Regardless of the structure of an M&A transaction, all purchase and sale agreements have two very important sections that are heavily negotiated: Reps and Warranties and Indemnification. It is essential for potential sellers to understand the reps and warranties they will be asked to make so they are not surprised or unprepared when they get a draft of a purchase and sale agreement.

Representations and Warranties

The buyer and seller make reps and warranties to each other in the purchase and sale agreement. The seller's reps and warranties typically make up the largest part of the purchase agreement. These reps and warranties serve two important purposes.

First, they inform the buyer. The seller's reps and warranties, coupled with the buyer's due diligence, enable the buyer to learn as much as possible about the seller's business before signing the definitive purchase and sale agreement and closing the deal.

Second, they protect the buyer. The seller's reps and warranties provide a way to protect the buyer (allowing the buyer to call upon the seller's indemnification) if the buyer discovers facts after closing that contradict the reps and warranties of the seller as of the closing date. As a result, the seller's reps and warranties provide the framework for the seller's liability to the buyer after the closing.

Before signing the purchase and sale agreement, the buyer will do extensive due diligence on the seller's operations and finances in order to learn as much as possible about the seller's business. To confirm the buyer's findings and give them assurance that they haven't missed anything, the buyer will require the seller to make extensive reps and warranties about its business. Many reps and warranties will be specific to the seller's business and industry. However, most purchase and sale agreements contain the following typical reps and warranties:

(a) Corporate Organization, Authority, and Capitalization - This assures the buyer that the seller was properly formed, has the appropriate licenses and authorizations to operate.  It also shows the buyer how the company is capitalized.

(b) Assets - This provides a buyer with assurances about what assets are included in the transaction, assures that the seller owns the assets and has the right to sell them, lists any encumbrances on the assets, and may include reps and warranties about the location and condition of the assets.

(c) Liabilities - This lists the company's liabilities, outlines which liabilities, if any, the buyer is assuming, and provides the buyer with assurances that there are no other liabilities that the buyer needs to know about.

(d) Financial statements - This assures the buyer that all of the financial data the seller has provided the buyer is true, accurate and not misleading.

(e) Taxes - This lists any tax liabilities and assures the buyer that all tax liabilities have been paid or properly reserved for and that there are no audits or other tax issues pending.

(f) Contracts, leases, and other commitments - This lists all of the material agreements with clients, vendors or suppliers and assures the buyer that the seller is not in breach or violation of any of them.

(g) Employment matters - This lists any human resource issues and assures the buyer that there are no potential liabilities including labor unrest, lawsuits or unfunded pension liabilities.

(h) Compliance with laws and litigation - This assures the buyer that the company and its management team have operated the business lawfully and that they have not violated any laws or regulations. This sections will also either disclose any threatened or pending lawsuits or assure the buyer that there are none.

(i) Product liability - This provides a list of any pending or threatened product liability issues or claims or assures the buyer that there aren't any.

(j) Environmental matters - This assures the buyer that the company is in full compliance with all environmental laws and regulations and discloses any issues the company may have had in the past.

Indemnification

Another important part of most purchase and sale agreements is the indemnification language, which goes hand in hand with the reps and warranties. Reps and warranties are the seller's statements of fact or promises to the buyer. The indemnification language provides the buyer with a remedy in the event that the seller's statements of fact are not true or the seller does not keep his promises. Indemnification language protects the buyer from things that occur after the closing and allocates the risks and responsibilities for these things between the buyer and the seller.

In addition, the indemnification section also outlines and addresses specific items that are disclosed in the seller's reps and warranties and for which the seller retains responsibility after the closing. An example is a pending lawsuit, a tax audit or certain environmental issues, the outcome of which cannot be predicted. Therefore, the buyer may request separate indemnification for litigation, environmental and tax liabilities beyond the seller's reps and warranties.

Duration

Generally, the indemnification language is heavily negotiated, and the seller will try to limit its post-closing indemnification obligations in several ways. First, the seller will attempt to limit the time after the closing for which it must indemnify the buyer. In theory, the duration of the indemnity should be based on the period during which the buyer, using reasonable diligence, should be able to discover a potential breach or misrepresentation or, if applicable, the period during which a third party would make its claim. In practice, the parties generally agree on a period of six months to three years after the closing. Exceptions are often made for environmental and tax liabilities which have longer tails. For these matters the indemnification period is typically the applicable statute of limitations.

Cap

Second, the seller will try to put a cap or limit on the total amount of its liability. Many sellers try to cap their indemnification to less than the total purchase price, but there is no standard or rule of thumb here. It depends on the perceived risk related to the issues covered in the reps and warranties. If the seller's business is "clean," and the risk to the buyer is relatively small, buyers are often comfortable agreeing to an indemnification cap.

Basket or Deductible

Third, the seller will try to negotiate a "basket" or a "deductible" on its indemnification obligations so they don't have to worry about small or inconsequential claims. A "basket" or "deductible" assures the seller that he does not have liability to the buyer for small claims until the amount of the buyer's losses in the aggregate exceed a certain amount. In the case of a "basket," when the buyer's losses exceed the agreed upon "basket" amount, the seller is liable for the total amount of the losses. In the case of a "deductible," like with an insurance policy, when the buyer's losses exceed the agreed upon "deductible" amount, the seller is only responsible for the losses above the "deductible."

Escrow

In order to ensure that funds are available to satisfy the seller's indemnification obligations, most buyers require that a portion of the purchase price be held in escrow by a third party for some period after the closing. Another option is for the buyer to hold back a portion of the purchase price and give the seller a promissory note for that portion but retain the right to offset the promissory note to satisfy its indemnification claims.

Unfortunately, many transactions fail because a seller gets cold feet after reading the reps and warranties they are asked to make and the indemnifications they are asked to give a buyer to get a deal closed. This primer is intended to help potential sellers to understand these two essential sections when a buyer presents them with a draft of a purchase and sale agreement.