What are reps and warranties, and why are they so important? When selling my mid-size business, what do I need to know before signing a purchase agreement containing representations and warranties?
Reps (short for “representations”) and warranties are statements of facts regarding a company’s business, assets, liabilities, and operations. They can relate to the past, present or future, and are included as one of several critical clauses in a purchase agreement.
- A representation is a statement of fact. If a representation is untrue, it is “inaccurate.”
- For example, a seller may represent that the assets of the business are in good repair, that all inventory is salable, that there are no hazardous substances used in the business, that the business has operated in compliance with all laws, or that the seller has the legal capacity to sign the purchase agreement.
- A warranty is an assurance. If a warranty is untrue, it is “breached.”
- For example, a seller may warrant that they will operate the business in a regular and normal manner and will comply with all laws until closing, or that they will pay all payroll taxes that will come due from past operations up to the time of closing.
In practice, however, no distinction is made between representations and warranties. They are collectively referred to as “reps and warranties” and are said to be breached if they are untrue.
We answer the following questions in this article:
- What are the most common issues addressed by reps and warranties?
- What role do reps and warranties play in the process of buying or selling a business?
- What is the purpose of reps and warranties?
- What happens if a rep or warranty is breached or inaccurate?
- Can a buyer walk away if a representation is breached?
- How are reps and warranties used to allocate risk between the buyer and seller?
- How do buyers use reps and warranties to force the seller to disclose material facts?
- What are baskets and caps, and how are they used?
- What are scopes and modifiers, and how are they used?
Reps and warranties are an important factor in the business of buying and selling business. Read on to discover how and why.
Table of Contents
- Issues Addressed by Reps and Warranties
- Why are Reps and Warranties Important?
- What is the Purpose of Reps and Warranties?
- Used to flush out material facts during due diligence
- Function as termination rights or closing conditions
- Used as a mechanism for allocating risk
- What Happens if a Representation or Warranty is Breached?
- Dispute resolution
- Baskets and caps
- Scope and Modifiers
Issues Addressed by Reps and Warranties
Reps and warranties may address any of the following topics (and others not mentioned here):
- Corporate authority
- Brokers’ fees
- Compliance with laws
- Employee benefits
- Product liability and warranties
- Material contracts
- Intellectual property
- Title to assets
- Real property
- Personal property
- Financial statements
- Customer agreements
- Environmental issues
In addition to explicit warranties drafted in the purchase agreement, Article 2 of the Uniform Commercial Code (UCC) also includes certain implied warranties, such as an implied warranty of title or an implied warranty of merchantability.
Why are Reps and Warranties Important?
Many sellers think that they can run off into the sunset after closing, free of all future obligations related to the sale of their business once the check clears. Not true.
The representations and warranties that are signed in the purchase agreement survive the closing when you sell your business. In most purchase agreements, the seller indemnifies the buyer, and a breach of a representation would be subject to indemnification.
In other words, if a statement you make later proves to be untrue, the buyer may offset a portion of the purchase price (i.e., setoff), withhold funds from escrow, or sue you to make themselves whole again.
For example, if you claim that your financial statements were prepared in accordance with GAAP and the buyer later proves this to be untrue, the buyer can seek damages from you, even after the closing.
You will remain liable for a significant period of time after the closing if any of the reps or warranties are breached or found to be inaccurate. For this reason, a significant amount of time is spent negotiating the reps and warranties.
What is the Purpose of Reps and Warranties?
Used to flush out material facts during due diligence
The representations serve as a method for disclosing material facts. Without reps and warranties, buyers would need to verify every statement made by a seller during the due diligence period. This would make for an inefficient process, and the cost of completing an acquisition would skyrocket. As a result, purchase prices would decline to offset the increased risk and higher professional fees needed to perform more thorough due diligence.
How do buyers use reps and warranties to flush out the facts? It’s simple: The buyer includes a set of comprehensive representations and warranties, then uses your response as a device for ferreting out areas of concern.
For example, the buyer may ask you to represent that your financial statements were prepared in accordance with GAAP. If you know this to be untrue, you will refuse to sign such a representation, and your attorney will either strike or heavily modify the clause. Your response will signal to the buyer that they need to perform more thorough financial due diligence. This may lengthen the due diligence period for selling your mid-size business and possibly result in a purchase price reduction if the buyer finds out there are significant deviations from GAAP.
Function as termination rights or closing conditions
For example, you may warrant that the business will operate in the normal course of events until the closing. If you decide to liquidate any assets, terminate any contracts, revise your product warranty, or make other material changes to the business outside the ordinary course of events, the buyer may have the right to terminate the transaction before the closing.
Used as a mechanism for allocating risk
For example, if you warrant that all equipment is in good repair, you will bear more risk than if you simply warrant that “all equipment is operational to seller’s knowledge.” The phrase “all equipment is in good repair” is more restrictive than “all equipment is operational to seller’s knowledge.” The language used to draft the reps and warranties plays a critical role in risk allocation.
What Happens if a Representation or Warranty is Breached or Inaccurate?
The specifics of how a dispute is handled are addressed in the purchase agreement (in a section usually called “Disputes”). For example, the agreement may require arbitration, or it may require litigation. In some cases, a breach of reps and warranties may be handled differently than any other breach. One of the most common disputes concerns errors in financial statements. Any representations made regarding the condition or accuracy of your financial statements should be carefully reviewed by your CPA.
There are several remedies available to the buyer of a mid-sized business.
- The primary method involves a holdback. This is when a portion of the purchase price is held in escrow for a period of time after closing for the sole purpose of being made available to the buyer in the event of a breach of a representation or warranty. Most holdbacks range from 10% to 20% of the purchase price and last between six and 24 months.
- Alternatively, some parties use a right of setoff against any future payments, such as an earnout or a promissory note. In some states, there is a statutory right of offset for specific claims.
- Finally, the parties may litigate.
Baskets and caps
Most reps and warranties are also subject to baskets and caps, which affect when a dispute may be triggered and how disputes are calculated:
- A basket is the minimum threshold that must be met before a dispute is initiated. A basket is similar to an insurance deductible. For example, if the basket is $50,000, the buyer must absorb the first $50,000 in damages before they are entitled to any indemnification from the seller.
- A cap is the maximum dollar limit of the seller’s indemnification obligations to the buyer.
Unfortunately, nothing in M&A is simple — the parties can negotiate varying baskets and caps for different types of losses, so it’s wise to hire an experienced M&A attorney to review your exposure. Note that losses occurring as a result of fraud are not usually subject to a cap.
Scope and Modifiers
Representations can be modified during the drafting process when selling a mid-sized business. One representation could be drafted dozens of different ways. While your M&A attorney will handle the drafting process, you should have a fundamental understanding of how modifiers work and how the language your attorney uses will affect your risk.
Here is a list of common modifiers and examples:
- Materiality: The seller is not aware of any pending zoning changes that may materially affect the operation of the business.
- Time Periods: The company has operated the business in compliance with all laws for a period of two years prior to the closing.
Understanding the role of reps and warranties and how they function in M&A transactions is critical if you are selling a mid-sized business. Protect yourself by being conservative in the representations you make and by hiring an experienced M&A advisor and attorney to represent you.