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A seller’s promise: The importance of representations and warranties

Buying or selling a business is similar to other substantive sales or purchases in life: sellers want to be clear to potential buyers about the business they are selling, and buyers want to fully understand the business they are purchasing.
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Buying or selling a business is similar to other substantive sales or purchases in life: sellers want to be clear to potential buyers about the business they are selling, and buyers want to fully understand the business they are purchasing.

To buy or not to buy

When purchasing a business, buyers aim to minimize their risk through the due diligence process and reliance on seller representations and warranties. Seller representations and warranties are contractual statements made by sellers about the business, its assets, liabilities and status. Buyers often rely on these statements, among other factors, to determine whether or not to proceed with the intended purchase and to protect against unknown risk.

Foundational elements

Representations and warranties are a key component of the purchase agreement. They supplement buyers’ due diligence and provide further information about the seller and the business being purchased. Representations require sellers’ time and effort to provide relevant information, and they can involve considerable negotiation regarding the specific content. If sellers provide inaccurate representations or breach warranties, buyers’ rights can include deal termination or compensation to cover the related damages.

Representations and warranties vary depending on if it is an asset or share sale, and the company type, but common areas covered include:

·       sellers’ authority to complete the deal;

·       target company is properly incorporated;

·       compliance with relevant laws;

·       financial statements present an accurate picture of the company’s financial condition;

·       tax compliance;

·       employee details (including pension, benefits, bonuses and more);

·       insurance policies;

·       environmental matters;

·       intellectual property;

·       details on material contracts; and

·       third party consents (if any) regarding the sale.

Representations in the purchase agreement are often accompanied by disclosure schedules, which are used to provide: (a) qualifications or exceptions to the representation (i.e., except as set forth in the disclosure schedule, there are no legal actions pending or threatened against or by the company); and/or (b) further details beyond the initial representation (i.e., the disclosure schedule sets forth a true and complete list of the names and locations of all banks in which the company has accounts, deposits or safe deposit boxes).

Seller’s preferences

Sellers generally want representations to be as specific as possible so buyers bear greater risk; conversely, buyers want them as broad as possible. Buyers’ counsel usually prepares the first draft of the purchase agreement, so sellers and sellers’ counsel need to review the agreement carefully. They should determine if they can limit any representations by: the seller’s knowledge; a materiality threshold (i.e., a material contract must be worth a minimum amount); or a specific time period. Additional items sellers should aim to obtain include:

·       disclosure of information for one representation accounts for disclosure for other representations where the same information is relevant;

·       if the purchase agreement is executed before the sale completion date, an ability to update disclosure schedules between execution and closing; and

·       confining the representations and warranties to only those found in the purchase agreement and related disclosure schedules, and not based on any other documents or conversations.

Buyer, beware

Buyers rely on sellers’ representations and related disclosure schedules to finalize their purchase of the target company, so buyers need to be diligent to avoid unexpected liabilities. If liabilities are disclosed to buyers before completing the transaction, buyers can factor the liabilities into the purchase price or make revisions in the agreement to protect from additional costs. Buyers generally want the opposite of the sellers’ preferences noted above, so negotiation is usually required. During negotiations, buyers should attempt to obtain a final “sweeper” representation where sellers state there is no event or circumstance which has not been disclosed that could reasonably be expected to have a material adverse effect. This is often difficult to obtain or will be qualified by sellers’ knowledge, but it is added assurance for buyers.

Start early

Once initial drafts of the purchase agreement have been exchanged, sellers are encouraged to start early with the preparation of the disclosure schedules. Ensuring there is enough time often leads to an initial draft of well-prepared disclosure schedules; the first draft can go a long way to putting buyers at ease.

Working together

Both buyers and sellers should have respective counsel and key personnel from the business side review and prepare the representations and related disclosure schedules. Legal counsel usually co-ordinates completion/review of the disclosure schedules and, for sellers, drafts the legal disclosures; meanwhile, business representatives often draft/review business-specific schedules. Ensuring regular communication between counsel and business representatives is essential for a smooth purchase or sale. 

Conclusion

Whether a buyer or a seller, you can succeed with your business sale by understanding the importance of representations and warranties and related disclosure schedules. You’ll want to start early, communicate regularly with your legal counsel, and understand that time and effective negotiation will help you make the most of your deal and limit your liabilities. 

To find out more, contact:

Scott Allen, Associate
Alexander Holburn Beaudin + Lang LLP
Direct: 604.484.1730
Email: [email protected]

BIV further explores the mechanics and strategies of buying and selling a business at its Business Excellence Series: Buying and Selling a Business panel April 17th at the Vancity Theatre .