Representations, Warranties, and Indemnifications

Steps to Selling your Business Part 36.

A critical section of the Purchase Agreement outlines the representations, warranties, and indemnification limits.

Get any of these wrong, and you could devalue your earn-out or potentially turn a great-looking sale into a personal disaster. Getting it right, though, requires experience and expertise —this is complex work.

Before we start, a few definitions:

Representation: an assertion as to a fact, true on the date the representation is made, that is given to induce another party to enter into a contract or take some other action.

Warranty: a promise of indemnity if the assertion is false.

Indemnification: compensation for harm or loss.

We know that a critical part of your sale’s success hinges on the representations and warranties you make.

When you offer to sell your business, you begin by representing the condition of your company to buyers. Again, if you’re working with Stillwater, these representations will disclose the unique value your company offers.

For example, you may tell a buyer, “Here are our numbers and here are our projections. Our receivables are in great shape; we don’t know of any major clients about to leave, no lawsuits, and these two exciting developments are set to go public next quarter.”

The buyer looks at the representations you’re making, the story of your business, as well as the risks that come with it and makes a decision to purchase your company.

The Purchase Agreement will contain many (some sellers feel too many) representations from the seller to the buyer about the condition of the business. This could range from the quality of the business’ accounts receivable, to customers, to contracts.

Someone on your M&A team will need to negotiate what happens if one of those representations is breached. Warranties are the protection you will give to the buyer in case any of these representations are wrong and cause a loss. When a representation is wrong, it is called a breach.  

As you know, we emphasize honesty and transparency, so we aren’t talking about anything you’ve deliberately hidden from the buyer in your disclosures – that in some cases is fraud, which is entirely different.

A good way to look at representations is that the seller is usually responsible for everything that existed up to and including the closing date.

There are many instances where the seller just doesn’t know if something found in the future would have impacted the business at closing (for example a lawsuit filed after closing for an event prior to closing). As well, markets and circumstances change. Even the most forthright business owner can find themselves in breach of a representation because something happen post-closing that they didn’t anticipate, like a large bad debt for a closing day receivable they thought was collectable. Warranties are put in place in the Purchase Agreement to protect buyers against that.

Each Purchase Agreement will have an indemnification section that sets out how losses resulting from a breached representation are claimed, settled, and paid.

The warranties you give are to protect the buyer, but your Advisors must defend your interests when negotiating those warranties and the indemnification of the breaches. They must effectively negotiate the answers to  the important questions to ensure you aren’t held to any unjust expectations against your representations. We all know that lower limits and shorter terms are always in the seller’s favour, but what is lower and what is shorter for these questions:

What is the maximum amount the buyer can claim against you?

How long do they have to make valid claims, and when does that term expire?

What safeguards do you, the seller, have in place against any malicious attempt to unfairly use their warranties against them?

Our advice is simple – you must work with M&A specialists at this stage. This is a shifting field, and even the most competent commercial lawyers often unknowingly find themselves out of their depth unless they have specific recent M&A experience. At Stillwater, we have invested time and resources into becoming leaders on representations, warranties, and indemnifications; this is an area we routinely handle with the confidence of experience and deep knowledge.

It is helpful to keep in mind that different countries have different laws and practices in settling contract breaches. We stay current on market conditions in multiple jurisdictions, and we are uniquely positioned to add significant value in Canadian, American, and cross-border transactions.

While we will not explore it here, there are now high-quality insurance products available to cover many of the seller exposures to representations and warranties.

One final point – agree on your key representations, warranties, and indemnification terms as early as possible. We prefer them included in the Letter of Intent.

If you wait to the end  to negotiate these, they will be handled by someone else after you have lost considerable negotiating leverage. That’s where things can quickly go sideways. Ideally, we want to go to the lawyers and attorneys with settled representations and warranties in hand and say, “please write these in exactly as written.”

Then there are no unpleasant surprises waiting for you, and you can rest confident that the gains you made through the entire sale process continue to be there when you close.

If you are planning to divest your business or have questions for one of our Advisors, please contact our team today.

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Written by: Douglas Nix