The representations and warranties on the Purchase and Sale agreement take effect the date of signing. According to the book, The Art of M&A – A Merger Acquisition Buyout Guide by Stanley Foster Reed, the conditions in the representations and warranties are:
“…intended to disclose all material legal, and many material financial, aspects of the business to the buyer. The seller also gives assurances that the transaction itself will not have adverse effects upon the property to be conveyed. The buyer should be aware that lenders providing acquisition financing will require the buyer to make extensive representations and warranties about the target as a condition to funding.”
Representations and warranties are very important in the sale of a company and, according to Reed, co-founder of the Merger Week at Northwestern University, “a buyer or seller will be able to back out of the agreement if he or she discovers that the representations or warranties of the other party are untrue to any material extent.” The phrase “no material adverse change” or “not material to the transaction” is key. In fact, the buyer or seller may insist on inserting the word material when referring to liabilities, litigation, etc. While the word “material” can be construed as ambiguous, the parties can set a dollar threshold that defines materiality in particular circumstances.
The important issues to focus on for representations and warranties are litigation, undisclosed liabilities, financial statements, and taxes. Regarding the latter, for example, if the sale of the company is a stock transaction, the following representations and warranties would be appropriate:
An explanation of the basket provision is also used to protect the seller, by indemnifying the buyer for damages only up to a certain amount. Furthermore, there is usually a cut-off date in which the buyer can seek claims from the seller, e.g., “three years is the outside limit.” One way to facilitate the buyer’s claims is to allow him or her to offset these amounts from the note due to the seller. Another method, for example, is to set up an escrow account equivalent to 5 to 10% of the purchase price.
The Purchase and Sale Agreement defines the parameters of both the purchaser’s and seller’s representations and warranties. The heaviest negotiating near the closing date usually involves the representations and warranties as well as the indemnifications. Also, the representations and warranties normally account for the largest part of the Purchase & Sale Agreement. The investigation then follows the execution of the Purchase and Sale Agreement and obviously occurs (or should occur) before the closing. If an adverse material fact surfaces after the closing, the seller will have to compensate the purchaser based on a breach of representation. The following seller’s representations and warranties are the most important:
The seller will, in effect, be expected to insure to the buyer that:
While most of the burden for representations and warranties lies with the seller, the buyer may be required to warrant that the acquisition does not violate their loan agreements or if stock is to be used, that it is properly authorized.
Obviously, if the transaction is a stock sale in which the buyer assumes all the assets and all the liabilities, the representations and warranties are more lengthy and complex. Often the buyer is only willing to undertake a stock transaction based on the tightness and thoroughness of the representations and warranties.
The important issue is which representations and warranties survive the closing and which ones cease. Those which customarily cease at closing include warranties on equipment and guarantees on licenses. Those which often survive the closing include matters of litigation.
In summary, the following advice of Nelson Gifford is noteworthy. As former CEO of the Dennison Manufacturing Company, he was involved in approximately three dozen transactions. He said from the buyer’s point of view,
“the critical aspect of negotiations is what is stated in the representations and warranties such that the document reflects the following: Everything you know, you told us. Everything you told us is true. Everything you didn’t know, you should have known.”