Protecting Your Interests: The Role of Reps and Warranties in M&A

Jeffery Baxter

Sellers Seller Articles Seller FAQ

When it comes to selling your business, you've probably thought long and hard about the price, non-compete agreements, training period, and closing date.

These elements are undoubtedly crucial for a successful transaction. But there's one aspect that often gets overlooked and it holds tremendous significance: representations and warranties.

Often referred to as “reps and warranties” are the statements of fact you make about your business during an M&A transaction. They serve as assurances to the buyer, providing crucial information about the state of your business and its various aspects.

Reps and warranties might sound like a bunch of legal and technical jargon, but taking the time to comprehend and thoughtfully compose them is crucial for safeguarding your interests and facilitating a seamless sale.

At MidStreet, we've witnessed the pivotal role reps and warranties play in shaping successful deals. That's why we’re here to provide you with the knowledge and resources to navigate this critical aspect of your transaction.

In the sections that follow, I'll guide you through the basics of reps and warranties, explore their purpose and implications, and shed light on some common questions.

By the end of this article, you will have the knowledge and assurance necessary to successfully navigate this crucial element of selling your business while safeguarding your interests.

Table of Contents

1. Uncovering the Basics: Representations and Warranties

2. Statements of Facts and Assurances

3. Scopes and Modifiers in Risk Allocation

4. Capping Damages to Mitigate Risk

5. There has been a Breach – Now What?

6. How Buyers Use Reps and Warranties to Force Seller Disclosure and Allocate Risk

7. The Emergence of Reps and Warranties Insurance

8. Summary

 

Uncovering the Basics: Representations and Warranties

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In the process of selling your business, it's essential to provide potential buyers with accurate and compelling information about your company. 

These representations, known as "representations and warranties", appear in your purchase and sale agreement and are heavily negotiated between the parties.

Reps and warranties form the bedrock of trust and transparency in the sale of your business. They cover various aspects, including the financial health of your business, its legal compliance, operational status, and more.

These assertions are crucial as they provide the buyer with a certain level of confidence regarding the condition of the business they are acquiring.

During the negotiation process, both you and the buyer will carefully scrutinize these reps and warranties to ensure they accurately reflect the true state of your business. This examination helps identify and allocate potential risks associated with the transaction.

For example, your representations may include statements such as your business being in good repair, the absence of hazardous substances, compliance with all applicable laws, or your legal capacity to sign the purchase agreement.

On the other hand, warranties assure the buyer that certain assurances will be upheld, such as your commitment to operate the business in a regular and normal manner or to fulfill specific obligations until closing.

A seller's representations play a vital role in protecting both parties. The buyer depends on you so they can make well-informed decisions regarding the acquisition while your aim is to minimize possible future liabilities and instill confidence in the buyer throughout the transaction.

In most M&A transactions, the representations and warranties will be drafted as general statements, and the seller is responsible for disclosing any exceptions to those statements. These exceptions are disclosed in a schedule attached to the purchase agreement called the disclosure schedule. When an exception is appropriately revealed, the buyer is considered to be aware of the information. However, if significant exceptions are not disclosed, it can potentially lead to an accusation of fraud against the seller.

Negotiating and finalizing the reps and warranties is a critical step in your M&A transaction. It requires careful attention to detail, thorough due diligence, and the expertise of experienced professionals, such as M&A advisors and attorneys, to ensure your interests are protected.

As we delve deeper into the world of reps and warranties, we will explore how they function, their importance in the buying and selling process, and the impact they have on mitigating risk in your M&A transaction.

Statements of Facts and Assurances

Representations and warranties cover a wide range of topics that are critical to the buying and selling process. By addressing these issues, both parties can gain a comprehensive understanding of the business and mitigate potential risks.

Let's explore some of the common issues typically addressed by reps and warranties:

  1. Corporate Authority: This includes statements regarding the seller's authority to enter into the transaction and sell the business.
  2. Brokers' Fees: The representations and warranties may cover the payment of any fees or commissions owed to brokers or intermediaries involved in the transaction.
  3. Insurance: The representations and warranties may address the status and adequacy of insurance coverage for the business, including liability, property, and other relevant types of insurance.
  4. Compliance with Laws: This encompasses statements regarding the business's compliance with applicable laws, regulations, permits, licenses, and any ongoing legal obligations.
  5. Employee Benefits: The representations and warranties may cover matters related to employee benefit plans, including retirement plans, health insurance, and other benefits provided to employees.
  6. Product Liability and Warranties: These address the accuracy of product warranties and any potential liabilities associated with product defects or other product-related claims.
  7. Material Contracts: The representations and warranties may focus on the existence, validity, and key terms of important contracts, such as customer agreements, supplier contracts, leases, and other significant agreements.
  8. Capitalization: This includes statements about the capital structure of the business, including the number of outstanding shares, stock options, warrants, and any restrictions on the transfer of shares.
  9. Intellectual Property: The representations and warranties may cover intellectual property rights, such as patents, trademarks, copyrights, and trade secrets, and ensure that the business has the necessary rights to use and protect such intellectual property.
  10. Title to Assets: This addresses the ownership and clear title to the business's assets, including real estate, equipment, inventory, and intellectual property.
  11. Taxes: The representations and warranties may cover tax-related matters, including the accuracy of tax returns, payment of taxes, and any ongoing tax disputes or audits.
  12. Real Property: This involves statements regarding the ownership, condition, and legal compliance of any real estate owned or leased by the business.
  13. Personal Property: The representations and warranties may cover the ownership, condition, and legal compliance of personal property assets, such as vehicles, equipment, and machinery.
  14. Financial Statements: This includes representations regarding the accuracy and completeness of financial statements, ensuring that they have been prepared in accordance with applicable accounting standards.
  15. Inventory: The representations and warranties may address the accuracy of inventory counts, valuation methods, and any potential issues related to obsolete or slow-moving inventory.
  16. Customer Agreements: This involves statements regarding the existence, terms, and status of key customer agreements and relationships.
  17. Environmental Issues: The representations and warranties may cover environmental compliance, including any known environmental contamination, permits, and ongoing environmental obligations.

Scopes and Modifiers in Risk Allocation

Scopes and modifiers are important elements in the risk allocation process of representations and warranties. They provide further clarity and define the boundaries of indemnification obligations.

"Scopes" refer to the extent or breadth of the reps and warranties being made. They define the range of coverage and specify the subject matter to which the reps and warranties apply.

Scopes can be broad or narrow, depending on the negotiation and the level of detail desired.

Clarifying the scope of reps and warranties helps ensure that both parties have a clear understanding of the risks associated with the transaction.

"Modifiers" modify the reps and warranties by adding qualifiers or conditions to their statements.

Some common modifiers include:

  • "to the best of the seller's knowledge"
  • "materially"
  • "to the extent required by law"
  • "except as otherwise disclosed"

These modifiers help qualify the assertions made, limiting the seller's liability and clarifying the circumstances under which indemnification may be sought.

Modifiers are negotiated to provide balance and mitigate potential disputes over the interpretation of reps and warranties.

Scopes and modifiers are key components of risk allocation, ensuring a fair and balanced agreement. Careful consideration of these elements is essential during negotiations to protect your interests while still providing the buyer with reasonable recourse for breaches or inaccuracies.

Capping Damages to Mitigate Risk

In addition to scopes and modifiers, it's important to consider capping damages as a means to mitigate risk and protect your interests. By implementing certain measures, you can limit your potential exposure and provide a level of certainty in the transaction.

Indemnification rights in transaction agreements are contractual in nature, which means that the parties involved can typically define the scope of their indemnification obligations.

As the seller, you have the opportunity to limit the buyer's potential recovery by imposing caps on the damages they can seek in case of a breach of representations and warranties.

Caps

Caps define the maximum dollar limit of the seller's indemnification obligations. They establish the upper limit of financial liability for the seller, providing a degree of certainty and protection. Caps help sellers manage their potential exposure to significant indemnification claims. 

By incorporating a cap on damages, you are setting a maximum dollar limit on your indemnification obligations. This serves to protect you from excessive financial liability and provides a level of predictability in terms of potential losses.

The negotiation of caps requires careful consideration and should be approached strategically. You need to evaluate the potential risks associated with your representations and warranties, and then determine an appropriate cap that balances your willingness to assume liability with your desire to limit exposure.

It's worth noting that while capping damages can provide a safeguard, it's important to ensure the cap is reasonable and does not unreasonably restrict the buyer's ability to seek compensation for legitimate breaches. Striking the right balance is key to maintaining a fair and equitable agreement.

It's also important to note that while caps impose a limit on ordinary breaches, they may not apply to claims arising from fraud, which are typically not subject to caps.

Alongside capping damages, another important aspect to consider is the use of baskets.

Baskets

Baskets act as a threshold that must be met before a dispute can be initiated or indemnification can be sought. They represent the minimum amount of losses that the buyer must incur before being eligible for indemnification. Baskets are similar to insurance deductibles and serve to limit the buyer's ability to seek indemnity for minor losses or trivial breaches. 

Baskets represent a minimum threshold that must be met before a dispute can be initiated. Similar to an insurance deductible, the basket acts as a buffer by requiring the buyer to absorb the initial losses up to a certain predetermined amount before they can seek indemnification from you.

For example, if the basket amount is $100,000, the buyer must first incur losses exceeding $100,000 before they can pursue indemnification for those losses.

By implementing baskets and caps, you can effectively manage your potential exposure and allocate risk in a more controlled manner. These provisions provide a level of protection and certainty for both parties involved in the transaction.

It's essential to work closely with experienced M&A advisors and attorneys throughout the negotiation process to ensure that the caps and baskets are appropriately structured and align with your goals. They can provide valuable insights and help you navigate the complexities of capping damages, ensuring a fair and balanced agreement.

There has Been a Breach – Now What?

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When selling your business, it's important to be prepared for the possibility of breaches in the reps and warranties you provided to the buyer. Understanding the procedures and remedies for resolving these breaches is crucial.

The purchase agreement typically outlines the specific procedures for addressing breaches or inaccuracies in the seller's representations and warranties, except in cases of fraud.

This section, often referred to as "Disputes," establishes the mechanism for resolving conflicts and may involve arbitration, litigation, or alternative dispute resolution methods.

If a breach or inaccuracy is identified, the buyer can seek remedies as specified in the purchase agreement. The available remedies are usually negotiated between the parties.

To navigate these situations effectively, it's essential to work closely with an experienced M&A attorney and advisor who can help negotiate and draft the agreement language. They can also guide you in understanding the dispute resolution provisions and available options to address any disputes that may arise.

Common remedies for breaches in representations and warranties include: 

  1. Holdbacks: Holdbacks involve setting aside a portion of the purchase price in escrow for a defined period after closing. We typically see buyers request a percentage of the purchase price be held for a specific period, usually between six and 24 months. This amount serves as a source of funds to compensate the buyer for losses resulting from breaches. It ensures that funds are available to cover indemnification purposes if any inaccuracies are discovered. Holdbacks are usually released to the seller after the holdback period, subject to valid indemnification claims.
  2. Setoff: Setoff allows the buyer to offset any future payments owed to the seller, such as earnouts or promissory notes, against losses incurred due to breaches. This provides the buyer with a means to recover their losses without direct financial outlays
  3. Litigation: In some cases, parties may resort to litigation to resolve disputes arising from breaches. This is usually a last resort. It involves bringing the matter before a court, where a judge or jury determines the appropriate remedies and damages

It's important to note that claims of indemnification for breach of representations and warranties can also be accompanied by claims for fraud. If the buyer discovers fraudulent actions or misrepresentations, they may have additional options for seeking remedies beyond the negotiated indemnification provisions.

In summary, addressing breaches in representations and warranties requires following the procedures outlined in the purchase agreement and seeking remedies through indemnification provisions.

Understanding the dispute resolution process, available remedies, and the impact of baskets and caps is crucial in effectively managing breaches and their financial implications. 

How Buyers Use Reps and Warranties to Force Seller Disclosure and Allocate Risk

Buyers utilize reps and warranties strategically to ensure they receive accurate and complete information about the business. Let's explore how buyers leverage representations and warranties to force seller disclosure and allocate risk:

  1. Disclosing Material Facts: Reps and warranties serve as a mechanism for sellers to disclose material facts about the business. Buyers include a comprehensive set of reps and warranties in the purchase agreement, covering various aspects of the business. These assertions prompt sellers to provide truthful and detailed information, enabling buyers to assess potential risks and opportunities.
  2. Due Diligence: By scrutinizing a seller's representations, buyers can identify areas that require further investigation during the due diligence process. If a buyer suspects potential issues or discrepancies, they can request additional information, documents, or clarifications to ensure a thorough evaluation of the business. This process helps buyers gain a deeper understanding of the business's current state and make informed decisions.
  3. Risk Allocation: Reps and warranties play a critical role in allocating risk between the buyer and the seller. Through negotiations, the parties determine which risks are assumed by each party. Buyers carefully review and evaluate the representations and warranties to assess the potential risks associated with the business. They may seek specific warranties to mitigate those risks or negotiate additional protection through indemnification provisions.
  4. Escrow Holdbacks: Buyers often negotiate for a portion of the purchase price to be held in escrow for a specified period after closing. This holdback serves as a form of security and provides the buyer with a source of funds in case of breaches or inaccuracies in the representations and warranties. It incentivizes sellers to provide accurate and reliable information during the transaction.
  5. Indemnification: In the event of a breach or inaccuracy in a representation or warranty, buyers may seek indemnification from the seller. This involves requesting financial compensation to cover the losses incurred as a result of the breach. Indemnification provisions are negotiated to ensure that the buyer has recourse and can recover damages in case of any misrepresentations or breaches.

By leveraging representations and warranties, buyers compel sellers to disclose material facts, conduct thorough due diligence, and allocate risk effectively. This process promotes transparency, reduces uncertainties, and allows buyers to make informed decisions regarding the transaction.

The Emergence of Representations and Warranties Insurance

As the landscape of M&A transactions continues to evolve, the emergence of representations and warranties insurance (R&W insurance) has become somewhat of a game-changer. It offers a win-win scenario by reducing risk, enhancing transaction efficiency, and instilling greater confidence in the deal.

What is Representation and Warranty Insurance?

Representations and warranties insurance (RWI) is a specialized insurance policy that provides an additional layer of protection in acquisition agreements. Such policies safeguard against breaches of representations and warranties, offering peace of mind to both buyers and sellers.

In the past, sellers were solely responsible for indemnifying buyers in case of losses arising from breaches. Representations and warranties insurance has revolutionized this landscape by transferring a significant portion of the risk from the seller to an insurance company.

This not only mitigates potential financial burdens but also promotes a smoother and more secure transaction process.

Benefits of RWI for Sellers:

  • Peace of Mind: With an RWI policy in place, sellers can limit or even eliminate the need to provide indemnity directly, providing them with a more certain and hassle-free exit strategy. In other words, you can sleep better knowing your net proceeds are not tied up in an escrow account pending the resolution of any potential claims.
  • Reduced Post-Closing Disputes: By utilizing RWI and shifting the indemnity burden to a third party, post-closing disputes can be significantly reduced or even eliminated. This saves time, stress, and potential negotiations. It also helps preserve the relationship between the parties. This can be especially valuable in situations where the seller remains involved in the business after the transaction.
  • Faster Closing: With the transfer of risk to an insurance company, buyers may be more inclined to close deals faster, making it a win-win situation for both parties. This can also result in a shorter due diligence process.
  • More Cash at Closing: With the potential for lower or no holdback amounts, sellers can receive more cash at closing, providing greater financial flexibility.

Benefits of RWI for Buyers:

  • Enhanced Deal Security: Reps and warranties insurance provides an additional layer of protection for buyers in case of breaches. This instills confidence in the deal and can lead to a smoother negotiation process.
  • Faster Transaction: With less need for extensive negotiation and scrutiny of reps and warranties, the due diligence process can be streamlined, allowing for a faster transaction.
  • Easier Claims Process: In case of any breaches, buyers can turn to the insurance policy to pay claims as part of recovery, instead of seeking indemnification directly from the seller. This simplifies and expedites the claims process.
  • Potential Cost Savings: RWI can potentially save buyers money by limiting the need for extensive legal and financial due diligence, as well as reducing or eliminating the need for holdbacks.

Other Considerations:

When considering the purchase of RWI, it's important to keep in mind the following factors:

  • Exclusions: Like any insurance policy, RWI also has several exclusions that may limit or restrict coverage. These typically include fraud, known breaches, and certain types of losses. Carefully review the terms and conditions of the R&W insurance policy to ensure that it provides adequate coverage. In some cases, certain exclusions may limit the scope of coverage and leave either party vulnerable to potential losses.
  • Coverage Limitations: RWI policies have limits, and the buyer may still bear some risk in case of large losses that exceed the policy limit. It's important to carefully review and negotiate these terms with the insurance provider.
  • Cost: RWI comes at a cost. Premiums can range from 2% to 3.5% of the policy limit, depending on the deal size and complexity. So, a $10 million policy limit would mean a $250,000 to $350,000 one-time payment. Since minimum premiums are running at $150,000 to $200,000, I don't recommend rep and warranty insurance if you need less than $5 million of coverage.
  • Who Pays: RWI is typically borne by the buyer. However, sellers may offer to cover or split the insurance premium as part of negotiations. In cases where there are few buyers, I often see the seller agree to pay for buy-side insurance. The buyer is the insured and the party engaging with the insurance firm, but it's the seller that pays, usually through a purchase price reduction.
  • Moving Downstream: In the past, RWI was predominantly utilized in larger middle-market deals. However, there has been a notable shift in recent times, with RWI increasingly becoming a standard feature in mid-sized transactions as well. This can be attributed to the growing recognition of the benefits and risk mitigation that RWI offers. Additionally, the rise in private equity firms and strategic buyers focusing on smaller and mid-sized companies has brought more sophistication downstream to this market.
  • Experienced Advisors: When it comes to R&W insurance, it is crucial to partner with knowledgeable insurance brokers and M&A advisors who can provide expert guidance. They will not only assist in comprehending the intricacies of coverage but also ensure that the policy is in perfect alignment with your unique requirements and the stipulations outlined in your purchase and sale agreement.
  • Timing: R&W insurance policies usually take time to underwrite and negotiate, which may delay the closing of the transaction. It's essential to factor in this timeline when planning for the deal closure.
  • Negotiation: As with any insurance policy, there may be room for negotiations in terms of coverage limits, deductibles, and other factors. It's crucial to work closely with an experienced M&A advisor who can help navigate these negotiations and secure a favorable policy.

It's important to note that while R&W insurance can be a valuable tool in the M&A process, it's not a substitute for thorough due diligence or carefully crafted reps and warranties. Instead, it complements these crucial elements of a transaction to create a more secure, more confident, and ultimately more successful sale.

Summary

In this article, we’ve explored the role of representations and warranties in the context of M&A transactions. Let's recap!

  1. Reps and warranties are not merely formalities but integral components of the transaction agreement. They are heavily negotiated and serve to allocate risk between the parties.
  2. Reps and warranties are statements of fact made by the seller about the business to induce the buyer to enter the transaction. They enable you to provide valuable information about the business, set expectations, and establish trust with the buyer.
  3. Breaches of representations and warranties can have financial implications. Indemnification provisions outline remedies for breaches, and holdbacks or setoffs may be utilized to counter a buyer's financial loss.
  4. Reps and warranties insurance has emerged as a valuable tool in M&A transactions. It is provided by a specialized insurance broker and shifts a significant portion of risk from the seller to the insurance company. The use of Reps and warranties insurance provides added security and confidence for both the buyer and the seller.
  5. Reps and warranties cover various aspects of the business, including corporate authority, compliance with laws, employee benefits, financial statements, intellectual property, and more.
  6. The purposes of reps and warranties include flushing out material facts during due diligence, functioning as termination rights or closing conditions, and allocating risk between the buyer and seller.
  7. If a representation or warranty is breached or inaccurate, dispute resolution procedures are followed, and remedies such as holdbacks, setoffs, or litigation may be pursued to cover a buyer's financial loss.
  8. Buyers utilize reps and warranties to force seller disclosure of material facts, conduct thorough due diligence, and reduce the risk of a financial loss. Escrow holdbacks and indemnification provisions provide buyers with recourse in case of breaches or inaccuracies.
  9. Baskets and caps set thresholds and limits for indemnification. Scopes and modifiers further define the boundaries and specifics of indemnification obligations.

Understanding the intricacies of reps and warranties empowers you as a seller. By being conservative in the representations you make, hiring experienced M&A advisors and attorneys, and conducting thorough due diligence, you can protect your interests.

Conclusion

You're one step closer to mastering the nuances of the M&A process, and that's a significant achievement! Knowledge is power, especially when it comes to something as important as selling your business.

At MidStreet, we have a deep understanding of the complexities involved in the M&A process. With over 20 years of experience and more than 400 successful transactions under our belt, we’re committed to providing the resources and expertise needed to navigate the sale of your business with confidence.

We invite you to continue your educational journey by exploring our resource center. Dive into our collection of videos, articles, and e-books, all developed to to address common questions, share valuable insights, and equip you with the knowledge to make informed decisions.

Or just give us a call. Our analysts are here to provide personalized consultations, understand your unique situation, and guide you through every step of the journey... even if you're not quite ready to sell.

We wish you the best of luck as you embark on the path to selling your business, and look forward to the possibility of working together to achieve your goals!

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