Representations and warranties in M&A play a crucial role in enabling deals to conclude and close quickly. The fast-evolving business landscape is resulting in the race to grab viable opportunities to maintain that edge over the competition.
Dealmakers want to complete transactions in shorter time spans than ever before. As a rule, M&A deals take anywhere from three to six months and can even extend to years. That is if the sector involves extensive regulatory compliances.
In an attempt to shorten the time lag, abbreviating the due diligence to move on to the closing is common. When negotiations are shorter, and dealmakers are under pressure to complete the signing quickly, they need risk-mitigating practices.
Representations and warranties in M&A in the purchase agreement secure buyers from unexpected surprises. Including these terms in the agreement helps lower the risk of post-closing litigation.
Even if the deal proceeds without adequate due diligence, including failsafe measures allows buyers and sellers to secure themselves. Also referred to as “reps and warranties,” these statements are facts and crucial information the seller reveals about their business.
These reps and warranties reassure buyers about the company they’re buying. Although these terms may include technical and legal jargon, understanding what they mean secures the deal for both parties. Reps safeguard interests and ensure that the deal progresses seamlessly.
As expert M&A advisors advise, drafting these clauses is as critical as the pricing, training period, and integration conditions. Make sure to include them when drawing up the closing date, non-compete agreements, and other terms of the M&A deal. Read ahead for detailed information on how it’s done.
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Understanding Representations and Warranties in M&A
When negotiating a merger or acquisition, the seller makes statements of facts about the company to interest the buyer. These statements offer accurate and compelling information about its assets, liabilities, and operations. They also work to allocate the risks of the deal between the parties.
In a conventional M&A deal, the seller (and/or shareholders) agree to compensate or indemnify the buyer. These compensations are subject to pre-determined baskets, time limits, exclusions, and caps and indemnify the buyer for any breaches.
Dealmakers ensure transparency when negotiating the reps and warranties extensively before adding them to the purchase document. Reps include aspects like the target company’s operational capacity, regulatory compliance, absence of hazardous materials, financial health, and IP ownership status.
Reps and warranties ensure the seller remains liable for any future obligations relevant to the sale of the company. Even after the deal closes and the check is signed, the seller has to indemnify the buyer for any misrepresentations.
The agreement includes conditions like placing a portion of the purchase price or “set-off” in escrow. That’s how the buyer offsets their risks. Alternatively, the buyer can reserve the right to sue the seller. However, reps and warranties typically come with a time limit.
This means that the seller is liable only up to a fixed time. So, dealmakers take extensive time and exercise due diligence when drafting the agreement. For instance, let’s say the seller fails to disclose any liens on the IP in a tech-driven M&A deal. The buyer can demand compensation for the damages.
Article 2 of the Uniform Commercial Code (UCC) outlines additional implied warranties that should be included in the purchase agreement. Aside from the typical reps and warranties, also add an implied warranty of title or an implied warranty of merchantability.
Representations allow buyers to make informed decisions about the deal and minimize potential liabilities after the transaction closes. Along with representations and general statements, sellers also include exceptions that they disclose in the disclosure schedule.
The disclosure schedule is attached to the purchase agreement and indicates that the buyer is aware of the information. If significant exceptions are not included or disclosed, the seller risks accusations of fraud. Having M&A advisors, attorneys, and other experienced professionals at the table is crucial.
The experts draft the agreement with careful attention to detail and extensive due diligence to protect the dealmakers’ interests.
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Breaches and Inaccuracies
When understanding representations and warranties in M&A, you should also define breaches and inaccuracies. Since representations are a statement of fact, any untrue assertions are “inaccurate.” For instance:
- The seller may represent that they have the legal right to sell the company.
- They have legal ownership of the Intangible Assets and Intellectual Property without any liens or encumbrances.
- The business assets are in good condition and operable.
- All inventory is usable and saleable.
- The business operates in compliance with all legal regulations
- No hazardous substances are used, and the workplace is compliant with labor laws.
Any warranties that are untrue are “breached” since they are assurances. For instance:
- The seller’s commitment to maintaining the business in operating condition.
- They will fulfill certain obligations before the closing, such as addressing cybersecurity risks or resolving pending litigations.
- They will cover all payroll taxes and any other dues from the past, present, and future.
Objectives of Having Representations and Warranties in M&A
Reps and warranties help speed up the M&A process and economize on the costs of due diligence. Dealmakers would have to verify every statement that the seller makes, which results in inefficiency. Since the costs of completing the deal become higher, the purchase price would take a hit.
Buyers would also have to cover additional overheads for completing the deal, including professional fees to pay for due diligence. Instead, they draw up a list of comprehensive representations and warranties and ask the seller to address them.
Let’s try an example. The buyer may ask the seller to represent that the company’s financials comply with GAAP regulations. If that is incorrect, the seller can refuse to sign the representation and work on resolving the non-compliance issues.
The seller’s refusal also indicates that the buyer may need to perform more extensive due diligence. They may have to examine the financial statements in detail to identify any other discrepancies. As a result, the deal can fall through or get delayed until the issues are sorted.
If the seller moves forward with the signing, the buyer is satisfied that the financials are in order. And the deal closes quickly.
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Breaches and Inaccuracies Can Terminate the M&A Deal
Breaches and inaccuracies can prompt the buyer to walk away from the deal. For instance, to go with the earlier examples, the seller warrants that they will ensure that the company continues operations.
However, the seller may liquidate the business assets or fire core personnel and talent, which affects company functions. Or, they may alter the product design or discontinue products in the portfolio. Any other changes they make that impact the company’s value entitles the buyer to terminate the deal.
The buyer can cite breaches in the warranty and has the right to terminate the transaction. Using the right terminology is a critical aspect of designing reps and warranties. That’s because the right terms can allocate risks more accurately.
Scopes and Modifiers
When drafting the representations and warranties in M&A, legal teams add scopes and modifiers to provide more clarity. These terms also help define the boundaries of the indemnification clauses.
Scopes clearly outline the extent and range of the risk coverage while specifying the particular issues or subjects where the reps and warranties apply. Scopes infuse clarity so that both parties are clearly aware of the risks of the transactions and applicable damages.
Modifiers are terms added to the reps and warranties to add more clarification and limit the extent of seller liability. They also outline the circumstances and situations under which the buyer can seek damages or compensation.
For example, The seller warrants that the business equipment is in good condition and usable. In that case, the purchase agreement will reflect:
All equipment is operational and in good condition.
Or, All equipment is operational and in good condition to the seller’s knowledge.
With the latter statement, the seller assumes a much higher risk. However, the earlier statement is more restrictive. Let’s try a few more:
- The seller is not aware of any applicable zoning changes that may materially affect the operation of the business.
- The seller has operated the company in compliance with all regulations for a period of at least two years prior to the closing.
Other common modifiers include:
- to the best of the seller’s knowledge
- to the extent required by law
- except as otherwise disclosed
Resolving Inaccuracies and Breaches
Ensuring accuracy in representations and warranties in M&A also helps dealmakers work out how to address any disputes. Having a game plan in place lets the deal progress smoothly, regardless of any disputes or disagreements.
Accordingly, the purchase agreement will reflect that the parties enter into arbitration or litigation. The agreement will also outline how to handle specific breaches. For instance, if the buyer identifies any discrepancies in the financial statements, they can get the records verified by an expert CPA.
Or, say the IP has unclear ownership or usage rights. In that case, the buyer can bring in expert teams to review the registration, patent, and copyrights. That’s how they can determine the veracity of the owner’s claims.
Remedies for Inaccuracies and Breaches
The purchase agreement will include the remedies to resolve the issues that arise. Dealmakers study and negotiate these remedies extensively to allocate risk. Typically, they make no allowances for the finding of intent or negligence before allowing recovery.
Several options are available to buyers to recover their potential losses in case of breaches. Like:
- Holdback in escrow: This is one of the primary remediation methods to indemnify the buyer. The dealmakers place a portion of the purchase price in escrow for a fixed time frame. The objective is to make the funds available to the buyer when any breaches of reps and warranties occur. The holdback amount is typically 10% to 20% of the purchase price and remains in escrow for six to 24 months.
- Set-off: This is another method to secure the buyer against any possible losses after the closing. They can lay claim on future payments, such as an earnout or a promissory note, to make up for risks.
- Right to litigate: This provision allows the parties to move a court of law to seek compensation for damages.
- Claims for fraud: These provisions entitle the parties to seek remedies beyond the scope of the purchase agreement and get indemnifications and damages.
Limitations on the Remedies for Breaches and Inaccuracies
Representations and warranties in M&A are subject to baskets and caps. These are the conditions that influence how disputes are triggered and how the damages are calculated. A core limitation is the time limit.
Most reps and warranties are only applicable for a fixed interval, and buyers can raise claims only within this time. Baskets and caps are other conditions applicable to disputes and remedy payouts. As with other aspects of the reps and warranties, dealmakers negotiate them extensively.
- Basket: A basket is the minimum limit in losses that the buyer must absorb before suing for damages. This amount is similar to an insurance deductible. For instance, if the pre-set basket is $75,000, the buyer must cover these losses before invoking the remedies clause. Only then can they request for compensation.
- Cap: This is the maximum dollar limit that defines the seller’s indemnification to the buyer. Caps help limit the seller’s risk exposure by limiting the buyer’s recovery amounts by infusing some amount of certainty. However, any claims arising from allegations of fraud cannot have caps. Further, caps are reasonable and cannot unreasonably restrict the buyer’s rights to sue for compensation for legitimate breaches.
Representations and warranties in M&A are essential tools to streamline the merger process and ensure that the transaction progresses smoothly. Legal advisors may also recommend that buyers and sellers invest in representations and warranties insurance (R&W insurance). This coverage adds an extra layer of protection for dealmakers.
The information in this article is intended to give you an overview of how reps and warranties work. Relying on the advice and expertise of trained professionals for guidance on how to draft them is always advisable.
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