Ready to sell your business? Very exciting. Also intimidating. There is a lot of talk, paperwork, and legal language flying back and forth. What is a representation and warranty? What about an indemnity? These are significant sections in your merger agreement, whether stock sale, cash sale, or asset purchase. The goal of this post is to give you a basic understanding of these legal provisions; however, because the sale of a business is very complex, you should always consult your lawyer when making decisions regarding these sections, and the sale, generally.
To best understand the viewpoint of each party, under these terms; whereas a buyer-friendly agreement would include broad and discretionary language to cover as many issues as possible, a seller friendly agreement would include narrowly tailored language to specify the exact terms being promised.
So, what are representations and warranties, and indemnities? Let’s get to it!
Representations & Warranties
Think about representations as your promises of the current business. This assures the buyer that your business is operating the way you say it is. On the flip side, warranties are a future outlook on the health of the seller’s company between typically a 12 to 24-month timeframe after closing. Here are few provisions that the representation and warranties section typically covers:
Your balance sheet presents fairly and accurately.
Meaning, the you own all of your assets and have no more liabilities than presented on the financial document.
You own the intellectual property (IP) you say you do.
This includes: trademarks, copyrights, utility patents, design patents, and any other IP transferring with the deal. Issues with often appear when the founders were moonlighting, didn’t sign PIIA agreements transferring IP to the company (see Snapchat), or conducted initial research for a public university or government agency.
No material contracts are in risk of termination.
In fact, you will likely include a list of your material contracts in a schedule attached to the agreement to prove this.
There are no outstanding tax payments.
For example, if the IRS came after the company for back taxes after the transaction was closed. The buyer will typically try to negotiate an indemnity (i.e. financial protection) outside of the initial cap for this provision.
Compliance with laws.
The buyer will ask the seller to expressly represent that it is in compliance with the law. The seller should negotiate qualifiers (i.e. language that says “to the seller’s best knowledge”) and a time restriction for three years prior to closing (or the appropriate statute of limitations).
More often than not, the representation and warranty list is often long and includes many schedules to prove the promises. The above list is not exhaustive. Ensure your representations and warranties present accurately your current and predicted state of business. If not, you will need to discuss your options with your lawyer to negotiate the changes. If for some reason, the buyer can prove you falsely promised a representation or warranty, the buyer can come after you for recompense. The “Indemnities” section stipulates these protections.
Basically, indemnification protects the buyer and seller from any gaps in the agreement that create loss. By indemnifying the other party, the breaching party must pay up and make the other party “whole” again. For example, if the seller represents that it is in compliance with the law; but, in reality the seller has violated a permitting law for the last two years before closing the deal. Now, the buyer has to pay a fine of $10,000. Because the seller represented that it complied with the law, it must indemnify the buyer and provide recompense for the $10,000 permitting fine. Got it?
In most cases, the seller will indemnify the buyer for any misrepresentations in the representations and warranties, or any contracted for loss resulting from the transaction. Frequently, this section extends to officers, directors, and employees. The parties heavily negotiate this section because the buyer wants ultimate protection and the seller wants to relinquish most responsibility. An obvious juxtaposition. When thinking about this section, you should consider the basic questions, like:
Who can be indemnified?
Typically, all parties can receive indemnification from the breaching party. However, the buyer’s indemnifications likely extend further than the seller’s coverage because the buyer is taking on risk with the purchase.
What is fair game for indemnification?
Often, when any of the following provisions are breached, the indemnities provide the non-breaching party with coverage: representations and warranties, covenants, environmental concerns, and pending litigation. This section also provides for attorneys fees, where the indemnifying party will cover the indemnified party’s fees.
This stipulates the time period by which the seller (or in limited circumstances, the buyer) can be held liable for any losses. Typically, the expiration date is 12 to 24 months after the closing date. However, the buyer might negotiate for a longer time frame if it reasonably expects a large liability.
Generally, the entire loss is covered; however, the parties can negotiate for a “basket” and a “cap”. Typically, the determined amount is held in escrow (a holding account) for the agreed upon time frame. Once the time frame passes, the seller receives the remaining escrow balance.
- A basket is the amount up to which the indemnified party must pay for the loss. Once the basket is in excess of the amount, the indemnifying party must pay for the excess loss.
- The cap creates a ceiling by which the seller is liable for any loss. For example, if the liability is more than $1 million, the seller will only cover the $1 million liability, not more.
With that, your Representation and Warranties, and Indemnities 101 is complete! As a reminder, always contact your lawyer regarding these issues. We hope this blog post makes that conversation easier to understand and participate in. Best of luck!