Representations And Warranties Are An Important Part Of The Purchasing Agreement When Buying Or Selling A Business
by Dave Driscoll
When a buyer wants to purchase a business, the process typically begins with drafting and negotiating a letter of intent (LOI) outlining the business terms of the transaction, such as the purchase price, an exclusive period for negotiation and post-closing agreements, such as non-compete, employment and other agreements. The LOI defines the “essence of the deal” as negotiated between the buyer and seller and is a valuable tool for keeping the deal consistent with what the parties agreed to when setting the process in motion.
Once an LOI is signed by both parties, due diligence as well as drafting and negotiating the definitive asset purchase agreement or stock purchase agreement begin, depending on the structure of the deal. The purpose of the purchase agreement is to finalize all terms and conditions of the transaction and should be consistent with the LOI — with the addition of important legal considerations not covered in the LOI.
One topic that is not typically addressed at the LOI stage, but is heavily negotiated for the purchase agreement, are “representations and warranties.” The LOI typically states that the seller will make customary representations and warranties to the buyer, and the purchase agreement will contain the full definition of such representations and warranties. In many cases a Representations and Warranties section can be the largest portion of the purchase agreement document.
Representations mean any details about the company that are claimed to be true as of the date stated to the other party. The purpose of representations and warranties — from the buyer’s perspective — is to provide comfort for items that may not be discoverable during the due diligence process. Common seller representations include assurances regarding the seller’s ownership of the company and the authority to consummate the transaction, as well as confirmations regarding litigation, titles to assets and conformity with laws and tax obligations. Depending on the type of business being sold, the representations may also address intellectual property, customer contracts, human resources, and regulatory and environmental issues.
Purchase agreement representations and warranties give the buyer more confidence to move forward with the purchase because if anything turns out to be incorrect or not as represented after the closing, the buyer will have a contractual cure against the seller. Sellers, of course, desire the “reps and warranties” to be narrow in scope, as this reduces their liability related to the transaction post-closing.
Although the seller’s representations are the more critical component of the purchase agreement, sellers also request that the buyer provide a set of representations that are typically reciprocal to the seller’s similar representations.
Another key area of negotiation in the purchase agreement is narrowing the scope of the representations and inserting qualifiers. For example, a representation may be qualified to the knowledge of the seller or may exclude certain items that would not have a material adverse effect on the company’s future success.
Example of a representation qualifier:
To the knowledge of the seller, the seller is not in violation of any laws, material governmental orders, rules or regulations, whether federal, state or local, to which the seller or the assets are subject, except where such violation does not result in a Material Adverse Effect on the assets of the business.
If you are contemplating the sale of your business, understanding that the negotiation process does not end with the signing of the LOI is significant. Representations and warranties will be a major component within the purchase agreement. In many cases, an LOI can be negotiated without legal counsel. However, after the LOI is executed, it’s crucial that you work with your attorney to draft the purchase agreement to define the transaction and determine the appropriate scope of representations and warranties.
Dave Driscoll is president of Metro Business Advisors, a business brokerage, valuation and exit planning firm helping owners of companies with revenue up to $20 million sell their most valuable asset. Reach Dave at DDriscoll@MetroBusinessAdvisors.com or 314-303-5600. For more information, visit www.MetroBusinessAdvisors.com.