Representations and warranties – reps and warranties for short – are statements and guarantees by both parties about the M&A transaction.
The seller’s representations primarily relate to the assets, liabilities, and contracts of the business they’re selling. They’re assuring the buyer that the representations are true, and if proven otherwise, the buyer is entitled to seek legal remedies.
Reps and warranties are hotly negotiated each time they’re discussed. Full reps and warranties are documented only in the purchase agreement and not in the letter of intent (LOI) so sellers don’t see what the buyer may be proposing until later in the transaction.
Sellers sometimes counter this by asking the buyer to mark up a draft purchase agreement, but this usually happens only in larger transactions.
The purchase agreement contains far more representations about the seller because the buyer has much more to lose. They’re concerned about dozens of aspects of the business and its operations.
The seller is primarily concerned with receiving payment – they’ll ask the buyer for representations about their access to capital and their authority to purchase the business.
Not only must the topic of an individual representation be considered, but so too the collective scope of all the reps and warranties in the agreement. This varies from deal to deal.
Normally, the buyer seeks to obtain protection from as many relevant parties as possible, as broadly as possible. Expanding the scope in this way can have major financial implications, so negotiations may become contentious.
Limitations to reps and warranties can be grouped into four categories: knowledge qualifiers, survival periods, baskets (minimums), and caps (maximums).
Most M&A firms will ask the seller for indemnification against any legal actions that may occur as the result of inaccurate information or material misrepresentation. They do this because many buyers pursuing litigation will cast a wide net over anyone involved in the transaction, including the M&A advisor.
Since the seller will receive roughly 95% of the proceeds of the deal and will be the source of all the relevant information, M&A advisors argue that responsibility for accuracy rests with the seller.
Picture the scene: clear skies, white-sand beaches, warm ocean breezes. And look! There’s you: tanned and rested, John Grisham thriller in one hand, pina colada in the other.
Then the phone rings. It seems your buyer has discovered your financial statements aren’t compliant with GAAP and your EBITDA was overstated. Six months after the transition, they’re demanding a reduction in the $2 million purchase price. But isn’t the deal already closed?
Welcome to the world of reps and warranties, that phrase you happily ignored during the sales process, but which could now put the kibosh on your deal and drain your bank account. That’s why they form the bulk of a purchase agreement and much of its negotiations.
Put the pina colada to one side. John Grisham will have to wait till tomorrow.
Representations and warranties, called reps and warranties for short, are statements and guarantees by both parties in an M&A transaction.
In a purchase agreement, the seller’s reps mostly relate to the assets, liabilities, and contracts of the business being sold. The seller is assuring the buyer that the representations are true, and if proven to be otherwise, the buyer is entitled to seek legal remedies, which could result in damages payable to the buyer.
Reps and warranties are heavily negotiated and used by many buyers to flush out potential problems. Their scope varies from deal to deal. For example, a stock sale may contain wider-reaching reps and warranties than an asset sale.
Likewise, a buyer who is intimately familiar with an industry and more confident in their due diligence may demand a narrower scope than a buyer who’s less so.
As the seller, you’ll want to ensure that any statements you make are factual and accurate. Otherwise, the buyer can seek an indemnification claim after the closing. Examples of representations you might make as a seller include:
Unfortunately, full reps and warranties are documented only in the purchase agreement and not in the letter of intent (LOI). As a result, sellers don’t have the opportunity to see what the buyer may be proposing. Sellers sometimes counter this by asking the buyer to mark up a draft purchase agreement, but this usually only happens in larger, generally nine-figure transactions.
Reps and warranties are drafted later in the M&A process. This results in two stages of negotiations – one when the LOI is hammered out, and another when the purchase agreement is worked on. This is why reps and warranties are so hotly negotiated – the parties have already struck a deal and now they must negotiate a second time.
The breadth and depth of the reps and warranties are also based on facts discovered during due diligence, so their substance may change based on what was found.
The purchase agreement contains significantly more representations about the seller because the buyer has much more to lose. They’re concerned about dozens of aspects of the business and its operations.
The seller is mostly concerned with receiving payment – they’ll ask the buyer for representations about their access to capital and their authority to purchase the business.
Reps and warranties are negotiated in two stages – once for the letter of intent and again for the purchase agreement.
Here’s a list of sample reps a seller might be asked to make:
Normally, the buyer seeks protection from as many parties as possible, including all shareholders, key managers, etc., and as broadly as possible, such as stating that all information the seller has provided is accurate. Not only must the topic of an individual representation be considered, but so too the collective scope of all the reps and warranties in the agreement.
When attempting to expand the scope to third parties, negotiations may become contentious as a breach can have major financial implications.
Transactions involving publicly traded companies also include reps and warranties, but they become ineffective at closing, meaning they don’t survive beyond that point.
This is because the selling entity normally ceases to exist after the closing, and it would be too difficult to obtain indemnification from a dispersed shareholder group of perhaps thousands who are not directly party to the purchase agreement.
Publicly traded companies are also subject to numerous Securities and Exchange Commission (SEC) disclosure rules and the information they provide is assumed to be more reliable than that provided by private companies. Therefore, extensive reps and warranties are not considered critical.
For public companies, the seller’s representations are usually minimal but include a statement to the effect that the company has made all required filings with the SEC in compliance with federal securities laws.
Occasionally, the buyer will require that you include a representation that the financial statements have been prepared per generally accepted accounting principles (GAAP), though this is less common.
The parties must recognize that no business is perfect. No matter how meticulously it has been operated, problems will arise. For example, few businesses are in compliance with literally every law.
Reps and warranties are not intended to insulate the buyer from every imaginable problem. Their purpose is to protect the buyer from undisclosed, material risks that occur outside the ordinary course of running the business.
The purpose of reps and warranties is to protect the buyer from risks that occur outside the ordinary course of running the business.
Representations should primarily cover past events. They should not be designed to give the buyer assurances about the future. Operating a business involves numerous risks, so the buyer should assume those risks and not attempt to mitigate future ones.
Use a matrix to analyze indemnification provisions. These provisions can be complex and it’s best to separate the legal language from the economic parameters.
Extract the economic elements of the provision and map them out on a spreadsheet. This helps organize and analyze the terms of indemnification and facilitates tradeoffs.
Buyers propose specific reps and warranties for a reason. As the seller, you need to find out these reasons and address the concerns directly. Often, the problem can be resolved through other creative means, or the buyer may misunderstand the risk they’re trying to mitigate. Open a dialogue to educate the buyer on the risk and other methods for reducing it.
Be very careful with financial representations, such as:
“Purchase Price is based on EBITDA for the most current year of $5.2 million … continued to a separate representation … and the financial statements have been prepared in accordance with Generally Accepted Accounting Principles.”
This is a potential landmine for a seller. If your financial statements are not prepared to GAAP, and most aren’t, then you have essentially given the buyer a blank check to later negotiate the purchase price.
Before signing representations about accounting or financial matters, have a CPA review them to ensure they’re accurate.
Here are some ways you as seller can reduce your potential vulnerabilities in the reps and warranties:
Insurance is available to sellers to minimize the potential liability of reps and warranties breaches. The price is normally 4% to 8% of the coverage amount and depends on the scope of the reps and warranties, the industry the business operates in, the deductible, and the term of the coverage.
This type of insurance has become commonplace in private middle-market M&A transactions but does not cover fraud or gross negligence.
Another effective strategy for reducing the exposure of reps and warranties is to limit them based on the seller’s knowledge. This helps to place the burden of proof on the buyer.
Knowledge qualifiers can also be limited to certain parties. For example, a representation can be limited exclusively to the seller’s knowledge or it could apply to the seller’s management team.
Most sellers should attempt to limit knowledge solely to their own, as broadening the scope of liabilities to third parties can increase risk.
Sample knowledge qualifiers include:
Most agreements specify that only material breaches will be subject to indemnification.
A representation’s materiality, meaning its relevance or significance, can be addressed either in individual reps and warranties or collectively in the Indemnification section. More commonly, materiality is addressed in the Indemnification section by the use of baskets (deductibles) or other thresholds.
In most transactions, the amount of the basket is 0.50% to 0.75% of the purchase price. For example, in a $10 million transaction, a claim must exceed $50,000 to $75,000 before it is subject to an indemnification claim.
Reps and warranties are almost always limited to a specified time limit, also called a survival period, which may differ depending on the type of representation.
For example, reps and warranties regarding tax and environmental concerns may last longer or may even be perpetual in certain cases. Nonetheless, survival periods can also serve to limit a seller’s level of exposure.
Indemnification claims can also be offset by unpaid amounts of the purchase price. If the buyer has been late on the seller’s note, for example, any indemnification claims could be subtracted from the outstanding balance.
You can require that the buyer insure against any potentially insurable risks and maintain your existing policies, if the policies are made on a claims basis vs. an occurrence basis. The indemnification should be net of any insurance reimbursements.
You should request that the insurer waive any subrogation rights you may have if you aren’t the named party in the policy. This prevents the insurer from coming after you in the event of a loss.
You can cap your total exposure to breaches of reps and warranties. Caps, or limits, are generally 10% to 20% of the purchase price but may be higher for specific types of claims, such as environmental claims.
The parties to indemnification can either be the selling entity or the individual shareholders. In most cases, the selling entity ceases to exist and the buyer requests that all operating shareholders sign the purchase agreement.
A selling shareholder must personally sign the purchase agreement to be subject to indemnifying the buyer.
If there are multiple shareholders, they should not agree to joint and several liability. If they do, they can be held liable either together as a whole (joint) or individually (separate).
For example, a 10% minority partner could potentially be liable for the entire amount of the claim. Or a 60% majority partner could be held liable for the entire claim and would then have to chase down the minority partners for reimbursement.
In the case of multiple shareholders, the seller should attempt to limit indemnification on a pro-rata basis where each shareholder pays their share of the award, as opposed to joint and several liability.
The limitations to reps and warranties can be grouped into the following four categories:
One of the simplest ways to limit the scope of a representation or warranty is through a knowledge qualifier.
A knowledge qualifier limits your exposure based on your knowledge of a representation. For example, if you state that the business’s financial statements have been prepared in accordance with GAAP, and the buyer later determines otherwise, you may not be held liable. The degree to which you’re liable depends on the parties’ exact definition of “knowledge.”
Sellers will be rightfully nervous if they’re asked to make representations regarding aspects of the business of which they’re unaware.
For instance, an absentee owner may not know whether all equipment is operational. The reps and warranties are therefore often limited based on the seller’s knowledge of that specific rep or warranty, as knowledge is defined in the purchase agreement.
The seller may not have knowledge of every aspect of the business. This is especially true when the seller is an absentee owner.
These statements may precede the reps and warranties section in a purchase agreement:
In these cases, the definition of knowledge is included in the statement itself, as opposed to being defined separately in the Definitions section.
In some purchase agreements, “Knowledge” is separately defined and included in the Definitions section, and the term Knowledge is then capitalized throughout the agreement to refer back to its definition.
The precise definition of knowledge, as defined in the agreement, will have significant implications for both parties. In the absence of any knowledge qualifier, you could be 100% responsible for any rep or warranty in the purchase agreement, regardless of whether you knew it was true or not.
Narrowing the definition of knowledge can dramatically alter the dynamics and can put the burden on the buyer to prove that you knew the representation was false at the time it was made. It can also significantly limit the buyer’s indemnification rights by shifting unknown risks to the buyer.
The buyer will attempt to expand the definition of knowledge to include “constructive” knowledge, which includes information that should have been known after reasonable or due inquiry, or that should be known based on the seller’s role in the business.
For example, a CEO will be presumed to have a different level of knowledge than the knowledge known to a CTO or CMO.
Uncertainty will always be a factor. Reps and warranties are not just a test of integrity, they are a legal mechanism for allocating risk.
Give careful consideration if you’re an absentee owner with little knowledge of the business. In such cases, the definition of knowledge should suit the circumstance.
Still, you should bear in mind that knowledge qualifiers are also used as a tool for allocating risk, and you may be required to make representations regarding areas of the business about which you are not knowledgeable.
Finally, the agreement should specify whose knowledge the reps and warranties cover. Are the reps and warranties based solely on the seller’s knowledge, or is the knowledge of officers or other employees also included in the definition?
In some circumstances, such as a management buy-out (MBO), the buyer(s) may have more knowledge regarding the operations than you. In this case, management may be willing to accept more risk, though this may depend on the demands of external financing sources such as banks or PE firms.
Without knowledge qualifiers, the seller could be 100% responsible for any rep or warranty in the purchase agreement, regardless of whether they knew it was true or not.
If third parties are to be included in the definition, then you must be willing to bear the risk of depending on the knowledge of those third parties.
In some cases, officers or key employees are asked to sign a certificate in which they individually certify knowledge of reps and warranties applicable to their roles. For example, a CFO may be required to sign a certificate relating to any financial representations.
Reps and warranties are almost always limited by time. Without a survival period, it’s not clear if they survive at all, or they may be subject to the statute of limitations relative to the specific breach, such as environmental or tax concerns.
Once the survival period elapses, you may no longer be held liable to the buyer for a breach, except in circumstances like a purposeful or willful breach or fraud.
Most buyers prefer to operate the business for at least a full year, or business cycle, to identify any potential breaches. As a result, the average life of representations ranges from 18 to 24 months.
An example of a Survival Period clause is, “The reps and warranties of the Seller shall survive for a period of 18 months beyond the Closing.”
Survival periods may also differ depending on the type and nature of the reps and warranties. For example:
Reps and warranties for publicly held firms don’t survive the closing. This is for two main reasons:
Reps and warranties are almost always subject to a basket or a minimum threshold that must be met before the seller becomes liable. This operates similarly to an insurance deductible.
The Indemnification section of the purchase agreement defines what happens in the event of a dispute. It features a clause addressing the basket, sometimes called “Limitations on Amount”. You’re not liable for claims until the basket, or deductible, is exceeded. The basket sets the minimum loss the buyer must bear before you can be held liable.
For example, most M&A transactions include a basket of 0.75% of the purchase price. In a $10 million transaction, a 0.75% basket would be $75,000. You would not be liable to the buyer until the cumulative amount of the claims exceeds $75,000.
The basket serves several purposes:
“Seller shall not indemnify Buyer until the aggregate amount of all indemnity claims against Buyer exceeds the Basket, which is $50,000.“
“Seller shall have no liability until the total of all damages exceeds $100,000, and then only for the amount by which such damages exceed $100,000. However, this Section will not apply to claims under Section x and xx (e.g., tax, environmental, etc.), or to any breach of which Seller had knowledge prior to the date the representations were made, or for any intentional breach of any covenant or obligation. Seller and shareholders will be jointly and severally liable for all damages with respect to such breaches.“
“Neither Seller nor Buyer shall be liable to the other for any indemnification until the aggregate amount of Damages due to an Indemnified Party exceeds One Hundred Thousand Dollars ($100,000) (the “Basket”). Once the Basket has been exceeded, the Indemnified Party shall be entitled to indemnification for all Damages, including the amount up to the Basket and any amount in excess.“
“This provision shall not apply to any Damages suffered, sustained, incurred, or paid by an Indemnified Party related to taxes or assessments by any governmental authority, or to any claim of actual fraud or intentional misrepresentation relating to a breach of any representation or warranty in this Agreement.“
Tipping Basket: With a tipping basket, the seller must reimburse the buyer for 100% of the losses once the basket is exceeded. For example, if the basket is $100,000 and there is a $101,000 claim, you must reimburse the buyer $101,000, not $100,000.
Once the Basket has been exceeded, the Indemnified Party shall be entitled to indemnification for all Damages, including the amount up to the Basket and any amount in excess.
Non-Tipping Basket: With a non-tipping basket, or deductible, the seller only reimburses the buyer for amounts that exceed the basket amount. In the case above, with a $100,000 basket and a $101,000 claim, you would only reimburse the buyer $1,000.
“Seller shall have no liability until the total of all damages exceeds $100,000, and then only for the amount by which such damages exceed $100,000.“
Some agreements require the parties to split losses up to the basket, or deductible amount. For example, if there were a $100,000 deductible and a $101,000 loss, the buyer would be required to pay $50,000 and the seller $51,000.
This provision requires the buyer to absorb a significant portion of any losses and so motivates them to be thorough in their due diligence to mitigate potential losses. It also motivates you to help mitigate smaller losses on behalf of the buyer. To some extent, it shrinks the buyer’s motivation to “tip” a tipping basket so that they’re reimbursed for the deductible.
The average basket size is 0.75% of the total purchase price. Buyers will argue for the lowest basket possible, while sellers will seek a higher amount.
Certain reps and warranties are often not subject to the basket, such as those relating to employees, the environment, title to assets, or tax issues, as specified in this example:
“This Section will not apply to claims under Section x and xx (e.g., tax, environmental, etc.) …“
The basket may also be voided if the seller commits a willful breach, or it may be limited based on the seller’s knowledge as defined in the purchase agreement. Still, most sellers contest this language because “willful” is subjective and could equate to costly disputes. For 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.”
A cap is the maximum amount of liability a seller can impose on the buyer. For most transactions, caps average 10% to 20% of the business’s purchase price.
Once the cap is exceeded, you are no longer liable to the buyer for damages, with minor exceptions such as fraud.
Caps can be higher, or even unlimited, for the following reps and warranties:
The following is a chart of general guidelines for baskets, caps, and survival periods.
If buyers pursue litigation, they will often cast a wide net over anyone involved in the deal, including the M&A advisor. Most M&A firms will therefore ask the seller for indemnification against any legal actions that may occur as the result of inaccurate information or material misrepresentation.
Since the seller receives roughly 95% of the proceeds of the transaction and will be the source of all the information, M&A advisors argue that responsibility for its accuracy rests with the seller.
In lawsuits arising from misrepresentations, buyers will cast a wide net over anyone involved in the deal, including the M&A advisor.
Without such an indemnification, the M&A advisor would be required to verify every bit of information that passed through their hands. Such a requirement would be burdensome and hamper the process.
In my opinion, advisors should not be indemnified from acts of fraud or gross negligence, but from problems that stem from a source of inaccurate information.
Opening up the investment banker to liability for inaccurate information would cause them to second-guess the business owner in an endless number of situations, adding significant cost and time to the process. Their fees would need to be massively increased to account for the extra time and risk.
The following is sample language that may be included in the LOI to address reps and warranties made therein:
“Seller’s acknowledgment of and agreement with the terms and conditions set forth in this Letter also constitute a representation and warranty that Seller has not entered into any executory agreements or accepted any commitments concerning any of the foregoing transactions. Seller hereby agrees to indemnify and hold harmless Purchaser from and against any and all losses, claims, damages, liabilities (or actions or proceedings commenced or threatened in respect thereof), and expenses that arise out of, result from, or in any way relate to the breach of the foregoing representation and warranty. The obligations of Company and Seller under this paragraph will survive any termination of this Letter and will be effective regardless of whether a definitive agreement is executed.“
Here is a general summary, though not a complete list, of typical reps and warranties provided by sellers:
Here is a general summary, though not a complete list, of typical reps and warranties provided by buyers:
It ain’t over till it’s over. Thanks to reps and warranties, sometimes not even then.
Reps and warranties are one of the few elements of a purchase agreement that survive the closing and which can easily come back to bite you.
The antidote? Be extremely careful and pay attention. As seller, you must read the reps and warranties meticulously and never sign them as if they were boilerplate, because they rarely are.
It’s my hope that the information above will help you to avoid costly snafus, to see reps and warranties from yours and the buyer’s side, and to nail everything down – from your tax audits to the very legality of the business you’re selling.
You’ve invested your blood, sweat, and tears into an enterprise that has provided for you, your family and your employees. The moment has finally come for you to start a new chapter in your life. Explore your options now.
