Introduction
In the sale of a closely held business, one of the most critical components of the purchase agreement is the representations and warranties section. These are the legal promises made by the seller about the state of the business, from financial statements to regulatory compliance, and they serve to protect the buyer from hidden risks. However, negotiating these terms can be challenging, especially when facing buyers with aggressive attorneys’ intent on maximizing protections for their clients.
This report provides a deep dive into the components of representations and warranties, outlines key negotiation strategies for sellers, and offers practical advice on how to achieve acceptable terms, particularly when dealing with tough negotiations early in the process—such as during the initial draft of the Letter of Intent (LOI).
Chapter 1: What Are Representations and Warranties?
Representations and warranties (R&W) are statements of fact about the business being sold. They cover various aspects of the company and its operations, ensuring the buyer has accurate information before completing the transaction. These provisions are crucial because they establish the foundation for the buyer's trust and set up potential claims for indemnification if the seller’s representations turn out to be inaccurate post-closing.
Common Representations and Warranties:
Financial Statements: Assurance that the company’s financial statements are accurate, complete, and prepared according to generally accepted accounting principles (GAAP).
Ownership of Assets: Confirmation that the company owns its assets free and clear, with no undisclosed liens or encumbrances.
Legal Compliance: A statement that the business complies with all relevant laws, including environmental, tax, and employment regulations.
Material Contracts: Disclosure of all material contracts the company is bound by, and an assurance that none of these contracts will be negatively impacted by the sale.
Litigation: An affirmation that the company is not involved in any pending or threatened litigation that could materially affect the business.
Intellectual Property: Confirmation that the company owns its intellectual property and that there are no disputes regarding its ownership or infringement.
Tax Matters: Assurance that the company has filed all tax returns accurately and paid all taxes owed.
Importance for Buyers and Sellers:
For Buyers: Representations and warranties help ensure the buyer is acquiring a business that is as it was presented. If these representations prove false, buyers can seek compensation.
For Sellers: Sellers want to limit the scope and duration of representations and warranties to minimize their post-sale liability.
Chapter 2: Key Negotiating Terms in Representations and Warranties
When negotiating representations and warranties, several key terms significantly affect the seller’s liability and the buyer’s protection. Sellers must be proactive in shaping these terms early in the negotiation to ensure an equitable agreement.
Materiality Thresholds
Materiality qualifiers help limit a seller’s liability by specifying that only significant inaccuracies or breaches trigger a claim. Without these qualifiers, even minor discrepancies could lead to claims and potential financial penalties.
Negotiating Tip: Push for materiality thresholds, where only breaches of a certain magnitude (financially or operationally) are actionable. For example, claims can be limited to inaccuracies that result in losses above a specified dollar amount (e.g., $50,000).
Knowledge Qualifiers
These qualifiers limit the scope of representations and warranties to matters that are within the seller's actual knowledge, reducing the risk of being held accountable for unknown issues.
Negotiating Tip: Request that certain warranties (especially those regarding legal compliance or potential litigation) be qualified by “knowledge” to avoid liability for unforeseen problems. Clarify that "knowledge" is limited to senior management and does not include speculative issues.
Survival Period
The survival period defines how long representations and warranties remain enforceable after the deal closes. Sellers typically prefer shorter survival periods to limit exposure, while buyers may push for longer periods, particularly for critical representations such as tax and environmental matters.
Negotiating Tip: Propose a survival period of 12–18 months for most representations and warranties. However, agree to longer periods (3–5 years) for specific areas like tax and environmental matters, which can have lingering liabilities.
Caps on Liability
A liability cap limits the seller's maximum financial responsibility for breaches of representations and warranties. Without a cap, sellers face unlimited financial exposure post-closing, which is undesirable.
Negotiating Tip: Negotiate a liability cap that is a reasonable percentage of the purchase price (e.g., 10-20%). This ensures that the buyer is compensated for major issues while protecting the seller from excessive claims.
Baskets and Deductibles
A "basket" or "deductible" sets a minimum threshold for claims. Only when the total claims exceed this amount is the seller liable. There are two main types of baskets:
Deductible Basket: The seller is liable only for amounts above the basket threshold.
Tipping Basket: Once the threshold is met, the seller is liable for all amounts, including those below the threshold.
Negotiating Tip: Aim for a deductible basket where claims only count once they exceed a certain dollar amount. This protects against numerous small claims that could drain proceeds.
Chapter 3: How to Navigate Aggressive Buyer Attorneys
Buyer attorneys often take an aggressive approach to protect their clients by pushing for broad representations, longer survival periods, and high liability caps. Sellers need to be prepared to negotiate confidently and push back on unreasonable terms.
Set Expectations Early in the LOI
One of the most effective ways to prevent overly aggressive demands later is to set key terms during the LOI stage. Although the LOI is non-binding, it can establish a framework for negotiating final deal terms and give both parties clarity.
Negotiating Tip: During the LOI, outline the basic structure of the representations and warranties, including general liability caps, survival periods, and material thresholds. Getting these agreed to early will prevent surprise demands during later stages.
Limit Buyer’s Ability to Expand Scope
Aggressive buyer attorneys may attempt to broaden the scope of representations and warranties to include details that go beyond typical due diligence. Sellers must recognize when a buyer is overreaching.
Negotiating Tip: Push for reasonable limitations on the scope of representations. For example, clarify that representations are limited to the knowledge of senior management and exclude matters that require exhaustive investigation.
Propose Compromise Positions Early
An aggressive attorney may push for an unreasonable initial draft of the purchase agreement. Sellers should respond by proposing well-reasoned counterpositions early to avoid being boxed into a corner later.
Negotiating Tip: Instead of outright rejecting unreasonable demands, present a compromise early in the negotiation. For example, offer to accept a longer survival period in exchange for a lower liability cap or more favorable basket terms.
Use Escrow as a Buffer
Escrow provisions can help manage risk when a buyer is concerned about the seller’s representations and warranties. Instead of accepting unlimited liability, the seller can agree to place a portion of the purchase price in escrow to cover any potential claims.
Negotiating Tip: Suggest an escrow arrangement where a small portion of the purchase price (e.g., 5-10%) is held for a defined period (e.g., 12-18 months) to cover any breaches. This limits the seller’s exposure to the escrow amount and provides a clear end date for liability.
Involve Legal Counsel Early
Facing aggressive buyer attorneys requires experienced M&A legal counsel on the seller’s side. An experienced lawyer can help identify overly aggressive terms and propose workable alternatives.
Negotiating Tip: Involve legal counsel early in the process, ideally during the LOI stage. This ensures that key terms are addressed before they escalate into contentious issues during later rounds of negotiation.
Chapter 4: Common Pitfalls and How to Avoid Them
Overly Broad Representations
Pitfall: Agreeing to overly broad representations can leave sellers exposed to risks they cannot control.
Solution: Narrow the scope by using qualifiers like materiality, knowledge, and reasonable time frames.
Ignoring Survival Periods
Pitfall: Sellers may focus on closing the deal and neglect how long they are liable for post-closing claims.
Solution: Always negotiate survival periods to be as short as possible for most representations, while recognizing longer periods for specific concerns like taxes.
Underestimating the Impact of Indemnification Caps
Pitfall: Sellers may not fully understand how high liability caps can lead to substantial post-sale exposure.
Solution: Negotiate clear caps that balance the buyer’s need for protection with the seller’s desire to minimize long-term risk.
Neglecting to Set Baskets or Deductibles
Pitfall: Failing to include baskets or deductibles can result in the seller being hit with numerous small claims.
Solution: Propose deductibles that protect the seller from minor claims, ensuring that only material breaches are actionable.
Chapter 5: Best Practices for Negotiating Representations and Warranties
Be Proactive in the LOI Stage
Outline key deal terms in the LOI to create a baseline for later negotiations.
Use Qualifiers Strategically
Use materiality thresholds, knowledge qualifiers, and other limitations to protect yourself from excessive liability.
Balance Buyer Protections with Seller Risks
While buyers need protections, sellers should push for reasonable limits on the scope, duration, and magnitude of liability.
Engage Experienced Legal Counsel Early
Work with legal and M&A professionals throughout the process to identify risks and propose strategic alternatives.
Conclusion
Successfully navigating representations and warranties in the sale of a closely held business requires careful planning, strong negotiation, and an understanding of key terms. By addressing these issues early—especially in the LOI—and working with experienced advisors, sellers can achieve favorable terms and protect themselves from future liabilities. Sellers should not underestimate the importance of these provisions, and by being proactive, they can ensure a smoother and more profitable transaction.