Representations and Warranties When Selling a Business
Business sale transactions in their simplest form are promises. Sellers promise to provide certain assets, properties, etc. and buyers promise to pay a certain price to purchase them.
When it comes to a business sale, buyers want assurances that they are getting what they’ve been promised. Those assurances that the facts and conditions of the sale are as promised are memorialized in a contractually binding statement known as representations and warranties.
What Are Representations and Warranties in a Business Sale?
When you buy a car, you want to know that the car has the equipment and the features promised, and it is, in fact, the car you selected. The car dealer provides you with a purchase agreement that includes information such as the make, model, VIN number, and year of the vehicle; and the options included. Your purchase agreement also includes a warranty that the car will function as promised or the dealer will pay for repairs.
It’s the same when you’re selling a business. Sellers must provide buyers with facts about the business and the sale and assurances that the business will continue to run as forecasted for a set period of time.
Representations—or reps for short—are statements of fact about the past and present condition of the business. Reps include items like the financial condition of the business, contracts in effect, litigation underway or pending, and the like.
The warranties portion of reps and warranties refers to present and future conditions. Warranties are assurances or guarantees that the business will continue to run as promised for a given period of time. Warranties might state that the business equipment is in good working order and won’t require replacement for the next two years, or employee contracts will remain in effect for the next 12 months.
Reps and warranties in a business sale also set out responsibilities for paying back buyers if the seller’s representations contain inaccuracies or assurances are breached. In mergers and acquisitions, this concept is called indemnification. Sellers agree to indemnify buyers by providing remuneration (or footing the bill in the case of litigation) if a buyer suffers losses due to the inaccuracy of information provided or breaches (although this gets more complicated as you’ll see below) in the warranties made.
What Items are Covered in Representations and Warranties?
Reps and warranties are included in the final purchase agreement signed by buyer and seller. Buyers and sellers start hashing out reps and warranties during the due diligence process and often keep negotiating these points right up until the purchase agreement is signed.
Reps and warranties in a business sale cover a whole host of items important to the future success of the business. Reps and warranties assure buyers that:
- the seller is authorized to sell the business, and no consent is needed from another party
- the business is registered with the appropriate regulatory authority and in good standing
- the financial statements are accurate
- the business is current on payment of taxes and there are no liens for non-payment of taxes
- the business has no pending or expected litigation
- the seller holds the title or rights to any real property or intellectual property included in the sale and there are no encumbrances on the property or assets
- no environmental issues are present
- the employee, vendor, and customer contracts are valid
Reps and warranties might cover additional items or fewer points depending on the business and its size. The declaration serves as a framework for conducting due diligence, and it allows buyers to take at least some of the aspects of the business at face value without having to verify each and every point.
What Limits Can Be Placed on Representations and Warranties?
When you’re selling a business, you might look to the closing date as the finish line. But if it turns out a buyer doesn’t get what’s promised, reps and warranties can keep the seller on the hook post-closing.
Sellers obviously want to keep their liabilities for errors in statements of fact and warranty breaches to a minimum while buyers want to hold sellers liable for as much and as long as possible. Reps and warranties can be a hotly contested topic in the sale process as a result.
The limits on a seller’s liabilities are set out in several ways in a business sale contract, depending on what the buyer and seller negotiate:
Survival Periods
The survival period details the amount of time for which sellers can be held liable for inaccuracies and breaches. As with most of the representations and warranties provision, it is subject to negotiation between buyer and seller and can be as long or as short as the parties agree to allow.
Baskets
Reps and warranties typically include baskets that establish minimum thresholds for making claims. There are two types of baskets:
Deductible baskets. Deductible baskets are like insurance deductibles. They set a minimum amount required for a buyer to make a claim. Deductible baskets give sellers some breathing room if they make an honest mistake and protect them from getting nickel-and-dimed by buyers.
Let’s say you are selling a $5 million business and you and the buyer have set a basket of $25,000. After the sale, the buyer finds that the value of your inventory was off by $30,000. With a reps and warranties basket of $25,000, the seller would only be liable for repaying the buyer the amount that exceeds the deductible basket, or $5,000.
Tipping baskets. Tipping baskets are used to indemnify buyers if a seller misrepresents certain facts that will cost the buyer money, such as undisclosed liabilities. Tipping baskets come into play when a buyer suffers a loss equal to or greater than the basket threshold. When a tipping basket provision is in place, the seller would be responsible for every penny of the costs the buyer incurs.
For example, suppose the seller described above represents that there is no pending litigation against the company, and after closing, the buyer is slapped with a lawsuit from a slip and fall that occurred prior to the sale closing. The cost of the lawsuit is $100,000–above the basket threshold. In this case, the seller might be held liable for covering the full cost of the lawsuit, including the deductible basket amount.
Indemnification caps. Indemnification caps set a maximum amount that sellers can be held responsible to pay. Without indemnification caps, sellers might be on the hook for expenses that significantly dilute the value of the business.
Here’s an extreme example. Suppose you sell your business for $1 million and you’re found liable for a misrepresentation that costs the buyer $250,000. If your reps and warranties didn’t include an indemnification cap, you’d lose a big chunk of your sale proceeds in that deal.
Holdbacks. A holdback is like the security deposit often required when you lease a home or building. Buyers and sellers often negotiate a provision whereby a portion of the purchase price is held in escrow for a certain period of time to cover losses due to breaches. That way, buyers can be assured that funds are available to cover any losses they might incur.
Choose Your Words Carefully When Writing Reps and Warranties
Just as the conditions you set in your representations and warranties can be difficult to negotiate, the language of these provisions can be extremely nuanced. One word or phrase can mean the difference between a seller’s liability to pay up or not.
Would you rather be held responsible for equipment you state is in good repair or that’s in good repair “to the best of the seller’s knowledge?” The former doesn’t give you much wiggle room if the equipment breaks down, whereas you might not be liable if you thought the machinery was in good repair.
The wording of reps and warranties won’t necessarily get you off the hook, but it can prevent some of the most dire consequences, such as the rescinding of a deal if a breach occurs.
How to Reduce Post-Closing Hassles
A seller’s indemnification obligations can be costly, regardless of whether the breaches are deliberate or unintended. You’ll want to engage a business broker and an attorney experienced in mergers and acquisitions to negotiate and write up the representations and warranties in your purchase agreement.
Some additional ways sellers can protect themselves post-closing include:
Provide true and accurate information. Use a CPA skilled in mergers and acquisitions to prepare and audit financial statements and tax returns and an attorney to review contracts and other legal documents.
Make full disclosure. As a seller, you have a duty to not just provide true and accurate information, but to provide all the facts surrounding the operation of your business and the sale.
You should make full disclosure of any exceptions to the representations and warranties prior to the completion of the definitive purchase and sale agreement so you don’t surprise buyers at closing.
Consider investing in representations and warranties insurance. You can purchase sell-side insurance that protects you from liability if the buyer claims you’ve breached your reps and warranties. Insurance companies also offer buy-side insurance that directly compensates buyers for breaches.
Include dispute resolution in your purchase agreement. Your purchase agreement should spell out how disputes will be handled. It should specify whether arbitration can be used or if litigation is to be the remedy for breaches.
Find a business broker through the BizBuySell Broker Directory and get help navigating the intricacies of selling your business.