Overview
This guide details the role, negotiation, scope, and limitations of representations and warranties (reps and warranties) in M&A transactions. It outlines strategies for both buyers and sellers to manage and allocate risk, and provides practical tips for structuring these provisions effectively.
Function and Purpose of Reps and Warranties
- Reps and warranties are formal statements and guarantees made by both parties in an M&A deal, primarily concerning the business’s assets, liabilities, contracts, and compliance.
- Their main function is to protect the buyer from undisclosed, material risks related to past events, not future outcomes.
- Sellers assure the accuracy and completeness of information; if a representation is found to be false, buyers may seek legal remedies, including damages.
- These provisions are a key mechanism for allocating risk between the parties after closing.
Negotiation Process and Stages
- Full reps and warranties are included only in the purchase agreement, not in the letter of intent (LOI), so sellers often do not see the buyer’s proposed terms until later in the process.
- Negotiations occur in two main stages: first during the LOI, and again when finalizing the purchase agreement.
- The scope and substance of reps and warranties may change based on findings from due diligence, which can reveal new risks or issues.
- In larger transactions, sellers may request buyers to mark up a draft purchase agreement earlier, but this is less common in smaller deals.
Seller vs. Buyer Representations
- The purchase agreement typically contains more extensive reps and warranties from the seller, as the buyer faces greater risk if information is inaccurate or incomplete.
- Sellers focus on receiving payment and often provide reps regarding their legal authority, compliance with laws, and the condition of assets.
- Buyers provide reps about their authority to purchase, access to capital, and organizational standing.
- Both parties negotiate these provisions to clarify responsibilities and reduce the risk of post-closing disputes.
Scope and Expansion Considerations
- Buyers usually seek broad protection, requesting reps and warranties from as many relevant parties as possible (e.g., all shareholders, key managers).
- Expanding the scope to include third parties or broad assurances can significantly increase negotiation complexity and financial exposure.
- The collective scope of all reps and warranties in the agreement should be considered, as it can vary widely from deal to deal.
- In stock sales, reps and warranties may be broader than in asset sales, and buyers less familiar with the industry may demand a wider scope.
Limitations and Risk Mitigation Strategies
- Four main limitations are commonly used to manage risk:
- Knowledge qualifiers: Limit reps and warranties to what the seller actually knows or should know.
- Survival periods: Specify how long reps and warranties remain enforceable after closing, often 18–24 months, but longer for issues like tax or environmental matters.
- Baskets (minimums): Set a minimum threshold for claims before the seller is liable, similar to an insurance deductible (often 0.5%–0.75% of the purchase price).
- Caps (maximums): Limit the seller’s total liability, typically 10%–20% of the purchase price, with higher or unlimited caps for certain claims (e.g., tax, environmental).
- Sellers can further reduce exposure by:
- Purchasing reps and warranties insurance (common in private middle-market deals, but does not cover fraud or gross negligence).
- Using materiality qualifiers to ensure only significant breaches are indemnifiable.
- Negotiating for pro-rata liability among multiple shareholders, rather than joint and several liability.
- Requiring buyers to maintain insurance for insurable risks and offsetting indemnification claims against unpaid purchase price amounts.
Tips and Guidelines for Negotiation
- Focus reps and warranties on past events, not future assurances, as buyers should assume the risks of future business operations.
- Use indemnity matrices to separate legal language from economic terms, making it easier to analyze and negotiate indemnification provisions.
- Clarify the underlying motivations for each rep and warranty, and address buyer concerns directly—sometimes alternative solutions can resolve issues.
- Be cautious with financial representations, especially those referencing GAAP compliance or specific EBITDA figures; have a CPA review these before signing.
- Define and narrow knowledge qualifiers to limit seller liability, specifying whose knowledge is relevant and how it is determined.
- When multiple shareholders are involved, avoid joint and several liability; instead, negotiate for each shareholder to be liable only for their proportional share.
Public vs. Private Transaction Differences
- In public company transactions, reps and warranties generally do not survive closing due to dispersed ownership and the difficulty of obtaining indemnification from many shareholders.
- Public companies are subject to SEC disclosure rules, so their information is presumed more reliable, and extensive reps and warranties are less critical.
- In private company deals, reps and warranties are more robust and survive closing, providing ongoing protection for the buyer.
Sample Representations and Warranties
- Seller reps and warranties commonly include:
- Ownership and good title to assets, free of liens or claims.
- Good standing and authority to enter into the transaction.
- Compliance with all applicable laws, permits, and regulations.
- No undisclosed liabilities, pending litigation, or material adverse changes.
- Accurate and complete financial statements, often prepared in accordance with GAAP.
- Proper condition and sufficiency of inventory and tangible assets.
- No outstanding claims or infringements related to intellectual property.
- Timely payment of all taxes and compliance with environmental laws.
- Disclosure of all material facts that could affect the buyer’s decision.
- Buyer reps and warranties typically include:
- Organizational authority and good standing.
- Accuracy of submitted financial statements.
- Authority and legal right to execute the purchase agreement.
- No undisclosed brokers’ or finders’ fees.
- Completion of due diligence and satisfaction with the assets and business.
- No violations of governing documents or creation of new liens or defaults.
Decisions
- Limit and structure reps and warranties based on risk allocation, knowledge, and materiality.
- Include survival periods, baskets, and caps in purchase agreements to manage exposure.
- Negotiate the scope and definitions of knowledge and materiality to ensure clarity and fairness.
Action Items
- Seller/Legal Advisor: Carefully review all reps and warranties before signing any purchase agreement, ensuring they are tailored to the specific transaction.
- Seller/CPA: Have a CPA verify the accuracy of all financial representations and statements included in the agreement.
- Buyer/Seller: Use an indemnity matrix to analyze and clarify indemnification provisions, responsibilities, and exposures.
- Both Parties: Consider reps and warranties insurance and other risk mitigation tools as appropriate for the transaction size and complexity.
Recommendations / Advice
- Negotiate reps and warranties carefully; do not treat them as boilerplate, as they are rarely standard and can have significant financial consequences.
- Limit reps and warranties to what is reasonable and supportable, focusing on past events and material risks.
- Use professional advisors, including legal counsel and CPAs, to review and structure reps and warranties and related indemnification provisions.
- Consider insurance and other mechanisms to further protect your interests and reduce potential liabilities.
- Ensure all parties understand the implications of the reps and warranties, especially regarding survival periods, baskets, caps, and the allocation of liability among multiple shareholders.