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So, assume you are a business owner who has worked hard to build a successful business, and now it is time to sell your business. Or think you are looking to buy and acquire a business with plans to expand and grow the business. Your attorney provides you with the stock or asset purchase agreement, and you notice that one of the longest articles within the agreement is the representations and warranties article for both the seller and the buyer. Generally, a seller will likely be making more representations and warranties than the buyer, but what are these representations and warranties and how do they impact you as a party to the acquisition? As a seller, what representations and warranties are you expected to make and what may the buyer request or require as non-negotiable to continue with the transaction? As a buyer, what representations and warranties do you want the seller to make or would you require the seller to make? The answer may depend upon the structure of the transaction and the specific facts and circumstances of the business or assets to be acquired but are very important to understand. This article will provide more information as to what a representation and warranty is, and furthermore, provide examples of what we find are common representations and warranties.
In an acquisition, a representation is a statement (almost an unconditional promise) from the seller or buyer that some set of facts and/or circumstances is true, correct, and/or accurate about the business or a party to the agreement and this fact or circumstance is likely to be very influential to the other party to enter into the agreement. The warranty further assures the buyer that the assets or stock being purchased are free from defects and is a legally binding commitment. Thus, a representation and warranty is a promise to the other party that certain facts and circumstances about the assets, stock or business are true and correct. Below are examples of common representations, warranties, and information on why a party to an acquisition would likely find the issue important. These examples and the reasoning should help in your understanding of why parties to an agreement will find the representations and warranties so important and why these sections are some of the most heavily negotiated issues in a business transaction or acquisition.
Authority
Generally, the seller or sellers in an acquisition will represent and warrant that the individuals executing the purchase agreement on behalf of the company or seller have the corporate or partnership authorized to execute the purchase agreement. So, why would a buyer care? As the buyer, you need to ensure that an individual or individuals with the appropriate authority based upon the selling company’s bylaws, operating agreement and/or other internal documents has the requisite authority to bind the seller and/or company to the terms with the purchase agreement and the other ancillary documents to the transaction. For example, say you are purchasing ABC, LLC, and Joe Smith states he is the managing member of ABC, LLC and will execute the purchase agreement on behalf of ABC, LLC. Upon your review of the operating agreement of ABC, LLC, the operating agreement does not allow for the managing member to sell all or substantially all of the assets of ABC, LLC, and the sale of all or substantially all of the assets of ABC, LLC outside of the ordinary course of business requires unanimous consent of all members. If Joe Smith is not the sole and 100% owner of ABC, LLC, Joe cannot technically bind ABC, LLC to the transactions contemplated in the purchase agreement and perhaps the ancillary documents to the transactions. If Joe were the only party of ABC, LLC to execute the purchase agreement, other members of ABC, LLC could later argue that the transaction is unenforceable and void because Joe never had the necessary authority to unilaterally enter into the transaction. Thus, although a representation and warranty related to the authority of those binding a company may seem “boilerplate,” it can be a very important representation and warranty.
Financial Statements
Generally, the company being sold and/or the sellers who own the company will represent and warrant that the financial statements provided to the buyer are true, accurate, and correct. Financial statements are likely to include the prior year tax returns, income statements (profit & loss statements), balance sheets, and other financial information disclosed to the buyer. This may be more obvious as to why the buyer would care, but generally if a buyer is purchasing the assets of a business or the stock of an individual, the financial status and success of the business have been a significant and influential factor in the buyer’s decision to purchase. Further, in addition to gross income and net income, which a buyer can use to calculate discretionary earnings, which generally play a large role in the underlying value of the business, the financial statements of the business should provide information such as debts and liabilities, which can be indicative of normal operating costs of the business that the buyer must consider to operate at a profit, or even show debt that could be evidenced by a lien and thus be encumbering the assets. Thus, for this reason, and many others that are not detailed, the financial representation and warranty made by the seller and/or company are essential to the buyer.
Debts, Liens & Encumbrances
In addition to representing and warranting the financial statements, a buyer will generally want the seller to represent and warrant that the assets or stock being purchased are free and clear from any liens, encumbrances, or other third-party rights such that the buyer is acquiring the assets with assets or stock with free and clear title. This being said, it is not uncommon in an asset purchase for there to be certain debts of the company that do encumber some of the assets being purchased. This issue is generally worked out through the asset purchase agreement with the debts being disclosed and then either satisfied before closing, with the closing proceeds, or the buyer assuming the liabilities encumbering the assets.
Litigation or Legal Proceedings
Another common representation and warranty a buyer is likely to request would be that there are not current or pending claims or legal proceedings against the business selling the assets or the individual selling their stock. Furthermore, it is not uncommon to see a representation or warranty that the company or seller of stock is also unaware of any fact or circumstance that could lead to some form or claim, litigation or legal proceeding. A claim or legal proceeding whether ongoing, pending, or known, would be important for a buyer to know, especially in a stock purchase because such claim could lead to a judgment that the buyer could be responsible for and eventually a third party right, claim or encumbrance to the assets of the business etc. Although, a buyer may be able to come across current litigation in their due diligence of the company or seller and/or disclosures from the seller, it can be very hard to always ascertain what potential claims may be looming but have yet to be filed or threatened, of which may need to be defended.
Tax Compliance & Legal Compliance
A seller should represent, and warrant that they are in compliance with all federal, state and local tax laws and regulations and that all returns and tax payments that would have been due prior to closing have been filed and paid. A buyer does not want a taxing authority to have any claim against the assets or stock purchased and some taxing authorities may have a priority lien on the underlying assets purchased if certain taxes were due at the time of closing. The same issue and potential exposure would hold true for general legal compliance in that the seller has been in compliance with all laws and is unaware of any lack of compliance.
The Catch-All
While the above representations and warranties are very common in an acquisition agreement, there are also many more that are likely to be found. That being said, it is not uncommon to have a “catch-all” representation and warranty. Generally, this representation and warranty would state that all of the documents and information provided by the seller are true, accurate, and correct and there has been no omission of a material fact that would cause any representation or warranty to be inaccurate or misleading. Although, this may not be a full proof manner to bind a seller or company, it can certainly strengthen the potential for a breach of contract claim if the buyer or purchaser finds or begins to see that certain representations and warranties made by the seller are incorrect or inaccurate and perhaps materially so to the point the buyer is incurring material financial damages or other damages.
The above examples of representations and warranties you may find in an asset purchase agreement or stock purchase agreement are just a few, but in my opinion are some of the most important. If you are involved in the sale or purchase of a business, whether via an asset sale or stock purchase, it is highly recommended you have representation from a business attorney to handle the matter and prevent unnecessary exposure as much as possible depending upon the circumstances. You can contact The McGuire Law Firm to discuss any related acquisition issues or questions with a business attorney.
