Reps and warranties refer to statements of fact that a seller makes as part of trying to persuade a buyer to purchase their business. Each of the parties in the transaction relies on the 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.
The buyer must be provided with sufficient information to support the seller’s asking price in the transaction. Some of this information includes financial statements, lists of current contracts, customer listings, and proof of asset ownership.
During the negotiations for the purchase of a business, it is the role of the buyer to demand more information from the seller in regard to certain statements of fact made by the seller. This is because the buyer bears more risks than the seller and, therefore, must make sure that all questions are forwarded to the seller for a response and that all information required for the transaction is provided.
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 to the seller that the stock provided is free of any encumbrances and that the buyer is legally allowed 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. The attorneys representing the parties 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 representations and warranties include:
1. Legality of the business: This involves scrutinizing the legal formation of the business, its authority to operate, and the seller’s rights to enter into a binding contract with the buyer.
2. Tax audit queries: Tax scrutiny ensures that the business for sale has never been on the radar of the IRS (or other appropriate tax authority) 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. Status of inventory: The seller can often disguise or fail to fully disclose its inventory status. For example, a seller might make a simple statement of amount of inventory but fail to disclose that some of the inventory is obsolete or damaged. Therefore, attorneys should require a statement of fact attesting that the inventory statement is accurate, complete, and up-to-date.
5. Employees’ benefits state of affairs: There should be 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 environmental issues.
7. State of the documents: A statement that any and all supplied trading documents are accurate and complete.
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 may have little or no other knowledge about the business. Here are some of the benefits of reps and warranties for both parties:
1. Provide disclosure of the seller’s 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 sale 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
The buyer provides reps and warranties to the seller regarding their ability to close the deal, such as proof of funds or financing.
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, that is not ideal for 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 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 resides within the contract, and it comes after the representation. If the seller breaches this part of the agreement, the buyer can seek compensation for damages but cannot terminate the contract.
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