Representations and warranties’ statements are a key component of business transactions like M&As. Fundamentally, these statements provide clarity on the past, current, and expected future state of a business or an asset, which then allows the parties involved to navigate the deal with confidence.
Without clear and accurate representations and warranties, there’s room for misunderstandings, disputes, or even costly legal battles down the line.
Given their critical role, it is vital to ensure that these statements are crafted with the utmost care. In this guide, we’ll delve deeper into the world of reps and warranties, sharing insights on how to craft them effectively.
But before we get into that, let’s start with the basics.
What Exactly Are Reps and Warranties?
Reps (short for representations or “seller representations”) and warranties’ statements are legally binding declarations made by the buyer and seller in a business transaction. These declarations can be made in reference to the past, the present, or the future and can be about a variety of elements like a company’s assets, liabilities, and operations.
Reps are statements of past and present facts in contract law. They can cover a spectrum of issues, from the physical condition of an asset to a business’s compliance with laws to the status of financial statements.
For example, a seller may represent that its financial statements have been prepared in accordance with generally accepted accounting principles or that its assets are free and clear of any liens, encumbrances, or claims of third parties.
Warranties are promises that certain conditions will continue to hold true or that certain actions will not be taken by a party for a defined time period.
For example, a seller may warrant that it will continue to conduct its business operations ordinarily or that no material changes will be made to its business activities until the closing of the transaction.
The Role of Representations and Warranties
Seller representations and warranties serve as a crucial safeguard, ensuring that the buyer has a clear and accurate understanding of the assets acquired. Let’s look at a few of the roles they play.
Risk Management
Reps and warranties are powerful risk management tools. They allow the parties to allocate risk by clarifying the responsibilities of each, and specifying which one will be responsible if certain expectations related to the deal aren’t fulfilled.
Assurance
Reps and warranties help provide assurance and instill confidence among the parties involved in a business transaction. When one party makes definitive statements of facts or promises, it imparts a sense of security to the other, enabling them to proceed with a heightened level of trust and certainty.
Negotiation and Valuation
The details in your statements can influence the deal negotiation process and the final price of the transaction. For example, if one party is making more extensive assurances or taking on more risk, that will be reflected in the final valuation.
In a nutshell, representations and warranties are instrumental in fostering trust between parties, ensuring that each side enters the transaction with full awareness and clarity, and backed by legal recourse should the reality after the deal be different from what was stated or promised.
Creating Effective Reps and Warranties Statements
Missteps in writing your statements might not just delay transactions but could also have severe legal and financial consequences for all parties down the road.
To create effective statements that facilitate smooth transactions and, most importantly, protect your business interests, follow these steps.
1. Define the Scope
This means defining the specific areas or operations, assets, and liabilities that your reps and warranties will cover.
Defining the scope right at the beginning helps set clear boundaries for what will be included in these statements, making the drafting process more efficient and focused.
Start by identifying the subject matter of the contract or the deal and listing the key assets and liabilities relevant to the transaction. For example, in a merger, this might include the target company’s intellectual property, real estate holdings, outstanding debts, and legal claims.
Then, determine which aspects of these assets and liabilities will be addressed within the reps and warranties. For instance, in case of a real estate property, you might focus on the condition of the property, any existing leases, or zoning compliance.
2. Identify Representations
Once the scope is set, the next step is to articulate the representations.
Remember that representations are statements of fact. So, before you make any statement, ensure you have a clear understanding of the current state of the subject matter. That might mean conducting audits, evaluations, and assessments.
For example, if you are making a representation about the condition of a piece of machinery, inspect it first to ensure that whatever you represent is actually true.
Here are a few more best practices for drafting effective representations:
- Be specific: Make your representations as specific or precise as possible. Avoid vague or broad statements, as these can lead to misunderstandings and disputes in the future. For example, instead of saying that a particular asset is in ‘good condition’, specify what good means. Rather than saying, ‘the company is in compliance with all relevant laws’, specify the laws and regulations you’re referring to.
- Use qualifying language: Use qualifying language like ‘to the best of the seller’s knowledge’ to limit the scope of the representations. This can protect you from unknowingly making false statements. It can also serve as an acknowledgment of limited knowledge in certain areas, which could protect you later if something goes wrong or turns out to be incorrect.
- Focus on material facts: Representations should cover important aspects of the business or asset that could significantly impact the deal if expectations are not met. Avoid trivial issues that have little to no bearing on the outcome of the transaction.
- Ensure consistency: Ensure consistency between representations and other parts of the purchase agreement, such as covenants and indemnity provisions to avoid confusion.
3. Determine Warranties
Warranties should be specific and clear, leaving no room for ambiguity. They should also use simple and straightforward language that all parties can easily understand.
Other best practices to consider when crafting warranties are:
- Avoid making absolute guarantees: While warranties provide assurances, avoid making absolute guarantees that might be impossible to fulfill. Instead, use language that reflects a commitment to reasonable effort on your part.
- Set materiality thresholds: Consider setting materiality thresholds for certain warranties. This means that only breaches of certain significance need to be disclosed or corrected, reducing the burden of minor issues.
- Clearly define the survival period: Clearly define the survival period during which the warranties will remain in effect after closing. Most survival periods are 12 to 24 months but can vary depending on the nature of the warranties and the type of transaction.
- Consider reps and warranties insurance: Depending on the type of transaction, determine whether the warranty should be backed with insurance. Reps and warranty insurance can provide additional protection in case of a breach.
4. Assess Indemnification Provisions
Indemnification provisions typically set out the rights, responsibilities, and remedies available to either party in case a representation is found to be untrue or there’s a breach of a warranty.
Crafting these provisions requires a balance between protection and fairness. Follow these best practices when adding indemnification provisions to your representations and warranties.
- Specify time limits: Set clear time limits for indemnity claims. Establish deadlines for notifying the indemnifying party of a potential claim and for resolution.
- Set standards of conduct: Define the standard of conduct required from both parties. For instance, clarify whether the indemnified party has a duty to mitigate losses and establish standards for the indemnifying party’s response to claims.
- Consider escrows or holdbacks: Consider using holdbacks to secure indemnification obligations. This involves setting aside a portion of the purchase price to cover potential claims, ensuring that the indemnified party has a source of payment if a certain post-closing condition is not met.
- Define exclusions: Clearly list any exclusions from indemnification. These could include losses caused by the indemnified party’s own negligence or intentional misconduct, among others. Exclusions should be explicitly stated to prevent disputes.
- Set cap and basket provisions: Consider including a cap on the total liability for breaches of warranties as well as a basket threshold, i.e., a minimum amount of damages that must be exceeded before claims are valid.
Final Thoughts
While the tips and best practices we’ve outlined here can help you create more effective statements, it’s also a good idea to involve legal experts in the process, particularly those experienced in the kind of business transaction you are conducting.
Remember that every word in reps and warranties can have serious implications. Legal experts can meticulously assess the language used, confirm compliance with relevant laws, and ensure protection for all parties involved.
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Sources
Divestopedia: Survival Periods
Perkins Coie : Representation and Warranty Insurance
Sean LaPointe is an expert freelance writer with experience in personal and business finance. He has written for several well-known brands and publications, including The Motley Fool and Angi/HomeAdvisor.
