Owners of companies in a sale agreement are asked to make an extensive set of representations and warranties as a part of the Purchase Agreement. This is a very normal and expected part of the process, and yet is one of the areas that will significantly define the post-closing exposure for owners. It is important in that it may define exposure that can cause the seller to have to “give back” purchase price. This is because such purchase price may be adjudicated to be improperly obtained if the buyer didn’t correctly understand what they were purchasing.
The common and always required representations orient toward things like:
-The assets being sold are fully owned by the seller
-The seller has told the truth in information provided about the Company
-There are no legal claims against the Company and its assets, which have not been disclosed
-There are no material adverse events known to the seller which impact future business, and which have not been disclosed.
The object of the game in review of such matters should be to make sure all disclosures represent “safe truth” in the written Definitive Agreement.
Many of the “representations” can be worrisome to sellers, and sellers must work diligently to consider each representation required before signing up to it in their final Definitive Purchase Agreement. Strong legal advisors can substantially help in this process, by finding ways to limit exposure. Such limitations might come from more explicit wording regarding areas of buyers’ concern, or even from specific “caps” to exposures listed.
The more clearly and explicitly defined each item is, the better. For example, a buyer might ask for a representation that the seller is aware of no known lost customers. An advisor might amend this to say that there is no customer with sales in excess of $X in the past year, who has given written notice of business discontinuance. Thus the population of customers to be considered is carefully defined, and requirement of written notice further narrows possibilities.
Often some of the more difficult representations might involve asset value. Accounts receivable for example, which might not be collected, would be reviewed by buyers. Doubtful accounts should be covered by a contra-asset, reserving for potential bad debt. More difficult issues might arise over things such as old, unused inventories. Such inventories that may expose the company to future write-off if they cannot be sold are more debatable. (It is easy to identify that as a pre-purchase problem, not disclosed, and yet failure to move the goods may in fact arise from the buyer’s failure to effectively sell.) Thus, issues of this type are far better resolved by careful full disclosure, with agreement between buyer and seller pre-closing.
Total seller exposure may be limited by a fixed “cap” on all such exposure. In many cases, we can agree in advance with the buyer that maximum exposure to our seller, no matter what, may not exceed 10% or even 20% of total purchase price. Such caps don’t make reps and warranties unimportant, so documents still should be subject to careful review and revision. But they DO help insure that the transaction can’t become a total loss for the seller, in any case. (Such caps normally would NOT apply if there was intentional misrepresentation by the seller about known impairments.)
If the buyer is unwilling to cap the seller’s exposure, it may require reconsideration by sellers. European buyers commonly engage in transactions with NO cap on seller exposure, and thus can be more difficult. We dealt with one such case for a Canadian seller where every top purchaser was European, and they all dug in substantially on this issue. We ended up compromising on an aggregate cap at 50% of total transaction value. That was five years ago, and there have been zero claims in that instance.
In summary:
-Read the Definitive Purchase Agreement carefully. Find slightly more accurate wording to make the rep acceptable.
-Consider Definitions of Materiality. “No inventory return claims” versus “No known inventory return claims in excess of $100k” may make a huge difference.
-Limit overall exposure to any and all representations. We often do 10% or perhaps 20% of aggregate purchase price.
-Limit time periods for any such claims. Most can be narrowed to one year, based on the fact that any known claim about the condition of assets at the date of sale would likely be known within a year.
It is worth substantial time and effort to ensure clean and livable wording around reps and warranties in the Definitive Agreement. If you want to KEEP the proceeds from sale, take the time to pay attention to a well-crafted agreement.
