During a merger or acquisition, sellers and buyers make a lot of promises and statements. In the due diligence state of a business purchase, business sellers lay out their financial records, showcase their company’s growth and highlight its potential for future earnings. When buying shares of the target company, buyers also must demonstrate that they have the funding to complete the sale.
But what if someone is not telling or showing the whole story? That’s where representations and warranties come into play in a purchase agreement. These reps and warranties spell out the current and expected future state of the business and protect the parties when the other side doesn’t disclose everything. If there’s material omissions in the due diligence process, there’s possible litigation if there’s a breach of the purchase agreement.
The reps and warranties, coupled with a very detailed indemnification clause, help determine what happens next.
What are some important breaches of representations and warranties?
The purchase agreement and accompanying due diligence show the health and operations of the business as it is now.
Things the seller might hide
- The true financial condition of the company
- The seller’s authority to actually sell the business
- Employee’s contracts or past issues with them key employees
- Liabilities to creditors or past litigations
- Taxes liabilities
- Noncompliance with laws related to its operations
- Ownership of trademarks and patents
- Pending or potential litigation
- Safe-keeping of important trade secrets
Essentially, warranties are written guarantees that the business will continue to run as forecasted into the future—at least two years. The due diligence stage and the content of the purchase agreement needs to be guided by an experienced advisor, specifically a lawyer and a seasoned accountant in acquisitions.
Reps and warranties provide opportunities for either party to end the deal and walk away. They ensure that neither party takes on all of the risk of the purchase. And they motivate both parties to lay out the facts instead of glossing over them or misrepresenting their interests.
What do reps and warranties cover?
Even for businesses with less than 200 employees, the reps and warranties provision of a purchase agreement can be lengthy and take up a considerable amount of time to negotiate. It can get complicated because it should cover all aspects of the business—from the ownership of the company itself to its assets, contracts, employee benefits and other issues. That’s why it’s especially important to have a lawyer with deep experience in M&A on your side.
For buyers who are paying cash, their reps and warranties may be limited. But still their reps and warranties will need to prove that they are in good standing, have the required financing and have no conflicts related to the purchase, among other things.
What happens when promises made in reps and warranties aren’t met?
Maybe the seller promised that there were no investigations into the operation but, as it turns out, federal agents have been looking into safety issues and, shortly after the sale, fined the company.
The indemnification section of a purchase agreement covers what happens when either party hasn’t lived up to its representations and warranties. It spells out, for example, who will be required to pay up, which issues will constitute a breach, how long each side is responsible for the losses and how much the injured party is owed.
In many M&A transactions, a portion of the purchase price is held in escrow for a period of time to pay for indemnification obligations that may arise. Once that time period expires, the seller claims the escrow balance minus any money that was paid out for indemnification issues.
More recently, a growing number of buyers and sellers are investing in representations and warranties insurance to reduce, or even nix, the need for an escrow account and so both parties face fewer risks or liabilities related to the sale.
During any M&A transaction, an acquisitions attorney they will ensure that your side is represented well in the thick of negotiations to ensure the purchaser of a business is a good fit for the transaction, or if you’re acquiring the business, whether it is going to be as profitable or has the potential you envision.
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