The Role of Representations and Warranties in Business Sale Agreements
The purchase agreement serves as the foundation of the transaction when buying or selling a business. It outlines the terms, conditions, and mutual obligations of both parties. The representations and warranties are the most critical components of this agreement. They establish the framework of trust and accountability between the buyer and seller. Whether you are preparing to sell your business or considering an acquisition, understanding this key element of the purchase agreement will ensure you can confidently navigate the transaction.
We will break down the legal importance of representations and warranties in business sale agreements, what sellers should expect to disclose, and how they can protect themselves by carefully crafting these provisions.
What Are Representations and Warranties?
These provisions are statements of fact and assurances the seller makes about selling the business. They cover a wide range of topics, from the accuracy of financial records to the ownership of assets and compliance with laws. They ultimately build trust between the buyer and seller.
Representations provide the buyer with a clear understanding of the business's current state, while warranties act as promises that these statements are factual and will remain so after the transaction. Some examples of shared representations and warranties in business sales include financial statements, ownership of assets, and legal compliance.
Legal Importance of Representations and Warranties
Representations and warranties serve as protection for buyers. They ensure the buyer is acquiring a business with complete transparency and provide recourse if the seller misrepresents anything. Misrepresentations can lead to claims for damages.
They also mitigate risk for sellers by allowing them to limit liability through precise disclosures. This sets clear boundaries for post-sale obligations, and detailed and accurate warranties avoid litigation.
Common Representations and Warranties Sellers Should Expect to Disclose
Financial Statements: Financial records should be accurate, and any outstanding debt or liabilities should be disclosed.
Ownership and Title: Ownership of assets and intellectual property should be clear. Any liens, encumbrances, or third-party interests should also be disclosed.
Legal and Regulatory Compliance: Adherence to laws and regulations in relevant jurisdictions should be outlined, and any ongoing or potential legal disputes should be disclosed.
Employment and Contracts: The status of employees, contractors, and key agreements should also be included. If there are any non-compete agreements or other restrictions, those should be listed as well.
Operational Risks include any environmental issues, product recalls, or reputational risks.
How Sellers Can Limit Liability Through Representations and Warranties
Providing complete and accurate information in disclosure schedules is imperative to avoid the consequences of failing to disclose material facts. Including clauses with thresholds that limit liability to “material” breaches or misstatements can also help. Also, plan to limit how long representations and warranties remain enforceable after closing. Establish caps and baskets. A “cap” is the maximum liability amount a seller agrees to bear. “Baskets” are the minimum claim threshold allowed before the buyer can pursue indemnification. Obtaining representations and warranties, insurance is also wise to protect both parties against breaches.
Best Practices for Sellers
Prepare Early: Get ahead of the game. Conduct internal audits and due diligence to identify any potential risks. Working with legal and financial advisors to draft accurate disclosures is extremely helpful during this time.
Negotiate Favorable Terms: Push for limitations on liability, such as caps, baskets, and survival periods. To minimize exposure, advocate for narrow and specific representations.
Maintain Clear Communication: Transparency in negotiations builds trust, reduces the likelihood of disputes, and ultimately saves time and money in the long run.
What Buyers Should Look for in Representations and Warranties
It is essential to conduct thorough due diligence to protect yourself with an acquisition. It is extremely important to verify disclosures and understand the business’s operations. Buyers must identify any red flags or gaps in representations. These would include gaps or inconsistencies in the seller’s disclosures. Missing details or overly broad language can indicate potential risks or issues the seller is unwilling to disclose fully.
When negotiating, request comprehensive warranties, especially for high-risk areas like intellectual property or pending litigation. Try to push for broader indemnification terms in the case of unexpected liabilities.
The Role of Legal and Financial Advisors
Legal and financial advisors can benefit sellers and buyers. Sellers can benefit from their assistance in creating precise representations and warranties. They can also provide guidance on disclosures and strategies to limit liability. When a buyer is conducting due diligence, advisors can assist in reviewing and validating representations. They can structure agreements to protect against potential risks.
Whether you are buying or selling your business, professional advisors like HartmannRhodes can help ensure a smooth and fair transaction. Contact us today, and we can ensure that your business is protected from liabilities and that you are getting the best possible outcome.
Mark Hartmann is a three-time Inc 500|5000 CEO with a rich sales, operations, and leadership background in the insurance, financial services, and healthcare sectors. With extensive experience growing and selling his own businesses, Mark leverages his expertise to help owners grow and sell businesses valued at $1M —$25M. He’s earned a Master of Business Administration from Eastern University, a master of science degree in organizational change management from St. Elizabeth University, and a graduate certificate in executive coaching from Columbia University. Mark’s professional certifications include Certified Mergers and Acquisitions Professional (CM&AP), Certified Business Intermediary (CBI), Certified Exit Planning Advisor (CEPA), and Certified Value Builder (CVB).