A core part of negotiating an M&A deal seeks to answer the question, what if something goes wrong after closing?

Unlike in real estate, where property due diligence can almost fully inform a buyer, in M&A, a buyer must rely on the seller’s assertions to buy the business. Thus, we have developed a system where the seller makes assertions about the business (representations and warranties), and the buyer trusts those assertions to buy the business.

What happens when one of those assertions are misrepresented and it causes a loss to the buyer after closing?

Then, the seller has to pay to the buyer an amount equal to that loss (grossly oversimplified). There are different ways to ensure the money is there to cover a loss (escrow, promissory note, rep & warranty insurance (covered in a previous post)).

Sellers do not like to be liable after closing, so they have devised ways to limit their liability.

On one end of the spectrum is a public deal (or “public- company-style”). Because there is enough information about the target (and difficulty in clawing back from public stockholders) the seller does not remain liable after closing (“as-is”).

In the middle market and upper middle market the seller or an insurer stands behind the seller’s assertions and seller remains liable after closing, but, sellers have sought to limit their post-closing liability.

They do this in 3 ways: survival, caps, and baskets:

1. Survival. Seller tries to limit the amount of time their assertions survive. For example, if there is a misrepresentation, it has to arise within 18 months. A buyer wants the assertions to last until the statute of limitations (usually 5 years). The market for sub-$50m deals is hard to assertain, but my experience in sub-$100m deals is we usually end up with###-###-#### months for non-fundamental representations (those assertions that are less critical to the business), and statute of limitations for fundamental representations (critical representations like, taxes, ownership of the business, etc.). The latest data is from 2022 and this is from larger deals:

2. Caps. Seller limits the total amount of liability. Buyer wants the total amount to be unlimited or at least the amount of the purchase price. Seller wants to cap their liability. The market (for sub-$100m deals) is for non-fundamental reps to be capped at 20%-50% of the purchase price and fundamental reps caped at the purchase price.

3. Baskets. Seller tries to further reduce their liability by adding a basket. A basket is a threshold that the loss has to equal before it can be claimed against the seller. For example, the loss has to be more than $100,000 for it to be claimed. This gives seller the comfort that buyer will not claim for small losses. There are two types of baskets, deductible and tipping. Deductible means if a loss hits the threshold the seller is responsible for all amounts above the threshold. Tipping means that once the threshold is met, seller is responsible for all amount from the first dollar of loss. The market for this is a deductible basket of 1% of purchase price for non-fundamental and no basket for fundamental reps. However, as the market softens for sellers, a growing number of deals have not basket at all:

Major caveat: I have increasingly been arguing for survival until the statute of limitations, no caps or baskets and have been including this in my LOIs (I will post my rationale another time).

As an example from a prior deal:

In a deal that closed last month, my client found out that the business’s top customer was leaving and seller knew about it before closing. The loss was calculated at $500k. A customer contract representation is a non-fundamental representation, so the buyer had 18 months survival. This was within the survival period. Buyer had a cap of $2 million for non-fundamental reps, so this was well within the cap. The basket was set at $200,000, but this was a tipping basket, so once it exceeded the basket, buyer could recover the full amount (if it was a deductible basket, buyer would only be able to recover $300k). In this case, the Seller had a promissory note, which was reduced by $500k. Where funds come from to cover a loss is for another post.

Survival, caps, and baskets often throw people off - I hope this was helpful.