By Dave Driscoll
When a buyer wants to purchase a business, the process typically begins with drafting and negotiating a letter of intent (LOI) outlining the business terms of the transaction, such as the purchase price, an exclusive period for negotiation, and post-closing agreements, such as non-compete, employment, and other agreements. The letter of intent defines the “essence of the deal” as negotiated between the buyer and seller and is a valuable tool for keeping the deal consistent with what the parties agreed to when setting the process in motion.
Once the LOI is signed by both parties, due diligence, as well as drafting and negotiating the definitive asset purchase agreement or stock purchase agreement begins, depending on the structure of the deal. The purpose of the purchase agreement is to finalize all the terms and conditions of the transaction; this should be consistent with the letter of intent, with the addition of important legal considerations not covered in the LOI.
One topic that is not typically addressed at the letter of intent stage but is heavily negotiated for the purchase agreement are “representations and warranties.”
The LOI typically states that the seller will make customary representations and warranties to the buyer, and the purchase agreement will contain the full definition of such representations and warranties. In many cases a Representations and Warranties section can be the largest portion of the Purchase Agreement document.
A representation means any details about the company are claimed true as of the date stated to the other party. The purpose of representations and warranties—from the buyer’s perspective—is to provide comfort for items that may not be discoverable in the due diligence process. Some common seller representations include assurances regarding the seller’s ownership of the company and the authority to consummate the transaction, as well as confirmations regarding litigation, titles to assets, and conformity with laws and tax obligations. Depending on the type of business being sold, the representations may also address intellectual property, customer contracts, human resources, regulatory, and environmental issues.
Purchase agreement representations and warranties give the buyer more confidence to move forward with the purchase because if anything turn out to be incorrect or not as represented after the closing, the buyer will have a contractual cure against the seller. Sellers, of course, desire that the “reps and warranties” be narrow in scope, as this reduces their liability related to the transaction post-closing.
Although the seller’s representations are the more critical component of the purchase agreement, sellers also request that the buyer provide a set of representations which are typically reciprocal to the seller’s similar representations.
Another key area of negotiation in the purchase agreement is narrowing the scope of the representations and inserting qualifiers. For example, a representation may be qualified to the knowledge of the seller or exclude certain items that would not have a material adverse effect on the company’s future success.
Example of a representation qualifier:
To the knowledge of the seller, the seller is not in violation of any laws, material governmental orders, rules or regulations, whether federal, state or local, to which the seller or the assets are subject, except where such violation does not result in a Material Adverse Effect on the assets of the business.
If you are contemplating the sale of your business, understanding that the negotiation process does not end with the signing of the letter of intent is significant. Representations and warranties will be a major component within the purchase agreement. In many cases, a letter of intent can be negotiated without legal counsel. However, after the letter of intent is executed, it’s crucial that you work with your attorney to draft the purchase agreement to define the transaction and determine the appropriate scope of representations and warranties.
Dave Driscoll is president of Metro Business Advisors, a mergers & acquisitions, valuation and exit/succession planning firm helping owners of companies with revenue up to $20 million sell their most valuable asset. Reach Dave at [email protected] or (314) 303-5600. www.MetroBusinessAdvisors.com
As seen in Dave’s monthly column in St. Louis Small Business Monthly
