Insights

Risks, Reps and Warranties

June 27, 2019 //

Managing Risk in an M&A Transaction

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:

• Financial. A buyer may not understand the true financial picture and prospects of a business. Value may change materially during or shortly after the transaction process, to the detriment of either party. A buyer may overpay for the business or fail to meet its payment obligations. The acquired company may not deliver the financial performance the buyer expects.
• Operational. Operations may not be as robust as represented. Processes may not function as well inside the buyer’s company as they did when standing alone. Key people can leave. Industry or market changes can render equipment, practices, or capacity obsolete.
• Legal. Either party could enter into the transaction without the legal right to do so. The company being sold may be subject to undisclosed or unforeseen litigation, or be breaking the law in some way. The transaction contract may lack key provisions, leaving one party or the other overly exposed to risk.

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.

 

Common Reps and Warranties

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:

• Financial statements are complete, accurate, a fair representation of the business, and prepared according to GAAP
• Accounts receivables include some guarantee of collection, at a negotiated rate, and it is clear how they will be disbursed once collected
• Property, plant and equipment are adequate to support daily operations
• Inventory is current
• Liabilities are all fully disclosed
• Taxes have been properly prepared, legally filed and paid in full
• Contracts and leases are fully disclosed, and transferable and/or assignable after the deal closes
• Supplier and customer schedules are complete, and relationships are clear and amicable
• Intellectual property is enumerated, and not contested by any third party
• Employee matters are in compliance with all applicable laws, benefit plans are in good order, and any ongoing or potential labour disputes have been identified
• Litigation, both threatened and pending claims, are disclosed
• Insurance coverage is adequate, and any claims, past refusals or denials of coverage are disclosed
• Environmental issues, obligations, and potential liabilities are fully described
• Data is available, secure, and properly backed up

Buyers’ reps and warranties generally relate to the form of consideration being used to complete the transaction, including:

• Buyer is legally authorized and financially able to make the purchase, and bound to follow through
• Form of payment is clearly defined and available, and includes how, when and where the money will be wired
• Shares are offered at their fair market value and free of any encumbrances
• Buyer’s business is viable, sustainable and profitable (if shares are offered)

Breaches

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.