Reps and Warranties
All Purchase and Sale agreements (“PSAs”) have sections called buyer and seller reps and warranties. The intent of these sections is to disclose and describe any known issues in the business and to address how they will be dealt with. It is generally accepted that any issues that come up post-sale, but that existed or were caused pre-sale are the responsibility of the seller, but the devil is in the details. Both parties are relying on each other to provide a true account of all information and supporting documents to close the transaction.
Rep Types and Time-frames
There are several types of reps and warranties: fundamental reps, reps regarding taxes and general business reps. Fundamental representations and warranties include:
- Organization and Standing
- Capital Structure (in a stock or membership interest sale)
- Brokers and Finders’ Fees
- Power and Authority
- Title to Securities (in a stock or membership interest sale)
- Title to Assets (in an asset sale)
In other words, you, the seller, represents that he/she actually owns the business and that it is a real, properly registered, legal business. Fundamental stuff. The time frame or “survival” of these types of reps is very long, often forever.
Tax reps are representations that you have filed and paid all the taxes that you should have. There can be differences of opinion here but at the end of the day, this is up to the tax authorities to decide. Survival typically shadows the tax authority‘s reach (for example, if the tax authorities can come after you for unpaid taxes 5 years ago then the seller will have to pay those assessed back taxes).
Business reps can arise out of employee issues, customer or supplier issues and their time-frame can range from as little as 1 year to up to 5 years an average.
Indemnity Thresholds, Baskets and Caps
One item that will always result in some back and forth is the materiality of issues. Neither the seller nor the buyer want to spend time cataloging small issues and therefore typically put in place a way of dealing with this.
Indemnification thresholds and limitations are referred to as baskets and caps. The cap refers to the maximum amount of remuneration a buyer can receive for losses caused by a seller representation breach. Indemnifying parties typically impose a limit on the total claims amount that they will indemnify. This limit, or cap, is generally calculated as a percentage of the overall deal price.
A “basket” (sometimes called a “deductible”) is a threshold amount of losses and damages that a buyer must incur before it is entitled to any indemnification from the seller. Let’s assume that issues in value of less than $50,000 are not material. The $50k is the basket and any one, or a number of issues that together add to more than $50k, will start to reduce the selling price. A variant on this called a “tipping basket” is that once the $50k amount is breached, all the breaches adjust the selling price (back to first dollar). Thus, a true deductible is the more favorable for a seller and a tipping basket is more beneficial to a buyer, but only to the extent of the threshold.
What is a “Materiality Scrape”, and why include this?
A “materiality scrape” is a provision that eliminates, for indemnification purposes, any materiality qualifiers, or in some cases knowledge qualifiers as well, in a representation and warranty (or covenant) when determining whether a breach of the representation and warranty (or covenant) has occurred. Materiality qualifiers serve different purposes within a purchase agreement, and the materiality scrape usually eliminates these qualifiers for some but not all of those purposes. A double materiality scrape is when it applies for both the purpose of determining whether a breach has occurred and also for calculating damages. Materiality qualifiers generally serve four different purposes:
- Determining whether closing conditions have been satisfied (e.g., closing conditions may require that the seller’s representations and warranties be true and correct “in all material respects” at the closing or that there be no MAE in effect as of the closing);
- Determining the scope of the seller’s disclosure (e.g., a representation may affirmatively require disclosure of all “material” contracts);
- Determining whether a breach of a representation has occurred (e.g., whether specific facts are contrary to the seller’s representation that it has complied with applicable laws “in all material respects”); and
- Determining the losses resulting from such a breach (in other words, where a representation is qualified by materiality, are the resulting losses that are subject to indemnity only those above a “material amount”?).
Some possible compromises to lessen the impact of a materiality scrape inlcude:
- Increase the amount of the deductible basket or tipping basket.
- Rely on specific dollar thresholds within the representations and warranties in lieu of materiality or MAE qualifiers.
- Have the materiality scrape apply to the determination of losses resulting from a breach, but not as to whether or not the breach occurred, i.e., implement a single materiality scrape in lieu of a double materiality scrape.
- Except from the materiality scrape any affirmative disclosure requirements, so that the seller need not disclose immaterial matters within its disclosure schedules.
- Specify that the materiality scrape does not apply to certain specific representations and warranties?e.g., the financial statement and full disclosure representations, and/or representations that are not subject to a basket.
Hold-backs and Escrow Amounts and Periods
A hold-back is always part of a purchase and sale agreement and ensures that the buyer can collect on rep and warranty breaches. The shortest amount and period would be in the 5% and 6 months range, whereas more typical is 10% and 1 year. A hold-back can be put in escrow (
i.e. kept in the custody of a law firm and taking effect only when a specified condition has been fulfilled) particularly if the financial condition of the buyer is not strong or there is distrust of the buyer).
Recommended Further Reading
For more on how long an acquisition takes, see: How Long Does it Take to Sell a Business?
For more on how to optimize net proceeds, see: Share Sale or Asset Sale: It is Mostly About Minimizing Taxes