The most significant sections in terms of party accountability and potential trailing liability in a business purchase & sale agreement are the clauses related to representations, warranties, and indemnification. These are the sections where knowledgeable, experienced legal counsel can demonstrate substantial value in knowing how to draft appropriate verbiage for specific situations and problem solve collaboratively with opposing counsel to find a pathway through rough terrain to satisfactory middle ground that will allow the parties to achieve their objective of a completed transaction. Representations, warranties, and indemnification are not an area where someone buying or selling a business should seek a one size fits all AI or boilerplate solution, as these sections are not the ones you want errors in if future litigation occurs post transaction.
What are representations, warranties, and indemnification in a business purchase & sale agreement? Representations and warranties are statements made by the parties that establish the fact trail about the company being sold. Indemnification is the accountability associated with what was disclosed.
Representations and warranties can either be flat or modified. A flat representation is one where there is no ambiguity related to the issue. Common examples of flat representations include ones that a party is authorized to complete the transaction contemplated, that the financial records provided are an accurate presentation of the past performance of the company, and the disclosure of past litigation against the company, an answer which could be none or provided with a disclosure schedule where resolved, pending, or threatened litigation against the business is disclosed. The key is that the situations were disclosed. A buyer can make a decision on whether to move forward or not based on known facts.
A modified representation is one where a seller may not have complete knowledge, but conveys what they know. Commonly employed verbiage by attorneys in this situation is, To the best of my knowledge. The use of the phrase to the best of my knowledge is often prudent for entrepreneurs because in a well-run organization where responsibilities are delegated there is no way an owner can know everything. A couple of scenarios where to the best of my knowledge, may be used relate to competition, customers, and violations of law. It is reasonable for a buyer to ask about competition and seek to understand the competitive landscape prior to completing an acquisition. It is also likely a known fact that a seller will not know everything about what their competition is doing or their plans for the future. Similarly, it is prudent for a buyer to do due diligence on the significant customers of a business prior to acquisition, however it is impossible for a seller to know completely their future intentions related to engagement with the business unless a contractual agreement exists outlining future purchases in specificity. Some buyers may think a flat representation related to violations of law is a reasonable ask. However, the devil is in the details. If a company has vehicles on the road is every parking ticket obtained by an employee driving a company vehicle something the business owner should be responsible for knowing and accountable for legally, even if they were never aware of the ticket and the employee paid or contested the fine directly to avoid their employer knowing about it.
Indemnification is the teeth behind representations and warranties. It is the legal verbiage that defines how long a party is accountable for a representation or warranty, when they will need to compensate the other party, and to what financial level they are responsible. Specific representations and warranties will frequently have different levels of indemnification as will different types of transactions.
Representations, warranties, and indemnification are the domain of the attorneys on the transaction teams. Significant benefits can be obtained for both a buyer and seller by engaging senior, experienced attorneys in this area, as well as larger firms where colleagues can be engaged for assistance with verbiage for more specialized areas of law (Tax, Real Estate, Intellectual Property, Union, etc.). Having an attorney who is a member of the local state bar can also be beneficial as state legal precedents can impact how verbiage is drafted in areas related to tax, non-competition, and non-solicitation.
Many mergers & acquisitions professionals completely defer to the attorneys related to representations, warranties, and indemnification. They stand back as they are drafted, negotiated, and accept the premise that solutions that result from issues arising from conflicts associated with the representations, warranties, and indemnification post transaction should be resolved through mediation and/or litigation. This is a great solution for the attorneys. They will make wonderful incremental income if confrontation should occur. It is not a great solution for the parties.
A top-tier business brokerage firm will inject themselves in the representation and warranties issue by performing two very important functions which not only enhance the quality of the transaction, but mitigate the likelihood of future confrontational issues.
The first thing the business broker should do is make sure that an environment of full disclosure is created for facilitation of the transaction. The best decisions are made from a foundation of knowledge. Entrepreneurship has substantial inherent risk. A buyer should know everything possible about the business they are buying from the condition of the equipment to compensation & benefits paid to the staff to revenue by customer. Important information from due diligence can be incorporated into the disclosure schedules associated with the purchase & sale agreement to establish known and agreed facts. If a buyer is not completing a comprehensive due diligence employing an accountant and other experts to support them, concern should exist on whether the party is up for the task of leading the business. Measuring twice and cutting once is never a bad thing when making a life course altering decision. Paying a professional to do a Quality of Earnings study or mechanic to inspect a fleet of vehicles can be the difference between buying a business with open eyes and naively trusting without verification.
The level of due diligence conducted by a buyer is their discretion. I have seen seasoned entrepreneurs complete due diligence in a week and parties who took months to reach a level of comfort with an acquisition. The time taken during due diligence has limited impact on the future success of the buyer. That frequently has more to do with their executive management ability than the business purchased. However, when due diligence is completed a buyer should be held accountable to attest that they reviewed everything desired and found it satisfactory. A seller should not have post transaction liability for the question not asked or the documentation not reviewed by the buyer. Businesses are sold “as is”. Past performance is not indicative of future results.
Many parties play important roles on transaction teams related to the purchase & sale of a business. The role of the business broker is to be an experienced guide through the process, make sure best practices are performed, bring in professional resources when necessary, and solve problems in real time under the bright lights when options and solutions are needed to move the transaction forward. IBA has been successfully selling privately held companies and family businesses for 51 years. If you want to achieve a business sale at a strong market value in a timely manner, we would welcome the opportunity to help you achieve your goal.
IBA, the Pacific Northwest’s premier business brokerage firm since 1975, is available as an information resource to the media, business brokerage, mergers & acquisitions, real estate, legal, accounting, banking, and wealth management communities on subjects relevant to the purchase & sale of privately held companies and family businesses. IBA is recognized as one of the best business brokerage firms in the nation based on its long track record of successfully negotiating “win-win” business sale transactions in environments of full disclosure employing “best practices”.