As a business transaction progresses, getting into the details relative to deal closing can be a hassle, especially if either party has less experience or is unwilling to capitulate. This article sheds some light on the various reps and warranties typically provided by both buyers and sellers, and what each means for the parties involved in the transaction.
Attorneys love 'all cash' deals for one simple reason: it greatly simplifies the reps and warranties required. When non-cash consideration is provided (such as shares), the seller will typically become more stringent on the representations and warranties. This is because the fair market value of the shares is, like the seller's business, dependent on the viability, sustainability and profitability of the buyer's business. The risks inherent to the buyer become relevant and material to the seller's shareholders, which leads the seller to require verification through more stringent buyer reps and warranties.
Apart from the form of payment, the seller will typically only require the buyer represent itself as duly authorized and financially able to make the purchase and bound by the agreement to follow through. If the seller is satisfied with the buyer's ability to pay, the reps and warranties are typically very simple and will include such details as how, when and where the money will be wired.
Some seller reps and warranties are standard language in a transaction. For instance, all buyers will want representation that the seller is fully authorized to sell. The buyer wants to be assured that it will own the business once consideration is paid and the deal closes.
From the buyer's point of view, the most important seller representations are those related to the nature, value, and operations of the company being purchased. Most representations are written so as to force the seller to disclose information material to the company that may not otherwise be obvious or discovered during other processes, including due diligence.
Such representations also give the buyer more latitude in controlling a potential termination of the agreement. Terminations typically occur when representations spelled out in the acquisition agreement are determined to be false or misleading.
Reps and Warranties
The following are detailed explanations of reps and warranties typically included in standard purchase and sale agreements:
Typical financial statement representations will require the financials be in accordance with generally accepted accounting principles, complete, fairly representative of the business, and factually correct for the showcased periods. In some cases, other reps may be required that reflect adherence to Sarbanes-Oxley.
Accounts Receivable (A/R)
A/R can be one of the most hotly contested reps included in the agreement process. Buyers and sellers will not only view the A/R in a completely different light, but they'll also have competing ideas on how the A/R should be treated, who should be responsible for its collection and at what rate. In a typical transaction, sellers represent that there are no known claims to offset A/R amounts in allowance for doubtful accounts. In most cases, reps include some variation on the guarantee for the collection of A/R and include detailed information on how A/R will be treated after the transaction has taken place.
Most sellers fail to recognize the need to spell out A/R and collection info before the transaction concludes. A/R that exists after a transaction, if not explicitly spelled out, will be under the power of the new owners and thus more difficult to access. This can be especially detrimental if the A/R is large and a portion of the payout or an earnout is dependent on A/R.
Property, Plant and Equipment
Sellers often will represent the property, plant and equipment owned by the company is functional and in good enough working condition to run the day-to-day operations of the business after the transaction closes. However, some sellers have run into difficult when they make specific warranties that particular equipment will not break down. Most sellers should understand why warranting such would be foolhardy and, wherever possible, intelligently avoided.
If not already completed prior to the sale, unusable or out-of-date inventory will be required to be written off the books prior to the sale of the business.
Non-explicit balance sheet liabilities typically are those contingent liabilities and lease liabilities that are not capitalized or which occur after the completion date of the financials. Buyers will often require representation that no undisclosed liabilities are present in the business, except for those outlined in the existing balance sheet. In many instances, such a warranty will include liabilities whose balances are below a specific dollar threshold.
Reps on taxes are standard in nearly every transaction and include the warranty that the seller's taxes have been properly prepared, duly filed on a regular basis and paid in full (i.e., income, excise, customs, sales, etc.). In the case of a stock sale, understanding tax issues will play an even larger role in the reps and warranties section of an acquisition agreement. This is because any tax reassessment subsequent to the transaction close will have to be paid by the company whose shares have been acquired, and therefore be on account of the buyer.
Contracts & Leases
The buyer will need to understand whether contracts are transferable and/or assignable after the deal is closed, as well as any obligations the buyer will be required to fulfill. As such, the seller will often be required to warrant they've included all existing and current contract obligations in which the buyer will be entering.
Catch All Representations
Business buyers will often ask for general blanket statements regarding omissions or misstatements in the reps and warranties. Such broad sweeping reps are especially typical in transactions where both parties value speed above other factors like due diligence or schedule prepping.
Customers and Suppliers
Schedules of current customers and suppliers are often required during due diligence. In addition, the seller is often required to warrant relations with both suppliers and customers are clear and amicable.
Where applicable, the seller will likely enumerate all intellectual property and, in some cases, represent that none of the IP is being infringed by a third party or that the seller itself is not infringing on the IP rights of a third party.
Not only should the reps outlining employee matters cover benefit plans, the buyer may require a representation as to compliance with employee laws such as ERISA (Employment Retirement Security Act of 1974). Unions, labor relations and potential unfair labor practices or labor disputes should and will be outlined in this section of reps and warranties.
Threatened and pending claims against the company will need full disclosure in this section of the reps and warranties. Pending litigation will not require knowledge qualification like a threatened litigation.
Material Adverse Changes
Often referred to as the material adverse change clause, this clause typically protects the buyer from any material change that may occur in the nature of the business between the time when the buyer and the seller consummate the deal.
Adequate and reputable insurance is required and warranted in most transactions. In addition, any information relative to the past refusal or denial of coverage will need to be disclosed in this section. In most instances, the buyer will require a specified schedule of the insurance purchased by the seller. The buyer may also require a detailed schedule of the claims made on the policies owned.
In deals where the environment is involved, buyers are often very stringent as to the level and depth of warranty. When lenders are involved in financing of the deal, the level of scrutiny on environmental protection issues included in the reps and warranties will be under stringent review due to the risk inherent in such issues. While environmental issues will remain important, it is often unwise to provide blanket statement reps involving environmental compliance in a transaction. The comprehensive nature of protective laws for the environment makes providing such warranties is risky in the event an environmental liability arises post transaction.
Data backup, Security, and Redundancy
Today's businesses which are concerned with privacy, security and data loss are including redundancy, backup and security reps in their agreements more frequently than they did in the past.
Deal Closing? Not So Fast
Fast deal closing is rare, thanks to many of the required representations and warranties included in some of today's most in-depth M&A deals. The details and nuances inherent throughout the negotiation process can cause many deal makers and sellers to get caught-up in 'the thick of thin things.' Simplifying the process by understanding such nuances and keeping a cool head provides assurances that deals will be completed with as little headache as possible. In my opinion, it's a miracle anytime a deal is successfully completed, especially when you look at all the reasons many buyers could use to simply back out after a rep and warranty agreement is forthcoming. Luckily, the cooler heads do prevail and value is eventually traded for value.