In an M&A transaction, the concept of reps and warranties is an important one to wrap your mind around.
When negotiating deals earlier on in my career, it was hard to grasp why this deserves so much attention.
After all, on the face of it, the reps and warranties are just a set of statements about the business that seem to be “obviously true”.
However, after witnessing in real-world scenarios what happens post-deal if the reps and warranties are not well thought out, their purpose became clearer to me.
Here are three main reasons why reps (i.e. representations) and warranties are so important.
𝗙𝗶𝗿𝘀𝘁, 𝘁𝗵𝗲𝘆 𝗯𝗿𝗶𝗱𝗴𝗲 𝗶𝗻𝗳𝗼𝗿𝗺𝗮𝘁𝗶𝗼𝗻 𝗮𝘀𝘆𝗺𝗺𝗲𝘁𝗿𝘆.
When doing a deal, the seller knows everything about the business. The buyer knows nothing about the target (to start with).
As the due diligence progresses, the buyer learns more and more.
However, no matter how deep the diligence, the buyer will never fully know everything about the business.
When it comes time to close the deal, the buyer has to make a decision – either walk away because there are still unknowns in the deal, or close the deal and assume some risk of the unknown.
This is where the reps and warranties kick in – the buyer asks the seller to make statements (to be included in the purchase agreement) – that give the buyer a higher degree of confidence in doing the deal.
𝗦𝗲𝗰𝗼𝗻𝗱, 𝘁𝗵𝗲𝘆 𝗵𝗲𝗹𝗽 𝘁𝗼 𝗺𝗶𝘁𝗶𝗴𝗮𝘁𝗲 𝗱𝗲𝗮𝗹 𝘁𝗶𝗺𝗶𝗻𝗴 𝗿𝗶𝘀𝗸.
Sometimes there is a gap between when the deal is signed and when it is actually closed.
And if there are material negative changes to the seller’s business during this gap period, the buyer should have the right to walk away from the deal (this can apply to sellers as well, but generally applicable to buyers).
So generally, both parties must agree that the reps and warranties in the signed documents still hold true at closing.
And if not, the non-breaching party has the right to walk away from the deal.
𝗧𝗵𝗶𝗿𝗱, 𝘁𝗵𝗲𝘆 𝗮𝘀𝘀𝗶𝗴𝗻 𝗱𝗲𝗮𝗹 𝗿𝗶𝘀𝗸 𝘁𝗼 𝘁𝗵𝗲 𝗿𝗶𝗴𝗵𝘁 𝗽𝗮𝗿𝘁𝘆 𝗶𝗳 𝘀𝗼𝗺𝗲𝘁𝗵𝗶𝗻𝗴 𝗴𝗼𝗲𝘀 𝘄𝗿𝗼𝗻𝗴 𝗽𝗼𝘀𝘁-𝗰𝗹𝗼𝘀𝗶𝗻𝗴.
If a seller’s representation (e.g. “no material environmental liabilities”) is found to be untrue a few months after the deal closes, the buyer can often claim monetary compensation from the seller.
There are many factors that affect what goes into specific reps and warranties…
but a few of them are deal structure (e.g. asset vs. stock deals), public vs. private deals, issues already found during due diligence, the specific industry and the other deal terms.
Drafting the reps and warranties requires close collaboration between the corporate dev team and the legal team – since the reps and warranties have to combine the knowledge gained from the due diligence work plus the expertise to structure this into deal documents.