Before we get into what representations (reps) and warranties actually are, let me share with you how this looks from the eyes of a SELLER.
Imagine this: you have just spent the last 60 – 90 days answering relentless questions and responding to additional due diligence requests by uploading document after document of financials, legal and insurance. And finally, they tell you they are finished with the due diligence, and you pass with flying colors.
Now, you think you get to take a rest and breathe because you have this really good M&A attorney who will take it home for you over the next few weeks, right?
Not so fast. There is this little thing called representations and warranties (“reps and warranties,” for short), that will demand your attention once again.
What are Representations and Warranties?
Reps and warranties form the basis of due diligence for buyers. Essentially, they provide an opportunity for the seller to disclose any potential issues with the company prior to completing the transaction. Reps and warranties come in three forms: promises the seller makes, promises the buyer makes, and promises both sides make. They are an integral part to every agreement. In most deals, reps and warranties are far more onerous for the sellers than the buyers. You will painstakingly need to document every major point in the agreement with reps and warranties. This will take a lot of your time because you will need to prepare a number of schedules and tables, as well as disclosing any verbal commitments you made and want to honor. And if you have any skeletons in your closet, now is the time to present them.
Real-World Reps and Warranties Examples
Let me give you a few “real-world” examples of reps and warranties:
- You promised your admin she could take a month off in the summer in addition to her normal schedule – this isn’t anywhere in your employee handbook, but you are doing this out of the kindness of your heart, or for whatever reason. You need to disclose that.
- You ran background checks on your employees, but one came back with some “issues” that you don’t feel are relevant anymore and shouldn’t impact the business. You need to disclose that.
- You committed to sending or participating in an upcoming conference but have not yet signed the paperwork or purchased the conference tickets. You verbally committed to a three-year investment, but there is no paperwork to support that. You need to disclose that.
- Your largest vendor has communicated to you that costs will increase or margins will decrease in six months, and is letting you know that ahead of time. You need to disclose that.
- Your largest customer is getting acquired by their competitor and they will most likely be using the vendor of the acquiring company. Therefore, you stand to lose the business. You need to disclose that.
- You haven’t been charging sales tax in a certain state and you are pretty sure there is a substantial liability mounting, but you are just hoping “no one will notice”. I see this one a lot! You need to disclose that.
While reps and warranties are full of legalese, they need to be taken very seriously, and your attorney is going to expect that you prepare these schedules (since only you know this information.) If you don’t fully disclose these, they can come back and haunt you. And if substantial, the buyer has recourse to be reimbursed from the money in escrow (more on that in my next post) and possibly through a lawsuit against you.
Once you receive a draft of your purchase agreement, each section covers various different aspects of the deal. You most likely will have to prepare a representation for each. Your attorney will give you guidance on that.
Examples of “Generic” Representations
Here are examples of some more “generic” representations you will need to make – beyond the more personal ones I mentioned above:
- Seller is the owner of the shares or assets, and they are free from any liens
- Seller has the legal authority to sell the shares or assets
- The sale of the shares or assets don’t violate or conflict with any laws, rules, or regulations of any governmental authority
- Change of control will not trigger some sort of material change, such as an agreement with a major customer or vendor that allows the customer or vendor to cancel
- The company has filed all required tax returns and no taxing authority has any liens against the assets of the company
- Seller has withheld or paid all payroll taxes
- And so on and so forth – lots more of this
As we mentioned earlier, the buyer also needs to make some warranties. And again, your attorney will point out those they are looking for. Some typical buyer warranties are as follows:
- Buyer represents that the company is a duly organized entity, validly exists, and is in good standing
- Buyer has the authority and legal right to execute the purchase agreement
- Buyer pays the fees for any advisor or agency used in the process of finding the seller
Finally, mutual representations might be as follows:
- Both parties agree to refrain from making any public announcement of the deal until after the deal closes
- Buyer and seller agree on methods to calculates taxes and working capital
- Buyer and seller make reasonable best efforts to fulfill their obligations in the agreement
Once both parties have written out their reps and warranties, then the other side is given time to review and comment or ask for more detail if needed. These are usually done the last 7 to 10 days of the deal process, because they must include all last-minute items.
Do not underestimate how long this actually takes. Many times, you are required to attach schedules of items that are already in the data room, but need to also reside in the final document, like customer lists, margin schedules, etc. While you think your attorney should be doing this for you, they cannot. Only you know where to find this data and how to present oral agreements that have been made. My advice: as soon as you get a draft of the purchase agreement, you should discuss with your attorney the sections of the agreements that require reps and immediately begin drafting them.
Reps and warranties are never fun, but they are a necessary part of the agreement and are there to protect you from future claims. You will certainly want to disclose any and all things that could possibly create a problem over the next year or two. So, fill up on coffee and an energy bar; this is the last push to getting this deal done. Then you can breathe…for a moment.