definition representations and warranties

Representations and Warranties: Everything You Need to Know

Representations and warranties in business contracts provide facts (representations) and security against loss (warranties) if the statements made are not true. 7 min read updated on February 01, 2023

What are Representations and Warranties?

Representations and warranties in business contracts  provide facts (representations) and security against loss (warranties) if the statements made are not true. Representations and warranties may also be shortened to "represents and warrants" in a contract.

If the representation in the contract is found to be false, it is called "inaccurate," while a false warranty is considered breached. Representations always refer to past information, as it is impossible for a company or individual to present future information as factual.

Every contract between two parties includes representations and warranties. For example, if you decide to go to an auto dealership to  buy a car , you would enter this transaction with several representations, such as:

• The car is actually what the seller represents it to be, in terms of model and make
• The dealership is legally authorized to sell cars to consumers
• The car will actually work when used properly

The warranty made by the dealership is that all of these concepts are valid. If it turns out that one or all of these representations are not true, the contract to buy the car may be cancelled. Another warranty made by the seller might be to repair any defect that arose because of the misrepresentation.

But the warranty may not last forever. In this example, the seller or manufacturer of the car might offer a period that the unit will work without any defects. Beyond that period, the warranty is no longer in effect. However, some warranties do last for the life of the product. In this case, the buyer in the agreement can expect the seller to repair or replace the product any time it malfunctions.

Warranties help provide protection to consumers on products, and they are subject to federal laws and the Uniform Commercial Code . If the seller offers an extended warranty, it must protect the product beyond the initial agreement made between the buyer and seller. A warranty is a form of insurance and is subject to the same regulations per state laws and the parties involved.

Representations and warranties  are commonly used in acquisition, joint venture , publishing, employment, and loan contracts . In a loan contract, the borrower involved in a financial transaction will provide representations and warranties to the lender as a way to convince the lender to issue a loan. But if the borrower's representation is no longer true, the lender can enforce the penalties spelled out in the contract.

In an acquisition or merger agreement, the company buying or acquiring the other company will likely want the other company to agree to a number of representations and warranties in the deal. These issues could include:

• Material contracts
• Compliance with laws
• Intellectual property
• Financial statements
• Capitalization

In an agreement of this nature, the company acquiring the other party will typically limit the contract to a few specific issues to have it "narrowly drawn."  

The three main purposes of representations and warranties are:

• To allow the buyer to gather information, learn as much as possible about the seller (or other company involved in the transaction), and make an informed decision
• To support both involved parties by spelling out the framework for the penalties and course of action if the contract issuer's representations are found to be false
• To protect the buyer and give him/her options to cancel or re-negotiate the contract terms before or after signing

Representations and warranties are especially important during the due diligence period, since this is the time that allows the signers to further investigate claims made before entering into the agreement. This section of a contract will also include an indemnification , or detail the protections and options given to the buyer in the terms.

Different laws might have different definitions of representations and warranties. But in loans and other contracts, representations refer to facts made by one party and warranties refer to the security for the involved party if the representations are not actually true.

The purpose of representations and warranties is to disclose information between the two parties. Those given by the seller in a business contract tend to be more extensive because they could include information about stocks, liabilities, assets, and any target companies involved in the transaction.

There are implied warranties and expressed warranties. Implied warranties fall within the restrictions of the Uniform Commercial Code, which means that all goods sold should be "fit for a specific purpose." Expressed warranties are included in written contracts and signed by both parties. If a buyer is trying to take legal action against a seller, it is easier to prove that the seller violated the terms of an expressed warranty than an implied warranty .

Why are Representations and Warranties Important?

In a contract or business agreement, the representations and warranties act as assurances given by one party to the other. While the actual contract and terms of the agreement may differ, the ideas of representation of facts and warranty to protect the involved parties are the same across all contracts. A buyer should rely on these representations as fact unless proven otherwise. Representations and warranties used together serve as the best form of protection for a buyer.

Both buyers and sellers should note that exaggerating the good points of a product or service does not constitute a false representation. Salespeople are expected to "puff" their products or services to a certain extent to help make them more appealing. But if any of the information presented as fact is found to be an outright lie, it would constitute a false representation.

Reasons to Consider Not Using Representations and Warranties

Some companies choose to never include representations in contracts or agreements because using representations puts the company at risk of being sued for fraud. You may also find that contract drafters leave the words "representations and warranties" off  the contract to keep it concise and eliminate redundancy. Simply referring to the information as representations can also reduce wordiness of a contract while accomplishing the same goal, which is to protect the buyer and seller.

Reasons to Consider Using Representations and Warranties

Including representations and warranties in a contract helps to allocate risk between both signers. Representations and warranties also become the foundation for security and protection to terminate or amend the contract. If one of the representations made is inaccurate, the warranty included outlines the action that the one signer can take against the other. In most cases when a representation is false, the warranty allows the other person involved in the contract to terminate or decline the transaction.

When a lawyer or legal representative drafts a contract, he or she has a legal obligation to protect the client against risks while securing advantages that will come from entering into the agreement. With representations and warranties included in the contract, the lawyer can feel confident that the contract fulfills both of these responsibilities.

If one party involved in a contract intentionally makes a false representation, the other party can make a common law claim of deceit, also referred to as a tort. In order to qualify as a common law of deceit, the party must prove:

• Conscious ignorance or knowledge of what makes the representation false
• Intent to make the contract signer rely on the other
• Justifiable reliance

Without proof of these elements, the claim will fail. If the contract issuer can prove that the other party knew about the falsity of the claim prior to signing, this will also cause the common law claim of deceit to fail in court.

What Could Happen When You Use Representations and Warranties? 

If your contract includes representations and warranties, they will help to protect you in case any of the claims made by the seller turn out to be false. The affected party can typically rescind or void the terms of the contract, then go on to obtain funds for recovery of the time and money spent as part of the transaction.

In some states, courts will use out-of-pocket measures to determine the damages when representations are false. The first way to measure damages limits the amount returned to the buyer. The measurement takes the amount the buyer paid for the item, then deducts what the item was worth. The resulting amount is what would be owed to the buyer in damages.

The second out-of-pocket measure to calculate damages looks at the benefit of the bargain. This method is more commonly used in violations of representations and warranties written into contracts. The formula for this method takes the value of the item as represented by the seller, then deducts the actual worth of the item.

What Could Happen When You Don't Use Representations and Warranties? 

One of the problems that many people face in relation to representations and warranties is implied warranties and how well those are protected. In the event that your contract or agreement doesn't include a spelled-out warranty, it's hard to claim that the representations made don't come with some type of common law warranty. If a seller is making claims about a product or service, the buyer should have protection even if the warranty isn't clearly stated.

In one example of this struggle, CBS Inc. took legal action against Ziff-Davis Publishing Co. in 1990. CBS claimed that Ziff-Davis falsely represented and warranted the financial condition of a division that it would be selling to CBS. During the due diligence period, CBS had its accountants review all financial statements of that division. The accountants reported that the financial statements did not match up with what was represented and warranted in the contract, but CBS representatives signed anyway.

In this example, which went to the highest court In New York, the issue was whether or not CBS could state a breach of the warranted claims, as those involved in the transaction had evidence that they were not true. But in this case, CBS won the fight and could end the contract without penalty.

Not using representations and warranties at all in a contract could put you at risk for signing an agreement with invalid terms. However, there is still some implied protection, which is how CBS won its case against Ziff-Davis. 

Frequently Asked Questions

• I signed a contract with representations of facts that I have found to be false. What can I do?

The warranties spelled out in the contract offer protection for false representations. Read your contract carefully to determine what your options are in the event that the representation is false. Most buyers can end the contract without penalty and sue for damages to recover any time and money spent on the transaction.

• My company has an expiring contract with a big customer. Should this be included as part of the representations and warranties in a contract with another customer?

Yes, because the contract with the other customer could impact the valuation of your company. It's important to be upfront about any changes to the company or value that could occur during the terms of any contract, in order to avoid legal action based on false representations.

If you need help with representations and warranties, you can  post your job  on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.

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Content Approved by UpCounsel

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• Difference Between Warranty and Condition in Contract Law
• Product Warranty
• Types of Warranty
• What Is Warranty and Condition in Contract Law?
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• Requirements for Disclaiming a Warranty
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“Representations,” “warranties” and “covenants” are so common in contracts that the words are likely to be overlooked. They appear not only as nouns, but as verb forms as well. Sometimes there is a separate section for each word, implying that they have distinct meanings. Often they are grouped together as “represents and warrants” or “represents, warrants and covenants.” Unfortunately, these repetitious phrases blur their meanings. Their imprecise use does not frequently result in litigation, but there’s much to be said for reducing redundancy and ambiguity.

These words are basic building blocks of contracts and have a long history. Each has traditionally had a distinct meaning and purpose. The key difference among these words is temporal – past and present for representations; past, present, but mainly future for warranties; and mainly future for covenants. The remedies for a false representation, breach of a warranty or violation of a covenant also have differed. Giving attention when drafting or editing a contract to their backgrounds and the traditional distinctions among them will promote clarity.

Representations

In traditional usage, a representation precedes and induces a contract. It is information by which a contracting party decides whether to proceed with the contract. A representation is an express or implied statement that one party to the contract makes to the other before or at the time the contract is entered into regarding a past or existing fact. An example might be that a seller of equipment represents that no notice of patent infringement had been received.

A representation traditionally was not part of a contract, and a claim for damages due to a misrepresentation generally would not be allowed. Instead, a claim that a misrepresentation induced a contract might be pursued in fraud, either to rescind the contract or for damages. In some instances, a claim might be based on the tort of negligent misrepresentation.

If a representation was included as part of a contract, it typically would function as a “condition” or “warranty.” A condition is a vital term going to the root of the contract (for example, that a lawyer hired under an employment agreement must be licensed to practice law), which, if the condition were false, would entitle the employer to repudiate the contract. In contrast, a representation in a contract might be a “warranty,” which would be an independent, subsidiary promise that did not go to the root of the contract (such as that the lawyer claims to always wear a suit to the office), and, if false, might give rise only to a claim for damages.

Warranties generally are promises that appear on the face of the contract. They are important parts of the contract, requiring strict compliance. Warranties may include representations, agreements or promises that a proposition of fact is true at the time of the contract and will be true in the future. A warranty provides that something in furtherance of the contract is guaranteed by a contracting party, often to give assurances that a product is as promised. It often is equivalent in effect to a promise that the warranting party will indemnify the other if the assurances are not satisfied.

Warranties may be categorized as affirmative warranties, i.e., those that focus on assurances that certain facts are true or acts have been performed at the time of the contract, and promissory warranties, i.e., those that are agreements for the future. Either type of warranty entitles the protected party to damages for breach or to the particular remedies set forth in the contract. Damages are based on the difference between the value of contract as agreed upon compared to the value of the contract given the facts at the breach.

Warranties now commonly provide protection for consumer products, and are subject to the Uniform Commercial Code and federal law. An “extended warranty” protects beyond the initial agreement between a buyer and seller. It is a form of insurance and may be regulated as such depending on state law and the particulars involved.

Comparing Representations and Warranties

Justifiable reliance generally is an element for a misrepresentation claim, but the state of mind of the party to whom the warranty is given is not pertinent to a warranty claim, and a party may enforce an express warranty even if the beneficiary believes the warranty will be breached and the problem it covers will arise.

Traditionally, a warranty also differed from a representation in these ways: (1) a warranty was always part of a contract, while a representation usually was a collateral (or a separate) inducement prior to the contract; (2) a warranty was on the face of a contract, while a representation might be written or even oral; (3) a warranty was conclusively presumed to be material, while a party claiming a misrepresentation had to establish materiality; (4) a warranty had to be strictly complied with, while substantial truth was enough for a representation; (5) a contract remained binding if a warranty was breached (unless the warranty was also a condition that was vital to the contract, e.g., that the lawyer hired under an employment agreement was licensed); and (6) only damages were recoverable from a breach of warranty, while a party defrauded by a misrepresentation might in some circumstances rescind the contract or recover damages for fraud.

A covenant in a contract traditionally has been a solemn promise in writing, signed, sealed and delivered, by which a party pledges that something has been or will be done or that certain facts are true. Historically, a covenant was in a sealed document that was self-authenticating, and witnesses were not required to establish the terms in the document. Of course, with the abolition of private seals over the last hundred years or more, contracts have been enforceable without being sealed documents.

Covenants usually are formal agreements or promises in a written contract, and are usually in agreements relating to real property. Covenants in or related to a contract usually are secondary to the main reason for the contract. They are an undertaking to do or not do something in the future; for example, that conditions will be maintained between the signing of a contract and the closing of the transaction, or while a loan is unpaid, or that a party will not compete or sue. A covenant – similar to a warranty – has always been part of the contract. A claim for breach of a covenant may be for damages or specific performance, or, potentially, if the covenant is important enough, for rescission or termination.

Dispensing with “representations,” “warranties” or “covenants” might be the norm for contracts in the future. Some commentators and model forms avoid the words, substituting “agree” or “obligate” or use “represent” to also cover “warrant.” Distinctions based on these terms have been important – perhaps to an excessive degree – in the past. Courts today are more willing than before to excuse formalism related to particular words, but it’s safe to warrant that archaic distinctions still matter in the digital age.

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Representations and Warranties | Practical Law

Representations and Warranties

Practical law glossary item 8-382-3760  (approx. 3 pages).

• Practical Law

Representations and Warranties

Practical law glossary item 8-382-3760  (approx. 3 pages).

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M&A Reps & Warranties | A Complete Guide

Executive Summary Representations and warranties (“reps & warranties” or R&W) are legal promises made by both buyer and seller. Reps & warranties are a foundational component of any purchase agreement, whether a stock purchase agreement or an asset purchase agreement. Following is a high-level outline of a typical purchase agreement and its various components: Key Terms: Purchase price, terms, form, or structure ( asset vs. stock ). Conditions: Events that must occur before a closing can take place, such as receiving employment or non-compete agreements from key staff, obtaining financing, and securing landlord approval. A common condition for closing is that the reps & warranties must be true as of the closing date — called a “bring-down” because the reps & warranties are “brought down” or reaffirmed at the closing if the purchase agreement is signed prior to closing. Covenants: Responsibilities of the parties during the time period between signing the purchase agreement and closing. Examples include the seller agreeing to operate the business as normal, and promises made by the buyer regarding how the business will be operated after the closing (e.g., retain a certain percentage of employees, fulfill outstanding purchase orders, etc.). Reps & Warranties: Promises and disclosures made by each party (seller has paid all taxes due; there is no outstanding litigation, etc.), which serve as “warranties” or “insurance” for each party in the event that a representation later proves to be untrue. Disclosure Schedules: Detailed description of any exceptions to the reps & warranties (such as whether there is outstanding litigation), and other schedules and exhibits. Most reps & warranties include language referencing exceptions to the R&Ws (e.g., “except as provided in the schedules”). Reps & warranties can then be worded in the affirmative, and any exceptions are listed separately in “Disclosure Schedules.” Indemnification: Obligation to cover costs of the other party for breaches of contract, such as if a representation or warranty proves to be untrue, or for other breaches of the purchase agreement. Miscellaneous: Expenses, notices, jurisdiction, governing law, severability, assignment, waivers, etc.

Representations & Warranties

Reps & warranties are nearly always included in the purchase agreement , survive the closing, and serve as the buyer’s basis for future lawsuits (under the “Indemnification” clause). Reps & warranties typically comprise the majority of the content in a purchase agreement and are one of the most hotly negotiated components of the purchase agreement, other than price and terms. This is because reps & warranties define the allocation of risk between the buyer and seller.

Definition: A representation is technically the statement of a fact (e.g., the corporation is duly authorized), and a warranty is a promise that a fact will remain true (e.g., seller warrants that the business has operated in compliance with all laws …); however, this distinction has proven unimportant. Reps & warranties are not listed separately in the purchase agreement, but are rather grouped together in one section called “Representations & Warranties.”

For example , most agreements state, “The Seller represents and warrants that …”

With minor exceptions, the other elements of the purchase agreement (price and terms, conditions, covenants, etc.) have no further implications after closing has taken place. On the other hand, the reps & warranties and related indemnification clauses “survive” the closing and can have implications for both parties for years thereafter. As a result, the reps & warranties are often heavily negotiated , especially when the seller wishes to retire and avoid any lingering obligations that may conflict with their peace of mind.

Most reps & warranties are worded similarly from deal to deal and exclusions are then documented in the disclosure schedules for the business based on several factors, such as the size of the business, the complexity and type of business, the structure of the transaction (asset vs. stock deal), and specific risks that may be present in the business. In practice, this means that the buyer’s attorney usually prepares the purchase agreement, which includes a standard list of reps & warranties, and the seller’s attorney is then obligated to list any exceptions in the disclosure schedules.

For example, a manufacturing company may have more representations concerning environmental and employee concerns (union, benefits, etc.), while a technology company may have more R&Ws regarding intellectual property.

How Reps & Warranties Can Speed Up Due Diligence

Due diligence can expose problems in the business that will subsequently be addressed through drafting tighter representations based on what was uncovered during the due diligence process. However, due diligence is unlikely to reveal every problem concerning the business.

In other words, R&Ws are drafted to protect the buyer from what they may have missed during due diligence and what a seller may have intentionally withheld. The buyer’s decision to buy the business is based on a combination of the due diligence they performed and the extent of the protections afforded to them in the purchase agreement in the form of representations & warranties.

Protections Afforded to the Buyer in the Purchase Agreement

The following protections are instituted in most transactions to protect the buyer from material misrepresentations or fraud:

• Reps & warranties

Indemnification

• Escrows or holdbacks

The Many Purposes of Reps & Warranties

Representations are engineered to require the seller to provide full disclosure to the buyer — in other words, they force the seller to disclose material issues regarding the business.

They also serve as a mechanism for allocating risk between the parties for events that are uncovered after the closing.

For example, if a customer sues the business for an event that happened prior to closing, the reps & warranties would serve to allocate the risk of such events between the buyer and the seller. The R&Ws would define who would be responsible for such an event, for how long, and to what extent.

Unknown risks are inherent in any business, and the R&Ws seek to allocate both known and unknown risks between the parties. In a buyer’s market, the role of reps & warranties in risk allocation strongly favor buyers, and vice versa.

R&Ws also serve as a condition to closing — if the representations and warranties are not true as of the closing date, the buyer may refuse to close.

Negotiating Reps & Warranties

Negotiating the reps & warranties should not be done in isolation but should instead be considered in concert with the following components of the overall deal structure:

• Purchase price
• Consideration (stock, cash, debt, earnouts , etc.)
• Terms of seller note , if applicable
• Allocation of the price for tax purposes
• Deal structure (asset vs. stock sale)
• Indemnification (caps, baskets, ceiling, etc.)
• Covenants (these are rarely heavily negotiated)
• Conditions to close (i.e., financing contingencies)

Introduction

The scene is like a living, breathing postcard from paradise. Clear skies, white-sand beaches, warm ocean breezes. And, look! There’s you: tanned and rested, John Grisham legal thriller in one hand, pina colada in the other.

In one sense, it took a lifetime to get here. You spent decades building your company and a grueling 12 months to get it sold. But you did it, and now you’re reaping the rewards. You’ve heard about former life-long business owners who found it impossible to relax after successfully exiting the fray. But that’s not you. There are going to be plenty more postcards like this one. Life is good.

Then the phone rings and life is about to get a little less good. It seems there is a problem with your financial statements. The buyer of your business discovered that the numbers are not compliant with GAAP and that EBITDA was overstated as a result. Not a big deal, you think … your deal closed six months ago, and it’s the buyer’s problem now. The buyer is demanding a reduction in the $2 million purchase price. But, hey, the deal is already closed!

You call your attorney in a fit of fury. Your attorney asks if you remember signing a representation or warranty stating that your financials were prepared in accordance with GAAP. Your response: “What’s a representation or warranty?”

Welcome to the world of reps & warranties, where in extreme instances a misrepresentation – inadvertent or otherwise – about the company you’re selling (or have already sold) could put the kibosh on the deal or a major drain on your bank account. The account where you keep the proceeds from the sale. Let the headaches and lawsuits commence.

As you’ll read below, reps & warranties typically make up the bulk of the content in a purchase agreement and are one of the most hotly negotiated components. That’s why I have devoted more than 50 pages to the topic here, and that’s why you should pay attention.

In addition to the accuracy of financial statements, reps & warranties can address the legality of the business, tax audits, the status of customer contracts, environmental liability, employee benefits, the status of inventory, and more. In the article that follows, we’ll touch on everything you need to know about reps & warranties and how they can impact a business sale from both the buyer’s and seller’s perspectives. After all, we wouldn’t want to spoil your day at the beach.

The Letter of Intent (LOI)

Unfortunately, the full reps & warranties are documented only in the purchase agreement and not the letter of intent (LOI) . As a result, sellers do not have the opportunity to see the reps & warranties that a buyer may be proposing in the LOI. Sellers sometimes counter this by asking the buyer to mark up a draft purchase agreement when evaluating a buyer’s LOI; however, this is customarily only done in larger transactions (generally, nine-figure transactions). The breadth and depth of the R&Ws are also based on facts discovered during due diligence, and the substance of the R&Ws may change based on what is uncovered during due diligence.

As a result, the reps & warranties are not drafted until much later in the process. In effect, this results in two stages of negotiations — once when the LOI is hammered out, and again when the purchase agreement is negotiated. This is why R&Ws are so hotly negotiated — the parties have already struck a deal, but now they must negotiate a second time.

Negotiating the Purchase Agreement

In most transactions, the buyer’s attorney prepares the purchase agreement, and the seller’s counsel responds by marking up the agreement. When drafting the R&Ws, the buyer’s attorney normally focuses on the likelihood and amount of potential exposure.

The scope of the negotiations is based on the aggressiveness of the buyer’s attorney’s initial draft and the bargaining positions (e.g., alternatives) of each party. This is why buyers often aim for a long exclusivity period — doing so reduces the seller’s bargaining power later in the process when the purchase agreement and R&Ws are being negotiated.

Consider a scenario in which the seller takes the business off the market after having spent tens of thousands of dollars conducting due diligence (e.g., fees paid to attorneys and accountants), after making a significant emotional investment in the transaction, and after having put all other potential buyers on hold for several months. Because the seller’s negotiating position has been weakened, the buyer may be able to negotiate much more stringent terms in the purchase agreement as a result.

The seller should carefully read through the representations and should not blindly sign them as if they were boilerplate — they’re not. If the seller is not 100% certain regarding a representation, that representation should contain a knowledge qualifier such as “to the best of the Seller’s knowledge” or “to Seller’s knowledge.” At the same time, exclusions can be documented in the disclosure schedules. Breaching a rep or warranty can have disastrous effects on either party and should therefore not be taken lightly.

Seller’s vs. Buyer’s Representations

The purchase agreement contains significantly more representations concerning the seller because the buyer has much more to lose than the seller does. The seller is primarily concerned about receiving payment — the buyer’s representations are therefore primarily about access to capital and authority to purchase the business.

On the other hand, the buyer is concerned about dozens of aspects of the business and its operations. Here’s a list of sample representations a seller might be asked to make:

• The seller is not delinquent regarding the payment of taxes.
• There are no judgments, claims, liens, or proceedings against the seller.
• The information the seller has given the buyer, including financial information, is accurate.
• The seller is a corporation in good standing and has the authority to enter the transaction.
• The assets being sold constitute all of the assets of the business, are in good repair, and are free and clear from liens, encumbrances, pledges, or claims.
• The seller is in compliance with all laws, including licensing, permits, zoning, environmental regulations, etc.
• The inventory is sufficient, unused, and saleable.
• The seller is not in default on any obligations or contracts.
• There are no hazardous substances used in the business.
• All accounts receivable are bona fide, have arisen in the ordinary course of business, and are not subject to offset.
• There are no undisclosed liabilities, legal proceedings, orders, or judgments.
• There are no undisclosed employment, consulting, bonus, or other agreements with employees or any third parties.
• The seller has disclosed all material facts that would affect the buyer’s decision to purchase the business.

Expanding the Scope of Reps & Warranties

Normally, the buyer seeks to obtain protection from as many parties as possible (all shareholders, key managers, etc.) and protection that is as broad as possible (e.g., all information the seller has provided is accurate). Not only must the topic of an individual representation be considered, but the collective scope of all R&WS must also be considered. When attempting to expand the scope to third parties, negotiations may become contentious as a breach can have major financial implications for such a party.

The Use of Reps & Warranties in Public vs. Private Transactions

Transactions involving publicly traded companies also include reps & warranties, but they become ineffective at closing (i.e., they don’t survive closing).

• This is because the selling entity normally ceases to exist after the closing , and it would be too difficult to obtain indemnification from a dispersed shareholder group (e.g., thousands of individual shareholders from the public who are not direct parties to the purchase agreement).
• Publicly traded companies are also subject to numerous Securities and Exchange Commission (SEC) disclosure rules and the information they provide is assumed to be more reliable than that provided by private companies. Therefore, extensive representations and warranties are not considered as critical as for public companies. For public companies, the seller’s representations are usually minimal but include a statement to the effect that the company has made all required filings with the SEC, and the filings comply with federal securities laws. Occasionally, the buyer will require that the seller include a representation that the financial statements have been prepared in accordance with GAAP; however, this is less common.

What Happens if Reps & Warranties are Breached? The Basics of Indemnification

This section of the purchase agreement addresses what will happen if a representation or warranty is breached. In most cases, an indemnity offers a party the right to recover losses and legal expenses. Indemnification is also a hotly negotiated component of the purchase agreement.

The indemnification is normally subject to limitations, such as minimum thresholds that must be triggered (similar to an insurance deductible, called a basket ) and the maximum limit of indemnification (a cap). Indemnification can also be limited by knowledge qualifiers (e.g., to the best of seller’s knowledge vs. to seller’s knowledge), materiality qualifiers , and survival periods (e.g., the R&Ws normally expire after 18 to 24 months). These collectively serve to limit the seller’s exposure level and further serve to allocate risk between the parties beyond the specific language provided in each individual representation.

An escrow of 10% to 15% of the purchase price is normally withheld from the seller’s proceeds to fund any indemnification claims.

Reps & warranties work like an insurance policy. There are exclusions , or events that the policy does not cover. There is also a deductible (basket) and a maximum payout amount cap. The seller’s goal is to limit their exposure through the following:

• Limiting the language of each representation individually
• Limiting “joint and several” liability
• Adding knowledge qualifiers (e.g., “to the best of the Seller’s knowledge”)
• Increasing the basket (deductible) that must be met before a claim is paid
• Reducing the maximum payout (cap)
• Reducing the amount of the escrow
• Reducing the survival period
• Reducing the length of the escrow
• Requiring the buyer to self-insure against certain risks

Negotiating Deal Structure and R&Ws

Deal structuring.

Negotiating reps & warranties cannot be done in isolation because they are one of many pieces that constitute the overall transaction structure. The trade-offs and tensions can be summarized as follows:

Seller’s Objectives:

• Maximize the purchase price
• Receive maximum cash down at closing
• Pay minimum taxes
• Reduce earnouts and escrows (e.g., contingent payments)
• Reduce the scope and breadth of reps & warranties
• Reduce the strength of indemnification via baskets, caps, and survival periods

Buyer’s Objectives:

• Minimize the purchase price
• Put minimum cash down at closing
• Maximize the tax-deductibility of assets acquired (by increasing the tax basis in these assets)
• Increase earnouts and escrows
• Increase the scope and breadth of reps & warranties
• Increase the strength of indemnification via baskets, caps, and survival periods

All of these components should be taken into consideration on a collective basis during negotiations. When negotiating, concessions should not be made in isolation.

For example, if the buyer proposes a lower purchase price, then the seller may concede but may request more cash down at closing or reduce the size of the earnout.

Or, if the seller insists on providing minimal representations to a buyer, the buyer may concede but may tighten up other elements of the deal structure, such as escrows, knowledge qualifiers, or thresholds.

The more assurances the seller is willing to provide to the buyer, the lower the risk for the buyer and the higher the purchase price the buyer can potentially afford to pay given the amount of risk they are assuming. Risk and return are directly related. The higher the risk, the lower the return — and vice versa. By lowering the risk for the buyer, the seller can potentially realize a higher purchase price.

The most fiercely debated elements of the transaction are:

• Terms of the seller note
• Post-closing purchase price adjustments (e.g., working capital adjustment )
• Escrow: size and length
• Contingent payments, such as earnouts and escrows
• Specific terms of employment/consulting agreements
• Allocation of purchase price, which affects the tax implications of the transaction
• Reps & warranties: survival period, knowledge, materiality qualifiers
• Indemnification: caps, baskets, survival period
• Conditions to closing, including material adverse change (MAC)

Negotiating

The scope of the reps & warranties is different from transaction to transaction. For example, a stock sale may contain a different scope of R&Ws than an asset sale. Likewise, a buyer who is intimately familiar with an industry and is, therefore, more confident in their ability to conduct due diligence, may demand a lesser scope than a buyer who is not familiar with the industry. As a result, no two negotiations are alike.

The scope of the negotiations over the reps & warranties is dependent on the following:

• The negotiating skills of each party
• The negotiating postures and bargaining strength of each party
• The structure of the transaction (asset vs. stock sale)
• If the shareholder group is dispersed, and the seller entity will cease to exist after the closing, the buyer will seek other protective deal measures, such as escrow.
• If the seller’s management team is purchasing the business, they will be familiar with the business and may request less-stringent R&Ws
• Businesses with more risks will be subject to more stringent R&Ws
• The extent of issues discovered during due diligence
• The more thorough due diligence is, the weaker R&Ws can be, in theory
• The buyer’s assessment and perception of the seller’s character
• The buyer’s perception of the business’s risks

The seller can therefore minimize the potential scope of reps & warranties by:

• Hiring an experienced negotiator, such as an investment banker or M&A advisor, to manage negotiations
• Conducting an auction to improve negotiating posture — the more buyers there are negotiating, the stronger the seller’s position will be
• Conducting pre-sale due diligence to identify and address problems before beginning the sale process
• Always be on time, always do what you say you will do, maintain your composure during negotiations, make conservative estimates, etc.

If the seller operates a basic retail or service business, the R&Ws likely won’t be very broad in scope. However, if it is a risky or complicated business, the seller can expect the buyer to demand much more stringent reps & warranties.

For example, if the seller’s business handles hazardous materials, the buyer will request stringent representations addressing potential environmental concerns, worker’s compensation claims (from the workers handling the hazardous materials), etc.

Comparing Offers

Unfortunately, letters of intent don’t include the full reps & warranties, so the scope of the R&Ws will not be able to be assessed until later in the transaction. LOIs often contain language that the purchase agreement will include “representations, warranties, and indemnification that are customary for a transaction of this size and type.” But customary based on whose definition? Some LOIs will include specifics regarding more contentious issues, such as the amount of earnouts and escrows. Less frequently, the LOI may include information regarding thresholds (caps, baskets, etc.).

Timing & Due Diligence

When negotiating an LOI, the buyer has not yet performed due diligence and has limited information on the business; therefore, the buyer is not in a position to know exactly what reps & warranties they will request from the seller. Only after the buyer has conducted due diligence will they be in a position to pin down the specifics. Ideally, the purchase agreement should be prepared in tandem with the due diligence process so the parties can negotiate the language as soon as possible in the transaction.

Sunk Cost Principle

Some buyers attempt to use time to their advantage and will wear down a seller using the “sunk cost” principle. The buyer figures that the more time and money they can get the seller to invest in the negotiations (i.e., sunk costs), the more likely the seller will give in on major deal points later in the transaction (to recover the sunk costs). This strategy can be countered by including milestones in the LOI, such as dates for completion of due diligence and preparation or signing of the purchase agreement.

The Shifting Dynamics of Leverage Throughout the Life of the Transaction

Sellers should also be aware that they have the most leverage early in the transaction, before the LOI is signed. Once the LOI is signed, the seller loses leverage and is subject to the buyer’s timetable. Most LOIs contain an exclusivity clause and require that the seller take the business off the market and cease negotiations with other parties, which further weakens the seller’s negotiating posture. For this reason, sellers should carefully negotiate all the terms of the LOI. If the seller has never sold a business before, it’s critical that they hire an experienced professional to handle the negotiations on their behalf.

The more buyers with whom a seller is negotiating, the stronger the seller’s negotiating posture will be. If the seller is negotiating with multiple parties, it may be suitable to move to a much more detailed LOI and outline in detail the components of the purchase price, such as price, terms, escrows, caps, baskets, survival periods, earnouts, allocation of the purchase price, etc. This will help a seller evaluate offers as opposed to blindly accepting an LOI with vague terms only for it to blow up later in the process.

Which offer would you accept?

• $3 million cash at closing
• $10 million earnout
• $8 million cash at closing
• $1,500,000 seller note
• $500,000 escrow

Trick question! You can’t decide. You don’t have enough information to make a decision.

We would have the following questions before we could evaluate either offer:

• What are the terms of the earnout? Is it based on revenue? EBITDA? How many years?
• Who will have control of the business post-closing?
• What is the allocation?
• What is the extent of the R&Ws, indemnification, escrow, etc?
• What are the terms of the seller note (months, interest rate, fully amortized, etc.)?
• What is the creditworthiness of the buyer? This is relevant for earnouts and a seller note. You don’t want to accept an earnout or note from a buyer who is not creditworthy.
• What is the related experience of the buyer?
• Is the buyer requesting exclusivity?
• Does the buyer have the cash, or is the LOI contingent on the buyer obtaining third-party financing?
• How many acquisitions has the buyer successfully completed in the past?
• How long does the buyer need for due diligence?
• How long after the completion of due diligence can the buyer close?
• What are the terms of the escrow?
• How long is the escrow period?
• What are the limitations of indemnification (caps, baskets, etc.)?
• What is the allocation of the purchase price?
• Is the transaction structured as an asset or a stock sale?
• What are the conditions for closing?
• What is the survival period of the reps & warranties?
• Is the buyer requesting that the seller remain with the business? If so, what are the terms of the employment agreement?

Unfortunately, we are approached all the time by sellers who have an offer in hand with terms similar to one of the offers above. It’s common for sellers to only focus on the price. Yes, the language in the LOI might look impressive — but 90% of it may be boilerplate, and the terms may be vague enough that the buyer can rewrite them later. When a seller receives an LOI, it’s critical to pin down the buyer on all the key terms of the transaction, otherwise, there is a good chance that the unwritten terms will not be favorable for the seller when they are finalized in the purchase agreement.

It’s also critical that reps & warranties are negotiated collectively with the other components of the deal structure. In other words, don’t negotiate R&Ws in isolation.

Impact of Market Conditions on the Scope of R&W

The current state of M&A activity and the extent to which it is a seller’s or buyer’s market heavily influences the scope of R&Ws. Market conditions impact not only the price of companies but also the terms of the transactions — and may dictate the prevailing definition or notion of what may be considered “reasonable” or “fair.”

For example, in a seller’s market, sellers can expect to sign reps & warranties that are far less broad in scope than in a buyer’s market. In 2009, sellers had to agree to extremely restrictive language in both LOIs and purchase agreements. Once the buyer’s market gained traction several years later, the scope of these restrictions loosened up.

Market conditions can influence the following:

• EBITDA multiples
• Terms (amount of cash down, amount of equity purchased vs. rolled over)
• Amount of contingent payments, such as earnouts
• Exclusivity periods — they are much shorter in a seller’s market
• Scope of indemnification
• Size of escrow (holdback)
• Indemnification limitations (baskets and caps)

Tips for Negotiating Reps & Warranties

Here are some tips for negotiating representations and warranties:, understand the purpose of reps & warranties.

The parties must recognize that no business is perfect. There are bound to be a variety of problems in any business, no matter how meticulously the business has been operated.

For example, few businesses are in compliance with literally every law.

Reps & warranties are not intended to insulate the buyer from every imaginable problem that can arise. The purpose of reps & warranties is to protect the buyer from undisclosed, material risks that occur outside the ordinary course of running the business.

Past Events Only

Representations should primarily cover past events. They should not be designed to provide the buyer with assurance regarding the future. Operating a business involves numerous risks, so the buyer should assume the normal risks and not attempt to mitigate future risks that occur in the ordinary course of business.

Maintain an Excellent Relationship

The seller should attempt to maintain an excellent working relationship with the buyer after the closing. The transaction must be win-win for both parties.

If the buyer later suffers from buyer’s remorse, they will have sufficient opportunities to obtain revenge on the seller through numerous protections afforded to the buyer in the purchase agreement. Such protections include escrows, post-closing purchase price adjustments (e.g., working capital adjustment), inventory adjustments, collection of accounts receivable, reps & warranties, earnouts, bonuses, etc.

The best antidote for disputes is prevention. How does that work? By maintaining an excellent working relationship with the buyer — not just professionally, but personally as well. If you are “friends” with the buyer, it’s easier to work out problems.

Be Prepared to Give in, at Times

Be prepared to negotiate and occasionally give in on some points. The parties must weigh the cost of a dispute vs. the potential benefits to be gained. Disputes are expensive and time-consuming, and even if you win, you lose.

No deal is perfect, and you can reasonably expect to encounter at least one substantial dispute in nearly every transaction. For immaterial matters, it may be most prudent to simply split the difference.

Make Concessions Known

Never make a silent concession — in other words, the seller should never give the buyer something without the buyer becoming aware of it.

For example, if the seller counts the inventory and it is $204,000, but the seller only plans to charge the buyer $200,000 for the inventory, the seller should let the buyer know. The more concessions that are made, the more likely the other party will be to concede on minor points, but only if they know about the concessions.

Analyze Indemnity Provisions Using a Matrix

Use a matrix to analyze indemnification provisions. These provisions can be complex, and it’s best to separate the legal language from the economic parameters.

Extract the economic parameters of the provision and map it out on a spreadsheet. This helps organize and analyze the terms of indemnification and facilitates making tradeoffs.

Understand Underlying Motivations

Buyers propose specific reps & warranties for a reason. The seller needs to find out these reasons and address the concerns directly. Often, the problem can be resolved through other creative measures, or the buyer may have a misunderstanding of the underlying risk the representation is intended to address. This can open a dialogue to educate the buyer on the risk and other methods for mitigating it.

Beware of Financial Representations

Be very careful when there is a financial representation, such as:

“Purchase Price is based on EBITDA for the most current year of $5.2 million … continued to a separate representation … and the financial statements have been prepared in accordance with Generally Accepted Accounting Principles.”

This is a potential landmine for a seller and is tantamount to giving the buyer a blank check. If the seller’s financial statements are not prepared in accordance with GAAP (most aren’t), the seller has essentially given the buyer carte blanche to later negotiate the purchase price. Before signing representations concerning accounting or financial matters, have a CPA review them to ensure they are accurate.

Here are Some Ways the Seller Can Reduce the Potential Exposure of Reps & Warranties:

Reps & warranties insurance.

Insurance is available to sellers to minimize the potential liability of R&W breaches . The price is normally 4% to 8% of the coverage amount and depends on the scope of the reps & warranties, the industry the business operates in, the deductible, and the term of the coverage. This type of insurance has become commonplace in private middle-market M&A transactions but does not cover fraud or gross negligence.

Knowledge Qualifiers

Limiting the reps & warranties based on the seller’s knowledge is an effective strategy for reducing the seller’s exposure and can place the burden of proof on the buyer to prove that the seller did not have knowledge of the information. Knowledge qualifiers can also be limited to certain parties.

For example, a representation can be limited exclusively to the knowledge of the seller, or it could apply to the seller’s management team.

Most sellers should attempt to limit knowledge solely to their own knowledge, as broadening the scope of liabilities of knowledge to third parties can increase the amount of risk.

Sample knowledge qualifiers include:

• “To the best of Seller’s knowledge” (presumes the seller has made proactive efforts to obtain knowledge)
• “To the Seller’s actual knowledge” (limits knowledge to what the seller actually has, and does not presume the seller has made sufficient inquiry)
• “To Seller’s knowledge”

Materiality Qualifiers

Materiality can be addressed either in individual reps & warranties or collectively in the indemnification section. More commonly, materiality is addressed in the indemnification section by the use of baskets and other thresholds. Most agreements specify that only material breaches will be subject to indemnification. The level of materiality is usually defined by providing for a specified basket, or deductible.

In most transactions, the amount of the deductible, or basket, is 0.50% to 0.75% of the purchase price. For example, in a $10 million transaction, a claim must exceed $50,000 to $75,000 before it is subject to an indemnification claim.

Survival Periods

Reps & warranties are almost always limited to a specified time period, also called a survival period. Survival periods may differ depending on the type of representation.

For example, R&Ws regarding tax and environmental concerns may be for longer periods or may even be perpetual (no time limit) in certain cases.

Nonetheless, survival periods can also serve to limit a seller’s level of exposure.

Right of Offset

Indemnification claims can also be offset by unpaid amounts of the purchase price.

For example, if the buyer has been late on the seller note, any indemnification claims could be subtracted from the outstanding balance.

Buyer Insurance

A seller can require that the buyer insure against any risks that are potentially insurable. The seller can also maintain their existing policies if the policies are made on a claims basis vs. an occurrence basis. The indemnification should be net of any insurance reimbursements.

The seller should be sure to request that the insurer waive any subrogation rights they may have if they aren’t the named party in the policy. This prevents the insurer from coming after the seller in the event of a loss since the seller is not the named policyholder.

Indemnification Caps

Sellers can cap their total exposure to breaches of reps & warranties.

Caps, or limits, are generally 10% to 20% of the purchase price, but may be higher for specific types of claims, such as environmental claims.

Shareholder Liability

The parties to the indemnification can either be the selling entity or the individual shareholders. In most cases, the selling entity ceases to exist, and the buyer requests that all operating shareholders sign the purchase agreement. A selling shareholder must personally sign the purchase agreement in order to be subject to being required to indemnify the buyer.

Multiple Parties: If multiple shareholders exist, they should not agree to “joint and several liability.” If joint (together as a whole) and several (individual) liability exists, the shareholders can be held liable either together as a whole (joint) or individually (several).

In other words, a 10% minority partner could be potentially liable for the entire amount of the claim. Or a 60% majority partner could be held liable for the entire claim, and the 60% partner would then have to chase down the minority partners for reimbursement. If multiple shareholders exist, the seller should attempt to limit indemnification on a pro-rata basis (each shareholder pays their share of the award), as opposed to “joint and several.”

Hiring a Team to Negotiate R&Ws

Tips for hiring advisors to help negotiate the purchase agreement.

When hiring a professional advisor, the number one thing you should look for is real-world experience buying and selling companies. Negotiating the purchase agreement for the sale of a middle-market business is a complex undertaking, and by no means should you risk your hard-earned money to pay an advisor to learn on the job. When hiring an accountant or attorney , look for experience. Don’t be shy when inquiring about qualifications. Ask how many M&A transactions they have worked on in the last three years and their role in each transaction. Ask what role they envision themselves playing in your situation — some advisors prefer to be in the background while others prefer to be on the firing line.

The reps & warranties can have significant implications for several years following the closing. In some instances, the liability a seller may incur in reps & warranties can be perpetual, such as in the case of environmental issues, the payment of taxes, or for employment-related matters. For buyers, one word in the agreement can make the difference between a million-dollar recovery of damages and no recovery at all. Both parties should be sure their advisors are familiar with all aspects of the purchase agreement, especially the reps & warranties.

Balance risks vs. rewards. Attorneys and accountants are conservative by nature. Find an advisor whose appetite for risk matches your own. Some advisors are excessively risk-averse. Likewise, some business owners are also risk-averse. You want an advisor whose risk profile matches your own.

Help your advisors understand your business from both an operational and a financial standpoint. Tell your CPA or attorney what your primary concerns are and work with your advisor to meet your needs before becoming buried in legal or financial jargon. Don’t lose sight of your objectives. Once your advisor understands your business and aspirations, you can work together to create package proposals that meet the buyer’s needs while also addressing the needs of your business.

Balance your advisor’s experience and judgment with your own objectives. Experienced accountants and attorneys will know what is customary and reasonable and what is not. The American Bar Association (ABA) compiles surveys from attorneys in the trenches based on what is currently considered reasonable in an industry. For example, the ABA study might indicate that 34% of M&A transactions under $10 million in purchase price include an earnout, or that the average escrow is for 18% of the purchase price. The ABA’s studies are highly detailed and contain specifics on every critical element of a purchase agreement. An experienced advisor can spot when the opposing party is making an unreasonable request and will be able to couple your objectives with current standards of reasonableness. A good advisor will tell you when to fight and when to acquiesce.

Know the role of your accountant or attorney based on your experience level. If you have never sold a business, be prepared for your advisor to play an instrumental role in the process. On the other hand, seasoned business owners will require less guidance from their advisors.

Your attorney will play a key role in negotiating the purchase agreement. But it’s your accountant who will take the lead in financial due diligence and examining the financial and tax implications of the purchase agreement, and negotiating any R&Ws that relate to the financial aspects of your business. Your accountant or CPA may examine the financial implications of reps & warranties, such as a representation that relates to:

• Capitalization
• Financial statements (accuracy of, in accordance with GAAP, etc.)
• Taxes and tax returns
• Books and records
• Accounts receivable
• Employee benefits
• Employee compensation

Finally, ask your advisors to conduct pre-sale due diligence. This involves conducting due diligence before you put your business on the market and will allow you to identify and resolve potential problems before you begin the sale process. Doing so may lessen the scope of the reps & warranties.

The M&A Advisor or Investment Banker

Both your attorney and your M&A advisor will play instrumental roles in the negotiation of reps & warranties. Your M&A advisor will negotiate with the buyer regarding the high-level elements of the transaction and how the various components of the transaction work together to form the overall deal structure. Experienced investment bankers treat negotiations as a win-win proposition as opposed to stating a position and firmly holding one’s ground. An experienced intermediary can be invaluable in uncovering a buyer’s true concerns and creatively structuring a transaction to meet both parties’ needs.

Most M&A firms will ask the seller for indemnification against any legal actions that may occur as the result of inaccurate information or material misrepresentation. Many buyers will enjoin the M&A advisor in any suit and will cast a wide net over anyone that was involved in the transaction. Since the seller will receive roughly 95% of the proceeds of the transaction and will be the source of all the information, M&A advisors argue that they should not be responsible if the information is inaccurate.

Without such an indemnification, the M&A advisor would be required to verify every bit of information that passed through their hands. Such a requirement would be burdensome and unnecessarily hamper the process. Such a request is reasonable; however, the degree to which the seller indemnifies the advisor against gross negligence is debatable. In our opinion, the advisor should not be indemnified from acts of fraud or gross negligence, although the M&A advisor should be indemnified from any problems that stem from a source of inaccurate information. Opening up the investment banker to liability for inaccurate information will cause them to second-guess the business owner in an endless number of situations and would add a significant cost and time delay to the process, and their fees would need to be commensurately increased to account for the inflated risk.

Other Specialists

Depending on the nature of your business and industry, other specialists may be employed during the process. Their level of involvement will impact the scope of reps & warranties. In some cases, retaining experts in advance can mitigate risk for the buyer, and the buyer may, in turn, reduce the scope of the reps & warranties.

• Environmental: The seller may want to consider hiring an environmental consultant if the business handles hazardous materials or is subject to environmental regulations. Buyers often hire environmental experts if they are purchasing land or buildings and suspect the property may be contaminated. Many jurisdictions impose strict liability for all past owners of real estate when environmental issues arise. Such issues represent the highest exposure levels for the parties. Retaining a consultant in advance may give you time to discover and address problems before they arise with the buyer.
• Employee Benefits: Employee benefits are the next-largest area of risk exposure for buyers. Sellers should consult with experts in this area well in advance of the sale to ensure assets exceed liabilities in the case of retirement plans and that a smooth transition of benefits can occur in the case of other benefits, such as deferred compensation, profit-sharing, stock options, employee stock ownership, health insurance, life insurance, etc. In most cases, the plans will be terminated; the seller is obligated to fulfill the termination requirements, and the employees continue under the buyer’s plan.
• Code Audit: When purchasing a software company, most buyers retain a third party to perform a code audit to ensure the software code is clean and well documented. A wise seller will hire a third party to perform the audit and clean up the code before the company is put on the market. The results of the audit and resulting cleanup can then be used as negotiating leverage with buyers to provide the buyers with some level of comfort regarding the documentation, accuracy, and organization of the code.

Asset vs. Stock Sale

A question in every transaction is whether the transaction should be structured as an asset sale or a stock sale. The form of the transaction has a significant impact on the scope of the reps & warranties. Reps & warranties are much broader in scope for a stock sale than an asset sale.

Most buyers prefer an asset deal due to the lower level of risk. In a stock sale, the buyer is inheriting all of the seller’s liabilities (called contingent or unknown liabilities) whereas in an asset sale, the buyer is only inheriting those liabilities the buyer is explicitly agreeing to assume in the purchase agreement, along with successor liabilities, which the parties cannot avoid regardless of the form of the transaction. As a result, the reps & warranties can be less in scope in an asset sale than in a stock sale.

If a buyer acquires the stock, the buyer is inheriting all of the liabilities of the seller. As a result, reps & warranties in stock deals are more comprehensive than in asset deals. Many larger transactions are structured as stock deals. In stock deals, the seller will make additional representations regarding the capitalization and liabilities the buyer will be inheriting.

Successor Liability

Regardless of the transaction structure, there is a possibility of successor liability. This can be mitigated to a certain extent with thorough reps & warranties, an escrow, and other protective measures; however, the risk can never be completely eliminated. In certain matters, successor liability can never be eliminated, such as for tax or environmental issues.

In other matters, such as employee issues, successor liability can be mitigated by reducing the possibility of being labeled a “continuation” if the sale is an asset sale. The business is considered a successor, or continuation, if the product lines, employees, and other aspects of the business are substantially similar both before and after the closing. In other words, if the business is essentially the same, the courts may characterize the business as a “mere continuation” and impose successor liability. This happens in most M&A transactions, meaning that successor liability exists in most M&A transactions. As a result, many of the reps & warranties are designed to address these potential areas of liability.

Here are some tips for reducing successor liability:

• The buyer should conduct thorough due diligence to uncover potential successor liabilities, especially those related to environmental, tax, and employment law.
• The purchase agreement can use a triangular acquisition structure to isolate liabilities in the subsidiary entity. In a triangular structure, the buyer entity forms a subsidiary entity, and the subsidiary entity either acquires or merges into the target. This structure isolates the liabilities within the subsidiary entity.
• In an asset deal, the buyer should explicitly list any liabilities the buyer is assuming and any liabilities the seller is retaining.
• Include stringent reps & warranties regarding potential issues that may be susceptible to successor liability.
• Include indemnification with reduced baskets for issues relating to successor liability.
• Reduce the appearance of “business continuity” to minimize the possibility a court may label the business as mere continuation and therefore impose successor liability.
• Require the seller to keep their entity open and liability insurance in place as long as possible. In certain cases, such as environmental or tax issues, liability may be indefinite, so the time the entity remains open should be carefully weighed against the potential for, and size of, the risk.

Funding Breaches Through Escrow

The majority of M&A transactions include some form of holdback, also called an escrow . In a holdback, a portion of the purchase price, normally 10% to 20%, is held by a third party (escrow) for a period of time, normally 12 to 24 months, and is used to satisfy any indemnification claims in the purchase agreement. If there are no claims, the money is released to the seller once the time period expires.

Why is an Escrow Necessary?

Escrows give the buyer assurance that money will be available to cover their expenses (from litigation, losses, etc.) if any of the seller’s representations or warranties later prove to be untrue or for other breaches in the purchase agreement.

For example, let’s examine the sale of a manufacturing plant that includes expensive machinery. The seller may have represented that the machinery is operable and in good repair. If a piece of machinery breaks after the closing, and the seller determines that there was deferred maintenance on the machine and the problem was concealed by the seller, the buyer will file a claim to seek reimbursement for the machine.

The holdback goes into an escrow account with a neutral third-party escrow agent. The funds are governed according to an escrow agreement. In most cases, the funds may only be released upon the mutual consent of the buyer and seller. If there are no claims, the money is released to the seller once the escrow period expires.

Are there alternatives to escrow?

Yes, most M&A transactions include some form of deferred payment, and nearly any deferred payment can also function as a form of escrow. Here are several alternatives to escrow:

• Promissory Note: The promissory note can also include explicit language that affords the buyer the right to withhold future payments in the event of a breach (called an “offset”).
• Earnout: Earnouts can also include a right of offset; however, the likelihood of the seller receiving any earnout payments should be considered.
• Consulting or Employment Agreement: Consulting and employment agreements can also include a right of offset; however, this may not be allowed in certain states that prohibit setoffs against employment agreements.

Sellers are likely to resist a right of offset against guaranteed, deferred payments (e.g., promissory note and consulting or employment agreements) because such an arrangement affords the buyer a significant amount of leverage since the buyer “controls” the money. Allowing the buyer to simply withhold payments may afford the buyer too much power, and sellers may justifiably prefer an escrow.

What Are the Major Terms of the Escrow Agreement?

The parties should consider the following as terms of the escrow agreement:

• Amount of Money: Most transactions include an escrow that ranges from 10% to 20% of the purchase price. The size of the escrow should correlate to the likelihood and magnitude of the potential risks and whether other forms of deferred payments also contain an explicit right of setoff.
• Time Period: The time period for most transactions ranges from 18 to 24 months, but we have seen time periods as short as 12 months and some as long as 36 months. Most buyers will prefer to prepare a full year’s P&L statement and close the books so they can examine an entire accounting period, which is why most time periods are at least 18 months. In most cases, two years is more than sufficient to uncover potential risks.
• Conditions: The escrow agreement should prescribe the conditions of the escrow, who controls its release (normally mutual), and how disputes are handled.
• Interest: Who should receive interest on the amount held in escrow?

How Are Disputes Normally Handled?

Disputes regarding the purchase agreement will be governed by the terms of the purchase agreement in conjunction with the terms of the escrow agreement. In some cases, supplemental agreements (e.g., a non-competition agreement) may have separate dispute mechanisms.

Most disputes will be governed according to the terms laid out in the “Indemnification” section of the agreement. There is no such thing as a “standard” indemnification provision. Indemnification language may be strongly debated by both buyer and seller.

In most cases, if a buyer discovers a problem or a breach, the buyer must notify the seller, and the seller may be given time to resolve the problem (i.e., “right to cure”), contest the damage, or choose to reimburse the buyer. If the parties cannot resolve the issue, then the money will remain in escrow while the parties attempt to reach a resolution.

A final question to consider is whether the escrow should be the buyer’s exclusive remedy or whether the buyer may be afforded additional remedies.

Limitations to Reps & Warranties

Limitations to reps & warranties can be broken down into the following four categories:

• Knowledge Qualifiers: Limit reps & warranties based on a definition of the seller’s knowledge of the representation or warranty being made.
• Survival Periods: Reps & warranties expire after a period of time — known as a “survival period.”
• Baskets (Minimums): The seller is not liable for claims until the basket amount is exceeded. This is similar to an insurance deductible.
• Caps (Maximums): The seller is only liable up to a maximum amount, also called a cap.

One of the simplest ways to limit the scope of a representation or warranty is through a knowledge qualifier. A knowledge qualifier limits the seller’s exposure based on the seller’s “knowledge” of a representation.

For example, if a seller states that the business’s financial statements have been prepared in accordance with Generally Accepted Accounting Principles (GAAP), and the buyer later determines that the financial statements have not complied with GAAP, the seller may not be held liable. But, the degree to which the seller is held liable depends on the parties’ exact definition of “knowledge.”

The seller may not have knowledge regarding every aspect of the business. This is all the more true when the seller is an absentee owner. Sellers may therefore become rightfully nervous if they are required to make representations regarding aspects of the business of which they may be unaware. For example, an absentee owner may not be aware if all equipment is operational. The reps & warranties are therefore often limited based on the seller’s knowledge (as knowledge is defined in the purchase agreement) of that specific representation or warranty.

Sample In-line Knowledge Qualifiers include:

• “To the best of Seller’s knowledge”
• “To Seller’s actual knowledge”

These statements may precede the reps & warranties section in a purchase agreement. For example, “To the best of Seller’s knowledge, the Seller represents and warrants that …”. In this case, the definition of knowledge is included in the statement itself, as opposed to being defined separately in the ”Definitions” section.

Sample Definitions of Knowledge include:

• Actual knowledge
• The best of a party’s knowledge after due and reasonable inquiry
• Actual knowledge, without any requirement of inquiry or investigation
• Actual knowledge that would have been obtained after reasonable inquiry
• Constructive knowledge to the extent such knowledge would have been obtained by due inquiry
• Actual knowledge of any officer of the company
• Actual knowledge of the officers and employees listed in Schedule XX

In some purchase agreements, “Knowledge” is separately defined and included in the “Definitions” section of the purchase agreement, and the term “Knowledge” is then capitalized throughout the agreement to refer to its definition in the “Definitions” section of the agreement.

The precise definition of knowledge, as defined in the agreement, will have significant implications for both parties. In the absence of any knowledge qualifier, the seller could be 100% responsible for any representation and warranties in the purchase agreement, regardless of whether the seller knew it was true or not.

Limiting the definition of knowledge can dramatically alter the dynamics and can force the onus on the buyer to prove that the seller knew the representation was false at the time it was made. It can also significantly limit the buyer’s indemnification rights by shifting unknown risks to the buyer.

The buyer will attempt to expand the definition of knowledge to include “constructive” knowledge, which includes information that should have been known after reasonable or due inquiry, or that should be known based on the seller’s role in the business (e.g., a CEO will be presumed to have a different level of knowledge than that of a CTO or CMO).

Regardless, the parties should remember that uncertainty will always be present, regardless of the parties’ desire. Reps & warranties are not solely a test of integrity but are rather primarily a legal mechanism for allocating risk.

Careful consideration should be given if the seller is an absentee owner and has little knowledge of the business. In such cases, the definition of knowledge should suit the circumstances, but the seller should bear in mind that knowledge qualifiers are also a risk allocation tool, and the seller may be required to make representations regarding areas of the business of which they are not knowledgeable.

In other circumstances, such as a management buy-out (MBO), the buyer(s) may have more knowledge regarding the operations than the seller. In this case, management may be willing to accept more risk; however, this may be limited depending on the demands of external financing sources, such as banks or private equity firms.

Whose Knowledge?

Finally, the agreement should specify to whose knowledge the reps & warranties are subject. Are the reps & warranties based solely on the seller’s knowledge, or is the knowledge of officers or other employees also included in the definition?

If third parties are to be included in the definition, then the seller must be willing to bear the risk of depending on the knowledge of those third parties. In some circumstances, officers or key employees are asked to sign a certificate in which they individually certify knowledge of reps & warranties that are applicable to their roles. For example, a CFO may be required to sign a certificate relating to any financial representations.

Reps & warranties are almost always limited in time. Without a survival provision, it is not clear if they survive at all, or they may be subject to the statute of limitations relative to the specific breach (e.g., environmental, tax, etc.). Once the time period elapses, the seller may no longer be held liable to the buyer for a breach, except in certain circumstances, such as a purposeful or willful breach or fraud.

Most buyers prefer to operate the business for at least a full year, or business cycle, to identify any potential breaches. As a result, the average life of representations ranges from 18 to 24 months.

Example: “The reps & warranties of the Seller shall survive for a period of 18 months beyond the Closing.”

Survival periods may also differ, depending on the type and nature of the representation. For example:

• Intellectual Property: Can often be as long as 36 months
• Environmental: Can be unlimited
• Tax: Unlimited, or the full period of limitation under local, state, or federal law
• Employment: ERISA and employment matters can range from two years to unlimited
• Organizational & Title: Can be unlimited
• Compliance with Laws: Can be unlimited

Why don’t reps & warranties for publicly held firms survive the closing?

There are two primary reasons:

• Accuracy of Information: Publicly held firms are required to file periodic reports with the Securities and Exchange Commission (SEC) and it is widely believed that public firms are held to a higher standard and that their information is more reliable than that of their private counterparts.
• Dispersed Ownership: Because the ownership of publicly held firms is dispersed, it is more difficult to chase down individual shareholders if there is a breach. In a public company, there are fewer shareholders available to indemnify the buyer.

Baskets (Minimum)

Reps & warranties are almost always subject to a basket, or a minimum threshold that must be met before the seller becomes liable. This operates similarly to an insurance deductible.

The indemnification section of the purchase agreement defines what happens in the event of a dispute. Within the indemnification section is a clause addressing the basket (sometimes called “Limitations on Amount”). The seller is not liable for claims until the basket, or deductible, is exceeded. The basket sets the minimum loss the buyer must bear before the seller can be held liable.

Example: Most M&A transactions include a basket of 0.75% of the purchase price. In a $10 million transaction, a 0.75% basket would be $75,000. The seller would not be liable to the buyer until the cumulative amount of the claims exceed $75,000.

The basket has several purposes:

• It incentivizes the buyer to bear some of the risk , similar to an insurance deductible. If the basket, or deductible, were zero, the buyer would have nothing to lose by submitting numerous frivolous claims.
• It acknowledges that no transaction is perfect . With a basket, the parties accept that problems will arise, and they agree to not submit claims until a material threshold is exceeded. This simplifies the transaction by requiring the parties to submit only material claims.
• It improves the efficiency of the transaction by eliminating immaterial claims.
• It encourages the buyer to be more thorough in their due diligence.

Sample language:

“Seller shall not indemnify Buyer until the aggregate amount of all indemnity claims against Buyer exceeds the Basket, which is $50,000.”

“Seller shall have no liability until the total of all damages exceeds $100,000, and then only for the amount by which such damages exceed $100,000. However, this Section will not apply to claims under Section x and xx (e.g., tax, environmental, etc.), or to any breach of which Seller had knowledge prior to the date the representations were made, or for any intentional breach of any covenant or obligation. Seller and shareholders will be jointly and severally liable for all damages with respect to such breaches.”

“Neither Seller nor Buyer shall be liable to the other for any indemnification until the aggregate amount of Damages due to an Indemnified Party exceeds One Hundred Thousand Dollars ($100,000) (the “Basket”). Once the Basket has been exceeded, the Indemnified Party shall be entitled to indemnification for all Damages, including the amount up to the Basket and any amount in excess. This provision shall not apply to any Damages suffered, sustained, incurred, or paid by an Indemnified Party related to taxes or assessments by any governmental authority, or to any claim of actual fraud or intentional misrepresentation relating to a breach of any representation or warranty in this Agreement.”

Tipping vs. Non-Tipping Basket

• “Once the Basket has been exceeded, the Indemnified Party shall be entitled to indemnification for all Damages, including the amount up to the Basket and any amount in excess.“
• “Seller shall have no liability until the total of all damages exceeds $100,000, and then only for the amount by which such damages exceed $100,000.”

Sharing the Deductible

Some agreements require the parties to split losses up to the deductible amount.

For example, if there were a $100,000 deductible and a $101,000 loss, the buyer would be required to pay $50,000 and the seller $51,000.

This provision requires the buyer to absorb a significant portion of any losses and therefore motivates the buyer to be thorough in their due diligence to mitigate potential losses. This also motivates the seller to help mitigate smaller losses on behalf of the buyer. This mitigates, to some extent, the motivation of a buyer to “tip” a tipping basket, so they are reimbursed for the “deductible.”

The average basket size is 0.75% of the total purchase price. Buyers will obviously argue for the lowest basket possible, while sellers will seek a higher basket amount.

Certain reps & warranties are often not subject to the basket, such as those relating to employees, environmental, organizational, title to assets, or tax issues, as specified in the language below.

“This Section will not apply to claims under Section x and xx (e.g., tax, environmental, etc.) …”

The basket may also be voided if the seller commits a willful breach, or it may be limited based on the seller’s knowledge (as it’s defined in the agreement); however, most sellers contest this language since determining “willful” is subjective and subject to costly disputes.

Example: “This Section will not apply to any breach of which Seller had knowledge prior to the date the representations were made, or for any intentional breach of any covenant or obligation.”

Caps (Maximum)

A cap is the maximum amount of liability a seller can incur to the buyer. Caps average 10% to 20% of the purchase price of the business for most transactions. Once the cap is exceeded, the seller is no longer liable to the buyer for damages, with minor exceptions (fraud, etc.).

Caps can be higher, or even unlimited, for the following reps & warranties:

• Intellectual property (IP)
• Title to assets
• Employee matters
• Employee benefits, ERISA
• Environmental issues
• Organizational issues

Example: “The aggregate amount of damages that may be recovered by the Buyer arising out of or in connection with the breach of any of these representations and warranties shall not exceed $35,000.”

General Guidelines

Following is a chart of general guidelines for baskets, caps, and survival periods.

Indemnification & Remedies

When a problem arises after the closing, the parties look to the “Indemnification” and “General” sections of the purchase agreement to determine how the dispute will be handled.

The ‘Indemnification’ section usually addresses the following:

• Parties: Who exactly is providing the indemnification? Is it solely limited to one shareholder or all shareholders indemnifying the buyer? If multiple shareholders are indemnifying the buyer, are they jointly and severally responsible? Is the buyer also indemnifying the seller?
• Scope: What specifically does the indemnification cover? What is the scope of the indemnification? Most typically cover breaches of reps & warranties, breaches of covenants, non-compliance with laws, liabilities arising from the assets, etc. Is the indemnification limited to the four corners of the agreement, or are ancillary documents — such as those provided to the buyer during due diligence — subject to indemnification? The precise scope of the indemnification is often subject to intense negotiation. Some agreements also contain separate remedies that aren’t covered by the indemnification section in the purchase agreement. This could include a non-compete agreement, for example, and those agreements will be governed by the provisions outlined within its agreement.
• Remedies: Is the indemnification the parties’ exclusive remedy, or are other remedies available to the parties?
• Survival: For how long will the representations, warranties, covenants, and other obligations in the agreement remain in place?
• Limitations: What are the financial limits (baskets, caps, etc.) of the indemnification obligations?
• Escrow: Will a portion of the purchase price be held in escrow? If so, how much, for how long, and what are the terms of the escrow?
• Right of Offset: Does the buyer have a right of offset against the promissory note, consulting agreement, or other obligations?
• Indemnification Process: How are indemnification claims handled? What role does the indemnifying party have in the role of the defense of the claim?

The ‘General Provisions’ section of the purchase agreement usually addresses the following:

• Jurisdiction: Addresses dispute resolution options (litigation, arbitration, mediation, jury trials, etc.), forum, selection of mediators or arbitrators, rules for mediation or arbitration, who pays expenses, remedies, to what extent the decision is final, etc.
• Enforcement: May provide the parties additional remedies, such as specific performance or injunctive relief.
• Waiver: May state that rights are cumulative and a failure to exercise a right does not constitute a waiver.
• Governing Law: Specifies which state’s law governs the agreement.
• Expenses: How are transaction-related expenses allocated between the parties?
• Notices: To whom are notices to be sent, and when are they deemed received?
• Entire Agreement: This clause usually states that the purchase agreement constitutes the entire agreement and supersedes all previously written or oral agreements.
• Severability: If any provision is determined to be invalid by a court, the remaining provisions will remain in effect.
• Assignment: The agreement usually limits assignment and provides that the agreement does not create any rights for third parties.
• Time of Essence: A clause explicitly stating that time is of the essence, which helps the parties to enforce deadlines, such as drop-dead and other dates.
• Execution: The agreement can be executed in counterparts or electronically.

Notice that there is some overlap between the indemnification provisions and the general provisions in the purchase agreement. In some purchase agreements, these sections may be combined. Other times, they remain separate. This underscores the need for the buyer and the seller to hire experienced attorneys to represent them, and the need to rely on their guidance in negotiating the terms of the reps & warranties and related indemnification and other clauses that govern how disputes will be handled.

The indemnification clause requires the parties to indemnify one another for breaches of representations, warranties and covenants, and other types of claims that may arise after the closing, such as those related to tax, environmental, or employee issues. The indemnification clause (sometimes called “hold harmless”) functions similarly to an insurance policy and requires the breaching party to reimburse the other party for all expenses resulting from a breach.

The value of the indemnification depends on the financial strength and creditworthiness of the party providing the indemnification. In most M&A transactions, 10% to 20% of the purchase price is withheld by a third party in an escrow account to fulfill any post-closing indemnification obligations, which mitigates any impact of a less-than-creditworthy seller.

Indemnification rights are much more specific than the general legal rights included in most contracts. The indemnification provisions include specific rules governing the level of involvement the parties may have in defending suits or other claims, and other options that are rarely afforded to the parties under other general legal rights in most purchase agreements.

The indemnification can be limited by:

• Limiting indemnification based on knowledge of a representation or warranty
• Limiting the indemnification to actual losses, as opposed to other types of damages, such as punitive or speculative damages
• Baskets, or deductibles, that function as a minimum threshold that must be met before a claim can be submitted
• Caps, or the maximum amount of liability
• Survival periods, which limit the time period a party may be liable to another for breaches

Examples of potential disputes include:

• Inaccurate financial statements
• Violations of post-closing covenants, such as non-competes or non-disclosure agreements
• Loss of key employees
• Loss of key customers
• Working capital calculations
• Undisclosed pending litigation
• Undisclosed material liabilities, such as unpaid bills
• Undocumented employees

The Language Should be Custom-Tailored

The indemnification language should be custom-tailored to the unique characteristics and circumstances of the business and the specific risks identified during due diligence. The relationship between time and dollar limits should also be taken into consideration. Businesses in certain industries may be better served by higher dollar limits and shorter time limits, and vice versa.

Who is Providing Indemnification?

It’s important to consider who specifically is providing the indemnification. If there are multiple shareholders of the selling company, are all shareholders indemnifying the buyer, or only the majority shareholders? Or is the selling entity indemnifying the buyer?

In most cases, the majority selling shareholders are required to personally indemnify the buyer. To be obligated under the indemnification clause, a selling shareholder must sign the purchase agreement directly or through a “joinder.” This is often the case because the selling entity normally ceases to exist after the closing date. If it does exist, the proceeds from the sale are normally distributed to the shareholders and the selling entity is left with little assets with which to fund a potential indemnification claim.

It’s difficult for the buyer to have to chase down multiple shareholders, which is why escrows are so prevalent. If there are multiple selling shareholders, the sellers should also attempt to limit their liability to “several” (separate) liability, as opposed to “joint and several” liability.

Indemnification Procedures and Specifics

The indemnification clause should also address the following:

• What recovery is available to the party in the event of a breach?
• What is the process for resolving a dispute? Most agreements require an initial complaint in writing. If the parties can’t resolve the issue, then the agreement determines how the parties must resolve the dispute.
• What are the procedural aspects of indemnity claims?
• What are the rights of the parties to take part in any legal proceedings?
• What notice requirements exist?
• Who controls the defense of a claim from third parties?
• How will a party collect on an indemnification claim? Is collection limited to the amount in escrow?
• What rights do both parties have to access information?
• What rights of subrogation do the parties have?
• Is indemnification the parties’ exclusive remedy?
• How do insurance proceeds affect the parties’ indemnification obligations?
• Does a failure to act on a breach constitute a waiver?
• How do the parties choose counsel to defend a claim? Who has control over the defense and the fees?

Buyer’s Indemnification

The buyer also normally agrees to indemnify the seller. Common areas include the buyer’s covenant (promise) to offer employment and certain benefits to the seller’s key people. The buyer may also indemnify the seller regarding environmental liabilities or accounts payable.

Following is sample language:

The Buyer covenants and agrees to indemnify, defend, protect, and hold harmless the Shareholders, the Seller, and any of the Seller’s officers, directors, stockholders, representatives, affiliates, assigns, successors in interest, and current and former employees, each only in their respective capacities as such, from, against, and in respect of:

(a) any and all Damages sustained, incurred, or paid by Seller or any other Seller Indemnified Party in connection with, resulting from, or arising out of, either directly or indirectly:

• (i) any breach of any warranty of the Buyer set forth in this Agreement or any Schedule or certificate delivered by or on behalf of the Buyer in connection herewith; or
• (ii) any nonfulfillment of any covenant or agreement on the part of the Buyer set forth in this Agreement; or
• (iii) the ownership of the purchased Assets or the operation of the Business by the Buyer following the Closing Date.
• (b) any and all Damages incident to any of the foregoing or to the enforcement of this Section.

Sample Indemnification Language

Each of the Sellers and the Shareholders, jointly and severally, covenants and agrees to indemnify, defend, protect, and hold harmless the Buyer and any of the Buyer’s officers, directors, stockholders, representatives, affiliates, assigns, successors in interest, and current and former employees, each only in their respective capacities as such (collectively, the “Buyer Indemnified Parties”), from, against, and in respect of:

• (i) any misrepresentation or breach of any warranty of the Seller or any Shareholder set forth in this Agreement or any Schedule or certificate delivered by or on behalf of the Seller or any Shareholder in connection herewith; or
• (ii) any nonfulfillment of any covenant or agreement on the part of the Seller or any Shareholder set forth in this Agreement; or
• (iii) the Business, operations, or Assets of the Seller prior to the Closing Date or the actions or omissions of the Seller’s directors, officers, shareholders, employees, or agents prior to the Closing Date (except with respect to the Assumed Liabilities); or
• (iv) the Excluded Liabilities.

Notice Procedure; Claims: If the Indemnifying Party, within a reasonable time after receipt of such Claim Notice, fails to assume the defense of any Third-Party Claim, the Indemnified Party shall (upon further notice to the Indemnifying Party) have the right to undertake the defense, compromise, or settlement of the Third-Party Claim, at the expense and for the account and risk of the Indemnifying Party.

Here is a simple abbreviated indemnification language: “Seller will indemnify, defend, and save Buyer harmless from and against any financial loss, legal liability, damage, or expense arising from any breach of the above representations and warranties.”

Process Overview

This section describes how reps & warranties fit into the overall process of selling or buying a business.

Shifting Positions Of Power

When buying or selling a business, it’s important to understand the shifting positions of power between the buyer and seller as the transaction progresses. Naturally, both buyer and seller will push for concessions when they are in the greatest positions of power and try to limit concessions when they are in a weaker negotiating position.

The seller has the greatest leverage early in the process. However, this leverage instantly shifts to the buyer the moment a letter of intent (LOI) is signed. Before an LOI is signed, the seller is free to negotiate with multiple parties, but once the LOI is signed, the seller is limited to exclusively negotiating with one buyer (assuming the LOI contains a “no-shop” clause, which most do). This obligation for the seller to exclusively negotiate with the buyer dramatically reduces the seller’s leverage from the LOI all the way to the closing.

A buyer has limited information on a company prior to signing a confidentiality, or non-disclosure agreement (NDA). Once a buyer signs an NDA, they are typically granted access to the seller’s Confidential Information Memorandum (CIM).

Most NDAs include a clause that limits the seller’s representations to those explicitly outlined in the purchase agreement. Others may include a clause that generically addresses the reliability of the information the seller provides to the buyer and limits specific representations to those contained in a purchase agreement, such as this one:

“You understand that the Seller has included in the Confidential Information materials which the Company believes to be reliable for the purpose of your evaluation, but you acknowledge that neither the Company nor any of its respective agents, representatives, or employees make any representation or warranty, either express or implied, as to the accuracy or completeness of the information. The only representations or warranties for which the Company is responsible are those set forth in any definitive acquisition that the Company may execute.”

Occasionally, the buyer may submit a term sheet to the seller prior to submitting an LOI. The purpose of the term sheet is to focus the parties on the material terms of the transaction as opposed to focusing on the precise legal language contained in a typical letter of intent. This saves the parties time by ensuring they agree on the material terms before they invest a substantial amount of time negotiating the exact language of the LOI.

The term sheet may include a broad reference to the representations and warranties that will be included in the purchase agreement, such as in the following example.

“The purchase transaction contemplated under these proposed terms is subject to the following conditions: Negotiation and execution of a definitive agreement setting forth representations and warranties of the two entities, covenants, and any other provisions customary in transactions of this nature.”

Letter of Intent

Once a buyer is prepared to make an offer, the buyer will submit an LOI. Most sellers are in a rush to sign the LOI and move on with the transaction, as they impatiently eye the end-zone. “Just a few more yards to go,” they think. Not so fast. When accepting an LOI, you are still on your 30-yard line, meaning there are 70 more yards to go.

Once the LOI is signed, the arduous process of due diligence begins. Unfortunately, most sellers are woefully unprepared for just how grueling the remaining 70 yards can be. The process from signing the LOI to closing can take several months or more, and less than half of companies make it all the way to the endzone.

This is the most critical stage of the process for the seller. The seller’s leverage instantly evaporates the moment the LOI is signed. Unfortunately, many sellers are excited and impatient at this stage and prefer to blindly sign the LOI while overlooking other crucial terms once they agree on a price. Caution is advised. The LOI contains critical provisions that will govern the dynamics of the relationship between the parties all the way until closing.

In most cases, the majority of the terms in the LOI are non-binding, with the exception of a few clauses, such as confidentiality and exclusivity. Most LOIs also state that the parties will begin preparing the purchase agreement within a certain timeframe, and also stipulate that the purchase agreement will contain representations, warranties, covenants, and indemnification obligation language customary for a transaction of the size and type being contemplated.

The LOI never includes the full scope of the reps & warranties, but the parties may choose to document any potentially contentious R&Ws in the LOI in an attempt to avoid these becoming deal breakers later on. It’s helpful if your attorney has access to the M&A Deal Points Studies, published by the American Bar Association, to give you an idea of what is considered customary for a transaction of your size and type.

It’s best to negotiate contentious issues during the LOI stage, as opposed to delaying their negotiation until later in the transaction. If an M&A advisor suspects that certain issues may become contentious later in the transaction, they will work to negotiate comprehensive language addressing these potential issues upfront before the LOI is signed. It’s better to negotiate these issues early on and potentially risk losing the buyer than to spend tens of thousands of dollars and several months negotiating with a buyer only to be hit with a last-minute deal-killer. If these issues are held until later, the buyer will have significant negotiating leverage over the seller, and it’s likely the seller will simply cave in to the buyer’s demands, even if they are unreasonable.

Here is sample language that may be included in the LOI that addresses reps & warranties, which may be contained in a definitive agreement:

“The Purchaser will prepare and deliver to the Seller within 10 days of the conclusion of Purchaser’s Due Diligence Review a definitive Purchase Agreement (the “Purchase Agreement”). The Purchase Agreement will contain terms and conditions customary in transactions of this type (including standard representations, warranties, covenants, and indemnifications), or which are reasonably necessary as a result of the Due Diligence Review. Representations regarding the Company will, for most items, survive closing for three years, and for other items, including without limitation environmental, taxes, ERISA, and title, the survival shall be for longer periods (and in some cases indefinite).”

Following is sample language that may be included in the LOI that addresses reps & warranties made in the LOI:

“Seller’s acknowledgment of and agreement with the terms and conditions set forth in this Letter also constitute a representation and warranty that Seller has not entered into any executory agreements or accepted any commitments concerning any of the foregoing transactions. Seller hereby agrees to indemnify and hold harmless Purchaser from and against any and all losses, claims, damages, liabilities (or actions or proceedings commenced or threatened in respect thereof), and expenses that arise out of, result from, or in any way relate to the breach of the foregoing representation and warranty. The obligations of Company and Seller under this paragraph will survive any termination of this Letter and will be effective regardless of whether a definitive agreement is executed.”

Components of a Term Sheet: The purchase transaction contemplated under these proposed terms is subject to the following conditions: Negotiation and execution of a definitive agreement setting forth representations and warranties of the two entities, covenants, and any other provisions customary in transactions of this nature.

Due Diligence

The outcome of due diligence will determine the scope of the reps & warranties that the buyer proposes.

The extent of the buyer’s due diligence also depends on the scope of the representations the seller is willing to provide to the buyer.

The buyer’s due diligence may be less thorough if the seller is willing to provide more extensive reps & warranties. However, reps & warranties should not be viewed as a substitute for thorough due diligence. Likewise, thorough due diligence should not be viewed as a substitute for thorough reps & warranties. The two should work hand in hand.

The parties should also bear in mind that due diligence will never uncover every problem in a business. There is always the possibility that something may slip through the cracks during the due diligence process. Buyers rely on reps & warranties to offer them protection for issues they may not uncover during due diligence.

Due diligence should also be mutual. Not only should due diligence be performed on the seller, but the seller should also perform due diligence on the buyer, especially if the seller is carrying a note or accepting the buyer’s stock as a form of consideration.

The scope of due diligence and the reps & warranties is driven by the type and size of the business. An industrial business will require an entirely different due diligence and R&Ws framework than a technology business. Regardless, due diligence and the reps & warranties should work in concert with one another.

Drafting the Purchase Agreement

The buyer’s attorney normally begins drafting the purchase agreement once the due diligence process begins. The reps & warranties contained in the purchase agreement are normally worded in the affirmative and exceptions to the R&Ws are then detailed in the disclosure schedules.

Because it’s customary for the buyer to prepare the purchase agreement, the buyer’s first draft sets the tone of the negotiations. If the first draft is heavily weighted in the buyer’s favor, you can expect negotiations to be contentious and lengthy. On the other hand, a “fair” first draft is more likely to speed up the process and facilitate smoother negotiations.

The buyer’s first draft of the purchase agreement (and therefore the reps & warranties) also functions as a disclosure tool. If the buyer is unsure regarding any aspects of the business, a representation covering that area will force the seller to disclose any exceptions to the representation. The purchase agreement can also be thought of as a tool for allocating risk between buyer and seller.

Some sellers may also attempt to control the pace of the negotiations by withholding the disclosure schedules until the last minute. This strategy can work either way — either in the seller’s favor or against — and should be carefully considered before implementing it.

The Purchase Agreement and Its Components

The final document signed at closing is called the Purchase Agreement, but may also be called:

• Definitive Purchase Agreement (DPA) — a general term referring to the purchase agreement
• Asset Purchase Agreement (APA) — for asset sales
• Stock Purchase Agreement (SPA) — for stock sales

The structure of the purchase agreement will vary primarily depending on whether the form of the transaction is an asset or a stock sale. Most purchase agreements for lower middle-market transactions range in length from 20 to 50 pages, excluding the schedules and exhibits.

The purchase agreement contains the following primary clauses or sections:

• Price & terms
• Covenants (or promises) — either affirmative or negative — imposed on the buyer and seller prior to or after the closing.
• Conditions (contingencies) to the seller’s and buyer’s obligations to close. These are conditions that must be satisfied before the parties are obligated to close.
• Indemnification clauses
• Miscellaneous provisions

The purchase agreement may also contain the following exhibits:

• Disclosure schedules. These are exceptions to the reps & warranties.
• Bill of Sale (if the transaction is structured as an asset sale)
• Assignment (for assignment of contracts, copyrights, trademarks, patents, etc.)
• Promissory note
• Security agreement
• Intercreditor/subordination agreements
• Employment agreements
• Consulting agreements
• Non-competition agreement
• Non-disclosure agreement
• Escrow agreement
• Earnout agreement

Parties to the Purchase Agreement

Whoever signs the agreement is a party to the agreement. If the seller signs the agreement in the capacity of an officer of the corporation, then in most cases, the seller cannot be held personally liable for breaches of the agreement.

The selling entity ceases to exist in most cases after the closing. That’s why most buyers either require that the majority shareholders of the selling entity sign the purchase agreement as individuals (not as officers of the corporation) or that a portion of the purchase price be set aside in an escrow account to fund indemnification obligations. Alternatively, the shareholders can sign a joinder agreement, which binds them to the purchase agreement.

Covenants are promises to do — or not to do — something and are seldom a contentious issue in purchase agreements. Covenants in a purchase agreement define the obligations of the parties between signing and closing, and sometimes also after the closing. Some purchase agreements intermingle the covenants with the reps & warranties. However, we recommend separating them to keep the agreement clear.

Sample language: “Until closing, Seller will operate the business in the normal manner and will use its best efforts to maintain the goodwill of suppliers, customers, the landlord, and others having business relationships with Seller.”

As noted above, covenants can either be affirmative — a promise to do something, or negative — a promise not to do something. The most significant covenant requires the seller to operate the business as usual prior to closing. This requires the seller to not make any material changes to the business prior to closing without the buyer’s approval. Such changes could include purchasing new equipment, hiring new staff, or changing compensation arrangements with employees.

Pre-closing covenants are necessary only if the purchase agreement is signed prior to the closing. In this situation, the pre-closing covenants define how the business will be operated during the period of time between signing the purchase agreement and the closing. If signing and closing occur simultaneously, then pre-closing covenants are usually unnecessary; however, the parties may include post-closing covenants, especially if the seller is carrying a note. Pre-closing covenants often require the parties to use their best efforts to obtain required consents or to cause the transaction to close, require the seller to provide information to the buyer during due diligence, or may preclude the seller from negotiating with other parties (an example of a negative covenant).

Post-closing covenants often require the buyer to offer employment to a certain number of the seller’s employees and provide certain benefits to those employees, or may require the seller to assist in collecting any outstanding accounts receivable. The only covenants that survive the closing are post-closing covenants.

Conditions are requirements that must be met before the parties are obligated to close on the transaction, and are included in a purchase agreement if it is signed before the closing. Conditions are also commonly called “contingencies.” Once the conditions are met, the closing can occur. The “conditions” section is also sometimes called “termination.” The conditions section typically lists a series of conditions that must be satisfied before the closing can occur.

Conditions do not survive the closing. Reps & warranties, on the other hand, do survive the closing. This is an important distinction for the parties as the reps & warranties section of the purchase agreement continues to be an important element of the purchase agreement for a couple of years after the closing (or whatever the survival period is, typically 18 to 24 months), whereas most other sections of the purchase agreement have no further implications once the closing has occurred.

A breach of a condition relieves the parties from the obligation to close and is unlikely to provide the parties with the option to initiate a lawsuit, whereas a breach of a representation or warranty provides the parties multiple remedies, as outlined in the indemnification section of the agreement. The sole remedy for a breach of a condition in most cases is simply the right to walk away from the transaction, also called a “termination right.” While termination fees are common in M&A transactions involving publicly traded firms, they are rare in the middle market. The rules and processes are significantly different for private and public firms.

One important condition to closing is for the reps & warranties to be materially accurate. Thus, each representation functions as a condition to closing. This throws a curveball into the mix in terms of timing. The purchase agreement often contains a condition that the R&Ws must be accurate prior to closing. However, an important question is if the R&Ws are accurate if the seller discloses an exception in the disclosure schedules. But I digress.

While such unknowns are common in M&A transactions, the parties must continue marching toward the finish line despite the existence of such grey areas. Successfully completing a middle-market M&A transaction requires a good deal of faith on both sides and not every potentiality can be neatly buttoned up in the agreements. In fact, the attempt to document every eventuality will only slow the transaction and lower the likelihood of a closing. Time kills deals. Either you waste time bickering over minutiae, or you speedily march toward the closing, balancing the need for clear documentation and good faith. An experienced advisor can provide guidance on when to proceed based on faith, and when faith is best put into writing.

The second question is what happens if the buyer is aware of a breach prior to closing but chooses to close despite the breach.

For example, if the seller represents that the inventory is all salable, but the buyer discovers that a portion of the inventory is not salable, yet decides to close anyway, can the buyer close and then later sue the seller for breach of representation?

While the purchase agreement would govern such a scenario, in most situations, the buyer would be contractually precluded from proceeding with the closing and then later suing the seller for a breach of the reps & warranties discovered prior to closing.

Most sellers prefer that buyers have a right to terminate the transaction only if material inaccuracies exist in the R&Ws. Buyers prefer broader rights — even for immaterial inaccuracies in the R&Ws, for example. The closing is also conditioned on the covenants. If the seller does not operate the business in the ordinary course, the buyer may have a walk-away right.

Important announcement — the party is starting — it’s getting really exciting. Now turn your head upside down and see if you can read the preceding three paragraphs upside down. I’ll wait.

Here’s the bottom line: let your attorney do what they do best while you focus on running your business. Keep your hands on the steering wheel while your attorney tinkers with the technicalities.

Here are sample conditions to the parties’ obligation to close:

• Seller shall have performed all acts and covenants required in the purchase agreement
• All seller representations and warranties are true as of the closing date
• All seller approvals and consents required are delivered to the buyer
• All seller actions have been taken to convey the intellectual property to the buyer
• The assets of the business are free and clear
• The parties shall have obtained all necessary third-party consents
• The business has not suffered a “Material Adverse Change” (MAC). This is a new invention since the 2008-2009 crash and is far beyond the scope of this article.
• The documents specified in the purchase agreement must be delivered to the parties (e.g., promissory note, non-competition agreement, etc.)

Following is language that requires that the reps & warranties be true as of the closing:

“The representations and warranties of the Seller and the Shareholders contained herein or in any Schedule attached hereto shall be true and correct in all material respects at and as of the Closing Date as if made at and as of such time.”

When is due diligence over? What if something happens to the business between the signing and the closing?

The simple (i.e., affordable), answer is “refer to the purchase agreement.” The complicated (i.e., expensive) answer, and the one most favored by attorneys, is “it depends.”

If the purchase agreement has been signed (most aren’t signed before the closing), then the purchase agreement will govern the buyer’s obligation to close, particularly the “conditions precedent to closing.” Most purchase agreements include a “Material Adverse Change/Effect” (MAC/MAE) clause, which outlines conditions under which the buyer may terminate the agreement. The purpose of a MAC clause is to shift risk to the seller for significant downturns, or other calamitous events, that may impact the business between signing and closing. In a nutshell, the buyer will not be obligated to close if any covenants have been breached, the conditions for closing have not been met, or the reps & warranties are untrue as of the closing.

The seller should inform the buyer as soon as possible if an event has occurred that makes a representation untrue. Examples include the loss of a major customer or the filing of a lawsuit. Some purchase agreements obligate the buyer to immediately notify the seller if they discover a breach and require the buyer to either terminate the agreement or waive the breach and proceed with the closing. Without such an obligation, the buyer could withhold this information and unload it on the seller at the last minute as a negotiating tactic. The following is such an example:

“The Seller shall promptly notify the Buyer in writing of any change in facts and circumstances that could render any of the representations and warranties made herein by the Seller materially inaccurate or misleading.”

Sample Termination Language for Seller:

This Agreement may be terminated at any time prior to the Closing: by the Seller, if the Buyer (i) fails to perform in any material respect any of its agreements contained herein required to be performed by it on or prior to the Closing Date, (ii) materially breaches any of its representations, warranties, or covenants contained herein, which failure or breach is not cured within 30 days after the Seller has notified the Buyer of its intent to terminate this agreement.

A “bring-down” condition requires the parties to reaffirm the reps & warranties at the closing. Normally, both the buyer and seller are required to deliver a bring-down certificate to one another at closing. A bring-down is necessary only if there is a delay between signing the purchase agreement and closing. In other words, the reps & warranties must not only be true as of the date the purchase agreement is signed, but they must remain true (in all material aspects) from the time the purchase agreement was signed through the closing.

If there has been a material change in the reps & warranties, the buyer may terminate the transaction if the purchase agreement contains a condition that the reps & warranties are true as of the closing date. The purpose of the bring-down condition is to shift the risk of operating the business prior to closing to the seller. The buyer seeks assurance that the company they are agreeing to purchase will be materially the “same” company at closing. To address materiality, a bring-down condition may include its own materiality limitations that are separate from indemnification limitations. The materiality limitation may be expressed as an actual number, or, more likely, qualitatively, such as:

“… except for such inaccuracies that do not and would not reasonably be expected to have, individually or in the aggregate, a material adverse effect.”

Materiality can be evaluated either on an individual or a collective basis. In most cases, the reps & warranties must be materially true on an aggregate basis before the closing can occur. For example, several immaterial inaccuracies may constitute materiality on an aggregate basis.

“Each of the representations and warranties of the Sellers contained in this Agreement shall be true and correct in all respects (without giving effect to any limitation as to “materiality” or any derivative thereof qualification set forth therein) as of the date hereof and as of the Closing Date as though made on the Closing Date, except for any failures to be so true and correct that, individually or in the aggregate, have not had or would not have a material adverse effect.”

Is your head spinning yet? If so, that’s good. This should serve as a wake-up call to rely on the guidance, experience, expertise, judgment, and objectivity of your attorney in such negotiations. While you should understand the high-level mechanics of the transaction, this is a perfect example of issues you should leave to your attorneys to sort out. If your head is spinning now — while you are presumably in a calm, cool state of mind — imagine trying to make sense of this in the whirlwind of one of the largest, most emotionally draining transactions of your life. And THAT is why you should hire the best advisors you can afford.

The degree to which the level of inaccuracies of reps & warranties must rise is subjective, regardless of the amount of effort your attorney invests into nailing down the precise language. As in business, there is a degree of uncertainty when selling or buying any company and the only antidote is faith. Even if you lack absolute trust in the other party, you should proceed with a degree of trust and willingness to move forward and be willing to accept a certain amount of risk. Here is a sample clause that addresses materiality:

“Each of the Fundamental Representations and Warranties of the Target contained in this Agreement shall be true and correct in all respects, except, in the case of the representations and warranties in Section X, where failure to be true and correct would not result in an increase in the aggregate amount of consideration required to be paid by Buyer under Article X of this Agreement by more than $100,000.”

Once the closing conditions have been satisfied, the closing can occur.

In most cases, the closing is uneventful … an anticlimactic formality … an ordinary occasion … an unforgettable event … a routine affair … a humdrum transaction. The more uneventful, anticlimactic, ordinary, unforgettable, routine, humdrum, the better. For that’s precisely how the closing should be. All problems should have been worked out well in advance of the closing and the closing process should be as uneventful as possible.

Post-Closing

Once the closing has occurred, the parties have a vested interest in working with one another to successfully complete the transition period. The parties are also contractually obligated to fulfill their post-closing covenants to the extent that such obligations exist. They should also be motivated to ensure the reps & warranties remain true after the closing.

For example, the seller may have represented that the receivables are collectible. If that’s the case, the seller should assist the buyer in collecting the receivables after the closing and is therefore incentivized to ensure the transition progresses as smoothly as possible.

For the seller, the “real closing” has not occurred until the following has transpired:

• The seller has fulfilled their transition obligations
• Post-closing adjustments have been made (e.g., working capital adjustments)
• The seller has received all the money due
• Earnout periods have expired
• The seller has satisfied the terms of employment and consulting agreements
• The indemnification period has elapsed

While the seller may have reason to rejoice at the closing, they should not get too caught up in the celebrations. The seller should not be ready to fully “let go” until the events above have occurred.

There generally won’t be a defining moment, but one day you will wake up and realize you have finally completed all of your obligations. Congratulations! When that happens, the largest transaction of your life will be successfully behind you.

Sample Representations, Warranties & Covenants

Seller reps & warranties.

Here is a general summary (not a complete list) of typical reps & warranties provided by a Seller:

• No approval or notice is required to do the deal except as scheduled.
• There are no liens on the borrower’s assets, except as disclosed to the bank or permitted pursuant to the loan agreement.
• The entity being sold owns the assets itemized in the list dated xx/xx/xxxx. At closing, the assets will be free from any claims of others.
• Seller owns the assets being sold. At closing, the assets will be free from any claims of others.
• To the best of Seller’s knowledge, the tangible assets are (and at closing will be) in good repair and good operating condition.
• To the best of Seller’s knowledge, the entity owns all the assets needed to operate the entity’s business.
• To the best of Seller’s knowledge, the assets being sold to Buyer constitute all the assets needed to operate Seller’s business.
• To the best of Seller’s knowledge, there are no judgments, claims, liens, or proceedings pending against Seller, the business, or the assets being sold, and none will be pending at closing.
• Seller has good title to all assets.
• To the best of Seller’s knowledge, the business and financial information in the financial statement dated xx/xx/xxxx that Seller has given Buyer is accurate.
• Tangible assets are in good working order, ordinary wear and tear excepted, except as scheduled.
• Seller is in good standing and duly organized and qualified in its legal jurisdiction to conduct business.
• Seller has no finders’ or brokers’ fees, except as scheduled.
• There are no judgments, claims, liens, or proceedings pending against the entity or its assets, and none will be pending at closing.
• Seller is not in default under any contract assigned to Buyer.
• The entity is not (and at closing will not be) in default on any contracts.
• To the best of Seller’s knowledge, Seller is not (and at closing will not be) in default on any contracts.
• The entity is (and at closing will be) a [corporation/limited liability company] in good standing under the laws of the State of _______.
• Seller is (and at closing will be) a [corporation/limited liability company] in good standing under the laws of the State of _______ and has (and at closing will have) the authority to perform the obligations contained in this sales agreement.
• The [shares/LLC interests] constitute all of the issued [shares/LLC interests] of the entity. No additional [shares/LLC interests] will be issued before the closing. At closing, the [shares/LLC interests] will be free from any claims of any persons or entities other than Seller(s).
• The Seller is a corporation duly organized and existing in good standing under the laws of the State of _______, and has all requisite power and authority (corporate and other) to carry on its business, to own or lease its properties and assets, to enter into this Agreement and to carry out its terms. Copies of the Certificate of Incorporation and Bylaws of the Company that have been delivered to Buyer prior to the execution of this Agreement are true and complete and have not since been amended or repealed. The Seller has no subsidiaries or direct or indirect interest (by way of stock ownership or otherwise) in any corporation, limited liability company, or partnership.
• Seller has not received any written notice from its largest customers of intention to discontinue or substantially reduce business except as scheduled.
• The borrower has no exposure under the Employee Retirement Income Security Act (ERISA).
• There is no union strike pending or underway or charges pending before the Equal Employment Opportunity Commission (EEOC).
• To the best of Seller’s knowledge, Seller is (and at closing will be) in compliance with all environmental laws. To the best of Seller’s knowledge, there are (and at closing will be) no hazardous materials on the business premises that may be a source of future liability under the environmental laws.
• The entity is (and at closing will be) in compliance with all environmental laws. There are (and at closing will be) no hazardous materials on the business premises that may be a source of future liability under the environmental laws.
• Seller is in compliance with all environmental laws and regulations, and Seller’s operating sites are free of any environmental contamination, or order to remediate, or penalty from any authority. Seller has all environmental permits required to operate its sites except as scheduled.
• Seller’s financial statements are prepared per generally accepted accounting principles (GAAP), are complete, and fairly present in all material respects the financial position of the business.
• To the best of Seller’s knowledge, all items in the inventory of merchandise are (and at closing will be) unused and of salable quality.
• Inventories are of a type and quality salable in the ordinary course and are valued at lower of cost or market on a first-in, first-out (FIFO) basis net of appropriate reserves for obsolescence, except as scheduled. Buyers seek “quality and fit-for-purpose” assurances.
• Seller is not aware of, has not been informed of pending claims, and has no current claims against the ownership or use of IP.
• Seller’s IP does not infringe the IP of others. No outstanding claims against the company for infringing the IP of others exist pre-closing nor do infringements of Seller’s IP exist pre-closing except as scheduled.
• To the best of Seller’s knowledge, Seller is (and at closing will be) in full compliance with all laws, ordinances, or regulations applicable to the operation of the business.
• Seller has complied and is in compliance with all laws in all material respects except as scheduled. Seller has all material approvals and permits for conduct of the business, and all are in full force and effect.
• The entity is (and at closing will be) in full compliance with all laws, ordinances, or regulations applicable to the operation of the business.
• No government agency is investigating, threatening to investigate, or has filed or threatened to file a claim against the Seller or target business.
• There are no undisclosed liabilities for which Seller is liable.
• There are no lawsuits pending or threatened against the borrower that are likely to have a material adverse effect on it if decided against the borrower, except as disclosed to the bank.
• There is no action or suit or governmental investigation to the knowledge of Seller pending or threatened with respect to the business that may affect the deal except as scheduled.
• There has not been any material adverse change in the business or financial condition of the business as a whole since a certain date, except as scheduled.
• To the best of Seller’s knowledge, the current uses of the Seller’s business premises are permitted under the applicable zoning laws. To the best of Seller’s knowledge, the business premises presently (and at closing will) meet all applicable health, safety, and disabled access requirements and are (and at closing will be) in good repair.
• At closing, Seller will have paid all taxes that have then come due and that affect the business and its assets.
• Seller has timely paid all taxes due.
• There is no fact relating to the Seller that the Seller has not disclosed to the Buyer in writing that materially and adversely affects the condition, assets, liabilities, operations, financial results, or prospects of the Seller.
• The information provided to the Buyer by the Seller and the Shareholders with respect to the Seller, the Assets, and the Business, including the representations and warranties made in this Agreement and in the Schedules attached hereto, and all other information provided to the Buyer in connection with their investigation of the Seller, does not (and will not at the closing date) contain any untrue statement of a material fact and does not omit (and will not omit at the closing date) to state any material fact necessary to make the statements or facts contained herein or therein not misleading.

Here is a general summary (not a complete list) of typical reps & warranties provided by a Buyer:

• The financial statements of the borrower that have been submitted to the bank are correct.
• Buyer represents that its company is a duly organized entity, validly exists, and is in good standing. In other words, Buyer promises that its company is a going concern.
• Buyer has the authority and legal right to execute the purchase agreement.
• Buyer is in good standing and duly organized and qualified in its legal jurisdiction to conduct business.
• Buyer is not in violation of its corporate governing documents and will not cause any liens or defaults, except as scheduled.
• Buyer has no finders’ or brokers’ fees, except as scheduled.
• Buyer has had the opportunity to visit with the Seller to discuss the target business;
• All materials and information requested by Buyer have been provided to the Buyer to the Buyer’s reasonable satisfaction;
• Buyer has made its own independent examination, investigation, analysis, and evaluation of the purchased assets and the target business, including Buyer’s own estimate of the value of the purchased assets and the target business;
• Buyer has undertaken the due diligence (including a review of the assets, liabilities, books, records, and contracts of the Seller) the Buyer deems adequate.
• Buyer has inspected the tangible assets [insert “of the entity” if an entity sale] that Buyer is purchasing and the leased premises and has carefully reviewed Seller’s representations regarding them. Buyer is satisfied with the physical condition of the tangible assets and the premises.
• To the best of Buyer’s knowledge, the business and financial information in the financial statement dated xx/xx/xxxx that Buyer has given Seller is accurate.
• Buyer is (and at closing will be) a [partnership/corporation/limited liability company] in good standing under the laws of the State of _______ and has (and at closing will have) the authority to perform the obligations contained in this sales agreement.

It was American baseball legend Yogi Berra who coined the phrase, “It ain’t over till it’s over.” To which we would add, “But even then, it may not be over.” That’s certainly the case with reps & warranties, as illustrated by the interrupted vacation example in the introduction above.

If you’ve made it this deep into the article, you know that reps & warranties are one of the few elements of a purchase agreement that “survive” the closing and which can come back to bite you in the butt if you’re not careful.

The antidote? Be careful. Pay attention.

As a seller, you need to meticulously read the representations and, as noted above, not blindly sign them as if they were boilerplate. They’re not. In fact, a breach of a rep or warranty – unwitting or not – can kill a deal at worst or lighten your bank account in less extreme circumstances. Obviously, neither outcome is desirable.

It’s my hope that the information in this article will help you avoid the snafus that can arise from a lack of preparation when it comes to dealing with reps & warranties — one of the most important and often overlooked aspects of a deal. Toward that end, I’ll leave you with a high-level synopsis of our discussion — a cheat sheet, if you will. For a broader explanation of any of the major points below, please refer to the article above.

R&Ws Recap: Just the Facts, Ma’am

*inspired by sgt. joe friday from the tv show “dragnet”.

What follows is the “CliffsNotes” version of the preceding section on reps & warranties. These are the key points, presented in “bullet” format. For a fuller explanation of each category, please refer to the respective sections above.

Purposes of Reps & Warranties

Why reps & warranties? Think of them as the glue that holds a deal together — or not. Here are the three major purposes of reps & warranties.

• Disclosure: Reps & warranties require the seller to provide full disclosure to the buyer. R&Ws cover what may be missed during due diligence.
• Risk Allocation: Reps & warranties serve as a mechanism for allocating risk (both known and unknown) between the parties for events that are uncovered after the closing and serve as the buyer’s basis for future lawsuits (under the “Indemnification” clause). In a buyer’s market, the role of reps & warranties in risk allocation strongly favors buyers, and vice versa.
• Condition to Closing: Reps & warranties serve as a condition to closing — if the R&Ws are not true as of the closing date, the buyer may refuse to close.

Typical Purchase Agreement Outline

Here are the key elements of a purchase agreement.

• Consideration (stock, cash, debt, earnouts, etc.)
• Miscellaneous: Expenses, notices, jurisdiction, governing law, severability, assignment, waivers, etc.
• Conditions: Events that must occur before a closing can take place (e.g., financing, landlord approval, etc.). A common condition for closing is that the reps & warranties must be true as of the closing date — called a “bring-down.”
• Covenants: Responsibilities of the parties during the period between signing the purchase agreement and closing (e.g., seller agrees to operate the business as normal, seller agrees to retain a certain percentage of employees, fulfill outstanding purchase orders, etc.). These are rarely negotiated.
• Knowledge & Materiality Qualifiers: If the seller is not 100% sure regarding a representation, that representation should contain a knowledge qualifier such as “to the best of the seller’s knowledge” or “to seller’s knowledge.”
• Exclusions: Exclusions are documented in the disclosure schedules.
• Survival Periods: The R&Ws normally expire after 18-24 months.
• Basket (Minimum): Minimum thresholds that must be triggered (similar to an insurance deductible). Average size is 0.75% of the purchase price. Baskets can be tipping or non-tipping, or the deductible can be shared between the buyer and seller.
• Cap (Maximum): The maximum limit of indemnification. Average size is 10% to 20% of the purchase price.
• Parties: The buyer seeks to obtain protection from as many parties as possible (all shareholders, key managers, etc.). If multiple shareholders exist, they should not agree to “joint and several liability.”
• Scope: What is the scope of indemnification?
• Remedies: Is indemnification the exclusive remedy?
• Indemnification Process: How are indemnification claims handled?
• Amount of Money: Usually ranges from 10% to 20% of the purchase price. Size is based on the likelihood and magnitude of potential risks.
• Time Period: Usually ranges from 18 to 24 months.
• Conditions : Who controls its release (normally mutual), and how disputes are handled.

Negotiating Process

Here is a summary of how the reps & warranties fit into the negotiation process.

• Due Diligence: The breadth and depth of the R&Ws are based on facts discovered during due diligence. The purchase agreement should be prepared in tandem with the due diligence process so the parties can negotiate the language as soon as possible in the transaction.
• Buyer’s Attorney: Prepares the purchase agreement, which includes a standard list of reps & warranties focused on the likelihood and amount of potential exposure.
• Seller’s Attorney: Lists any exceptions to the R&Ws in the disclosure schedules.
• Negotiations: R&Ws are one of the most hotly negotiated components of the purchase agreement, other than price and terms, especially when the seller wishes to retire and avoid lingering obligations. The scope of negotiations is based on the aggressiveness of the buyer’s attorney’s initial draft and the bargaining positions (e.g., alternatives) of each party. The current state of the market impacts not only the price of companies but also the terms of the transactions (e.g., R&Ws). Buyers aim for a long exclusivity period to reduce the seller’s bargaining power later in the process when the purchase agreement and R&Ws are being negotiated. The seller’s leverage vanishes once the LOI is signed.
• LOI vs. Purchase Agreement: The full reps & warranties are documented only in the purchase agreement and not the letter of intent (LOI). When negotiating an LOI, the buyer has not yet performed due diligence and has limited information on the business; therefore, the buyer is not in a position to know exactly what reps & warranties they will request from the seller. This results in two negotiations — the LOI and the purchase agreement. This is why R&Ws are so hotly negotiated — the parties have already struck a deal but now they must negotiate a second time.
• Content: The purchase agreement contains more representations concerning the seller because the buyer has much more to lose than does the seller.
• Survival: Reps * warranties survive (almost always) the closing and can have implications for both parties for years thereafter. The other elements of the purchase agreement (price and terms, conditions, covenants, etc.) have no further implications after closing has taken place. Transactions involving publicly traded companies include reps & warranties, but they don’t survive the closing.
• Post-closing adjustments have been made (e.g., working capital adjustments )

The Parties’ Objectives

Here is a summary of the buyer’s and seller’s objectives as they relate to the reps & warranties. Not unsurprisingly, the buyer and seller usually have opposite motives.

Scope of Negotiations

Here is a list of the factors that can affect the scope of the negotiations over reps & warranties.

• The structure of the transaction (asset vs. stock sale) — reps & warranties in stock deals are more comprehensive than in asset deals.
• The financial strength of the seller to indemnify the buyer — If the shareholder group is dispersed, and the seller entity will cease to exist after the closing, the buyer will seek other protective deal measures, such as escrow.
• The buyer’s knowledge of your business and industry
• The nature of the business and its industry — Businesses with more risks will be subject to more stringent R&Ws.
• The buyer’s ability to conduct thorough due diligence — The more thorough due diligence is, the weaker R&Ws can be, in theory.

How best to work out an agreement on R&Ws? Let us count the ways …

• Understand the Purpose of Reps & Warranties: No business is perfect. R&Ws are not intended to insulate the buyer from every imaginable problem that can arise. The purpose of R&Ws is to protect the buyer from undisclosed, material risks that occur outside the ordinary course of running the business.
• Past Events Only: Representations should primarily cover past events. They should not be designed to provide the buyer with assurance regarding the future.
• Maintain an Excellent Relationship: The seller should attempt to maintain an excellent working relationship with the buyer after the closing. If you are “friends” with the buyer, it’s easier to work out problems.
• Be Prepared to Give in, at Times: Be prepared to negotiate and occasionally give in on some points. Disputes are expensive and time-consuming, and even if you win, you lose.
• Make Concessions Known: Never make a silent concession.
• Analyze Indemnity Provisions Using a Matrix: Use a matrix to analyze indemnification provisions.
• Understand Underlying Motivations: Buyers propose specific reps & warranties for a reason. Find out the reason and address their concern directly.
• Beware of Financial Representations: Before signing representations concerning accounting or financial matters, have your CPA review them to ensure they are accurate.

Tips for Limiting the Seller’s Exposure

Here are tips and strategies for limiting the seller’s exposure in relation to the reps & warranties.

• Adding knowledge qualifiers (e.g., “to the best of the seller’s knowledge”)

Other Strategies:

• Pre-Sale Due Diligence: Conducting pre-sale due diligence to identify and address problems before beginning the sale process.
• Team: Hiring an experienced negotiator, such as an investment banker or M&A advisor, to manage negotiations.
• Auction: Conducting an auction to improve negotiating posture — the more buyers with whom you are negotiating, the stronger your position will be.
• Credibility: Conducting themselves in a trustworthy manner at all times.
• Milestones: Including milestones in the LOI, such as dates for completion of due diligence and preparation or signing of the purchase agreement.
• Alternatives: Consider alternatives to escrowing part of the purchase price, such as an offset to the seller note, an earnout, or a consulting agreement with a right of offset.
• Reps & Warranties Insurance: Insurance is available to sellers to minimize the potential liability of R&W breaches . The price is normally 4% to 8% of the coverage amount and depends on the scope of the reps & warranties, the industry the business operates in, the deductible, and the term of the coverage.
• Buyer Insurance: A seller can require the buyer to insure against any risks that are potentially insurable. The seller can also maintain their existing policies if the policies are made on a claims basis vs. an occurrence basis.

Tips for Hiring Advisors To Help Negotiate the Purchase Agreement

• Experience: When hiring a professional advisor, the number one thing you should look for is real-world experience buying and selling companies. Ask how many M&A transactions they have worked on in the last three years and their role in each transaction.
• Role: Ask what role they envision themselves playing in your situation — some advisors prefer to be in the background while others prefer to be on the firing line. Know the role of your accountant or attorney based on your experience level. If you have never sold a business, be prepared for your advisor to play an instrumental role in the process.
• Appetite for Risk: Attorneys and accountants are conservative by nature. Find an advisor whose appetite for risk matches your own.
• Attorney: Your attorney will play a key role in negotiating the purchase agreement.
• Accountant: Your accountant will take the lead in financial due diligence and examining the financial and tax implications of the purchase agreement, and negotiating any R&Ws that relate to the financial aspects of your business.
• M&A Advisor: Your M&A advisor will negotiate with the buyer regarding the high-level elements of the transaction and how the various components of the transaction work together to form the overall deal structure. Most M&A firms will ask the seller for indemnification against any legal actions that may occur as the result of inaccurate information or material misrepresentation. Without such an indemnification, the M&A advisor would be required to verify every bit of information that passed through their hands.
• Environmental: The seller may want to consider hiring an environmental consultant if the business handles hazardous materials or is subject to environmental regulations.
• Employee Benefits: Sellers should consult with experts in this area well in advance of the sale to ensure assets exceed liabilities and that a smooth transition of benefits can occur in the case of other benefits. In most cases, the plans will be terminated; the seller is obligated to fulfill the termination requirements, and the employees continue under the buyer’s plan.
• Code Audit: When purchasing a software company, most buyers retain a third party to perform a code audit to ensure the software code is clean and well documented.
• Pre-Sale Due Diligence: Ask your advisors to conduct pre-sale due diligence. Doing so may lessen the scope of reps & warranties.

Sample Representations a Seller Might be Asked to Make:

• The inventory is sufficient, unused, and salable.

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What are Representations and Warranties?

Representations and warranties refer to the matters and facts within a contract. Representations are statements of facts that are understood to be a condition of the sale. Warranties, on the other hand, generally define the conditions of the contract at some point in the future.

Representations and Warranties Examples

Examples of what representations and warranties might cover:

• Example 1. Financial assurances
• Example 2. The company is operating lawfully
• Example 3. Company assets are owned outright

Here’s another web page about representations and warranties.

Meet some of our Representations and Warranties Lawyers

Angela Hayden is an accomplished and driven attorney with a diverse professional background that sets her apart. Having served as a former Assistant Public Defender in Allegheny County, Angela acquired invaluable expertise in navigating the complexities of the criminal justice system. Her trial experience spans a wide range of cases, from minor retail theft to complex criminal homicide, demonstrating her ability to deliver successful outcomes for her clients. Prior to her focus on criminal defense, Angela honed her skills in public policy and political consulting through her work with both the Pennsylvania and United States House of Representatives. This experience provided her with a deep understanding of the intricacies of public policy and the ability to offer strategic guidance to clients. Angela's career also took her to a civil defense firm, where she traveled across the country, defending clients in litigation. This experience enhanced her ability to handle complex civil matters and strengthened her litigation skills. In addition to her expertise in criminal defense and civil litigation, Angela has demonstrated her proficiency in employment law, providing guidance and consultation to small businesses and non-profit organizations. Her keen insight into employment law matters ensures that businesses operate within legal boundaries while fostering a positive work environment. Furthermore, Angela is a licensed realtor, well-versed in residential real estate transactions. This additional knowledge allows her to offer comprehensive legal support to clients involved in real estate matters, ensuring their interests are protected throughout the process. Angela holds a degree from Hampton University and obtained her Juris Doctor from the University of Dayton School of Law. She is pursuing a Master of Business Administration. She is licensed to practice law in Pennsylvania and the District of Columbia, demonstrating her commitment to providing exceptional legal services in multiple jurisdictions. With her extensive experience and passion for achieving favorable outcomes for her clients, Angela Hayden is a dedicated advocate ready to guide you through your legal journey.

Licensed in MI since 2010. Practiced SSDI appeals and auto negligence for over a decade until 12/2022 when I left largest personal injury firm In MI to open my own estate planning firm. Looking for part-time contract/remote work to supplement income as I build my own practice.

Seasoned corporate, business and real estate attorney with 30 years experience managing private practice groups and in-house legal functions for publicly traded, privately held, and family companies.

I am an experienced family law attorney licensed in California and Florida with over 13 years of experience.

I have worked for over 20 years in the areas of family law, business formation, contracts and real estate law. In the area of family law, I represent clients in all areas of family law including child custody, child support, spousal support and marital property division as well as preparing prenuptial and separation agreements. I am experienced in real estate law, including commercial and residential leases, preparing various types of real estate related contracts. I am also experienced in business formation among other business law matters. I currently work in the area of grant management with the Small Business Administration.

Oliver Keene is not your typical attorney. With a personal touch and a passion for helping others, he goes above and beyond to provide exceptional legal services. Born and raised in the heart of the Appalachian coalfields, Oliver understands the value of hard work and perseverance. His small-town upbringing instilled in him a deep sense of community and a commitment to making a difference in people's lives. Oliver's journey in the legal field began with a Bachelor's degree in Criminal Justice from Bluefield University. He went on to earn his Juris Doctorate from Lincoln Memorial University - Duncan School of Law, where he excelled in his studies and developed a strong foundation in law. Throughout his career, Oliver has gained invaluable experience working as a public defender, an attorney advisor for the Small Business Administration, and in various legal roles. With a focus on estate planning and business law, Oliver is dedicated to helping individuals and families protect their assets, plan for the future, and navigate the complexities of the legal system. His approachable demeanor, attention to detail, and genuine care for his clients set him apart. Oliver's clients can trust that he will go the extra mile to ensure their legal needs are met with the utmost professionalism and personalized service. Outside of his legal practice, Oliver enjoys spending time with his wife and daughter, exploring the great outdoors, and indulging in his passion for hunting and fishing. His commitment to serving military families is evident in his offering of discounted services as a token of gratitude for their sacrifices. When you choose Oliver Keene as your attorney, you're not just hiring a legal professional - you're gaining a trusted advisor and a compassionate advocate. With Oliver by your side, you can have confidence that your legal matters will be handled with the highest level of expertise and care.

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Representations and Warranties

Practical law canada glossary 5-575-1583  (approx. 3 pages).

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Understanding Contract Recitals, Covenants, Representations, and Warranties

Recitals are usually one of the first sections of a contract. They are not required, but they are very helpful. Recitals provide general information about the parties and the agreement, such as the contracting parties’ intentions or understanding of the purpose for the contract. They are a good way to ensure that the contract is interpreted correctly by all parties.

Covenants are the center piece of a contract. They are what you think of when someone says there were “promises” made under a contract. Covenants are the promises that each party makes to the other regarding the contract. When one party fails to keep one of these promises, that party is said to have “breached” the contract.

Representations are statements made by one of the contracting parties about a fact concerning the contract. Representations and covenants can look very similar, but they are technically very different. The difference is in the details even though both look like promises.

The difference between a covenant and a representation is that a covenant is a promise that one party will do something in the future while a representation is a promise that a present fact or circumstance is true .

For example, in a real estate contract a representation would be a statement by the seller that there are no defects in the sewer system (i.e. a present fact or circumstance). While a covenant in a real estate contract would be a statement by the buyer that the buyer will pay the purchase price on a certain date (i.e. a promise to do something in the future).

Warranties are one step deeper. A warranty is a statement that the representations are true. The function of a warranty is that if a representation is untrue, then the contracting party who made the representation is on the hook for breach of warranty—a separate and distinct cause of action with its own set of remedies (money awards).

If you have any questions about a contract or would like to speak with an experienced Florida business attorney or contract attorney, contact Boyer Law Firm today and set up a consultation .

Representation vs. Warranty: What’s the Difference?

The main difference between representation and warranty is that representations are generally limited to the time of agreement whereas warranties may extend beyond the initial transaction and cover a specified period.

Before we move to more differences, let’s first understand Representation and Warranty:

• Representation : A Representation is a statement of fact made by one party to another during the negotiation or execution of a contract.
• Warranty : A warranty is a promise or guarantee made by one party to another regarding the performance, quality, or condition of a product or service.

Now, let’s get to Representation vs Warranty:

Major differences between Representation and Warranty

So, these are the main differences between the entities.

• Protocol vs. Procedure
• Procreate vs. Photoshop
• Multivariable vs. Multivariate

You can see other “differences between…” posts by clicking here .

If you have a related query, kindly feel free to let me know in the comments below.

Definition and Purpose of Representations and Warranties

In order to understand the use of the terms “representations” and “warranties” we need to begin with a definition of each.

A representation is “a statement of fact made to induce another to enter into a contract”. One party provides information to the other at the time the contract is made and the other party decides whether to proceed with the contract. For instance, the seller represents that the chattels have been in good working order. This representation is relied on by the other party to enter into the agreement.

A warranty is “a promise that a proposition of fact is true”, and they are assurances as to future events indicating that certain aspects of the deal will remain “as is” up to and through the closing.

From the point of view of the purchaser, the major purpose of representations and warranties is to require the seller to reveal certain facts that, when combined with due diligence, will disclose risks that can be assessed. This allows the purchaser to make an informed decision as to whether or not to complete the purchase. If any representations or warranties made by either party prove to be incorrect or non-factual the other party is entitled to seek compensation.

You can access the full article on this topic in our July 2012 Newsletter by clicking here.

The content of this blog is intended to provide a general guide to the subject matter. The information does not constitute legal advice and a solicitor and client relationship is not created.

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Representations and Warranties

"Representations and Warranties" is a crucial term that holds significant importance. This article aims to provide a concise yet comprehensive overview of this concept, its key elements, and examples of how it is handled in commercial contracts.

What are Representations and Warranties?

Representations and warranties are statements made by one party (the "representing party") to the other party (the "relying party") during contract negotiations. These statements are intended to provide assurances about certain facts, conditions, or circumstances relating to the transaction or the parties involved.

Key Elements in the Clause:

1. Accuracy: Representations and warranties should be accurate and based on the best knowledge, information, and belief of the representing party at the time of making them. They should not be misleading or intentionally false.

2. Materiality: The representations and warranties should be material to the transaction, meaning that they should be significant enough to influence the relying party's decision to enter into the contract.

3. Survival Period: The clause should specify the survival period for representations and warranties. This determines the duration during which the relying party can bring a claim against the representing party for any breach of the statements made.

Examples of Handling Representations and Warranties in Commercial Contracts:

1. Sale of Business: In a contract for the sale of a business, the seller may provide representations and warranties regarding the financial condition, ownership of assets, absence of litigation, and compliance with laws. If any of these representations and warranties are later found to be untrue, the buyer may have the right to seek remedies such as contract rescission, indemnification, or price adjustments.

2. Software License Agreement: In a software license agreement, the licensor may provide representations and warranties regarding the functionality, performance, and non-infringement of intellectual property rights related to the software being licensed. If the software fails to meet the specified standards or infringes upon third-party rights, the licensee may be entitled to seek compensation or termination of the agreement.

Representations and warranties are essential provisions in commercial contracts as they establish trust and provide assurances to the relying party. Careful consideration should be given to drafting these clauses, ensuring accuracy, materiality, and specifying the survival period. By including robust representations and warranties, parties can mitigate risks, protect their interests, and maintain a fair and transparent contractual relationship.

How to manage clauses like these effectively?

Check out Clause Library implementation from ContractKen. It has a really smooth, easy to use interface which allows for easy curation, management, tagging, commenting and retrieval (from Microsoft Word) of your clauses.

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Representations vs. Warranty in Commercial Contracts: Understanding the Key Differences

This article on ‘Representation vs. Warranty in Commercial Contracts: Understanding the Key Differences’ was written by Amruta Patil , an intern at Legal Upanishad.

Introduction

A contract is an agreement that is enforceable by law as defined under Section 2(h). A contract has numerous terms, clauses, conditions and warranties which are involved in the making of it.  A few key clauses are the Representation and Warranty Clauses which are often part of various kinds of contracts such as commercial contracts, Loan agreements and others.

The terms Representation and Warranty are often seen to be part of the contract and are often used interchangeably. But both the terms not only have independent definitions but are also remedied differently in case of a breach which is different from case to case. The same clauses are elaborated below in the article.

Commercial Contract: Meaning and Concept

A commercial contract can be defined as a contract that helps in regulating the business equations between businesses or individuals which would include a range of clauses defining the purpose of the business and a dispute resolution mechanism in case of a breach of the terms and conditions. Representation and Warranty are often part of commercial contracts, which are placed in contracts that indemnify the parties concerned in case of a breach on the part of either of the parties. Under the Indian law of contracts, it indemnifies the seller by placing greater responsibility on the buyer through the principle of Caveat Emptor which means let the buyer be aware.

What is a representation clause in a contract?

Representation means a presentation of facts that are true to the date of execution. In a commercial contract, the party asserts that the facts which are mentioned in the contract are true to nature. It can be implied which is through the conduct of the party or is explicit in nature which would induce the other party to enter into the contract. Representation is not defined under the Indian Contract Act, 1872. However, the Act does define Misrepresentation which means a false statement of facts which are made to induce the other party to enter into the contract.

Misrepresentation is of two kinds:

• Right to claim damages- the innocent party can claim for the damages which have been incurred due to the fraudulent misrepresentation leading to acting upon the contract.
• Right to repudiate the contract- is when the party either through his actions or by words does not intend to perform the obligations set out in the contract.
• Innocent Misrepresentation- when one party makes a statement to another party to induce them into entering into the contract without knowing whether the statement made is correct or false.

What is a warranty clause in a contract?

A warranty is a statement or assurance made by the party about the facts or conditions in a contract. A warranty can be implied or expressed. A warranty is made concerning incidents that can occur either in the present or in future. A warranty is usually used in contracts of sale. Not all representations form as part of the contract but the ones which do are called stipulations. An example would be this Mobile will receive software updates for the next three years. In this case, if the device as promised does not receive the updates then the device company can be sued by the user.

Role of warranty and representation in a commercial contract

In a commercial contract clauses such as representation and warranty play a very crucial part in the contract. They both act as protective clauses or measures which are enclosed in a contract in case a breach occurs, it safeguards the buyer in a contract. Both the clauses are often used together in the realm of commercial contracts while execution of these clauses does not share the same process.

These clauses help in reducing the risk often arising due to the breach of contract. While the seller would prefer the clause to be such that it minimizes the damage incurred by the seller if the buyer decides to sue. On the other hand, the buyer would prefer the interpretation of the clauses in broader terms which would indemnify the buyer from all possible damages that could be incurred by him.

Are the two defined under the ICA?

The Indian Contract Act 1872, does not define Representation and Warranty in the act. As mentioned above, the Act defines Misrepresentation and provides remedies for the same.

The Warranty is however defined in Section 12 of the Sales of Goods Act,1930 (SOGA). the act defines a Warranty as stipulation collateral to the main purpose of the contract, a breach which gives rise to a claim for damages but to a right to reject the goods and treat the contract as repudiated.

How are the Representation and Warranty Clause different?

In All India General Insurance Co v. S P Maheshwari (AIR 1960 Mad 484), the Hon. Madras High Court discussed the distinction between representations and warranties-

Warranties are representations which are made the basis of the contract whereas a representation is not strictly speaking a part of the contract or the essence of it, but rather something preliminary and like an inducement to it.”

The Indian Contract Act is very much based on the principles of English Common law, hence both the terms are well elaborated in the English Law as opposed to the Indian Contract Act.

As often being drafted together in commercial contracts can easily give an illusion that they both are the same. But when looked at closely one can see that both the clauses are different and breaches of either of the clauses have different remedies.

While on the one hand Representation is the way the statement of facts is in the present situation or has been in the past. A warranty is a promise about the present or the future.

The common thing which is between the two clauses is that in case there is a breach of either of the conditions it would result in damage to the parties involved. The quantum of the damage and remedy would be based on the kind of contract and the applicability of the laws of the land where the breach occurs.

Things to be kept in mind while drafting warranties and representation clauses in the contract

There are a few steps that can be followed when drafting Representation and Warranty Clauses in the contract. They are as follows-

• Set it out separately- when a contract is formed it would be a prudent move to set the representation and warranty clauses separately to avoid future confusion during the issue of a breach of the contract. As the former deals with the facts concerning the present or that which has taken place in the past, the latter deals with events that are promised in the present or have the possibility of happening in the future.
• Disclosure of the business- the buyer must have complete knowledge about the seller’s business to the buyer. Also, the buyer needs to run a thorough check as to whether the facts being presented are true or not.
• The method of resolution – both the representation and warranty clause are defined separately and in case of a breach are also to be dealt with in the same manner. By mentioning the method of resolution when the facts are misrepresented or the warranty of the object of the contract is not fulfilled it would be helpful to determine the damages if the method of resolution is already mentioned in the contract.

Representation and Warranty often appear to be two sides of the same coin. But in reality, both these clauses are very different, while one is a statement of fact, the other is a promise of the future. These clauses aim to bring the experience of the past with the possibility of the future in terms of the contract. Often clubbing these clauses together creates difficulty in interpretation, it would be best that the two clauses are drafted in simpler language along with interpreting them independently.

List of References

• Ashima Obhan and Vrinda Patodia, Revisiting Representation And Warranty Clauses, MOndaq, 19 June 2020, available at: https://www.mondaq.com/india/contracts-and-commercial-law/955660/revisiting-representation-and-warranty-clauses
• Representations and Warranties, Thomson Reuters, available at: https://uk.practicallaw.thomsonreuters.com/8-382-3760?transitionType=Default&contextData=(sc.Default)&firstPage=true#:~:text=A%20representation%20is%20an%20assertion,if%20the%20assertion%20is%20false .
• Sankeit Taneja, Representation and warranties in a contract and the effect of non-compliance, iPleaders Blog, 14 July 2020, available at: https://blog.ipleaders.in/representation-warranties-contract-effect-non-compliance/

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