If you are buying a business, you want assurances from the seller about how the assets are in good condition and the company is performing well. The seller will also want to ensure you can continue with this transaction. This is when reps and warranties come into play in an M&A purchase agreement.
Reps and warranties are statements about key aspects of the transaction and promises regarding the accuracy of the provided information.
Most representations and warranties found in the contract will be aimed at declaring the condition of the business. The contract will enlist certain information about the company being sold, and promise to compensate the other party if the assertions are false.
Representations and warranties are one of the most negotiated areas of an agreement and will take a great deal of the contract’s content. Aside from conducting due diligence, reps, and warranties provide an extra layer of protection and reduce considerably the possibility of entering a bad deal.
Here, we will help you understand what are representations and warranties, their importance in M&A, and what happens if they are breached.
What are reps and warranties in M&A?
Short for “representations and warranties”, these are statements found in purchase agreements where both the seller and the buyer define what they will contribute to the transaction. While the seller will make assertions relating to the assets and performance of the business, the buyer will declare its capacity to buy the company.
Representations define the state of the assets or stock that are included in the transaction and warranties promise the veracity of that information.
There are slight differences between both terms, but in practice they are used collectively as “reps and warranties” and lumped into the same section.
What are representations?
In M&A, a representation is a statement of fact made before the closing of the transaction. They inform about different present, past, or future aspects of the business, such as the condition of its assets or the company’s performance. If the representations are not true, or “inaccurate”, the breaching party will indemnify the opposite according to the agreement.
Among some of the representations a seller can include in a business transaction are that the business has the required permits to operate, that there is a specific number of outstanding shares, that the company has the right over its trademarks, the existence of agreements, or any liabilities related to environmental issues.
What are warranties?
On the other side, warranties are promises about the accuracy of the provided information, and they take place after the transaction, typically within 12 to 24 months after closing. This means that warranties are meant to confirm the business is as stated and give confidence to the other party by facing legal implications in case they are untrue.
As an example, a seller will warrant that no employee is suing the company for unfair dismissal.
While representations and warranties apply for both parties in a business acquisition, the seller covers most of this section, since this party needs to be specific about the different aspects of the company.
A seller will want to limit reps and warranties to material things that the seller is aware of to limit its exposure, the buyer wants them to be as broad as possible.
When buying a business, it is key for the purchasing party to conduct due diligence to examine the condition of the business. After this investigation, the lawyer will use the findings of the investigation as a basis for the purchase agreement. A qualified M&A attorney will ensure the contract is written in a way the risk is balanced between the parties.
What is the importance of representations and warranties in a transaction?
After a business acquisition, the buyer will want to ensure the business will keep running and have an optimal performance. Even when the transaction is closed, reps and warranties ensure the parties will have contractual obligations.
This is why it is so important to properly handle this section of the contract:
- Disclosure: Through reps and warranties, each party will share relevant information to help each understand the value of the transaction. The seller provides assurances about the accuracy of the information provided, while the buyer relies on these assurances when deciding to acquire the target company. This will ensure transparency and clear expectations from both parties.
- Mitigate risks: In a business transaction, it is key to ensure the risk is fairly allocated among the parties. Reps and warranties serve as the foundation for an indemnification claim and allow the affected party to have compensation for losses associated with false statements.
- Protection: Serving as closing conditions, reps and warranties can help parties withdraw from the deal if the terms are not satisfied.
Common issues addressed by reps and warranties
Some of the topics business buyers and sellers will address include the following:
- Corporate authority: Both parties will demonstrate they have the right to enter the transaction and sell the business. Also, ensure the legality of the transaction.
- Fees: This section who is going to cover brokers and finders fees
- Governance: Proper organization and good standing of the target company
- Liabilities: Absence of undisclosed liabilities or changes
- Ownership: The title to the assets, such as real estate, equipment, and inventory.
- Compliance: Informs whether the business has the required permits and licenses, and complies with health, labor, and safety regulations.
- Financials: States the accuracy of the provided income statements, balance sheets, and cash flow statements. Discloses whether the company has outstanding debts or other financial liabilities.
- Taxes: Compliance with tax obligations and disclosure about potential tax risks.
- Employee benefits: Cover anything related to benefit plans, employment contracts, benefits and compensation, and employment compliance.
- Assets: Discloses the state of equipment, machinery, inventory, technology infrastructure, and other physical assets.
- Intellectual property: Confirms the ownership and validity of patents, trademarks, copyrights, and trade secrets.
- Contracts: Disclose the existence, validity, and key terms of important agreements, such as customer contracts.
- Legal proceedings: Ensures there are no current or threatened legal disputes
What happens when there is a breach in reps and warranties?
When the promises stated in the purchase agreement are inaccurate, the available remedies will vary according to the applicable law of transaction and what was negotiated in the purchase agreement. The purchase contract must specify a procedure to follow aiming to avoid disputes and compensate the injured party.
Dispute resolution: In a purchase agreement, a qualified business lawyer will ensure to include a dispute resolution section that will define the procedure in the event of breaches or inaccuracies
Parties can get to a settlement through negotiation, mediation, or arbitration.
a) Holdback: A business buyer can use a holdback, which is when a portion of the purchase price is retained for a specific time to cover potential indemnification claims.
b) Setoff rights: A setoff right allows the buyer to unilaterally reduce the amount of any payment owed to the seller by the amount of any indemnity claim against the seller. The payments may be those related to earnout payments or promissory notes.
c) Litigation: As a last resort, parties may opt to take the case to court. If a party believes the other party purposedly gave false representations, they can file a lawsuit in court to seek compensation or performance of the contract.
Baskets and caps
Damages are assessed on an indemnity basis, called baskets and caps, that determine the amount a buyer can claim against the representations.
Baskets establish the minimum dollar amount on when a party is responsible for indemnification. They are typically determined as a percentage of a purchase price. On the other side, caps limit the overall liability of the seller to a maximum dollar amount.
Representations and Warranties vs Indemnities: What’s the difference?
While representations are statements regarding the accuracy and completeness of the information about the target company, indemnities outline the process for compensating the injured party as a result of those allegations being untrue.
Indemnifications are provisions in an M&A agreement that provide a framework for resolving disputes related to breaches of representations and warranties. They specify the rights and obligations of the parties in case of breaches of reps and warranties, defining the scope of indemnification and the process for seeking compensation for losses.
Indemnifications come into play after the deal has closed and a breach of a representation or warranty has occurred, allowing the injured party to seek compensation from the breaching party.
Although representations and warranties offer considerable protection in a transaction, it is key to conduct the M&A process accordingly to put safeguards in each step of the way.
Other clauses included in M&A Agreements
Although representations and warranties are essential, your contract should also include other clauses that give both parties assurance that the sale is going to be transparent and mutually beneficial.
Contingencies are the conditions in the contract to protect you if are ever unsure about how certain events might play out. Contingencies are important if you do not want to enter a deal unless other events happen first.
For example, if you are in a business purchase, having a financing contingency is essential just in case you are not able to pay for the business. In M&A, you also want to have a due diligence contingency where, as a buyer, you are not obligated to buy unless the results of due diligence are satisfactory.
On the flip side, if you are a seller, you want the contingencies to be as narrow and specific as possible so that the buyer cannot too easily back out of the deal. If the contingencies are too vague, then a lost deal can result in an opportunity cost for other deals that came by.
Covenants are the promises each side makes as part of the contract. For some contracts, covenants are as easy as one party buying something and the other party paying for it. But in most business deals, it’s important to take the time to know exactly what you need from the other side and get those promises in writing.
For example, if you are buying a business, you may ask the seller for help to transition the business for a few months. Or if you are entering into a long-term relationship with another party, you may ask that they carry certain insurance.
Do not ever assume that the other party just knows what you require and will assume what they will do. If you want something done by the other side, get it in writing.
At Motiva Business Law, our team of M&A attorneys is dedicated to ensuring that your transaction is a resounding success. With our expertise and commitment to excellence, we will meticulously handle every aspect of the process, including due diligence, reps and warranties, and the overall M&A strategy.
We will ensure that your rights are safeguarded and that any potential risks are mitigated through skillful negotiation and drafting.
Guiding you through each step of the transaction, our expert advice and innovative solutions to will help you overcome any challenges that may arise. Our proactive and results-driven approach will pave the way for a seamless and successful M&A transaction.