June 27, 2019 //
For all their potential benefits to both buyers and sellers, acquisitions are risky. Broadly, the risk associated with any M&A transaction falls into three categories:
Risk, of course, looks very different from the buyer and seller’s perspectives. Prior to deal close, sellers bear most of the risk. They must share a great deal of confidential information with companies that may be current or prospective competitors. If word leaks out that a deal is being considered – or has collapsed – it can damage the organization’s reputation, valuation, negotiating power, and ability to retain employees. In a cash only transaction, the seller’s risk drops dramatically after deal close. But if the buyer’s shares are part of the payment, then a decline in their value represents an ongoing source of risk.
Buyers, in contrast, bear little risk until a transaction is completed, and then a great deal thereafter. Lack of strategic clarity, overly optimistic financial predictions, due diligence shortfalls, integration challenges, and material market changes can all come back to haunt them.
Through this lens, we can see that many of the acquisition best practices discussed in previous articles are in fact ways of managing risk. Strategic alignment, thorough due diligence, sensible valuation, deal structuring that reflects the parties’ different perspectives and concerns and rigorous integration planning all help buyers to mitigate the risks of acquisition. As these practices also increase the likelihood of a transaction being completed to everyone’s satisfaction, they also reduce the risk to the seller.
Another important risk management tool is the use of representations (“reps”) and warranties in the purchase and sale agreement. These refer to assertions made by either party, that all information in the contract and supporting documents is true and complete, and the penalties incurred in the event of a breach.
Sellers’ reps and warranties usually pertain to the information that a buyer relies on to value the company, especially the nature and value of the operations. Typical examples include:
Buyers’ reps and warranties generally relate to the form of consideration being used to complete the transaction, including:
A breach occurs when a representation or warranty proves to be false or is subject to dispute. Common sources of dispute include undisclosed pending litigation, financial statements with mistakes or omissions, an undisclosed material liability, or illegal immigrant employees. The first recourse if a breach occurs is to claim money held in escrow for that purpose, though in more serious cases one party may sue the other, or the transaction itself may be cancelled. When negotiating reps and warranties, two questions are paramount: how much can be claimed if there is a breach, and for how long can it be claimed?
In the next article we will examine an emerging alternative to the traditional practice of holding funds in escrow: Reps and Warranties Insurance.