This is part seven of our series discussing the sale of a business from the seller’s perspective. We’ve covered deal structure issues, seller financing, earn-outs, letters of intent, due diligence, and the first section of the purchase agreement dealing with major business points. In this post, we’ll discuss the seller’s representations and warranties and the related disclosure schedules to the purchase agreement. Lawyers frequently debate the subtle and esoteric differences between “representations” and “warranties”, but for our purposes, in this post, they are basically statements that the parties make about themselves and their businesses, and we’ll refer to them simply as “representations”.
The purchase agreement will typically contain a comprehensive list of representations that the seller is asked to give. Often, there will be 20 to 30 different sections covering various areas of the seller’s business, assets, etc. The following is just a sample:
- Due organization and good standing
- Capitalization
- Noncontravention (i.e., the purchase agreement will not contravene the seller’s organizational documents, any laws, any governmental orders, etc.)
- Financial statements
- Compliance with laws
- Tax matters
- Intellectual property
- Contracts
- Litigation
- Employees
- Environmental, health, and safety
- Related party transactions
- Customers
The representations serve three primary purposes from the buyer’s perspective. First, they further the due diligence process by (hopefully) ferreting out problems or issues with the seller’s business or assets so they can be addressed before an agreement is signed or taken into account in arriving at a purchase price; if they are sufficiently grave, the parties may abandon the deal.
Second, in the case of a deal in which the purchase agreement is signed and the closing is scheduled for a later date (as opposed to simultaneous signing and closing), the representations serve as a basis for allowing the buyer to walk away from the deal without closing (“walk rights”) if the buyer learns that the representations are not accurate at closing.
Third, they serve as a basis for allowing the buyer to recover some of its purchase price (through indemnification) after closing if the seller’s representations are inaccurate and the buyer incurs damages (this latter function is referred to as “risk shifting” in industry jargon because each party is attempting to negotiate the language of the representations to shift the risk of post-closing events to the other party).
Here’s sample language from a purchase agreement requiring the seller to represent that it is in compliance with legal requirements:
The Seller is, and has been since January 1, 2010, in compliance with all applicable laws (including rules, regulations, codes, plans, injunctions, judgments, orders, decrees, rulings, and charges thereunder) of federal, state, local, and foreign governments (and all agencies thereof), and no action, suit, proceeding, hearing, investigation, charge, complaint, claim, demand, or notice has been filed, commenced, or threatened against the Seller alleging any failure to so comply.
As is customary, the buyer has used very broad language in this representation and the seller needs to know how to handle the representation in its negotiations of the purchase agreement. With that in mind, here are some tips for sellers engaged in those negotiations:
Tip 1 — Consider Who Should Give the Representations. The purchase agreement will typically include a lead-in statement that applies to the entire list of representations, such as the following:
The Seller and Shareholders, jointly and severally, represent and warrant to Purchaser that the statements contained in this Section 2 are true, correct and complete as of the date of signing and the Closing Date, as modified in the applicable section of the disclosure schedule accompanying this Agreement (the “Disclosure Schedule”).
This particular language is from an asset deal and requires the seller (the entity) and the shareholders of the seller to make the representations. So task one is to determine if this is appropriate or not. Ideally, in an asset deal, the seller’s shareholders will not have to give the representations, but often the buyer will insist that they do (at least perhaps majority owners). The smaller the company and the fewer the shareholders, the more likely it will be that individual shareholders will have to make the representations.
Also note that the representations are joint and several — meaning that the seller (the entity) and the shareholders are on the hook for the statements. At the end of the day, it may be the case that the entity and the shareholders have no choice but to give some or all of the representations, but think this through very carefully and limit shareholder responsibilities as much as possible.
Tip 2 — Review and Narrow. The buyer’s initial draft of the purchase agreement will likely request overly broad representations from the seller as to its business and assets. The seller’s initial task is to review the statements very closely and determine those that it can give with certainty and those that are perhaps less certain. As an example, many sellers might react as follows when reviewing the sample representation on legal compliance above: “I think we’re in compliance with all laws but I am not totally sure.”
In that case, the seller’s goal is to make the statement completely true with as much certainty as possible by either narrowing the representation and/or making adequate disclosures (the latter is discussed below). When reviewing the representations, be sure to get input from others in the organization who might have knowledge of any issues covered by the statements (e.g., a human resources manager).
After you have a good understanding of your ability to make each representation with certainty (or not), consider narrowing the representations as much as possible, particularly those that result in significant risk to the seller and its shareholders. Common ways to narrow representations include adding “knowledge” and/or “materiality” qualifiers to the statements requested by the buyer. As an example, here’s the representation on legal compliance quoted above rewritten from the seller’s standpoint (with the seller’s additions in bold):
Except as set forth on disclosure schedule [cross-reference section number], and except with respect to any violations which would not have a Material Adverse Effect, the Seller is, and has been since January 1, 2012, in compliance with all applicable laws (including rules, regulations, codes, plans, injunctions, judgments, orders, decrees, rulings, and charges thereunder) of federal, state, local, and foreign governments (and all agencies thereof), and no action, suit, proceeding, hearing, investigation, charge, complaint, claim, demand, or notice has been filed, commenced, or, to the knowledge of the Seller, threatened against the Seller alleging any failure to so comply.
The seller’s modified language changes the representations in four ways. First, the seller has added a disclosure schedule in which the seller will note any violations of laws or pending or threatened suits, charges, etc.
Second, the seller’s version limits the entire representation to legal violations that would cause a Material Adverse Effect (a term that will be defined in the purchase agreement to indicate the negative effect of certain events on the seller’s business), but not that there are no violations, period.
Third, the seller has changed the applicable date from January 1, 2010 to January 1, 2012.
And fourth, the seller has added a knowledge qualifier with respect to issues that are simply threatened rather than actually in process. Taken as a whole, the representation as revised by the seller poses much less risk for the seller and hopefully the seller can now make this statement with a high degree of certainty.
Tip 3 — Disclose, Disclose, Disclose! The seller must disclose any items required to make a representation true. So for example, if the legal requirement representation described above is true except that the seller believes it may have violated an employment law and has received an initial notice from the EEOC, then the disclosure schedule can be used to make the representation true. Here’s a sample disclosure:
The Seller received notice from the EEOC on [date] that it was reviewing a complaint filed by [ex-employee] alleging age discrimination.
The disclosure schedules are sometimes referred to as “insurance” in industry jargon, in the sense that they help insure the seller against future claims by the buyer.
Tip 4 — Update Disclosure Schedules. Most deals are of the “sign and close later” variety (as opposed to a “simultaneous sign and close”). When closing follows the signing at a later date, the seller must monitor the representations between the date of signing and the closing. It’s almost certain the buyer will require the seller to make the representations at the time of signing and at the time of closing. The seller needs to update its disclosure schedules such that they, as well as the representations they modify, remain true on the closing date.
The representations and warranties section of the purchase agreement is often the longest and most laborious section of the document. Knowledgeable sellers will pay significant attention to the statements included and limit their risk by narrowing the reach of the representations and by making adequate disclosures. Don’t simply leave these to your counsel and assume they are just verbiage for the lawyers to tinker with — know what the representations state about you and your company.
In the next post, we’ll discuss conditions to closing.
This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.
