As you explore the possible sale of your business, you’ll hear a lot of references to “representations and warranties” (casually referred to as “Reps” in M&A deal jargon). The process of negotiating, drafting, revising, and responding to Reps is a critical and time-consuming aspect of any M&A deal. But what exactly are “Reps” and why do they matter to M&A sellers? We explain in this article.
1. What Are Representations and Warranties?
- A “representation” (distinguished from a “warranty” for the moment) is an assertion as to a fact that is true on the date the representation is made and which is given by a party to an M&A deal for the purpose of inducing the other party to enter into the acquisition agreements and close the underlying transactions.
- A “warranty” is a promise of indemnity if the underlying representation/assertion is not true.
Practically speaking, the terms “representation” and “warranty” (combined to mean ‘Reps’ for purposes of this article) are used together. If a representation is not true it is “inaccurate.” If a warranty is not true it is “breached.”
While buyers make limited Reps in M&A deals (e.g., such as the buyer is authorized to enter into the acquisition agreements and is a duly incorporated entity, etc.), sellers make much more exhaustive Reps as buyers rely on them in exchange for their willingness to close the deal and pay the acquisition price.
2. What do M&A Sellers Make Reps About?
Sellers always make a litany of Reps about the status, condition, assets, liabilities, employees, intellectual property, and on and on, of the business they’re selling. The seller’s Reps normally cover virtually every financial, operational, and legal element of the target business that one could possibly conceive. At a minimum, Reps for any transaction of reasonable size will extend to the following areas of the target company’s business:
- Accounting Matters and Financial Statements
- Legal Existence and Good Standing
- Compliance and Regulatory Matters
- Real Estate
- Intellectual Property
- Liens on Assets
- Labor Matters and Employee Benefit Plans
- Capitalization and Ownership
- Product Liabilities
- Customers and Suppliers
- Licenses and Permits
- Related Party Transactions
While the Reps given by M&A sellers are normally comprehensive, like with everything else in life and business, there should also be limits as to what a seller should represent and warrant to, and a well-advised seller will point to market deal studies around customary categories of Reps that are readily available to M&A professionals. For example, these studies show limited use today of draconian and open-ended “catch-all” reps that were historically more prevalent in M&A deals. On the other hand, a buyer may have identified areas of concern or known liability potential, such as ongoing litigation or known product liability issues. In these instances, the corresponding Reps are often negotiated to address the buyer’s risk on the specific areas of concern.
If the transaction size justifies it, obtaining a Representations and Warranties Insurance Policy (RWI Policy) is typically well worth the cost of the premium and can sometimes significantly reduce the typical extensive negotiations over the scope of the Reps and associated holdbacks and indemnity liability of sellers. RWI Policies, once reserved for public companies and higher-market M&A deals, have become more prevalent in lower middle-market deals. Recent trends show that RWI Policies, which provide liability coverage for breaches of Reps made by M&A sellers, are now being used in an estimated 25% of private company deals.
3. Why Do Reps Matter to Sellers?
Reps made by M&A sellers are significant to them for many reasons, including the following:
- A seller must indemnify a buyer for losses incurred because of the seller’s breach of a Rep.
- In some cases where the acquisition agreement is signed before the deal closes, it may permit the buyer to walk from the deal or terminate the agreement before closing.
- Buyers often try to shift an unwarranted amount of legal and financial risk to sellers by requiring Reps of a certain nature, which may sometimes be unjustified or overreaching.
- There may be holdbacks or escrows of purchase price funds that don’t get paid to sellers for some substantial post-closing period (a ‘survival period’) and which will only be paid if the seller has not breached Reps during that survival period.
- To support due diligence materials provided by sellers to buyers.
- To avoid fraud (g., in some cases by giving a Rep on certain matter and provided the Rep is true, it will prevent a fraud claim by the buyer on the matter at issue).
4. General versus “Fundamental” Reps and the Differences in Survival Period and Limits of Liability
In most M&A deals, various categories of Reps are more important than others. Those that are most important are termed “Fundamental.” Determining which Reps are Fundamental is often heavily negotiated and can change from deal to deal. Whether a specific Rep is Fundamental might also be affected based on the industry of the target company and/or heightened areas of risk identified by the buyer during its due diligence. Regardless, the following categories of Reps are almost always Fundamental:
- Existence and Good Standing
- No Liens
- Power and Authority
- Broker Fees
Sellers prefer the survival period of their Reps to be as short as possible and for liability to be limited or capped. The typical survival periods for non-Fundamental Reps are between 12- and 24-months after closing. But the survival periods for Fundamental Reps will always be longer—often until the lapse of the applicable statute of limitations (this can be 6 years or more for certain matters like taxes or even much longer for Reps on environmental matters in cases where environmental is relevant).
The amount of liability exposure for sellers also differs between Fundamental and non-Fundamental Reps. For example, the maximum liability for breaches of non-Fundamental Reps will normally be capped at between 10-20% of the purchase price. In contrast, the maximum liability for Fundamental Reps is often much higher (normally up to 100% of the amount of the purchase price).
5. Practical Negotiation Tips for M&A Sellers Regarding Reps
Here are some practical negotiating tips for M&A sellers regarding Reps:
- Engage highly experienced M&A counsel with proven knowledge and understanding about the use and importance of Reps. This includes knowledge of what Reps are common or overbroad, what’s objectively Fundamental (and what’s not), and the ways that Reps can translate to losses and indemnification obligations (as well as the differing survival periods and liability limits depending on whether the Rep in issue is Fundamental).
- Sellers must understand exactly what they’re asserting in the Reps—they must be able to work with their M&A counsel to provide evidence, background, and other reliable factual support to ensure they are making Reps that are 100% accurate.
- Make sure the seller’s disclosure schedules are correct in all respects. Disclosure schedules are formal legal qualifications and attachments that accompany the definitive acquistion agreement and either support or provide exceptions to the Reps. For more on disclosure schedules, see our article “M&A Disclosure Schedules: What They Are and Why They Matter.”
- Evaluate the utility and appropriateness of a possible RWI Policy.
Key Takeaways on Negotiating Reps
Negotiating Reps and the consequence of their breach is a laborious but critically important component of any M&A transaction, and what sellers don’t know can hurt them. Reps must be accurate, and the category of a particular Rep can have liability for sellers over longer periods of time and for higher amounts. Knowing which Rep belongs to what category, what’s market, and everything in between requires guidance and M&A counsel with deep experience obtained over many M&A transactions.
You can learn much more about negotiating Reps and other important components of M&A deals in our FREE guide: 10 Key Components of Successfully Selling Your Business.
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Linden Law Partners has been lead counsel for countless M&A transactions, yet we recognize the uniqueness of each deal. Contact us to discuss how we can support you in your next M&A endeavor.