Not So Fast – Representations and Warranties

Representations and warranties (reps and warranties) are statements of facts regarding a company’s business, assets, liabilities, and operations. As discussed in greater detail in the previous chapter and elsewhere in this book, reps and warranties 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.

The reps and warranties that are signed in the purchase agreement survive the closing when you sell your business.

Issues Addressed by Reps and Warranties

Here is a list of sample topics reps and warranties may address: 

• Corporate authority
• Brokers’ fees 
• Insurance 
• Compliance with laws 
• Employee benefits
• Product liability and warranties 
• Material contracts 
• Capitalization 
• Intellectual property 
• Title to assets
• Taxes
• Real property
• Personal property 
• Financial statements
• Inventory
• Customer agreements 
• Environmental issues

Why Reps and Warranties Are 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 reps and warranties that are signed in the purchase agreement survive the closing when you sell your business. In most purchase agreements, you must indemnify 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, also called a setoff, withhold funds from escrow, or sue you to make themselves whole again. For example, if you claim 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. 

The Purpose of Reps and Warranties

Reps and warranties serve three main purposes, so let’s look at each of them. 

Purpose 1: Reps and warranties flush out material facts.

The representations serve as a method for disclosing material facts. Without reps and warranties, buyers would need to verify every statement you make as the seller. 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 would result in performing 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.

Purpose 2: Reps and warranties function as 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.

Purpose 3: Reps and warranties are used to allocate 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 the seller’s knowledge.” The phrase “all equipment is in good repair” is more restrictive than “all equipment is operational to the seller’s knowledge.” The language used to draft the reps and warranties plays a critical role in risk allocation.

Limitations to Reps and Warranties

There are four limitations that you need to keep in mind with reps and warranties. 

Limitation 1: Knowledge Qualifiers

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 a seller states that the business’s financial statements have been prepared in accordance with generally accepted accounting principles, or GAAP, and the buyer later determines that the financial statements haven’t complied with GAAP, the seller may not be held liable. But, the degree to which the seller is held liable depends on the parties’ exact definition of “knowledge.”

Sample knowledge qualifiers include:

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

These statements may precede the reps and warranties section in a purchase agreement. For example, “To the best of Seller’s knowledge, the Seller represents and warrants that … .” 

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 representation and warranties in the purchase agreement, whether or not you knew it was true. 

Limiting the definition of knowledge can dramatically alter the dynamics and put the onus 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 your role in the business. For example, a CEO will be presumed to have a different level of knowledge than that of a CTO or CMO.

Regardless, the parties should remember that uncertainty will always be present, regardless of the parties’ desires. Reps and warranties are not solely a test of integrity but are primarily a legal mechanism for allocating risk. 

Finally, the agreement should specify to whose knowledge the reps and warranties are subject. 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? 

If third parties are to be included in the definition, you must be willing to bear the risk of depending on the knowledge of those third parties. In some circumstances, officers or key employees are asked to sign a certificate in which they individually certify knowledge of reps and warranties that are applicable to their roles. For example, a CFO may be required to sign a certificate relating to any financial representations.

Most buyers prefer to operate the business for at least a full year or business cycle to identify any potential breaches.

Limitation 2: Survival

Reps and warranties are almost always limited in time. Without a survival provision, it isn’t clear if they survive at all, or they may be subject to the statute of limitations relative to the specific breach, such as environmental, taxes, etc. Once the time period elapses, you may no longer be held liable to the buyer for a breach, except in certain circumstances such as 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. For example: “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 representation including: 

• Intellectual Property: Can often be as long as 36 months. 
• Environmental: Can be unlimited.
• 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 and Title: Can be unlimited.
• Compliance with Laws: Can be unlimited.

Limitation 3: Baskets or Minimums

Reps and warranties are almost always subject to a basket, or a minimum threshold that must be met before you become liable. This operates similarly to an insurance deductible. 

The indemnification section of the purchase agreement defines what happens in the event of a dispute. Within the indemnification section is a clause addressing the basket, sometimes called “Limitations on Amount.” You are not liable for claims until the basket, or deductible, is exceeded. The basket sets the minimum loss the buyer must bear before the seller can be held liable.

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. The seller wouldn’t be liable to the buyer until the cumulative amount of the claims exceeds $75,000.

The basket has several purposes, including that it:

• Incentivizes the buyer to bear some of the risk: This is similar to an insurance deductible. If the basket, or deductible, were zero, the buyer would have nothing to lose by submitting numerous frivolous claims.
• Acknowledges that no transaction is perfect: With a basket, the parties accept that problems will arise, and agree to not submit claims until a material threshold is exceeded. This simplifies the transaction by requiring the parties to submit only material claims.
• Improves transaction efficiency: The process goes smoothly by eliminating immaterial claims.
• Encourages the buyer to be more thorough: They will take more time to do their due diligence.

Some agreements require the parties to split losses up to the 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 therefore motivates the buyer to be thorough in their due diligence to mitigate potential losses. This also motivates the seller to help reduce smaller losses on behalf of the buyer. This lessens, to some extent, the motivation of a buyer to “tip” the tipping basket, so they are reimbursed for the “deductible.”

The average basket size is 0.75% of the total purchase price. Obviously, buyers will argue for the lowest basket possible while sellers will seek a higher basket amount. 

Certain reps and warranties are often not subject to the basket, such as those relating to employees, environmental, organizational, title to assets, or tax issues.

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 it’s defined in the agreement. However, most sellers contest this language since determining “willful” is subjective and opens them up to costly disputes.

Limitation 4: Caps or Maximums

A cap is the maximum amount of liability a seller can incur to the buyer. Caps average 10% to 20% of the purchase price of the business for most transactions. 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:

• Intellectual property (IP)
• Title to assets
• Employee matters
• Employee benefits and Employee Retirement Income Security Act (ERISA)
• Environmental issues
• Tax issues
• Organizational issues

Guidelines for Baskets, Caps, and Survival Periods

Here is a chart of general guidelines for baskets, caps, and survival periods:

General Indemnity Provision Guidelines for Baskets, Caps, and Survival Periods
	Basket	Cap(% of Purchase Price)	Survival Period
Title to Assets	None	100%	Unlimited
Taxes	None	100%	Unlimited
Organization	None	100%	Unlimited
Employees, ERISA	0.75% to 1.0%	20%	24 to 36 Months
IP	0.75% to 1.0%	20%	24 to 36 Months
Environmental	0.75% to 1.0%	10% to 100%	24 to 36 Months
All Other	0.75% to 1.0%	10% to 20%	18 to 24 Months

Tips for Negotiating Reps and Warranties

How best to work out an agreement on reps and warranties? Let us count the ways …

• Understand the purpose of reps and warranties: No business is perfect. Reps and warranties aren’t intended to insulate the buyer from every imaginable problem that can arise. The purpose of reps and warranties is to protect the buyer from undisclosed, material risks that occur outside the ordinary course of running the business. 
• Past events only: Representations should primarily cover past events. They shouldn’t be designed to provide the buyer with assurance regarding the future.
• Maintain an excellent relationship: You should attempt to maintain an excellent working relationship with the buyer after the closing. If you’re “friends” with the buyer, it’s easier to work out problems.
• Be prepared to give in at times: Be prepared to negotiate and occasionally give in on some points. Disputes are expensive and time-consuming, and even if you win, you lose.
• Make concessions known: Never make a silent concession.
• Analyze indemnity provisions using a matrix: Use a matrix to analyze indemnification provisions.
• Understand underlying motivations: Buyers propose specific reps and warranties for a reason. Find out the reason and address their concern directly.
• Beware of financial representations: Before signing representations concerning accounting or financial matters, have your CPA review them to ensure they are accurate. 

Tips for Limiting Your Exposure

Here are tips and strategies for limiting your exposure in relation to the reps and warranties.

• Tighten the Language:
  • Limit the language of each representation individually.
  • Limit “joint and several” liability in which responsibility is shared by two or more parties.
  • Add knowledge qualifiers, such as “to the best of the Seller’s knowledge.”
• Reduce Financial Exposure (Money):
  • Increase the basket, or deductible, that must be met before a claim is paid.
  • Reduce the maximum payout, or cap. 
  • Reduce the amount of the escrow.
• Reduce the Length of Exposure (Time):
  • Reduce the survival period.
  • Reduce the length of the escrow.
• Limit Indemnification:
  • Limit indemnification based on your knowledge of a representation or warranty. 
  • Limit the indemnification to actual losses, as opposed to other types of damages, such as punitive or speculative damages.
• Pre-Sale Due Diligence: Conduct pre-sale due diligence to identify and address problems before beginning the sale process. 
• Team: Hire an experienced negotiator, such as an investment banker or M&A advisor, to manage negotiations.
• Auction: Conduct an auction to improve negotiating posture – the more buyers with whom you are negotiating, the stronger your position will be.
• Credibility: Conduct yourself in a trustworthy manner at all times.
• Milestones: Include milestones in the LOI, such as dates for completion of due diligence and preparation or signing of the purchase agreement.
• Alternatives: Consider alternatives to escrowing part of the purchase price, such as an offset to the seller note, an earnout, or a consulting agreement with a right of offset.
• Reps and Warranties Insurance: Purchase reps and warranties insurance to minimize the potential liability of breaches. The price is normally 4% to 8% of the coverage amount and depends on the scope of the reps and warranties, the industry in which your business operates, the deductible, and the term of the coverage.
• Buyer Insurance: Require the buyer to insure against any risks that are potentially insurable. Maintain your existing policies if the policies are made on a claims basis vs. an occurrence basis. 

Sample Representations 

You may be asked to make representations that are broad or specific, such as the samples below:

• The seller is not delinquent regarding the payment of taxes.
• There are no judgments, claims, liens, or proceedings against the seller.
• The information the seller has given the buyer, including financial information, is accurate.
• The seller is a corporation in good standing and has the authority to enter the transaction.
• The assets being sold constitute all of the assets of the business, are in good repair, and are free and clear from liens, encumbrances, pledges, or claims.
• The seller is in compliance with all laws, including licensing, permits, zoning, environmental regulations, etc.
• The inventory is sufficient, unused, and salable.
• The seller is not in default on any obligations or contracts.
• There are no hazardous substances used in the business.
• All accounts receivable are bona fide, have arisen in the ordinary course of business, and are not subject to offset.
• There are no undisclosed liabilities, legal proceedings, orders, or judgments.
• There are no undisclosed employment, consulting, bonus, or other agreements with employees or any third parties.
• The seller has disclosed all material facts that would affect the buyer’s decision to purchase the business.

Key Points

It was American baseball legend Yogi Berra who coined the phrase, “It ain’t over till it’s over.” To which I would add, “But even then, it may not be over.” That’s certainly the case with reps and warranties, as illustrated by the interrupted-vacation example in the introduction above.

• If you’ve made it this deep into the section, you know that reps and warranties are one of the few elements of a purchase agreement that “survive” the closing, which can come back to bite you in the butt if you’re not careful. The antidote? Be careful. Pay attention.
• As a seller, you need to meticulously read the representations and, as noted above, not blindly sign them as if they were boilerplate. They’re not. 
• A breach of a rep or warranty – unwitting or not – can kill a deal at worst or lighten your bank account in less extreme circumstances. Obviously, neither outcome is desirable. 

In most M&A transactions, 10% to 20% of the purchase price is withheld by a third party in an escrow account to fulfill any post-closing indemnification obligations.