Representations and Warranties Play a Crucial Role in Business Transactions

Representations and warranties play a crucial role in business transactions and are commonly used in merger and acquisition agreements to allocate risk between sellers and buyers. Accurate representations and reliable warranties are essential for maintaining trust and ensuring fair business transactions.

Let’s break down what they mean:

Representations

Representations are statements about the current status of a business or its operations which provide factual information and fairly describe the existing state of affairs. They can cover a wide range of areas, such as the financial condition of the business, the validity of contracts, the accuracy of financial statements and the company’s compliance with applicable laws and regulations, among many other things.

Representations fall into two broad categories. Fundamental representations are basic assurances about a seller’s ownership of the assets or business that is being sold, as well as their authority to enter into an agreement. Non-fundamental representations relate to various aspects of the business that a buyer would want to know about.

For example, in an agreement to purchase a business, the seller’s representations might include:

• The company’s financial health, including revenues, cash flow and debt;
• The company’s major product or service lines, as well as customer groups; and
• The status of internal operations, the age and condition of equipment and the experience of the labor force.

If a representation in a contract is found to be inaccurate and therefore unreliable, it is considered breached.

Warranties

Warranties go beyond representations by guaranteeing the truth of the statements made. They define the conditions of the contract at some point in the future. Warranties help protect buyers since they are future-oriented and provide assurances about the future state of the assets. This may include warranting that any equipment being sold is in good working order, or that no intellectual property being transferred infringes on any third-party rights.

In a business transaction, warranties can cover various aspects of the company being acquired, such as financial performance, condition of equipment or other assurances.

Some warranties have a specific duration while others may be undefined in terms of timeframe.

Indemnification

A breach of a representation or warranty typically requires the breaching party to hold the other harmless for losses or damages pursuant to an indemnification clause. The indemnification will set forth the scope of the obligation, including such examples as:

• Duration that a claim may be made, which is referred to as a “survival period;”
• Any limitation, “cap,” or maximum dollar amount that the breaching party will be held responsible; and
• Any requirement for a minimum claim before there is an obligation to pay.

When Do ‘Reps’ and Warranties Matter the Most?

There are three periods during transaction negotiations when representations – often called “reps” – and warranties are critical:

• Due diligence – During the due diligence phase, it’s essential for a potential buyer to verify the accuracy of any reps and warranties, identify potential risks and determine allocation of responsibility for indemnification. At this point, the buyer may request supporting documentation for any representations, or conduct an independent investigation to confirm the seller’s statements of facts.
• Pre-closing – The agreement has been signed but the transaction has not yet closed. During this period, a buyer will examine the company closely, and if any inaccuracies or breaches are found in the reps and warranties, the deal could fall apart, or re-trade a business point and reduce the purchase price.
• Post- closing – At this point, the transaction is done. But if the buyer discovers any misrepresentation in the reps and warranties, it may trigger a legal action that could result in compensatory damages. Typically, there is a limited period of time post-closure that such an action can be initiated by a buyer.

How to Satisfy the Lawyers

Lawyers representing buyers will look for specific information in the reps and warranties, including:

• Legality of the business
• Tax audits
• Accuracy of financial statements
• Status of inventory
• Status of the employee benefits accounts
• Environmental liability
• Statement that all supplied trading documents are accurate and complete

Reps and warranties are not just another task to be accomplished on the road to selling your business. They can be a strategic tool for risk management, providing protection for both seller and buyer. When written properly, they help ensure a smooth transaction and post-closure integration. The key is that the reps and warranties must be customized to your specific deal. There’s no such thing as “off the shelf” reps and warranties.