Intro to M&A Representations and Warranties

In each M&A transaction, the main contract includes assurances and assertions known as "representations and warranties," often shortened to "reps." These statements cover past, present, and sometimes future facts regarding the status, business, assets, liabilities, properties, condition, operating outcomes, operations, and prospects of the party making the assertions, a group of companies under their control, or a set of assets and liabilities. The reps and warranties section can be extensive, ranging from 15 to 30 pages in a transaction agreement and potentially more when incorporating referenced text from the Definitions section. Negotiating the terms within these representations and warranties typically consumes a significant amount of time and effort in finalizing the deal.

Why do representations and warranties get so much attention?

Disclosure

Initially, they serve as vital disclosures from one party, leveraging their informational advantage, to inform the other party, especially in the case of the seller, regarding the target company or assets. Generally, this information pertains to the target company or assets and is transferred from the seller to the buyer, except in cases where a portion of the purchase price involves buyer stock.

These representations and warranties act as an extension of the due diligence phase, mitigating information imbalances between the parties. Often, during the process of formulating these representations and warranties (alongside the related disclosure schedules), parties uncover significant findings that can substantially impact the deal's overall value proposition.

Walk rights

Secondly, representations and warranties can provide a basis for one party to exit the deal before it's finalized. In most deals where there's a gap between the signing and closing, the main transaction agreement sets forth certain conditions that must be met. These conditions typically require the other party's assertions and guarantees to have been accurate at the start and to remain accurate at the closing. If these conditions aren't met, it usually allows the non-breaching party to cancel the transaction agreements and withdraw from the deal. Thus, these assurances enable ongoing scrutiny of the deal during this interim period and offer protection to a buyer (or a seller receiving shares) from adverse events that might affect the other party or the target company.

Risk-shifting

Thirdly, in conjunction with indemnification rights, representations and warranties function as a mechanism to shift risks—errors in these assertions may entitle one party to receive financial compensation for resulting losses. This concept mainly applies to private M&A transactions, as post-closing indemnities are exceptionally rare in public deals. In private transactions, this aspect of representations and warranties primarily aims to ensure that the seller, rather than the buyer, assumes a significant portion, if not all, of the risk associated with losses stemming from inaccurate statements. This allocation of risk offers the buyer greater certainty, allowing for more accurate deal pricing and better planning for post-closing operations.

During negotiations, parties should keep this risk-shifting aspect in mind. It's not unusual for one party to object to a proposed representation or warranty by stating that it's not entirely accurate or verifiable. In response, a seasoned M&A lawyer might argue that this objection doesn't negate the purpose, emphasizing that the client shouldn't carry the risk. Ultimately, these assertions aren't solely about factual accuracy but also signify which party is responsible for losses arising from specific events or conditions.

Discipline

The final critical role of M&A representations and warranties stems from the preceding functions. The possibility of the opposite party terminating the deal or seeking compensation due to breaches strongly encourages the party making these assurances to ensure their accuracy (or the assurance of their accuracy at the specified time). For instance, if a party asserts representations regarding good standing, authorization, and absence of conflicts, they'll work towards ensuring the entity or the target company is indeed in good standing, possesses the authority for the transaction, and isn't involved in conflicting agreements. Consequently, the aim to avoid the expenses related to a failed deal or breached assurances often positively influences the fundamental aspects of the agreement.

What do representations and warranties say?

The representation and warranty clause covers a wide range of topics, spanning from the legal status of the target company, its compliance with regulations, to the buyer's ability to finance the deal and fulfill obligations in the agreement.

Here's an example of a standard representation regarding the absence of conflicts from the seller:

"Subject to obtaining all required consents, approvals, and authorizations outlined in Section 3.07, the execution, fulfillment, and performance of this Agreement by the Seller will not (a) breach any provisions in the Seller or the Company's Organizational Documents, (b) conflict with or violate any applicable Laws or Government Orders concerning the Seller, the Company, or their assets, properties, or operations, or (c) result in contractual breaches, defaults, termination rights, or the creation of any encumbrances on the Shares or Assets under any agreements involving the Company, except as indicated in Section 3.06(c) of the Disclosure Schedule."

Other reps like this one you may encounter in a typical private company stock purchase agreement would address all or some combination of the following subjects:

• organization and good standing

• authority and enforceability

• capitalization and ownership

• subsidiaries

• financial statements

• books and records

• accounts receivable and accounts payable

• inventories

• absence of undisclosed liabilities

• absence of certain changes and events

• assets

• real property

• intellectual property

• material contracts

• tax matters

• employee benefits

• employment and labor

• environmental, health and safety

• compliance with law

• legal proceedings

• customers and suppliers

• product warranties

• product liability

• insurance

• related-party transactions

• guarantees

• brokers and finders fees and

• full disclosure.

The agreement typically includes buyer's reciprocal representations and warranties to the seller. In cases where the buyer pays with shares, their assurances often align closely with those given by the seller because it involves the seller investing in the buyer's securities. However, when cash is the primary payment method, the buyer's representations and warranties are generally more limited.

In transactions without stock consideration, the buyer's representations and warranties typically cover various aspects:

• Organization and standing

• Authority and enforceability

• Avoidance of conflicts

• Necessary government approvals

• Disclosure of legal proceedings

• Intent and purpose behind the investment

• Financing arrangements

• Details about brokers or finder fees

• Independent due diligence and investigation.

What determines which representations and warranties are given in a deal

The precise configuration of representations and warranties in a particular deal is a function of a number of factors in addition to whether part of the purchase price will be paid in buyer shares. These include:

The scope and specifics of representations and warranties in a transaction agreement can vary due to multiple factors:

• Transaction structure: Differences arise in representations, such as valid issuance in stock purchases or sufficiency of assets in asset deals.

• Public or private deal: Public deals often involve representations regarding SEC filings and compliance, offering added assurance due to federal securities laws and stock exchange standards.

• Due diligence depth: Parties conducting thorough due diligence may demand more comprehensive representations from the other side.

• Specific issues uncovered: Discoveries during due diligence, like IP disputes or environmental concerns, may lead to enhanced representations in those areas.

• Target company's industry: Industry focus varies, with technology deals emphasizing intellectual property and chemical transactions requiring more environmental coverage.

• Evolving market practices: Norms change over time, making what was once standard possibly uncommon today.

• Past practices and preferences: Previous transaction agreements and individual preferences influence concessions and priorities.

• Allocation of post-closing risk: Indemnification terms impact the extent of representations, influencing resistance or acceptance of broad assurances.

• Representations and warranties insurance: The presence of insurance can shift risk and influence the contents of representations.

• Buyer's strategic options: Detailed seller representations might ease a buyer's decision-making on the deal.

• Bargaining power: Competitive situations often favor sellers in resisting extensive representations.

• Qualifying definitions: Terms like "knowledge" or "Material Adverse Effect" are critical and affect the frequency and limitations of each representation.

• Complexity and cost considerations: Lengthier representations increase drafting time and legal expenses.

• Inclusion of broad representations: Comprehensive representations may lead to lesser insistence on specific ones from the buyer's end.

• Draft preparation: The initiating party for the agreement draft typically influences the extent of representations; a buyer-prepared draft may feature more extensive seller representations than one prepared by the seller.