The Purchase Agreement Essentials: Representations and Warranties

Protect Yourself During the Buying and Selling Process

The representations and warranties section of the Purchase Agreement is one of the most negotiated sections of any agreement between a buyer and a seller. It covers statements of fact and promises about what is sold. The seller will make several representations and warranties about the target and assets.

If the transaction is a stock deal, there will also be representations and warranties about the target’s equity. While the buyer may have conducted their own due diligence, they will still usually expect the seller to confirm several facts in this section. They will also need to stand behind those facts throughout the selling process.

Keep reading to uncover the answers to popular questions about the representations and warranties section.

What is the Timeline of the Representations and Warranties?

Representations and warranties go into effect on the date of the purchase agreement. If the closing takes place on a later date, the representations and warranties will be re-made. This happens on the closing date through a “bring down” certificate. Also called the bring down condition, it states that the date changed and all parties agreed.

In the course of negotiations, the seller will seek to qualify the scope of this section to limit its risk and exposure. This is accomplished by adding time, materiality and knowledge qualifiers. In addition, the representations and warranties is included on the disclosure schedules.

What are the Disclosure Schedules?

The seller prepares the disclosure schedules. It contains various facts, exceptions or clarifying information about the representations and warranties.

From both parties’ perspective, full disclosure is critical. This is because the purchaser will be taking the purchased assets or equities subject to all disclosed issues and matters. For the purchaser, full disclosure means there are no surprises after the closing.

The purchaser wants to know that they will be getting the benefit of the bargain. If there are issues, then that requires the seller to provide specific indemnities to cover any potential losses. If there were material, unexpected issues between signing the purchase agreement and closing, then the purchaser might terminate the deal. They could also request a reduction in the purchase price.

How Do You Develop the Disclosure Schedules?

The disclosure schedules may require a good deal of time and attention to prepare, so it is important that the seller begins preparing them as early as possible. Often, the seller’s chief financial officer handles their preparation in conjunction with the seller’s attorneys. If the closing of the transaction will not occur simultaneously with the signing of the purchase agreement, then the disclosure schedules will need to be updated at the closing.

This time commitment is an important consideration that is not always appreciated by sellers. If the seller is spending the majority of time attending to the transaction, then the business might suffer. This, in turn, could have a negative impact on the purchase price or earn-outs.

What is Included in the Representations and Warranties?

The ultimate scope depends on the size and nature of the transaction. The target and seller will generally make the following representations and warranties.

To make this information easier to digest, we are breaking this list down into five categories. They are finances, third parties, ownership issues, laws and others.

Finances

• Equity Securities: If the transaction is a stock transaction, no third party owns any interest in equity securities of the seller parties. They also won’t have any right to have any equity securities of target issued. There are no agreements or agreements to issue or transfer any equity securities to any third party. At the closing, the purchaser will receive good titles to all issued and outstanding equity securities of the target. They will be free and clear of all liens, encumbrances and rights of third parties.
• Financial Statements: The financial statements delivered to purchaser:
  • are true and complete.
  • have been prepared from the books and financial records of the target.
  • were prepared in accordance with sound accounting principles.
  • present accurately the financial condition and results of operations of the target.
  • the books and financial records used for financial statements are true and correct. They reflect only actual transactions and have been maintained in accordance with sound business practices.
• No Undisclosed Liabilities: That there is no debt or other liabilities about the operation other than:
  • those disclosed in or reserved against in the aforementioned financial statements.
  • those incurred in the ordinary course of business since a particular date. They are similar in nature to those disclosed in the financial statements.
  • if the purchaser is assuming certain liabilities, those are included.
• Tax Matters: The target has timely filed all required tax returns. All such tax returns are true, complete and correct in all material respects. All taxes have been timely paid in full. There are no tax contests, audits or liens.

Ownership Issues

• Authority: The target and each seller party has:
  • full legal right, capacity, power and authority to execute the purchase agreement. Plus to consummate the transactions contemplated it.
  • all authorizations, consents and approvals required by law, regulation or other restriction.
• Corporate Power: The target and each seller party has the requisite corporate power and authority to conduct its business. This means to own, lease, operate and use its assets and properties. This target will also perform all its obligations under its contracts.
• Ownership of Target Company; No Subsidiaries: Each seller party owns the issued equity interests of target. They are free and clear of all liens, encumbrances and rights of third parties. There are no subsidiaries of the target. All of the issued equity securities of target were issued in compliance with all applicable federal and state laws.
• Title and Sufficiency of Purchased Assets: Each seller party owns the good sold. At the closing, the seller will transfer and deliver to the purchaser the goods and all purchased assets. All of them will be free and clear of all liens, encumbrances and rights of third parties. The purchased assets constitute all of the material assets, properties and rights necessary. The tangible personal property is in good operating condition and repair, except for with the exception of normal wear and tear. All items of tangible personal property are located at target’s premises.

Laws

• Legal and Authorized Transactions: The purchase agreement constitutes the legal, valid and binding obligation of the target and each seller party. They are enforceable against them in accordance with its terms.
• Compliance with Laws: There are no violations by the target of any law relating to the target, its equity, assets or the transaction.
• Licenses and Permits: The target has all required licenses and permits.
• Litigation: There are no claims, lawsuits, investigations or judgments relating to the target, its equity, assets or the transaction.
• Organization: The target and each seller party is in good standing under the laws of its jurisdiction of organization. The target has been delivered to the buyer the organizational documents. They are not in default under any of them.
• Full Disclosure: The purchase agreement does not contain any untrue statement of a material fact. It does not omit to state any material fact necessary to make the statements made not false or misleading.
• Contracts: Except as set forth in the applicable disclosure schedule, the target is not bound by any contract, lease or other agreement. The contracts set forth on the applicable disclosure schedule are each:
  • a legal, valid and binding obligation of Target and the other parties there to.
  • in full force and effect in accordance with its terms.
  • may be assigned to the purchaser and will continue in full force and effect after closing.
  • there are no breaches or defaults under any such contract.
  • the seller parties have delivered to a complete copy of each contract.

Other

• Title: If the transaction is an asset transaction that the target owns, they will deliver it to the buyer. It will be free and clear of all liens, encumbrances and rights of third parties.
• Absence of Certain Changes: The target has conducted its business. There has not been any material adverse change to the target, its business or assets.
• No Conflict; Third Party Consents: The target’s and each seller party’s execution, delivery and performance of the purchase agreement do not:
  • violate or constitute a default under any other contract.
  • violate any provisions of any law, rule, regulation, order, judgment or decree applicable to the assets.
  • require notice to or the consent, approval or waiver of any governmental authority, any other person or entity.
• No Brokers: There is no broker, finder, investment banker or other intermediary entitled to any fee or commission in connection with the transaction.

Less Common Items Included in Representations and Warranties

Depending on the nature of the target’s business, there may be many other representations and warranties. Examples of those include:

• Customer and Suppliers.
• Product Warranties to Customers.
• Customer Credits.
• Intellectual Property and Confidential Information.
• Employee and Labor Matters.
• Environmental, Health and Safety Matters.
• Inventory.
• Real Estate.
• Insurance Matters.
• Affiliate and Related Party Transactions.
• Securities and Investment Representations. This is only if the seller will be receiving equity as part of the price.

What are the Representations and Warranties Limited To?

The representations and warranties of the purchaser are usually limited to the following:

• Legal and Authorized Transactions.
• No Conflict; Third-Party Consents.
• Authority.
• No Litigation.
• Organization.
• Corporate Power.

If the purchaser issues equity securities to the seller, then additional representations and warranties will happen.

[Editor’s Note: This is part of a series of articles written specifically for the business owner who is thinking about selling. To start reading from the beginning, read “Business Transition and Exit Planning: Welcome to the Jungle!”]

To learn more about this and related topics, you may want to attend the following webinars: Key Provisions in M&A Agreements and Negotiating an M&A Deal. This is an updated version of an article that was published on April 3, 2015.]

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• Recognizing Special Situations in Private Companies