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Reps and Warranties

Statements of fact made by a seller to pursue a sale of a business

What are Reps and Warranties?

Reps and warranties refer to statements of fact that the seller makes when trying to persuade the buyer into the purchase of the business. Each of the parties in the transaction relies on each other to provide true information about the transaction. The seller provides assurance that the business is worth the investment that the buyer plans to make.

On the other hand, the buyer must be provided with information to support the seller’s stand in the transaction. Some of the information includes financial statements, lists of current contracts, customer listings, proof of asset ownership, etc.

 

Reps and Warranties

 

During the negotiations for the purchase of a business, it is the role of the buyer to demand more information from the seller with regards to certain statements of fact made by the seller. It is because the buyer bears more risks than the seller and must make sure that all information required in the transaction is provided and all questions are forwarded to the seller for a response.

The buyer’s legal team is also tasked with ascertaining that the deal is within the legal framework. If the buyer intends to use its stock as part of the consideration for the transaction, it must make a statement that the stock provided is free of any encumbrances and is legally able to offer the stock.

 

What Lawyers Look For in Reps and Warranties

The reps and warranties present an avenue for the buyer to conduct due diligence for the transaction, and the attorneys representing the buyer must scrutinize the deal to ensure it is fair to both the buyer and the seller.

Some of the information that the buyer’s attorneys check in the representation and warranties include:

1. Legality of the business: It involves scrutinizing the legal formation of the business, authority to operate, and rights to enter into a binding contract with the buyer.

2. Tax audit queries: The scrutiny ensures that the business on sale has never been under the radar of IRS for breach of income and deductions disclosures.

3. The accuracy of the financial instruments: A statement of fact that requires the seller to fully disclose all financial statements of the business and provide the assurance that they are clean, current, and accurate to the point of verifiability.

4. State of the inventory: Most often, the seller can disguise its inventory status and fail to disclose its stock status. Therefore, attorneys should require an accurate statement of fact revealing that the inventory is accurate and up-to-date.

5. Employees state of affairs: They should ensure there is a statement of declaration of the settlement of employees’ contributions and benefits.

6. Environmental liability: An assurance that there are no pending obligations relating to the environment.

7. State of the documents: Supplied trading documents are accurate and correct.

 

Benefits of Reps and Warranties

In a buy and sell agreement, the seller is required to provide detailed information to back up the statements of facts presented to the buyer who has little or no knowledge about the business. Here are some of the benefits of reps and warranties to both parties:

 

1. Disclosure of the prospect business

The seller has the full knowledge of the business while the buyer is interested in getting the full disclosures about the business to facilitate the transaction.

 

2. Set grounds for closing the transaction

Since the detail document requires the seller to disclose the business position in terms of the number of customers, past revenues, inventory, current contracts, etc., it sets the stage for the closing of the business transaction.

 

3. Mitigate financial loss

The reps and warranties contain an indemnification clause that mitigates the risk of financial loss if either of the parties omits important representations that may lead to a post-transaction financial loss.

 

4. Assurance of the proceeds

Well-drafted reps and warranties act as a catalyst in persuading the buyer into the purchase of the business thus providing assurance of the two parties closing the transaction.

 

Challenges facing reps and warranties

In any business transaction, neither of the involved parties wants to lose. It is, therefore, of mutual interest if both parties get a win-win deal. However, on some occasions, the representations and warranties may face the following challenges:

 

1. Cost relating to survival periods

During negotiations, the cost of doing business may vary depending on the survival period. Mostly, the buyer prefers a longer survival period for more scrutiny. However, it is not ideal to the seller who wants to close the deal within the shortest time possible. Therefore, if there are poor negotiations of the survival period, both parties may incur unnecessary expenses.

 

2. Confusion between the two terms

It is confusing when representations and warranties are used separately because of their legal interpretation shifts. Therefore, when using these terms independently, both parties should be careful about their interpretation. Here is why:

  • A representation is used to entice the buyer to enter into the contract. If the seller breaches the contract, besides seeking compensation for damages, the buyer can terminate the contract.
  • On the other hand, a warranty recedes within the contract, and it comes after the representation. If the seller breaches the agreement, the buyer can seek compensation for damages but cannot terminate the contract.

 

Additional resources

CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:

  • Caveat Emptor (Buyer Beware)
  • Personal Goodwill
  • Intangible Assets
  • Network Effect

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