What are reps and warranties, and what is their role in M&A transactions?

Join Arjun Murthy, Managing Director at Cascade Partners, and special guest Taft Law Partner, Justin Hanna, in a thought-provoking two-part Cascade Conversation!

Part 1: Discover the crucial role of Representations and Warranties in M&A transactions and gain valuable insights into their impact on corporate deals. Be sure to tune into this insightful discussion!


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Arjun Murthy: Well, hello everyone. My name is Arjun Murthy. I’m a managing director at Cascade Partners. We are an investment bank located in Detroit, Michigan with offices in Cleveland and Grand Rapids. And today I’m joined by Justin Hanna, who will introduce himself.


Justin Hanna: Hi, I’m Justin Hanna. I am a partner at Taft Law. We’re a full service business law firm with over 850 lawyers spanning across nine offices and seven states.


Murthy: Well, Justin, thanks for taking some time to join us today. Talk about some really interesting topics. Really the purpose of the conversation today is to talk about reps and warranties. As I think, you know, we know there are reps and warranties and we’d want to get into understanding, really, okay. What does that really mean from basic concept? So, when someone says reps and warranties as it relates to purchase documents or just in general in the context of m&a what does that really mean?


Hanna: So, representations and warranties are statements that sellers make to buyers in connection with m&a transactions. The buyer wants to make sure that they’re getting their benefit of the bargain, and they ask sellers to make certain statements about the operating business so that they understand what the risks, what the liabilities, what the obligations of that business are. These statements, along with the corresponding disclosure schedules, that sellers put together are used by these buyers to flesh out those liabilities as a part of the m&a process.


Murthy: So, basically, when you’re signing up to sell your business as a seller, you’re basically making a series of promises essentially, that you’re signing up to. And so from a buyer’s perspective, are there certain—I guess—representations and warranties that they’re absolutely looking for? And conversely, from the seller’s side are there reps and warranties in which in the first turn of the documents they may not want in there for certain reasons?


Hanna: Yeah, I mean, I would say there are probably a standard suite of reps and warranties that typically get included in your average m&a deal. Those are really broken down between what we call fundamental reps and warranties and non fundamental or general reps and warranties. So, there are general suites of reps and warranties that typically get included in m&a transactions. Those can be expanded depending on if there are industry specific items that need to be included, if there are certain regulatory considerations that need to be taken into account, and they can also be pulled back a little bit on some smaller deals where maybe the buyer’s getting what we’d call a sweetheart deal or a really nice purchase price. Or if it’s a distress transaction, sometimes you don’t necessarily get that full suite of reps and warranties. But I would say there’s probably a standard set of 20 or so reps that are generally included in most deals, and those are broken down, as I had mentioned, between fundamental and general reps and warranties.


Murthy: And fundamental, there’s probably, what, six or seven standard fundamental reps such as fraud, taxes, some other aspects in which those are always gonna be in the agreements no matter what. Is that fair statement?


Hanna: Yeah, so, I would say the way that I think about fundamental reps are; these are a seller making representations that are so fundamental to the business that they’re selling what they’re expected almost every time. And those would include things such as the organization of the business. So, what is its corporate structure? Things like authority to actually enter into the agreement to sign the documents. Things like enforceability of the documents themselves. Sometimes you’ll see items such as for example, whether or not there’s a broker or a broker broker’s fee involved, that’s typically fundamental. You’ll see certain aspects of like no conflicts reps. That or the entire rep that might become fundamental. And then there’s regulatory items such as taxes, as you mentioned, environmental is sometimes fundamental and employee benefits is sometimes fundamental.


Murthy: No, I got that makes a ton of sense. And then, so as we’re thinking about that, and we know that there’s gonna be a standard suite of reps and warranties that kind of start in the template. Whether they’re on the buy-side or sell-side, they’re typically in both stock purchase agreements and asset purchase agreements. So, it’s not like necessarily they’re gonna be excluded from one or another. But, we worked together, and we worked on a fair amount of deals together as investment bankers and lawyers. What are some things that we can do ahead of time before we even get to the documents to help prep our clients for this? Such as, one thing that we tend to do a lot of times with the letter of intent (LOI) is outline the reps and warranties, what our expectations are and ask buyers to give us their view on those. What are some other tactics that you guys have used with your clients to maybe ensure that you’re getting to the same page before you get to the actual documentation?


Hanna: Yeah, I mean, it really just depends on if we’re representing the buyer or a seller in a transaction. As a seller, you want to try to outline it as best as possible. You maybe even want to list the representations and warranties that are going to be included. As a buyer, I’m somewhat hesitant to do that because I haven’t really had a great opportunity to dig into the due diligence and to really understand what all the things that I may need to be covering are.

So, as a buyer, I wanna be as general or generic as possible and just say standard reps and warranties that include, but are not limited to, these handful of things. As a seller, you wanna identify them as, as much as possible, as you said. And the other I would say, important component at the LOI pays is it’s really to identify those reps and warranties that are going to be fundamental. Because to make the distinction between the fundamental and the general reps: Fundamental reps generally have dollar one recovery, longer survivability, period. Sometimes they survive forever, typically squarely within a seller’s control.

So, as a seller, I really want to make sure that I’m identifying those and not including—or trying not to include—what I would consider general or operational reps in what is considered fundamental or not.


Murthy: And and how often do you see it from what we, as investment bankers, try to put in the LOI on the sell-side as our expectations as we’ll negotiate the LOI, how often do you see that actually translate into the purchase agreement? Or how much variation do you normally see?


Hanna: Just like anything else with an LOI, it’s a guidepost, but it’s not necessarily binding. So, I would say it just depends. As with many answers that a lawyer will give you, it just depends. If there are issues that arise after you get into that due diligence, even if you’ve agreed to a number of reps in the LOI, a buyer can still make an argument like, “Hey, we really need to include this. We didn’t know that this was out there.” And circumstances change once you’ve really had an opportunity to dig into the information. So, while the LOI is a really great, helpful guidepost to use when negotiating the primary documents themselves, it’s not the end all be all.


Murthy: Right, that makes a ton of sense. One of the—and you mentioned dollar once—I think this is a logical segue that we try to talk about during the LOI phase, and before we get to the purchase agreements there are baskets and caps. Can you explain what baskets and caps are and how they work in practicality?


Hanna: Yeah. So generally speaking, you know, we have all these reps and warranties in the agreement. But, at the end of the day, a seller doesn’t want a buyer, and a buyer doesn’t want to do to the seller. They don’t wanna nickel and dime them, right? So, if there’s a damage and that damages, you know, $5,000 in the context of a $25 million deal, it’s probably not material enough for a buyer to actually go out and make a claim. And, so, we try to negotiate in advance in the actual purchase agreement a basket for what is the minimum threshold. And the basket can be either a tipping basket or a deductible. You would set a dollar amount—that dollar amount depending on the deal size. And the industry is anywhere between 1 percent of the overall purchase price and 2.5 percent of the overall purchase price.

Again, it tends to be a little higher on the smaller transactions, but you set this dollar amount and that either acts as a deductible, meaning once you’ve hit that threshold, if the losses exceed that threshold, that is what the buyer can make a claim for. Or in a tipping basket scenario, once you’ve hit that threshold, buyer can then make a claim from the first dollar.


Murthy: And what have you seen being kind of more prevalent in today’s market? Is it the tipping basket, is it deductible? Does it kind of depend on the deal?


Hanna: It depends on the deal and it depends on the percentage. So, generally speaking, if it’s a higher percentage of the overall purchase price, a buyer’s gonna push for it to be a tipping basket. If it’s a lower percentage of the overall purchase price the buyer may be more willing to live with a deductible. And then, you know, beyond the baskets themselves, sellers also want to put in place a cap on what their liability could be.

So, I don’t wanna sell my company as a seller and then potentially be on the hook for half of the purchase price or more. Because, at the end of the day, the buyer’s buying a business as a going concern. And while is, you know, providing these indemnities to buyer with respect to the reps and warranties, they can’t indemnify them for everything under the sun. Buyer has to take some risk because they’re also potentially getting the upside of the operating business. So sellers put in place a cap on general reps, typically that runs anywhere between 10 percent and 25 percent, and it works the same way as with the baskets; depends on the deal size.

So, the smaller the deal, the likely the larger the cap may be. And you know, it’s also dependent on industry risk level for that particular transaction. And that cap typically applies to the general or operational reps. Fundamental reps may have a different cap on fundamental reps. Buyers will argue those are things that are squarely within a seller’s control. If there is a breach, it’s because the seller did something wrong. And they’re willing, oftentimes, to put a cap on that. But typically that cap is more like the purchase price. Now we’re talking about circumstances that are very unlikely to happen where there’s ever a claim for that much. But, at the end of the day, a seller never wants to be on the hook for more than what they actually received in the deal, even if there’s a breach that results in a complete, blow up of the company.


Murthy: Yep, that makes a ton of sense. And, we try to do our best to put a limit in terms of what that cap is on the purchase price, but—like you said—it all depends on the risk of the deal, the industry, et cetera. So, one of the topics that we’re gonna get into in a second is rep and warranty insurance that can maybe help streamline some of this. But in the event that there isn’t rep and warranty insurance, what are some elements that buyers tend to put in place to cover for the risk of these reps and warranties such as escrows, maybe holdbacks, et cetera. Can you talk a little bit about that?


Hanna: Yeah, sure. So, I would say, generally speaking, with most lower middle market m&a transactions there’s going to be an indemnity escrow. And that indemnity escrow is held by a third party and it’s intended to cover indemnity claims that get made in excess of that basket that we talked about earlier. The purpose of this escrow is so the buyer doesn’t necessarily have to go after the seller or sellers. And there may be numerous sellers right after the closing. They actually have a pool of money that they can draw on if needed. And it gives the buyer some comfort that sellers are standing behind their reps and warranties. And typically, you know, the amount of the escrow can be negotiated, typically some percentage of what the overall purchase price is. And, it’s definitely something that’s lower than that cap that we talked about earlier. It’s pretty significantly lower, but it’s something that gets oftentimes negotiated at the LOI phase.

As a seller, you wanna try to negotiate that upfront because that’s an item that the seller isn’t getting at the closing. It’s being held for some period after the closing— it may be held for 12 months, 18 months, I’ve seen. And there may be periodic releases over time if claims haven’t been made. So that’s one avenue of some buyer protection that I would say is market. Another avenue, as you mentioned, is a holdback. If—and this is very deal specific—I would say it’s probably not the norm, but it’s not unusual either. There might be some deferred purchase price or intentional holdback for items that are discovered over the course of the due diligence period. And a buyer might want a special indemnity for those known items of liability or risk for some period of time after the closing that they’ve identified. So, they can do it in a holdback—meaning that they retain those funds and don’t pay them out until some point in the future—or they can do it in an escrow which is held by a third party.


Murthy: Right. And I think you kind of mentioned this, but escrow seems to be more commonplace, right? Holdbacks are in more rare situations where there’s probably more risk associated in the deal, it’s probably used as leverage for another negotiating point, et cetera. Because clearly if for a seller standpoint, they’d rather have their money in escrow, at least it’s been paid out and somewhere it’s earning interest theoretically as well.


Hanna: Yeah. Sellers are always hesitant to put in place holdbacks because they have the feeling that buyers just gonna find some excuse to keep that money and never pay it out. Now, obviously the buyer has to act in good faith, but at least if it is with a third party, the third party has certain standards by which those funds get replaced. And it’s typically A) a joint instruction from both buyer and seller instructing them to release funds, or B) typically, it’s a final order from a court that instructs the escrow agent to release funds in a certain way.


Murthy: Right. And we talk about reps and warranties, we talk about baskets, caps, and escrows, holdbacks—all that good stuff. But I think it’s important to note, as well, when buyers are doing transaction, their intent is to not nickel and dime and make sure they capture every single thing. I think it’s really to protect the buyer, but also protect the seller in certain instances as well, because buyers have to make certain representations as well at closing. Can you talk about what some of those are?


Hanna: Yeah, so I would say buyers typically make fundamental like representations and warranties at closing. Similar things, like items such as their organization and corporate structure, the enforceability and authority to enter into the documents themselves, if there’s any litigation that could potentially affect the transaction itself. If the buyer has a broker, it’s typically included. But beyond that, if there are deferred purchase price obligations or if there’s rollover on the part of the seller, the seller may look to get some additional reps to provide them with some comfort with respect to those deferred purchase price obligations or their rollover.

So, that might include, I’ve seen things such as financial statements, rep from a buyer, if there’s rollover, the seller wants to know that the benefit of its rollover is actually worth what a buyer says it’s worth. Sometimes, their capitalization representations that break down the capital structure of the buyer in a rollover type scenario or a deferred purchase price type scenario, you would see things such as a solvency rep or ability to pay. A seller wants to know that if and when that time comes for those deferred purchase price obligations to become due, the buyer has the ability to pay them.


Murthy: Right. That, that makes sense. I wanna get paid if I meet my obligations.


The conversation will continue with Reps and Warranties Part 2 on Cascade Conversations, coming soon!