Seller's "Representations and Warranties" in Business Purchase and Sale Agreements - Why They Matter
The central legal document in the purchase and sale of any business is the Purchase and Sale Agreement. It fleshes out the details behind the key points mentioned in the "letter of intent" and contains the procedures needed to meet or carry out the respective requirements of buyer and seller. Although, customarily, the purchaser is responsible for providing the initial draft, sellers should not assume that the provisions of the Purchase and Sale Agreement (sometimes referred to as the "PSA") require little of their attention.
If an attorney has not yet been consulted for assistance with the transaction, NOW would be an excellent time to remedy that. PSAs vary considerably and, depending upon whether viewed from the perspective of buyer or seller, some language will be more beneficial than other. In addition, provisions appropriate in one deal may actually be harmful in another. For a more in-depth look at the overall process and documentation involved in the purchase and sale of a business, view my seminar PowerPoint presentation Buying and Selling a Business - Legal Insider's Practical Guide. To read my blog post about choosing whether to structure the transaction as an "asset" or "stock" deal, click here .
Regardless of how the transaction is structured, perhaps the most important, and often the most intensely negotiated, part of the PSA to both sellers and, especially, buyers are the "Representations and Warranties", sometimes simply referred to as "Reps and Warranties". A seller's representations and warranties are essentially assurances from the seller and/or seller's shareholders about the nature, scope. and condition of the business. As such, they operate in tandem with a prospective purchaser's due diligence activities, but should definitely not be viewed as a substitute for that. Because liabilities come automatically with the purchase in a stock/equity deal, reps and warranties are particularly important in those transactions. When the deal is largely or entirely seller-financed, a seller's representations and warranties may become somewhat less important because the buyer will have the ability to offset remaining payments due against any problems; however, even here the content of what is said still matters.
For prospective purchasers, there are three main reasons for focusing on a seller's Reps and Warranties:
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Due Diligence. Reps and warranties are often utilized as a device for obtaining disclosure of crucial information about a company and its business and financial affairs. In this way, they can help aid and organize other due diligence activities. In addition, reps and warranties can also help reduce any transitional "learning curve" after the purchase by providing the buyer with much useful information about how the business operates.
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Exit Hatch. Reps and warranties can also serve as a basis for terminating the transaction if due diligence activities of the prospective purchaser reveals false or inconsistent information prior to Closing
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Damages. Reps and warranties establish what is being bought by providing a detailed depiction of the comapny and its business/financial affairs as it will exist at Closing, thus giving the buyer some assurance that the buyer's expectations of what is being purchased will in fact be that. If the reps and warranties turn out not to be true, that can give the buyer the right to refuse to pay the balance of the purchase price or to demand indemnification from the seller.
From a seller's pont of view, the main reason to pay attention to the "reps and warranties" they are asked to make is that it may affect their abilty to receive the full purchase price bargained for if the reps and warranties prove to be incorrect in any way. Depending upon how the agreement is written, this can be true even if the seller didn't know a particular rep and warranty was incorrect.
So what seller reps and warranties should be included? It depends on the individual transaction, but generally all or most of the following will be included;
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Organization and Good Standing - Seller is properly formed from a legal standpoint
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Authorization; Enforceability - Corporate resolution or other appropriate company or shareholder/owner action authorizing the sale has been taken and nothing else must be done for the deal to be enforced against the seller
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No Violation - Seller is not prohibited from selling by any agreement with any other party or any court order
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Title to Assets; Permitted Encumrances - Key provision for both buyers and seller because it defines what is being sold and its value after taking into account debt to creditors.
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Condition of Assets and Facilities - Extent of specificity will reflect s buyer's areas of concern. materiality and knowledge qualifiers may be appropriate, but should be carefully evaluated.
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Financial Statements - Essentially intended as assurance that Buyer can rely upon the accuracy and completeness of financial statements provided by the seller during the due diligence period. Which financial statements and whether they must be "audited" or merely "reviewed" financial statements depends upon factors such as availibility, relevance to the buyer's commercial valuation of the acquisition and the burden and expense to the seller which the buyer wishes to impose and the seller is able and willing to bear
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Environmental Matters - pertinent when real estate is involved
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Customers and Suppliers - References key contracts and provides assurances that they are valid and enforceable
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Litigation - Provides assurance that except as disclosed on a schedule, the company is not involved in any pending or threatened litigation
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Taxes - promises that taxes are paid current or reserved for in the financial statements
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Compliance with Law - Company is not in violation of any state, federal or local law
In a typical transaction, there will be exceptions or matters that need to be disclosed to make reps and warranties accurate. As a compromise between a buyer trying to minimize post-sale risks and a seller reluctant to make absolute blanket reps and warranties, the exceptions or limitation to the reps and warranties are set out on schedules referencing particular reps and warranties and attached to the PSA. Because these schedules alter the scope of the rep and warranty, it is important for the buyer to carefully review the contents of these exhibits.
While all parts of the PSA are important and should be carefully reviewed, the content and language of the seller's reps and warranties can have the most impact on both parties. Thus both buyers and sellers should take extra care to be certain that these reps and warranties properly reflect the deal as they understand it. (And, yes, a good attorney can really help you here..... :-))
