M&A Monday: What if I buy a business and something goes wrong? What is my recourse?

Each Monday I post one lesson buyers or sellers of a business should know. These are tips I learned representing top private equity groups and learning from some of the best M&A lawyers in the world. I endeavor to write these lessons in simple, clear English.

Almost all Buyers ask what their recourse is if they buy a business and something goes wrong and sellers say they want to sell, "as-is".

First, I tell my buyer clients, we can reduce, but not eliminate the risk.

1. Diligence. Diligence reduces risk. Learn everything about the business, and hire the right people to do diligence.

Tip: You can and should do all the legal searches in the world, but the best information comes from conversations. Talk to the management, employees (if you can), and do customer calls.

2. Representations and Warranties. This is a fancy way to say, promises. Selling a business is not a foreclosure auction. Seller has to make certain promises about the business and its condition. Sellers sometimes erroneously think they are making promises about future performance (not true). I tell sellers, having run this business you are best positioned to know the business. You should feel comfortable making certain promises about the business condition. Sellers try to limit the scope of these promises through what I call, the Holly Trinity of Qualifiers: Knowledge, Materiality, Lookback (lawyers battling over reps and warranties could be its own post).

3. Indemnification.* Promises are only as good as the enforcement mechanism. Enter, Indemnifications. If one of these promises are untrue or misrepresented and Buyer to loses money, Seller has to pay for these losses.

Example: Seller says to Seller's knowledge, none of their top customers want to terminate. A week after closing the top customer terminates. Depending on how that promise was written, Seller may have to pay for that loss. 4. Escrow; Holdback; Note Setof; RWI Insurance. What if Seller makes these promises, they misrepresented, but now the Seller is on their yacht enjoying martinis. Buyer has a collection problem. Thus, Buyer wants an easier way to recover losses so they can keep running the business. Classicly, buyer puts some of the purchase price in an escrow for 12, 18, or 24 months until they can be sure no skeletons are falling out of the closets. This can also be done with a holdback of funds at closing (buyer keeps the money and pays it out), a promissory note setoff (if there is a seller note, the loss can be deducted from the note), or representation and warranty insurance (an insurer stands behind seller's promises).

While each of these topics could be its own post, it is important to the Buyer's recourse and the mechanics of an M&A transaction.

As always, let me know of any questions.

*excluding public-style deals.