Representations & Warranties: Top Q&As for M&As
- Author Lisa Thorsen
- Published February 12, 2020
- Word count 2,695
Congratulations! You just sold your business and think you are in the clear. You go to cash that big check and spend it all when BAM! You get hit with an indemnification claim from the buyer. Perhaps you should have read this article before you sold.
As a seller, the representations and warranties you make in a purchase agreement will be the basis for your post-closing liability. As a buyer, the representations and warranties will be your protection to ensure that you got what you paid for.
Is it really any wonder that in most M&A transactions, one of the largest, and most thoroughly negotiated portions of the purchase agreement are the representations and warranties?
What are representations and warranties?
Representations and warranties are comprised of statements of facts (i.e. representations) and promises (i.e. warranties), related to past, present (and sometimes future) facts or conditions concerning a business.
While both buyers and sellers make representations and warranties in a purchase agreement, the sellers’ will be by far the most comprehensive, for good reason. After all, it is the seller who has all the information about the business being sold. So, the seller makes the most representations and warranties in the purchase agreement, and the buyer relies on those statements and promises as fairly representing the nature of the business that they are buying.
What do they include?
In a standard mid-market M&A transaction, a seller will make 10-30 representations and warranties. A buyer paying cash upfront will typically make less than 5 (which relate to their ability to enter into the contract and pay). A buyer with ongoing payment obligations or who is purchasing stock may have about 10. However, for the purposes of this post, we will focus on seller representations and warranties.
Typical seller representations and warranties include, among others, the following:
Organization – The company has been properly organized and has the power and authority to enter into the purchase agreement.
Charter Documents – The company’s organizational documents are accurate, and all steps required by such documents (i.e. board approval, etc.) have been taken.
Capital Structure – The company’s capital table accurately reflects all shares or membership interests issued.
Financial Statements – The company’s financial statements accurately reflect business operations.
No Liabilities – There are no outstanding undisclosed liabilities or potential liabilities.
Litigation – There is no litigation pending or threatened against the company.
Taxes – All taxes have been paid and tax returns filed. There are no outstanding tax liabilities.
Sufficiency of Assets – The company has, and is transferring to buyer, all of the assets it needs to operate its business as currently being operated.
Title to Assets – The company owns the assets that it claims to own.
Real Property – The company does or doesn’t own any real property interests.
Intellectual Property – The company owns or licenses the right to all of its intellectual property.
Material Contracts – The company has disclosed all contracts material to its operations.
Compliance; Permits – The company has all required permits to operate its business and is in compliance with all government rules and regulations.
Employee Matters – The company has disclosed all employees and independent contractors, the terms of their engagement with the company (ex. compensation structure, benefit plans, etc.). There are no outstanding liabilities (vacation pay, etc.) to such employees or contractors.
Insurance – The company has disclosed all insurance policies owned by it, the limitations of such policies and all claims relating to the same.
Absence of Changes – There have been no materially adverse changes to the company or its operations since the date of the latest financial statements (or between the signing of the agreement and closing).
Product and Service Warranties – The company has adequately disclosed any ongoing contractual obligations to customers concerning product and service warranties. There are no undisclosed liabilities or claims from customers concerning the same.
Suppliers and Major Customers – The company has disclosed all major suppliers and customers and no such persons are considering severing their relationship with the company.
Brokers – The company has disclosed any relationship with brokers or finders.
No Misleading Statements – The company has not failed to disclose any information or otherwise made misleading statements in its representations and warranties.
The above list is just a cursory list of topics. In an actual purchase agreement, each representation and warranty will consist of numerous statements and facts which will further dissect and distill each topic. The representations and warranties average about 10-40 pages long, depending on the size, structure and complexity of the deal. As a seller, you will not know the breadth of these representations and warranties until you receive the first draft of the purchase agreement from the buyer’s attorney.
Why are they important?
Just like with the sale of any product, if a seller tells you that you are buying a product that functions a certain way or has certain features, and when you get home you find out that the product does nothing of the sort, you will return the product and get your money back. Businesses are similar. Sellers are held responsible post-closing for inaccurate representations or breached warranties.
Attorneys often say that representations and warranties represent an "allocation of risk" between the parties. This is because their breadth and scope determine each party’s post-closing liability.
To avoid a post-closing conflict, it is in both party’s interest that the representations and warranties are full, accurate, and complete. Anything short of that and the buyer will likely seek damages or indemnification from the seller.
How do I limit my liability as a seller?
When a seller receives the first draft of the purchase agreement, they may feel like the representations and warranties are unnecessarily extensive, that they don’t know all the answers, or that some representations and warranties, as drafted, are simply not true.
But rather than striking out a specific representation or warranty entirely, which could raise a red flag to the buyer, a seller should attempt to qualify it, which can be done in a number of ways. Take for example, the following representation:
"All contracts of the company are in full force and effect, are valid and enforceable in accordance with their terms, and no party is in default or breach of any such contracts."
- Knowledge qualifiers – As I stated above, there will be representations and warranties that deal with things that you don’t quite know. For example, can you really say for certain that no one you work with is in default of their contract? This is where knowledge qualifiers are helpful. For example, you could modify the above representation as follows:
"To the Knowledge of Seller, all contracts of the company are in full force and effect, are valid and enforceable in accordance with their terms, and no party is in default or breach of any such contracts."
The buyer’s and seller’s attorneys will argue over when and where knowledge qualifiers are appropriate. As a seller, it is unlikely that you will find a buyer willing to absorb all future risk for the unknown, but it really comes down to who negotiates the best in light of each party’s respective bargaining power.
Notice that the term "Knowledge" is capitalized. This means that it is defined term. In defining that term, the attorneys will argue about (i) whose "knowledge" applies (i.e. all sellers or just the board members, officers and significant shareholders), and (ii) what constitutes knowledge (i.e. actual knowledge or constructive "should have known" knowledge).
Disclosure Schedules – A seller can also qualify a statement by disclosing exceptions to it on the seller disclosure schedule. In this case, the above sample representation would read as follows:
"Except as otherwise set forth on Schedule [#] of the Seller Disclosure Schedules, all contracts of the company are in full force and effect, are valid and enforceable in accordance with their terms, and no party is in default or breach of any such contracts."
Almost every purchase agreement will have a seller disclosure schedule and the work of preparing these schedules generally falls on a business owner or top executive. Sellers need to make sure they have someone, with extensive knowledge of the company’s operations, to commit to completing the seller disclosure schedule. It is a tedious and time-consuming task.
Disclosure schedules are typically attached as an Exhibit to the purchase agreement and are numbered in correspondence with the section number of the representations and warranties to which they apply. In this case, if the seller was aware of a specific contract that wasn’t enforceable or which a party was in default, they would list that contract on the disclosure schedule in order to make this specific representation a full, accurate, and complete disclosure.
Materiality qualifiers – Sometimes there may be so much to disclose that you want to separate the significant from the insignificant. This can be accomplished by a materiality qualifier, such as the following:
"All Material contracts of the company are in full force and effect, are valid and enforceable in accordance with their terms, and no party is in default or breach of any such contracts."
Again, here the term "Material" should be defined by the attorneys.
Other similar qualifiers that speak to materiality include the following:
Dollar qualifiers: "All contracts of the company, which have a value in excess of $10,000, are in full force and effect, are valid and enforceable in accordance with their terms, and no party is in default or breach of any such contracts."
Time qualifiers: "All contracts of the company, entered into within the five-year period prior to Closing, are in full force and effect, are valid and enforceable in accordance with their terms, and no party is in default or breach of any such contracts."
Materiality clauses are a little tricky in that even if a seller negotiates for their inclusion, it may not have much effect on the seller’s ultimate liability post-closing, specifically if the buyer includes something called a "materiality scrape" into the indemnification provisions. But even if it doesn’t affect dollar amounts, including a materiality qualifier will help to make preparing the seller disclosure schedules more manageable.
Other language – An attorney well versed in mergers and acquisitions will know how to craft the language of your representations and warranties in a manner that will limit (or if you are a buyer, expand) the scope of the statements. For example, the differences between the words "would" and "could" can have a significant impact on the scope of the representation being made.
Even with proper qualifiers, there will never be a risk-free transaction. If there are post-closing losses or damages, either the seller or the buyer is going to be on the hook. This is why a buyer’s attorney will attempt to make the representations and warranties as broad as possible and will want to know everything! As a seller, it’s your attorney’s job to make the representations and warranties as narrow as possible (without being unreasonable), know what is customary to negotiate for and know which battles to prioritize. This is why you want an attorney well versed in mergers and acquisitions to represent you, not an attorney who primarily does divorce law, trust and estates, personal injury, etc.
When is the moment of truth?
Due to the dynamic nature of a business, a statement about a business that is true one day, may not be true the next. For this reason, a purchase agreement will specify at what time the representations and warranties have to be true. This might be at signing, is most typically at closing, and may sometimes be at a future date, or some combination of the above. If the buyer requires that a representation and warranty be true both at execution and at closing, they may have a "walk right" to cancel the agreement before closing if one of the statements made at signing is no longer true.
How much liability are we talking?
As I stated above, there will never be a risk-free transaction for both parties. Sellers and buyers will each assume a certain amount of liability risk.
However, attorneys can, and often do, negotiate certain parameters of such risk, such as liability baskets (a minimum amount of damages that must be incurred before a buyer can seek relief), caps (a maximum amount of damages), and classifications of representations (general and fundamental representations often have different liability limitations). Depending on all those factors, a seller’s post-closing liability could be capped at a certain amount, be equal to the purchase price or, in some cases (such as intentional misrepresentations or fraud), may exceed the purchase price.
Who is liable?
The party making the representations and warranties is the party that will be liable for any misrepresentations or breaches. If there is more than one seller (for example, a company with multiple shareholders), the purchase agreement will often specify which sellers are responsible and for how much.
Typically, representations and warranties are joint and several, meaning the buyer can hold any or all of the sellers 100% responsible for damages, usually up to their pro-rata portion of the sale proceeds. Some representations and warranties may only apply to a specific seller.
In fact, majority shareholders may have a fiduciary or contractual duty to shoulder most of the risk, particularly when minority shareholders had no knowledge of or control over the representation or warranty at issue. Furthermore, a minority shareholder may have signed an agreement (such as a stock restriction agreement) that has a "drag along" provision requiring them to sell their shares if the majority owners vote to do so. However, that same provision will often stipulate that in such instance the minority shareholders will not be held responsible for representations and warranties, at least not for more than their pro-rata share.
Do I really have to tell them everything?
If you take nothing else from this article, I hope you can remember the following three rules for sellers: Disclose. Disclose. Disclose. To highlight these three rules, I will give you common real-life questions that attorneys often face when dealing with sellers in the M&A process:
Seller has done "creative accounting" in the past and their financials haven’t really been prepared in accordance with GAAP as stated in the representations and warranties. Seller wants to know if disclosing this is really necessary as it might scare the buyer away. YES, DISCLOSE.
Seller provided buyer with access to "everything" during the due diligence process. A certain representation and warranty in the purchase agreement isn’t "technically true" but according to the seller, the buyer should already know that or have discovered it during due diligence. Does the seller really have to bring this to the buyer’s attention? YES, DISCLOSE.
The representations and warranties are asking for all contracts entered into over the past ten years, but that’s A LOT of contracts. It will be really, really tedious to list all those contracts on the disclosure schedule. Does the seller really have to list them all? YES, DISCLOSE.
How long do I have to wait until I can buy my Ferrari?
This depends on how long each representation and warranty "survives" the closing, which is another issue that your attorneys will negotiate. Often times certain representations that are deemed to be "fundamental" will survive longer than more "general" representations. If the buyer makes a claim during the proper survival period, the sellers will either have to pay up, or the buyer will deduct the claim from a future payment (such as an installment payment under a promissory note) or money held back in escrow. However, once the survival period for a representation or warranty ends, the seller is no longer on the hook and the buyer assumes full liability going forward.
Representations and warranties are a critical part of an M&A transaction. Do not rush, gloss over, or otherwise skimp on disclosures. Make sure that you have a competent attorney by your side.
If you are a seller or buyer who needs help drafting or negotiating representations and warranties, the attorneys at Business Lawyer Austin can help.
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