The Impact of ‘Reps and Warranties’ on Business Sales

Representations and Warranties Impact Business Sales

The term ‘representations and warranties’ (also known as reps and warranties) refers to facts and assurances given to a buyer by the seller of a business as a part of the purchase agreement. Reps are statements of facts about the present and past condition of a business. An example of a rep is the seller representing that its employment contracts with its staff are presently in good standing. Warranties are assurances about the future prospects of the business. An example of a warranty is the seller assuring the buyer that all of its employment contracts will be in good standing six months after the sale. The difference is key since most business owners are not comfortable giving assurances about what could happen in the future after the closing, especially since the buyer will affect the outcome as the new owner. Generally, reps and warranties allocate risk between buyers and sellers, help ensure transparency, serve as a legal recourse for inaccuracies, and influence the final purchase price.

Formal Due Diligence

Representations and warranties reflect the allocation of risk between the buyer and seller as to who is responsible when a fact or assurance given by the seller about the business does not turn out as expected. The best way to reduce this risk is through the formal due diligence period. Formal due diligence is where the buyer formally investigates all aspects of a business after a deal goes ‘under contract’ by virtue of a signed Letter of Intent (LOI) or purchase agreement. Closing is almost always contingent on the buyer’s satisfactory completion of formal due diligence. A prudent buyer may take advantage of the formal due diligence process so they may independently verify the seller’s reps and warranties. Conversely, the seller is incentivized to provide the buyer with as much information as possible during formal due diligence so that the buyer may use their own judgment (rather than the seller’s reps and warranties) about the valuation of the business.

Negotiate Reps and Warranties in Purchase Agreement

  • The reps and warranties clause is negotiated between the buyer and seller (often by their attorneys) in the final purchase agreement.
  • The seller will naturally want to limit their reps and warranties so that they do not find themselves in breach of contract in case a fact or assurance given to the buyer turns out not to be true.
  • The buyer will naturally wants to broaden the scope of reps and warranties which serves to broadens their comfort level that the facts and assurances given to them by the seller will turn out to be true.
  • An important way that the seller may reduce their potential liability is by inserting the phrase “to the seller’s knowledge” before all representations.
  • For example, the rep that “to the seller’s knowledge, all employment contracts are current and in good standing” differs greatly from “all employment contracts are current and in good standing”.
  • By adding “to the seller’s knowledge”, the risk is significantly lessened for the seller in case they are simply mistaken (rather than lying) about a representation made to the buyer.
  • When negotiating warranties, sellers will rarely give assurances about the future prospects of the business including future relationships with vendors or employees.
  • This is because the seller will have little or no control over the operations of the business after the closing, and thus may not be responsible for whether such warranties are met.
  • A common situation of where warranties are given by the seller involves customer service agreements for products previously sold or services previously rendered.
  • This is especially the case for service related businesses such as HVAC companies, pest control, or plumbing companies, which often warrant work performed or products sold to its customers for a set period of time.
  • Overall, buyers and sellers of businesses – particularly larger and more complex firms – negotiate the scope of rep and warranty provisions via the use of survival periods, caps, and holdbacks.

Survival Periods for Reps and Warranties

The survival period is the amount of time after closing in which the seller may be liable for breaches of their reps and warranties. Similar to a statute of limitation, the seller will want this as short as possible so that they are free and clear of any possible liability. A rep made about the accuracy of the seller’s financial statements usually will have a shorter survival period than a rep made about a condition of the business that is harder to discern for a buyer. An example of this would be the environmental condition of a property owned by the business, for which many buyers require an indefinite survival period.

Caps of Rep and Warranties

A cap of a rep and warranty clause limits the seller’s total liability to a certain monetary amount. The capped amount is often a percentage (typically ten percent) of the overall purchase price of the business. Clearly, sellers have every reason to insist on a reasonable cap of their allowable damages. A seller’s argument to cap their damages is stronger when the buyer is allowed to conduct a thorough and complete formal due diligence process. If the buyer has every available opportunity to independently verify and inspect all aspects of the business during formal due diligence, then the seller can more forcefully argue that the buyer had a full and fair opportunity to inspect any facts or assurances made about the business. As such, the seller may argue it is unfair for their liability to exceed a reasonable amount.

Holdbacks for Reps and Warranties

A holdback is a portion of the purchase price (typically 5-15%)  held in escrow after the closing for a set period of time. The escrowed money is used to indemnify the buyer for any breaches of the reps and warranties made by the seller. After the expiration period of the holdback period, the money remaining in escrow is released to the seller. Most sellers will not agree with a holdback period unless there is a compelling reason for doing so. Holdbacks are more often needed when the seller has active warranty contracts with customers for products sold or services rendered. The money held back in escrow may be used by the buyer to cover their costs associated with the seller’s warranty contracts.

Business owners should be aware of potential representations and warranty provisions in purchase agreements for the sale of their business. Buyers should always be aware that the formal due diligence phase is generally the best way to be assured as to the accuracy of the facts and prospects of the business that they are purchasing.

Give Martin at Five Star Business Brokers of Palm Beach County a call today at 561-827-1181 for a FREE evaluation of your business.