In any M&A transaction, one of the most important sections of the purchase agreement is the representations and warranties section of the document. Each party in a transaction relies on the other party to provide factual information. Representations are statements of facts provided by one party to the other. Warranties are assurances of the facts provided by one party to the other.
Most representations are from the seller to the buyer, since the buyer is taking on more risk. This would include items pertaining to the status of the business. Representations on the buyer’s side include the form of consideration for the transaction, such as buyer’s stock.
There are several items that can be included in the representations and warranties section of the purchase agreement provided by the seller. These items are based on negotiations between the buyer and the seller. The most common information provided is as follows:
- Organization: The organization is incorporated with the regulatory authority and has the right to enter into a contract with the buyer.
- Capitalization: Verification of the shares issued and the amount of paid-up capital against the shares.
- Financial Statements: The information in the financial statements provides an accurate picture of the company’s business standing.
- Tax: The company has accurately filed taxes in the past.
- Ownership of Assets: The company has legal ownership of all the assets described in the financial statements.
If the seller’s representations and warranties are breached, the seller indemnifies the buyer for the damages. The indemnification has a cap, along with an expiration date after the closing of the transaction. Some items may also be excluded from indemnification based on negotiations between the parties. Usually, the seller also provides an escrow at the closing of the transaction which is a percentage of the payment it receives from the buyer.
The parties can also opt for insurance against representations and warranties which protects the buyer against losses if they are breached by the seller. This insurance offers a lot of benefits to both parties.
On the buyer’s side, having insurance will make their bid more attractive, as it would result in a lower amount or complete elimination of the escrow required to be held by the seller. It would also allow the buyer to focus more on the core business of the company being acquired, rather than the representations and warranties. Having insurance also leads to broader representations and warranties, as the seller will be more comfortable.
For the seller, insurance can reduce or eliminate the amount in escrow in case the representations and warranties are breached. It can also reduce the contingent liabilities of the seller, providing a much cleaner exit.
The question of who pays for the insurance against representations and warranties depends on numerous factors. The attractiveness of the transaction for either party and their willingness to conclude the transaction quickly can play a major role in determining who will bear this financial burden.
In general, the buyer pays if the seller is not willing to provide any indemnification against breach of representations and warranties. This would also allow the buyer to seek losses directly from the insurance company rather than claiming them from the seller and provide flexibility to the buyer in choosing the limit and tenure of the insurance coverage.
The seller generally pays for the insurance if it results in a lower amount, or complete elimination, of escrow, entailing more cash flow at the closing of the transaction and a lower contingent liability. The buyer and seller can both share the cost of insurance if the seller is only willing to provide a limited escrow.
It is important for the parties to understand what is covered and what is out of the scope of the insurance policy. In some instances, the insurance may not cover items that the buyer wants covered, and the traditional representations and warranties structure with indemnification and escrow might be the best option.
For further information on representations and warranties, please do not hesitate to consult with the Mazars Healthcare TAS Team. For more information about our services, please visit www.mazars.us/fa.
Wayne Pryor, Partner | Wayne.Pryor@MazarsUSA.com
Richard Koppel, Director| Richard.Koppel@MazarsUSA.com
Uzair Azmat, Consultant | Uzair.Azmat@MazarsUSA.com