Today's #smb #eta post is about Reps and Warranties, which play an important role in the final stages of an SMB #acquisition. I see a lot of content here about the search and diligence parts of the process and less about what happens when you're ready to close. Here we go:
1) R&Ws are formal statements or promises made by the seller to the buyer about the status of the business. “Representations” offer a snapshot of the business’s condition at the moment of closing the deal, while “Warranties” are forward-looking promises, safeguarding the buyer against potential post-acquisition issues.
2) R&Ws can include statements about:
- - The condition of the business’s assets
- Its financial health
- Its legal standing
3) These are vital assertions and assumptions upon which the purchase of the business relies.
4) R&Ws play an important role at two stages of the acquisition process: Pre-Closing, enabling a buyer to reassess or withdraw from closing the deal if inaccuracies or breaches are discovered; and Post-Closure: allowing them to seek compensatory damages from the seller if a misrepresentation or unfulfilled promise is found.
5) In cases of a breach in R&Ws, the seller is typically required to indemnify the buyer, effectively bearing the financial burden of the breach. These situations could range from pending lawsuits based on pre-acquisition actions to unexpected tax liabilities from past missteps.
6) A common practice is to retain a percentage of the purchase price in an escrow account for a specified duration to offset potential breaches.
7) The indemnification cap is also important in this context. It determines the maximum amount that a buyer can claim from the seller in the event of a breach. For instance, should a breach result in $750K of damages but the indemnification cap is set at $500K, the buyer can only seek compensation up to the cap limit.
8) To protect the seller from small claims related to normal business activity, reps and warranties typically include a deductible mechanism (a standard deductible ranges from 0.5% to 1.0% of the purchase price). Claims below this amount are the responsibility of the buyer.
9) R&Ws are more complex with larger and more complex business acquisitions. Experienced attorneys are invaluable in creating efficient R&Ws, as they can strike a balance between necessary protections and not overwhelming the seller.
10) Reps and Warranties Insurance (RWI) is becoming increasingly common in small business M&A transactions. It brings a new dynamic to business acquisitions by reducing the need for escrow accounts and decreasing risks and liabilities for all parties involved.
Overall, R&Ws are more than just contractual obligations. They are strategic tools for risk allocation, serving as the safety net in buying a small business. When carefully crafted, they offer substantial protection for both parties, ensuring a smooth transaction process and successful post-acquisition integration.