxesNone100%Unlimited
OrganizationNone100%Unlimited
Employee, ERISA0.75% to 1.0%20%24 to 36 Months
IP0.75% to 1.0%20%24 to 36 Months
Environmental0.75% to 1.0%10% to 100%24 to 36 Months
All Other0.75% to 1.0%10% to 20%18 to 24 Months

Indemnification & Remedies

When an issue arises after the closing of a deal, the parties turn to the “Indemnification” and “General” sections of the purchase agreement to determine how the dispute will be addressed.

The ‘Indemnification’ section typically covers the following points:

  • Parties: It clarifies who is responsible for indemnifying. Is it one shareholder or all shareholders involved in indemnifying the buyer? If multiple shareholders are involved, are they jointly and severally responsible? Does the buyer also indemnify the seller?
  • Scope: This outlines what falls under indemnification. It often includes breaches of representations and warranties, covenant breaches, non-compliance with laws, and liabilities related to the assets. Negotiations often revolve around the scope’s specifics. Some agreements may include separate remedies not covered by the indemnification section, like non-compete agreements.
  • Remedies: It defines whether indemnification is the exclusive remedy or if other remedies are available.
  • Survival: This specifies how long the obligations in the agreement, such as representations, warranties, and covenants, remain in effect.
  • Limitations: It sets financial limits, such as baskets and caps, on indemnification obligations.
  • Escrow: Addresses whether a portion of the purchase price will be held in escrow, including the amount, duration, and escrow terms.
  • Right of Offset: Explores whether the buyer has a right of offset against obligations like the promissory note or consulting agreements.
  • Indemnification Process: Details how indemnification claims are handled, including the indemnifying party’s role in defending the claim.

The ‘General Provisions’ section of the purchase agreement generally covers:

Dispute-related matters:

  • Jurisdiction: Addresses dispute resolution options, including litigation, arbitration, mediation, jury trials, and more. It covers the choice of forum, selection of mediators or arbitrators, mediation or arbitration rules, expense responsibilities, available remedies, the finality of decisions, and related aspects.
  • Enforcement: May provide additional remedies, such as specific performance or injunctive relief.
  • Waiver: Often states that rights are cumulative and that failure to exercise a right doesn’t constitute a waiver.
  • Governing Law: Specifies which state’s law governs the agreement.

Identifying the Source of Indemnification:

It’s crucial to determine the source of indemnification in your agreement. Questions to consider include:

  • Who is responsible for providing indemnification?
  • If there are multiple shareholders in the selling company, are all shareholders liable for indemnifying the buyer, or only the majority shareholders?
  • Is the selling entity itself responsible for indemnifying the buyer?

Typically, in most cases, the majority of selling shareholders bear the responsibility of personally indemnifying the buyer. To bind a selling shareholder under the indemnification clause, they must either sign the purchase agreement directly or provide a “joinder.” This is because, after the closing date, the selling entity often ceases to exist. If it does persist, its assets are usually distributed among the shareholders, leaving minimal resources for potential indemnification claims.

To simplify matters for the buyer and avoid chasing down multiple shareholders, escrows are commonly utilized. If there are numerous selling shareholders, it’s advisable for the sellers to seek a limitation of their liability to “several” (individual) liability rather than “joint and several” liability.

Indemnification Procedures and Specifics:

The indemnification clause should also encompass the following aspects:

  • Determining the available recourse in the event of a breach.
  • Outlining the dispute resolution process, often commencing with a written complaint. If parties cannot resolve the issue, the agreement should dictate the dispute resolution procedure.
  • Addressing procedural aspects of indemnity claims.
  • Defining the parties’ involvement in legal proceedings.
  • Specifying notice requirements.
  • Establishing control over the defense of third-party claims.
  • Clarifying the methods for collecting indemnification claims, including any limitations tied to escrow amounts.
  • Outlining both parties’ rights to access information.
  • Defining subrogation rights.
  • Clarifying whether indemnification is the exclusive remedy.
  • Addressing the impact of insurance proceeds on indemnification obligations.
  • Considering whether a failure to act on a breach constitutes a waiver.
  • Determining the selection of counsel for defending claims and allocating control over defense and associated fees.

Buyer’s Indemnification

In addition to the seller’s indemnification, it’s standard practice for the buyer to reciprocate with its own indemnification commitments. These typically encompass the buyer’s pledges, such as ensuring continued employment and benefits for key personnel from the seller. Moreover, the buyer may also assume responsibility for indemnifying the seller against potential environmental liabilities or outstanding accounts payable.

Here’s a sample of the indemnification language:

The Buyer firmly commits to indemnify, defend, safeguard, and absolve the Shareholders, the Seller, as well as any officers, directors, stockholders, representatives, affiliates, assigns, successors in interest, and current and former employees of the Seller, each within their respective roles, from, against, and concerning:

  • (a) Any and all Damages incurred, sustained, or paid by the Seller or any other parties entitled to indemnification by the Seller, directly or indirectly stemming from:
    • (i) Any violation of the warranties provided by the Buyer in this Agreement, or in any Schedule or certificate delivered by or on behalf of the Buyer in connection herewith.
    • (ii) Failure to fulfill any covenant or agreement outlined in this Agreement by the Buyer.
    • (iii) The ownership of the acquired Assets or the operation of the Business by the Buyer following the Closing Date.
  • (b) Any and all Damages related to any of the above circumstances or the enforcement of this Section.

Sample Indemnification Clause

Each of the Sellers and the Shareholders collectively and individually commits to indemnify, defend, protect, and absolve the Buyer, as well as any officers, directors, stockholders, representatives, affiliates, assigns, successors in interest, and current and former employees of the Buyer, solely within their respective capacities (referred to as the “Buyer Indemnified Parties”), from, against, and in relation to:

  • (a) All liabilities, claims, losses, damages, punitive damages, causes of action, lawsuits, administrative proceedings, demands, judgments, settlement payments, penalties, and costs and expenses (including, but not limited to, reasonable attorneys’ fees, travel expenses, expert witness fees, and disbursements of every kind and nature) collectively referred to as “Damages,” suffered, sustained, incurred, or paid by the Buyer or any other Buyer Indemnified Party directly or indirectly resulting from:
    • (i) Any misrepresentation or breach of warranty made by the Seller or any Shareholder in this Agreement, or in any Schedule or certificate provided by the Seller or any Shareholder in connection with this Agreement.
    • (ii) Failure to fulfill any covenant or agreement outlined in this Agreement by the Seller or any Shareholder.
    • (iii) The Seller’s Business, operations, or Assets before the Closing Date, or actions or omissions of the Seller’s directors, officers, shareholders, employees, or agents before the Closing Date (except for the Assumed Liabilities).
    • (iv) The Excluded Liabilities.
  • (b) Any Damages related to the above circumstances or the enforcement of this Section.

Notice Procedure; Claims: If the Indemnifying Party, within a reasonable time after receiving the Claim Notice, fails to assume the defense of any Third-Party Claim, the Indemnified Party has the right (with further notice to the Indemnifying Party) to take charge of the defense, settlement, or compromise of the Third-Party Claim, at the expense and risk of the Indemnifying Party.

Here is a simplified indemnification language: “The Seller will indemnify, defend, and protect the Buyer from any financial loss, legal liability, damage, or expenses resulting from breaches of the representations and warranties mentioned above.”

Process Overview

This section outlines the role of representations and warranties in the broader process of buying or selling a business.

Shifting Positions Of Power

In the process of buying or selling a business, it’s essential to recognize how the balance of power shifts between the buyer and seller as the transaction unfolds. Naturally, both parties will seek favorable terms when they hold the upper hand and aim to safeguard their positions when they have less negotiating strength.

Initially, the seller typically enjoys the upper hand. However, this advantage swiftly transfers to the buyer upon the signing of a letter of intent (LOI). Prior to the LOI, the seller can engage in negotiations with multiple potential buyers. Yet, once the LOI is executed, the seller is typically bound to negotiate exclusively with one buyer, particularly if the LOI includes a “no-shop” clause, which is customary. This exclusivity significantly diminishes the seller’s negotiating leverage from the time of the LOI through to the closing of the deal.

NDA

Before a buyer gains access to detailed information about a company, they typically need to sign a confidentiality or non-disclosure agreement (NDA). Once this NDA is signed, the buyer is granted access to the seller’s Confidential Information Memorandum (CIM).

Most NDAs incorporate a clause that confines the seller’s representations to what’s explicitly outlined in the purchase agreement. Others may include a provision that broadly addresses the reliability of the information provided by the seller to the buyer, limiting specific representations to those explicitly stated in the purchase agreement, as exemplified below:

“You acknowledge that the Seller has included information in the Confidential Information materials, which the Company deems reliable for your evaluation. However, neither the Company nor any of its agents, representatives, or employees make any express or implied representations or warranties regarding the accuracy or completeness of this information. The Company’s sole responsibility for representations and warranties lies within any definitive acquisition agreement it may execute.”

Term Sheet

On occasion, the buyer might present a term sheet to the seller before submitting a formal Letter of Intent (LOI). The primary aim of the term sheet is to streamline discussions, focusing on the fundamental transaction terms rather than delving into the intricate legal language typically found in an LOI. This approach saves both parties valuable time by ensuring alignment on the key terms before committing extensive effort to negotiate the precise wording of the LOI.

The term sheet may encompass a general reference to the representations and warranties that will ultimately be incorporated into the purchase agreement, as demonstrated in the following example:

“The proposed terms governing the purchase transaction are contingent upon: The negotiation and execution of a definitive agreement that outlines the representations and warranties of both parties, covenants, and any customary provisions for transactions of this nature.”

Letter of Intent

Once a buyer is ready to extend an offer, they will submit a Letter of Intent (LOI). Sellers, often eager to kick-start the transaction and reach the finish line, might rush to sign the LOI. It’s tempting to think, “We’re almost there, just a few more yards to go.” But, hold on, when you accept an LOI, you’re actually only on the 30-yard line, with a full 70 yards ahead.

The signing of the LOI marks the beginning of the intensive due diligence process. Regrettably, many sellers underestimate the challenges that lie ahead in that remaining 70 yards. The journey from LOI to closing can span several months or even longer, and less than half of companies successfully reach the endzone.

This phase is pivotal for sellers, and their negotiating leverage diminishes as soon as the LOI is inked. However, sellers often get excited and impatient during this stage, hastily signing the LOI once a price is agreed upon, sometimes overlooking other critical terms. It’s essential to exercise caution here because the LOI contains crucial provisions that will govern the relationship between the parties until the deal is finalized.

In most cases, the majority of terms in the LOI are non-binding, except for a select few, such as confidentiality and exclusivity clauses. Additionally, the LOI typically outlines a timeframe for preparing the purchase agreement and specifies that the purchase agreement will include representations, warranties, covenants, and customary indemnification language tailored to the transaction’s size and nature.

While the LOI doesn’t encompass the full scope of representations and warranties, parties may choose to address potentially contentious ones in the LOI to preempt any deal-breaking disputes later on. It’s advisable for your attorney to have access to the M&A Deal Points Studies published by the American Bar Association, offering insights into customary terms for transactions of your size and type.

It’s wise to negotiate contentious issues during the LOI stage rather than deferring them to later in the transaction. If an M&A advisor anticipates potential sticking points, they will work to negotiate comprehensive language upfront before the LOI is signed. This proactive approach is preferable to investing significant time and resources in negotiations with a buyer only to face last-minute deal-breakers. Delaying these discussions gives the buyer substantial negotiating leverage, even if their demands are unreasonable.

Here’s sample language that can be incorporated into the LOI to address representations and warranties, both in the definitive agreement and those made within the LOI itself:

“The Purchaser will promptly prepare and deliver to the Seller, no later than 10 days after the conclusion of the Purchaser’s Due Diligence Review, a comprehensive Purchase Agreement (referred to as the ‘Purchase Agreement’). This Purchase Agreement will encompass the standard terms and conditions customary for transactions of this nature, including the typical representations, warranties, covenants, and indemnifications. Any additional terms necessitated by the Due Diligence Review will also be included. Representations concerning the Company will generally remain in effect for a period of three years after the closing. However, for certain items, such as environmental, tax, ERISA, and title matters, their survival period may extend for longer durations, and in some cases, indefinitely.”

Additionally, here’s language for the LOI that addresses representations and warranties made within the LOI itself:

“The Seller’s acceptance of the terms and conditions outlined in this Letter serves as a representation and warranty that the Seller has not engaged in any binding agreements or accepted commitments pertaining to the transactions mentioned herein. The Seller hereby commits to indemnify and shield the Purchaser from any losses, claims, damages, liabilities (including actions or proceedings initiated or threatened in connection with these matters), and associated expenses arising from or related to any breach of the aforementioned representation and warranty. These commitments by the Company and the Seller will persist even if this Letter is terminated and will remain in effect regardless of whether a definitive agreement is executed.”

Key Elements of a Term Sheet: The proposed purchase transaction under these outlined terms is contingent upon specific conditions, including the negotiation and execution of a comprehensive agreement that outlines the representations and warranties of both parties, along with customary covenants and other provisions typical for transactions of this kind.

Due Diligence

The extent of the representations and warranties (reps & warranties) that the buyer proposes hinges on the findings of their due diligence.

Similarly, the thoroughness of the buyer’s due diligence is influenced by the extent to which the seller is willing to provide representations.

It’s crucial to understand that reps & warranties should complement due diligence rather than serve as a replacement. Conversely, due diligence should not be considered a substitute for robust reps & warranties. These two aspects should operate in tandem.

It’s essential to acknowledge that due diligence may not uncover every issue within a business. There’s always the possibility of something slipping through the cracks during this process. Reps & warranties serve as a safeguard, offering protection for issues that may elude detection during due diligence.

Furthermore, due diligence should be a two-way street. While due diligence is typically performed on the seller, the seller should also conduct due diligence on the buyer, particularly if the seller is extending credit or accepting the buyer’s stock as part of the deal.

The scope of both due diligence and reps & warranties is inherently linked to the type and size of the business. An industrial enterprise, for instance, will necessitate a distinct due diligence and reps & warranties framework compared to a technology-based business. Regardless of the business type, due diligence and reps & warranties should complement each other seamlessly.

Drafting the Purchase Agreement

The buyer’s attorney typically takes the lead in drafting the purchase agreement once the due diligence process is underway. The representations and warranties (reps & warranties) within the purchase agreement are typically stated affirmatively, with any exceptions or qualifications detailed in the disclosure schedules.

Since it’s customary for the buyer to initiate the preparation of the purchase agreement, the initial draft from the buyer sets the tone for negotiations. A heavily biased draft in the buyer’s favor often leads to contentious and protracted negotiations. Conversely, a more balanced initial draft tends to expedite the process and promote smoother negotiations.

It’s essential to recognize that the buyer’s first draft of the purchase agreement, including the reps & warranties, serves as both a disclosure tool and a means of risk allocation between the buyer and seller. If the buyer has uncertainties about any aspects of the business, a representation covering that area will compel the seller to disclose any exceptions. In this sense, the purchase agreement acts as a mechanism for defining risk-sharing between the parties.

Occasionally, some sellers may employ a tactic of withholding the disclosure schedules until the final stages of negotiations. This strategy can have varying outcomes, either favoring the seller or working against them, and should be carefully evaluated before implementation.

The Purchase Agreement and Its Components

The document finalized and signed at the closing stage is commonly known as the Purchase Agreement, although it may also go by these names:

  • Definitive Purchase Agreement (DPA) – a general term encompassing the purchase agreement.
  • Asset Purchase Agreement (APA) – used in asset sales.
  • Stock Purchase Agreement (SPA) – employed in stock sales.

The structure and content of the purchase agreement primarily depend on whether the transaction takes the form of an asset or stock sale. In most cases, purchase agreements for lower middle-market transactions typically span 20 to 50 pages, excluding the schedules and exhibits.

The purchase agreement encompasses several key clauses or sections:

  • Price and Terms
  • Representations and Warranties
  • Covenants – These can be either affirmative or negative commitments imposed on the buyer and seller, both before and after the closing.
  • Conditions – These are contingencies that must be met before the parties are legally obligated to close the deal.
  • Indemnification Clauses
  • Miscellaneous Provisions

Additionally, the purchase agreement may include various exhibits, such as:

  • Disclosure Schedules – These outline exceptions to the representations and warranties.
  • Bill of Sale (in the case of an asset sale)
  • Assignment Agreements – Used for transferring contracts, copyrights, trademarks, patents, etc.
  • Promissory Note
  • Security Agreement
  • Intercreditor/Subordination Agreements
  • Employment Agreements
  • Consulting Agreements
  • Non-Competition Agreements
  • Non-Disclosure Agreements
  • Escrow Agreement
  • Earnout Agreement

Parties Involved in the Purchase Agreement

Those who sign the agreement are considered parties to it. When the seller signs the agreement as an officer of the corporation, they are typically shielded from personal liability for breaches of the agreement in most cases.

In many instances, the selling entity ceases to exist after the closing. Consequently, most buyers insist that the majority shareholders of the selling entity sign the purchase agreement as individuals (rather than corporate officers). Alternatively, a portion of the purchase price may be reserved in an escrow account to cover indemnification obligations. Shareholders can also opt to sign a joinder agreement, which binds them to the purchase agreement.

Covenants

Covenants are commitments to perform or refrain from specific actions, and they rarely spark disputes within purchase agreements. They delineate the responsibilities of the parties from the agreement’s signing until the closing, and sometimes even afterward. While some purchase agreements blend covenants with representations and warranties, we recommend keeping them separate to maintain clarity.

Here’s a sample covenant language: “Until the closing, the Seller will continue to operate the business in its normal course and exert its best efforts to uphold positive relationships with suppliers, customers, the landlord, and other parties involved.”

As previously mentioned, covenants can be either affirmative (promising to do something) or negative (promising not to do something). The most significant covenant typically obligates the seller to maintain business operations as usual until closing, requiring their approval for any significant changes, such as acquiring new equipment, hiring staff, or altering employee compensation arrangements.

Pre-closing covenants come into play when the purchase agreement is signed before the closing date. They dictate how the business will be managed during the period between signing and closing. In cases where signing and closing occur simultaneously, pre-closing covenants are often unnecessary. However, parties may include post-closing covenants, especially if the seller is financing part of the deal. These covenants may involve efforts to secure required consents, facilitate the transaction’s closure, mandate the sharing of information during due diligence, or restrict the seller from negotiating with other parties (an example of a negative covenant).

Post-closing covenants frequently require the buyer to extend job offers to a specified number of the seller’s employees and provide specific benefits to those employees. They may also obligate the seller to assist in collecting outstanding accounts receivable. It’s worth noting that only post-closing covenants survive the closing itself.

Conditions

Conditions, often referred to as contingencies, are prerequisites that must be fulfilled before the parties become obligated to complete the transaction. When a purchase agreement is signed before the closing, conditions are included to specify these requirements. Once all conditions are met, the closing can take place. This section is sometimes also labeled as “termination.” It typically outlines a series of conditions that must be satisfied to proceed with the closing.

It’s essential to note that conditions do not persist beyond the closing. In contrast, representations and warranties (R&Ws) survive the closing. This distinction holds significance for the parties involved, as the R&Ws section remains vital for a couple of years post-closing (typically 18 to 24 months). Conversely, most other sections of the purchase agreement hold no further implications once the closing is finalized.

Breach of a condition provides the parties with relief from the obligation to close, but it’s unlikely to give rise to the option of initiating a lawsuit. In most cases, the sole remedy for a condition breach is the right to walk away from the transaction, often referred to as a “termination right.” Although termination fees are common in M&A transactions involving publicly traded companies, they are infrequent in middle-market transactions. The rules and processes significantly differ for private and public companies.

One crucial condition for closing is the material accuracy of the representations and warranties (R&Ws). In essence, each representation serves as a condition to closing. This introduces a timing complication. The purchase agreement often stipulates that the R&Ws must be accurate before closing. However, a significant question arises when the seller discloses an exception in the disclosure schedules: Are the R&Ws still considered accurate? This complexity is not uncommon in M&A transactions, and the parties must continue advancing toward closure despite these gray areas.

Successfully navigating a middle-market M&A transaction demands a level of trust from both sides, recognizing that not every contingency can be exhaustively documented in the agreements. In fact, attempting to cover every conceivable scenario only prolongs the transaction and reduces the likelihood of closure. Time can be detrimental to deals, whether it’s spent on minutiae or utilized to efficiently progress toward closing. An experienced advisor can provide valuable guidance on when to rely on trust and when to formalize agreements in writing.

The second question to consider is what happens if the buyer becomes aware of a breach before the closing date but chooses to proceed with the closing despite this breach.

For instance, if the seller has represented that all inventory is salable, but the buyer uncovers that a portion of it is not, and still decides to close the deal, does the buyer retain the right to sue the seller for breaching the representation later?

While the specifics would be outlined in the purchase agreement, in most cases, the buyer would be contractually bound to complete the closing and would likely be barred from suing the seller for breaching the representations and warranties that were known to be inaccurate before closing.

In general, sellers prefer to grant buyers the right to terminate the transaction only in cases of material inaccuracies in the representations and warranties. On the other hand, buyers often seek broader rights, even for immaterial inaccuracies in these representations. Additionally, the closing is typically contingent on the covenants. If the seller fails to operate the business as agreed, the buyer may have the option to walk away.

In summary, entrust your attorney to handle the legal intricacies while you stay focused on managing your business. Let them navigate the technical aspects while you steer the course.

Here are some conditions that must be met for the parties to proceed with the closing:

  • Seller must have fulfilled all obligations stated in the purchase agreement.
  • All representations and warranties made by the seller must remain accurate on the closing date.
  • Any necessary approvals and consents from the seller must be provided to the buyer.
  • All required actions to transfer intellectual property to the buyer must have been completed.
  • The business’s assets must be free and clear of any encumbrances.
  • All essential third-party consents must be obtained.
  • The business should not have experienced a “Material Adverse Change” (MAC), a term introduced after the 2008-2009 financial crisis, which is beyond the scope of this article.
  • All specified documents mentioned in the purchase agreement, such as promissory notes or non-competition agreements, must be delivered to the respective parties.

Here is a statement that ensures the accuracy of the reps and warranties at the closing:

“The representations and warranties made by the Seller and the Shareholders in this agreement or any attached Schedule shall remain true and accurate in all material respects as of the Closing Date, as if they were made at that time.”

When does the due diligence process come to an end? What if unexpected events occur between the signing of the agreement and the actual closing of the deal?

The simple, cost-effective answer is to consult the purchase agreement. However, the more complex and, often, expensive answer preferred by legal professionals is “it depends.”

Once the purchase agreement is signed (although most are signed at or after the closing), it takes charge of regulating the buyer’s obligation to proceed, especially through the “conditions precedent to closing.” Many purchase agreements feature a “Material Adverse Change/Effect” (MAC/MAE) clause that outlines conditions allowing the buyer to terminate the agreement. The purpose of a MAC clause is to allocate risk to the seller in the event of significant downturns or catastrophic incidents affecting the business between the signing and closing. In essence, if any covenants are breached, closing conditions aren’t met, or representations and warranties are untrue at closing, the buyer is not obligated to complete the deal.

If an event occurs that renders a representation untrue, the seller should promptly inform the buyer. For example, this could involve losing a major customer or facing a lawsuit. Certain purchase agreements may obligate the buyer to immediately notify the seller upon discovering 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 might withhold this information and reveal it at the last moment as a negotiating tactic. Here’s an example of such a provision:

“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 before the Closing by the Seller if the Buyer (i) fails in any material respect to perform any of its obligations contained herein that are required to be performed on or before the Closing Date, (ii) materially breaches any of its representations, warranties, or covenants contained herein, provided such failure or breach is not remedied within 30 days after the Seller has given notice to the Buyer of its intent to terminate this agreement.

Bring-Down

A “bring-down” condition necessitates both the buyer and seller to reaffirm the representations and warranties during the closing process. This requirement comes into play if there is a gap in time between signing the purchase agreement and the actual closing. In essence, the representations and warranties must not only be accurate as of the purchase agreement signing date but also remain accurate (in all material aspects) from that date through the closing.

If there is a significant change in the representations and warranties, and the purchase agreement includes a condition stating that these must be true at the closing, the buyer might have the option to terminate the transaction. The purpose behind the bring-down condition is to shift the responsibility for the business’s performance before closing to the seller. The buyer seeks assurance that the company they are acquiring will essentially be the same company at the closing. To address materiality, a bring-down condition might specify its own materiality thresholds, distinct from indemnification limitations. Materiality can be expressed as a specific number or, more often, qualitatively, such as:

“…except for inaccuracies that would not reasonably be expected to have, either individually or in combination, a material adverse effect.”

Materiality can be assessed on an individual or aggregate basis. Generally, all the representations and warranties must be materially accurate in the aggregate for the closing to proceed. In some cases, multiple immaterial inaccuracies, when considered together, could become material.

“Each of the seller’s representations and warranties in this Agreement must be completely true and correct (without considering any ‘materiality’ or similar qualifications set forth therein) as of the date of this Agreement and as of the Closing Date, as though they were made on the Closing Date, except for any inaccuracies that, either individually or in aggregate, have not caused or would not cause a material adverse effect.”

Feeling a bit overwhelmed? That’s okay. This underscores the importance of relying on your attorney’s guidance, experience, expertise, judgment, and objectivity during such negotiations. While you should grasp the fundamental mechanics of the transaction, issues like this are precisely what you hire attorneys to handle. If you’re finding it complex now, envision trying to make sense of it in the whirlwind of one of the most significant and emotionally charged transactions of your life. That’s precisely why investing in the best advisors you can afford is essential.

The level at which inaccuracies in the representations and warranties must rise is a matter of judgment, regardless of how much effort your attorney puts into fine-tuning the precise language. In business, there’s always a degree of uncertainty when buying or selling a company, and the remedy is trust. Even if you don’t have complete trust in the other party, you must proceed with a degree of trust and readiness to move forward while acknowledging some level of risk. Here’s a sample clause addressing materiality:

“All the Fundamental Representations and Warranties by the Target in this Agreement must be entirely true and correct, except for the representations and warranties in Section X, where the failure to be true and correct would not result in an increase in the total consideration required to be paid by the Buyer under Article X of this Agreement by more than $100,000.”

Closing

Once the closing conditions have been met, the closing can proceed.

In most cases, the closing is a smooth and seamless process—a mere formality that signifies the successful culmination of all prior efforts. It’s an occasion marked by its ordinary nature, yet it holds a significant place in the journey—a reminder of the meticulous planning and negotiations that led to this point. Ideally, the closing is an unremarkable affair, devoid of surprises or setbacks.

Post-Closing

After the closing, both parties have a shared interest in ensuring a smooth transition period. They are also bound by their contractual post-closing commitments, should any exist. Motivated by these obligations, they work together to maintain the accuracy of the reps and warranties beyond the closing.

For instance, if the seller represented that the receivables are collectible, it’s in the seller’s best interest to assist the buyer in collecting these receivables after the closing, fostering a seamless transition.

However, for the seller, the true closure comes when:

  • They have fulfilled their transition responsibilities.
  • Post-closing adjustments, such as working capital assessments, are settled.
  • All payments due have been received.
  • Earnout periods, if applicable, have concluded.
  • Employment and consulting agreement terms are met.
  • The indemnification period has passed.

While the closing may bring a sense of accomplishment, it’s essential for the seller to remain diligent until these key milestones are reached. There may not be a definitive moment of closure, but one day, you’ll wake up and realize that you’ve successfully fulfilled all your obligations. Congratulations! At that point, the most significant transaction of your life will be comfortably behind you.

Sample Representations, Warranties & Covenants

Seller Reps & Warranties

Here is a concise overview (though not exhaustive) of the typical representations and warranties provided by a Seller:

Approvals No approvals or notices are required for the transaction, except as outlined. Assets (Title to Assets, Ownership, Condition, Encumbrances, etc.)

  • There are no liens on the seller’s assets, except those disclosed to the relevant parties or permitted according to the agreement.
  • The entity being sold indisputably owns the assets specified in the list dated xx/xx/xxxx, and these assets will be free from any third-party claims upon closing.
  • The seller unequivocally owns the assets being sold, and upon closing, these assets will be free from any third-party claims.
  • To the best of the seller’s knowledge, the tangible assets are, and will remain upon closing, in good working order and condition.
  • The entity possesses all the assets necessary for its business operations, to the best of the seller’s knowledge.
  • The assets being transferred encompass all the assets required for the seller’s business operations, to the best of the seller’s knowledge.
  • There are no judgments, claims, liens, or ongoing legal proceedings against the seller, the business, or the assets being sold, and none are anticipated at the time of closing.
  • The seller holds clear and valid title to all assets.
  • The business and financial information provided to the buyer, as per the financial statement dated xx/xx/xxxx, is accurate, to the best of the seller’s knowledge.
  • Tangible assets are in satisfactory working order, accounting for ordinary wear and tear, except as documented. Authority The seller is duly organized and qualified in its legal jurisdiction to conduct business and is in good standing. Brokers and Agents No finder’s or broker’s fees are owed by the seller, except as specified.

Claims (Judgments, Claims, Liens, Proceedings)

  • There are no ongoing or anticipated judgments, claims, liens, or legal proceedings against the entity or its assets.

Contracts

  • The seller is not in breach of any contracts assigned to the buyer.
  • The entity is not currently or expected to be in breach of any contracts.
  • To the best of the seller’s knowledge, there are no current or anticipated breaches of any contracts.

Corporate Status

  • The entity is, and will be at closing, a [corporation/limited liability company] in good standing under the laws of the State of _______.
  • The seller is, and will be at closing, a [corporation/limited liability company] in good standing under the laws of the State of _______. The seller also possesses the necessary authority to fulfill the obligations outlined in this sales agreement.
  • The [shares/LLC interests] being transferred represent the entirety of the issued [shares/LLC interests] of the entity. No additional [shares/LLC interests] will be issued prior to closing, and at closing, these [shares/LLC interests] will be free from any claims by any other parties except the seller(s).
  • The seller is a corporation, duly organized and in good standing under the laws of the State of _______. The seller has the requisite authority to conduct its business, own or lease its assets, execute this Agreement, and fulfill its terms. The provided copies of the Certificate of Incorporation and Bylaws of the Company are accurate and unaltered. The seller has no subsidiaries or direct or indirect interests (including stock ownership) in any corporation, limited liability company, or partnership.

Customers

  • The seller has not received any written notices from its largest customers indicating an intention to discontinue or significantly reduce their business, except as documented.

Employees

  • The borrower is not subject to any liabilities under the Employee Retirement Income Security Act (ERISA).

Labor and Equal Employment

  • There are no ongoing union strikes or pending charges before the Equal Employment Opportunity Commission (EEOC).

Environmental

  • To the best of the seller’s knowledge, the seller is, and will be at closing, fully compliant with all environmental laws. Furthermore, there are, and will be at closing, no hazardous materials on the business premises that could potentially lead to future liabilities under environmental laws.
  • The entity is, and will remain, in full compliance with all environmental laws. Additionally, there are no hazardous materials on the business premises, nor will there be at closing, that might result in future liabilities under environmental laws.
  • The seller complies with all environmental laws and regulations, and its operational sites are entirely free from any environmental contamination, remediation orders, or penalties imposed by any governing authority. Seller possesses all the necessary environmental permits required for site operation, except as previously disclosed.

Financials

  • Seller’s financial statements adhere to generally accepted accounting principles (GAAP), offering complete and materially accurate representations of the business’s financial standing.

Inventory

  • To the best of the seller’s knowledge, all items within the merchandise inventory are, and will be at closing, unused and of saleable quality.
  • Inventories consist of items suitable for ordinary course sale, meeting quality and fit-for-purpose standards. Valuation is based on the lower of cost or market, utilizing a first-in, first-out (FIFO) approach, with appropriate reserves accounted for obsolescence, as previously disclosed.

Intellectual Property (IP): Trademarks, Patents, etc.

  • Seller is unaware of any pending claims and has not received information regarding such claims against the ownership or usage of intellectual property (IP).
  • Seller’s IP does not infringe upon the IP rights of others. Furthermore, there are no outstanding claims against the company for IP infringement before closing, nor any infringements involving Seller’s IP before closing, except as previously documented.

Laws (Compliance, Permits, and Licenses)

  • To the best of the seller’s knowledge, the seller currently complies with, and will continue to comply with, all laws, ordinances, and regulations relevant to the business’s operations.
  • Seller has meticulously adhered to all laws in all material respects, except as previously disclosed. Moreover, Seller possesses all critical approvals and permits required for the business, each of which remains valid and effective.

Liabilities (Absence of Undisclosed Liabilities, No Undisclosed Liabilities)

  • No undisclosed liabilities are attributed to the seller.

Litigation

  • There are no ongoing lawsuits that pose a significant adverse impact on the borrower should they be decided unfavorably, except as previously disclosed.
  • To the best of the seller’s knowledge, there is no pending or threatened legal action, or governmental investigation, which could affect the transaction, except as previously documented.

Material Adverse Change/Effect (MAC/MAE)

  • There have been no material adverse changes in the overall business or financial condition of the business since a specific date, except as previously noted.

Operations

  • As far as the seller knows, the current usage of the business premises complies with zoning laws. Furthermore, the business premises currently meet all relevant health, safety, and disabled access requirements and are, and will remain at closing, in excellent condition.

Taxes

  • At the time of closing, the seller will have promptly settled all due taxes that impact the business and its assets.
  • Seller has diligently met all tax obligations in a timely manner.

Catch-All

  • Any fact pertaining to the Seller that may significantly and adversely impact the Seller’s condition, assets, liabilities, operations, financial results, or prospects has been duly disclosed to the Buyer in writing.
  • All information shared by the Seller and the Shareholders regarding the Seller, the Assets, and the Business, including the representations and warranties in this Agreement and attached Schedules, along with all other information provided to the Buyer during their investigation of the Seller, does not, and will not as of the closing date, contain any false material statements or omit any material facts necessary to prevent misrepresentation.

Buyer Reps

Buyer’s Representations and Warranties:

  • The financial statements submitted to the bank by the borrower are accurate.
  • Buyer’s company is a duly organized entity, validly existing, and in good standing, signifying its status as a stable business.
  • Buyer possesses the authority and legal right to execute the purchase agreement.
  • Buyer is duly organized, qualified to conduct business in its legal jurisdiction, and in good standing.
  • Buyer is not in violation of its corporate governing documents and will not cause any liens or defaults, except as disclosed.
  • Buyer does not incur any finders’ or brokers’ fees, except as previously disclosed.
  • Due Diligence:
    • Buyer has had the opportunity to engage with the Seller to discuss the target business.
    • All requested materials and information have been provided to Buyer’s reasonable satisfaction.
    • Buyer has conducted an independent examination, investigation, analysis, and evaluation of the purchased assets and the target business, including assessing their value.
    • Buyer has performed due diligence, including a comprehensive review of assets, liabilities, books, records, and contracts.
  • Buyer has physically inspected the tangible assets [add “of the entity” for an entity sale] and the leased premises, verifying the accuracy of Seller’s representations. Buyer is content with the condition of the tangible assets and premises.
  • To the best of Buyer’s knowledge, the business and financial information in the financial statement dated xx/xx/xxxx, provided by Buyer to Seller, is accurate.
  • Buyer is (and at closing will be) a [partnership/corporation/limited liability company] in good standing under the laws of the State of _______, possessing the authority to fulfill the obligations outlined in this sales agreement.

Conclusion

American baseball legend Yogi Berra famously said, “It ain’t over till it’s over.” We’d like to add, “But even then, it may not be over.” This certainly holds true for reps & warranties, as demonstrated by the vacation interruption example in the introduction.

If you’ve reached this point in the article, you understand that reps & warranties are among the few components of a purchase agreement that persist beyond the closing, potentially causing issues if not handled carefully.

The solution? Be vigilant. Stay attentive.

As a seller, it’s crucial to thoroughly review the representations and not simply sign them without scrutiny. They are not boilerplate; they are significant. A breach of a rep or warranty, whether intentional or unintentional, can derail a deal or lead to financial consequences. Needless to say, neither of these outcomes is favorable.

I hope the information in this article equips you to avoid pitfalls arising from inadequate preparation when dealing with reps & warranties, a critical yet often underestimated aspect of a transaction. To summarize our discussion, here’s a concise cheat sheet. For more in-depth explanations of these key points, please refer to the article above.

R&Ws Recap: Just the Facts

*Inspired by Sgt. Joe Friday from the TV show “Dragnet”

Here’s a condensed version of the previous section on reps & warranties, presented in a straightforward bullet format. For detailed explanations of each category, please consult the corresponding sections above.

Purposes of Reps & Warranties

Why reps & warranties? Think of them as the glue that holds a deal together — or not. Here are the three primary purposes of reps & warranties:

  • Disclosure: Reps & warranties require the seller to provide full disclosure to the buyer. They cover what may be missed during due diligence.
  • Risk Allocation: Reps & warranties serve as a mechanism for allocating risk (both known and unknown) between the parties for events that are uncovered after the closing. They also serve as the buyer’s basis for future lawsuits under the “Indemnification” clause. In a buyer’s market, the role of reps & warranties in risk allocation strongly favors buyers, and vice versa.
  • Condition to Closing: Reps & warranties serve as a condition to closing. If the R&Ws are not true as of the closing date, the buyer may refuse to close.

Typical Purchase Agreement Outline

Here are the key components of a purchase agreement:

Key Terms:

  • Purchase price
  • Consideration (stock, cash, debt, earnouts, etc.)
  • Allocation of the price for tax purposes
  • Deal structure (asset vs. stock sale)
  • Miscellaneous: Expenses, notices, jurisdiction, governing law, severability, assignment, waivers, etc.

Conditions & Covenants (Do Not Survive the Closing):

  • Conditions: Events that must occur before a closing can take place (e.g., financing, landlord approval, etc.). A common condition for closing is that the reps & warranties must be true as of the closing date — called a “bring-down.”
  • Covenants: Responsibilities of the parties during the period between signing the purchase agreement and closing (e.g., seller agrees to operate the business as normal, seller agrees to retain a certain percentage of employees, fulfill outstanding purchase orders, etc.). These are rarely negotiated.

Protections Afforded to the Buyer (Survive the Closing):

  • Reps & Warranties: Promises and disclosures made by each party (e.g., seller has paid all taxes due; there is no outstanding litigation, etc.), which serve as “warranties” or “insurance” for each party in the event that a representation later proves to be untrue. R&Ws comprise the majority of the content in a purchase agreement and vary significantly based on the type of business (e.g., manufacturing will have environmental and employee concerns while technology companies have IP concerns). Reps & warranties are worded in the affirmative, and exceptions are listed in “Disclosure Schedules.”
  • Knowledge & Materiality Qualifiers: If the seller is not 100% sure 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.”
  • Exclusions: Exclusions are documented in the disclosure schedules.
  • Survival Periods: The R&Ws normally expire after 18-24 months.

Indemnification: This governs dispute resolution and the obligation to cover costs for contract breaches. Typically, 10% to 15% of the purchase price is escrowed for indemnification, with limits set by baskets (minimums) and caps (maximums).

  • Basket (Minimum): These are minimum thresholds, similar to an insurance deductible, which must be triggered. The average size is 0.75% of the purchase price. Baskets can be tipping or non-tipping, or the deductible can be shared between the buyer and seller.
  • Cap (Maximum): This is the maximum limit for indemnification, usually averaging 10% to 20% of the purchase price.
  • Parties: The buyer seeks protection from various parties, including shareholders and key managers. In cases with multiple shareholders, they should avoid agreeing to “joint and several liability.”
  • Scope: What falls under the scope of indemnification?
  • Remedies: Is indemnification the exclusive remedy for disputes?
  • Indemnification Process: How are indemnification claims handled?

The Escrow Account (usually not a separate section in the purchase agreement):

  • Amount of Money: Typically ranges from 10% to 20% of the purchase price, depending on potential risks.
  • Time Period: Usually spans 18 to 24 months.
  • Conditions: Control over its release (typically mutual) and dispute resolution.
  • Interest: Determination of who receives interest on the held escrow amount.

Negotiating Process

The Role of Reps & Warranties in the Negotiation Process

  • Due Diligence: The extent and specifics of reps & warranties hinge on due diligence findings. It’s crucial to prepare the purchase agreement alongside due diligence to expedite language negotiation.
  • Buyer’s Attorney: The buyer’s attorney drafts the purchase agreement, including a standard set of reps & warranties based on potential risks.
  • Seller’s Attorney: The seller’s attorney identifies exceptions to the reps & warranties in disclosure schedules.
  • Negotiations: Reps & warranties are a focal point during purchase agreement negotiations, particularly if the seller aims to retire without lingering obligations. Negotiations’ scope depends on the buyer attorney’s initial draft and each party’s bargaining position, influenced by market conditions. Buyers often seek extended exclusivity to strengthen their position.
  • LOI vs. Purchase Agreement: Reps & warranties are fully detailed in the purchase agreement, not the letter of intent (LOI). Negotiating the LOI precedes due diligence, so specifics are unclear until later. Hence, two negotiations occur — one for the LOI and another for the purchase agreement.
  • Content: Purchase agreements contain more seller representations as buyers have more at stake.
  • Survival: Reps & warranties typically endure post-closing, impacting both parties for years. Other elements of the purchase agreement conclude at closing. Publicly traded companies’ transactions involve reps & warranties that don’t persist beyond closing.
  • Closing: For sellers, the “true closing” follows specific criteria:
    • Fulfilling transition obligations
    • Addressing post-closing adjustments (e.g., working capital)
    • Receiving full payment
    • Completion of earnout periods
    • Satisfaction of employment and consulting agreement terms
    • Conclusion of the indemnification period

The Parties’ Goals

Let’s succinctly outline the distinct objectives of both the buyer and the seller concerning reps & warranties. It’s no surprise that these objectives often diverge.

SellerBuyer
Purchase PriceMaximizeMinimize
Cash DownMaximizeMinimize
TaxesPay Minimum TaxesMaximize Tax-Deductibility
Earnouts MinimizeMaximize
EscrowsMinimizeMaximize
R&WsMinimize ScopeMaximize Scope
IndemnificationMinimize caps & survival periodsMaximize caps & survival periods

Scope of Negotiations

Below, you’ll find a list of factors that can influence the scope of negotiations regarding reps & warranties.

Negotiating Skills & Posture

  • The negotiating skills of each party
  • The negotiating postures and bargaining strength of each party

Legal Structure

  • The structure of the transaction (asset vs. stock sale) — reps & warranties in stock deals are more comprehensive than in asset deals.

Financial Strength & Credibility of Seller

  • The financial strength of the seller to indemnify the buyer — If the shareholder group is dispersed, and the seller entity will cease to exist after the closing, the buyer will seek other protective deal measures, such as escrow.
  • The buyer’s assessment and perception of the seller’s character

Industry

  • The buyer’s knowledge of your business and industry
  • The nature of the business and its industry — Businesses with more risks will be subject to more stringent R&Ws.
  • The buyer’s perception of the business’s risks

Due Diligence

  • The extent of issues discovered during due diligence
  • The buyer’s ability to conduct thorough due diligence — The more thorough due diligence is, the weaker R&Ws can be, in theory.

Tips for Negotiating Reps & Warranties

Effectively navigating the realm of Reps & Warranties involves several key strategies:

  • Comprehend the Purpose: Remember that R&Ws aren’t about achieving perfection. They exist to shield the buyer from undisclosed, significant risks outside normal business operations.
  • Focus on the Past: R&Ws primarily pertain to past events and shouldn’t provide guarantees about the future.
  • Foster a Positive Relationship: Maintaining a good rapport with the buyer post-closing can help resolve issues more smoothly.
  • Be Flexible: Be ready to negotiate and occasionally yield on certain points. Disputes are costly, even if you win.
  • Transparency is Key: Never silently concede a point during negotiations.
  • Employ an Indemnity Matrix: Utilize a matrix to assess indemnification provisions.
  • Uncover Motivations: Understand why buyers propose specific R&Ws and address their concerns directly.
  • Caution with Financial Representations: Before signing representations related to accounting or financial matters, ensure accuracy by having your CPA review them.

Tips for Limiting the Seller’s Exposure

Here are practical methods to minimize the seller’s liability concerning reps & warranties:

  • Precise Language: Fine-tune the wording for each representation separately.
  • Individual Liability: Restrict “joint and several” liability.
  • Knowledge Qualifiers: Incorporate qualifiers like “to the best of the seller’s knowledge.”
  • Financial Safeguards: Mitigate financial exposure by:
    • Raising the deductible (basket) required for claim payment.
    • Capping the maximum payout.
    • Decreasing the escrow amount.
  • Time Constraints: Shorten the survival period and escrow duration.
  • Indemnification Limits: Constrain indemnification based on the knowledge of a representation or warranty.
  • Damage Types: Confine indemnification to actual losses rather than punitive or speculative damages.
  • Self-Insurance: Require the buyer to self-insure against specific risks.

Additional Strategies:

  • Pre-Sale Due Diligence: Initiate thorough pre-sale due diligence to proactively identify and resolve issues before entering the sale process.
  • Experienced Team: Engage a skilled negotiator, such as an investment banker or M&A advisor, to lead negotiations effectively.
  • Auction Approach: Opt for an auction strategy to bolster your negotiating position. Negotiating with multiple potential buyers enhances your leverage.
  • Credibility Matters: Maintain a consistent and trustworthy demeanor throughout the process.
  • Milestone Inclusions: Specify crucial milestones in the Letter of Intent (LOI), including deadlines for due diligence completion and purchase agreement preparation/signing.
  • Explore Alternatives: Consider alternatives to escrowing a portion of the purchase price, such as offsetting with a seller note, an earnout, or a consulting agreement with offset rights.
  • Reps & Warranties Insurance: Sellers can mitigate potential liability from R&W breaches by securing insurance. Costs typically range from 4% to 8% of the coverage amount and depend on various factors like R&W scope, industry, deductible, and coverage term.
  • Buyer Insurance: Sellers may require buyers to obtain insurance for insurable risks. Sellers can also maintain their existing policies, particularly if they are claims-based rather than occurrence-based.

Tips for Hiring Advisors To Help Negotiate the Purchase Agreement

  • Expertise: When selecting a professional advisor, prioritize real-world experience in buying and selling companies. Inquire about their recent involvement in M&A transactions over the past three years and their specific roles in those deals.
  • Advisor’s Role: Clarify the role your advisor intends to play in your situation. Some advisors prefer a background role, while others thrive on direct involvement. Align your attorney or accountant’s role with your level of experience. If you’re new to selling a business, be prepared for your advisor to take a hands-on role.
  • Risk Alignment: Ensure that your chosen advisor’s risk tolerance matches your own. While attorneys and accountants tend to be conservative, finding an advisor with a risk appetite in line with your preferences is crucial.
  • Attorney: Your attorney will play a critical role in negotiating the purchase agreement, protecting your legal interests throughout the deal.
  • Accountant: Your accountant will lead financial due diligence, examining financial and tax implications within the purchase agreement, and negotiating any financial-related reps and warranties.
  • M&A Advisor: Your M&A advisor will negotiate high-level aspects of the transaction, crafting the overall deal structure. Most M&A firms may request indemnification from the seller to protect against legal actions resulting from inaccurate information or material misrepresentation.
  • Environmental: If your business handles hazardous materials or faces environmental regulations, consider hiring an environmental consultant.
  • Employee Benefits: For a smooth transition of benefits, consult with experts well in advance of the sale to ensure assets exceed liabilities. In most cases, benefit plans will be terminated, with the seller fulfilling termination requirements and employees transitioning to the buyer’s plan.
  • Code Audit: In software company acquisitions, buyers often engage a third party for a code audit to ensure clean and well-documented software code.
  • Pre-Sale Due Diligence: Request pre-sale due diligence from your advisors. This proactive approach can reduce the scope of reps and warranties, benefiting your overall deal.

Sample Representations a Seller Might be Asked to Make:

  • The seller confidently maintains up-to-date tax payments.
  • No judgments, claims, liens, or proceedings challenge the seller’s status.
  • The seller assures the utmost accuracy in the information provided to the buyer, including precise financial data.
  • As a corporation in good standing, the seller possesses unwavering authority to engage in this transaction.
  • The assets being transferred encompass the entirety of the business, are impeccably maintained, and are entirely unencumbered by liens, encumbrances, pledges, or claims.
  • The seller steadfastly adheres to all applicable laws, spanning licensing, permits, zoning regulations, environmental standards, and more.
  • The inventory is not only ample but also in pristine, saleable condition.
  • The seller meticulously fulfills all contractual obligations and remains free of default on any commitments.
  • Hazardous substances have no place in the business operations.
  • All accounts receivable are authentic, arising in the ordinary course of business, and without any offset claims.
  • There exist no undisclosed liabilities, ongoing legal proceedings, court orders, or judgments.
  • No concealed employment, consulting, bonus, or other agreements exist with employees or third parties.
  • The seller transparently discloses all material facts that could impact the buyer’s decision to acquire the business with unwavering confidence.
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