My last post cautioned against fixating on purchase price to the detriment of risk allocation in the sale of a company. I believe sellers should leave closing without a nagging concern about keeping the purchase price just paid to them. This second part of my series on risk allocation in M&A is about warranties and representations, often referred to as "warranties and reps" or even just "reps."
The difference, if any, between warranting and representing in a business sale is technical, and a matter of some dispute among legal experts. Since you live in the real world, I won't bother with the details, but will encourage you, instead, to focus on responding to both warranties and reps and on limiting the buyer's remedies for their breach, the subject of the last post of this series.
Warranties and reps may seem the Badlands of a sale contract
No law requires a seller to make any representation or warranty when selling a company; it's purely a matter of negotiations. Custom and relative bargaining power drive those negotiations. While a deal can be "as is," without any warranty or rep, typically the seller will at least say he or she owns what is being sold.
An ownership rep in a stock deal might look something like this:
Seller owns all of the Shares, free and clear of any restrictions on transfer (other than any restrictions under the Securities Act and state securities laws), Taxes, Security Interests, options, warrants, purchase rights, contracts, commitments, equities, claims, and demands.
In a deal with insiders, an owner selling stock to a key employee for instance, the reps might not go much beyond ownership. The buyer knows the company well, and has low bargaining power relative to the seller, who is likely taking some risk selling to someone who is probably paying over time.
Contrast that to a cash buyer who is unfamiliar with the business. That buyer will demand extensive reps about the past, present, and even future of the company. Pages and pages of reps will constitute the bulk of the transaction agreement. Purchase price is a good predictor of reps -- a premium price typically bears more extensive reps than a bargain basement deal. In addition, because stock deals are riskier to buyers, those contracts have tougher reps than asset deals.
Unknown or unquantifiable risks dictate the M&A risk allocation dance. Known liabilities or fixed obligations are handled in pre-closing negotiations, which leads to Disclose-Disclose-Disclose as a selling lawyer's mantra. "Disclosure Schedules" attached to the contract are where sellers identify known or anticipated problems that buyers have to live with. Of course, a buyer can respond by demanding a purchase price reduction, but since the deal hasn't been signed, the seller has options, including walking away. Knowing this, a buyer who has likely spent some serious bucks just getting the deal to this point tends to be more reasonable BEFORE closing.
The post-closing shocker, the discovery of a substantial and previously unknown liability, is a different matter. The take-it-or-leave-it option is gone; deals are hardly ever undone. The buyer has no reason to be reasonable, and likely has the stronger negotiating position, including control of unpaid purchase price through a promissory note, holdback or escrow.
Another classic rep puts the challenge of the unknown in perspective:
The Company has complied 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 no action, suit, proceeding, hearing, investigation, charge, complaint, claim, demand, or notice has been filed or commenced against it alleging any failure so to comply.
"How can anybody say that?" is often a seller's initial response, followed closely by something like "I don't know of any laws, or at least any important laws, that we've violated." Known problems can be handled by the Disclosure Schedules, but should the seller be responsible for the unknown? A seller with (a) great confidence in the business, or (b) a belief that what happens on his or her watch is his or her problem, might accept this rep.
Other sellers, however, might argue that unknown legal violations, or at least unknown and immaterial violations, are part of the risk of being in business. Those sellers will take the position that unlikely risks should go with the business. Those sellers may want the rep limited to known, but undisclosed problems, by inserting a phrase like "to the best of Seller's knowledge." Knowledge qualifiers are part of the game, but they should be more precise than that. What does a seller have to do to meet the "best" standard, and if the seller is a company, not a person, what does a company "know?"
Fuzzy language has no role in M&A. (Thanks to daughter Olivia for her photo)
Limiting the rep to material violations is another option. "Materiality" qualifiers are also part of the process, but they beg the question, what's material?, and often get undone in "basket" clause of the indemnification section.
As you can tell, a seller needs to put substantial thought into negotiating reps and warranties, and creating Disclosure Schedules, however, you can't stop there. The indemnification section prescribing a buyer's remedies is most critical part of the risk shifting mechanism in an M&A contract, and it will be the subject of the final post in this series.