Representations, warranties and indemnities in M&A

Representations, warranties and indemnities in M&A

Author: Joris Kersten, MSc

M&A Advisory + Valuation @ The Netherlands. www.kerstencf.nl

Business Valuation & Deal Structuring Training (5 days). 4th – 8th November 2024 @ Amsterdam. www.joriskersten.nl

Source used: Closing the deal, Jacob Orosz, Morgan & Westfield.

Introduction

The most heavily negotiated components of an M&A deal are:

·???????? Purchase price;

·???????? Terms of the vendor loan;

·???????? Post closing price adjustments (e.g. net working capital adjustments);

·???????? Size and length of the escrow;

·???????? Contingent payments, such as earnouts and escrows;

·???????? Terms of employment/ consulting agreements post deal;

·???????? Allocation of the purchase price (accounting wise, in relation to tax);

·???????? Survival period, knowledge and materiality qualifiers of the “reps & warranties”;

·???????? Caps, baskets and survival period of the “indemnities”;

·???????? Conditions to closing like MAC (material adverse change).

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“Reps and warranties” are promises and disclosures made by each party.

This serves as an “insurance” for each party if a representation later proves to be untrue.

If you aren’t 100% sure regarding a representation, that representation should contain a knowledge qualifier (“to the best of seller’s knowledge”).

Exceptions to the reps & warranties should be taken up in the “disclosure schedule”.

And reps & warranties should expire after a certain (negotiated) time period.

The amount of “indemnification” is limited by baskets/ minimums and caps/ maximums.

And the purchase agreement contains “contingencies” when it’s signed before closing.

“Contingencies” are events that must occur before a closing can take place. Such as “financing” or “landlord approval”.

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Representations & warranties: A little more detail

Reps and warranties are legal promises made by both the seller and buyer.

Reps and warranties serve as the buyer’s basis for future lawsuits under the “indemnification” clause.

A “representation” is technically a statement of a fact (e.g. corporation is duly authorised).

And a “warranty” is a promise that a fact will remain true (e.g. business has operated in compliance with law).

But in practise reps & warranties are grouped together in one (same) section of the purchase agreement.

Reps & warranties protect the buyer from material misrepresentations or fraud.

These protections include:

·???????? Reps & warranties;

·???????? Indemnification;

·???????? Escrow and holdbacks.

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The reps & warranties that are signed in the purchase agreement survive the closing when you sell your business.

Here you indemnify the buyer, and a breach of a representation would be subject to indemnification.

So you will remain liable for a significant period after the closing, if any of the reps or warranties are breached or found to be inaccurate.

Note, representations should primarily cover past events.

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Scope of the reps & warranties

You can minimise the potential scope of the reps & warranties by:

·???????? Hiring an experienced negotiator (M&A advisor) to undertake the negotiations;

·???????? Line up as many buyers as you can, this will enhance your negotiation position;

·???????? Undertake a vendor due diligence (DD by the seller itself, upfront) to address potential problems;

·???????? Behave trustworthy at all times, from the beginning on.

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And exposure on the reps & warranties can be reduced as follows:

·???????? Insurance for reps & warranties;

·???????? Knowledge qualifier use (“to best of knowledge”);

·???????? Materiality qualifiers (use baskets/ thresholds);

·???????? Survival periods (time limitations);

·???????? Indemnification caps (set limits);

·???????? Shareholder liability (pro rata per shareholder).

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Indemnification

The indemnification section in the purchase agreement requires parties to indemnify one another for breaches of representations, warranties, covenants and other types of claims that may arise post closing.

The value of the indemnification depends on the financial strength, and creditworthiness, of the party providing the indemnification.

In most deals a part of the purchase price is withheld by a third party in an escrow account.

This to fulfil any post closing indemnification obligations.

And this mitigates any impact from a not very creditworthy seller.

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Concerning indemnification in the purchase agreement, this specific section addresses the following components:

·???????? Parties (who exactly provides the indemnification);

·???????? Scope (what specifically does the indemnification cover);

·???????? Remedies (are other remedies available?);

·???????? Survival period (time period for representations, warranties, covenants and other obligations to be in place);

·???????? Limitations (limits such as baskets and caps on the indemnification obligations);

·???????? Escrow (hold back of the purchase price);

·???????? Right of offset (can the buyer offset against for example the vendor loan or earnout);

·???????? Indemnification process (how is the claim handled operationally).

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Hope this blog gave you more insight on the purchase agreement of M&A deals.

As a dealmaker I undertake the negotiations myself, but this in good cooperation with the M&A lawyer, Tax lawyer and accountant.

See you next week again with a new blog.

Best, Joris??

Kersten Corporate Finance