Representations and Warranties - An Overview of Importance in M&A Transactions
In any Merger and Acquisition (M&A) transaction, Representations and Warranties (R&Ws) play a critical role in ensuring a smooth and successful deal. These contractual statements and assurances are negotiated during the confirmatory due diligence phase and are included in the purchase agreement. R&Ws are statements of facts and promises that serve to appropriately allocate risk between the parties participating in an M&A transaction. R&Ws are often concerned with the company's business operations, assets, and liabilities and can relate to past, present, and future time periods. Both the buyer and the seller make numerous R&Ws as part of the transaction, with the seller typically making more due to their intimate knowledge of the business. The scope of R&Ws varies deal-by-deal, depending on various factors including deal structure, strategic rational for the transaction, and other details related to the target’s business operations. In this blog, we will explore the key differences between Fundamental, Special, and General R&Ws and highlight their significance in M&A transactions.
Fundamental R&Ws: Ensuring the Basics are Sound
Fundamental R&Ws are core to any M&A transaction. They are critical elements upon which the buyer relies on to proceed with the deal. Should any of these Fundamental R&Ws prove false, the buyer may not have proceeded with the transaction in the first place. Critical areas where we often see Fundamental R&Ws include ownership and capitalization of the company, the due authorization of the transaction under applicable law, and taxes.
General R&Ws: Complementing the Fundamental Picture
R&Ws that are deemed non-Fundamental are considered General R&Ws, subject to any Special R&W carve-outs. These often cover a broader range of aspects about the target company, providing a comprehensive overview of its current state and future prospects. While not as critical as Fundamental R&Ws, General R&Ws are still crucial in painting a complete picture of the business for the buyer. Some common examples of General R&Ws we often see include accuracy of financial statements, employee and labour relations, environmental concerns, and contracts and obligations.
Special R&Ws: Covering Unique Circumstances
Special R&Ws are usually carved out as its own class of R&W with a separate survival period and indemnification cap. They serve to address unique circumstances, risks, and complexities associated with the deal and target company. We often see intellectual property (IP) matters carved-out as a Special R&W. For technology and software businesses, IP is especially important and can sometimes require a unique risk allocation profile satisfied via a Special R&W carve-out.
R&W Breaches: The Indemnification Process
Fundamental, Special, and General R&Ws are negotiated by each party’s legal team during the broader negotiation of the purchase agreement. When there is a breach of an R&W causing damages, the affected party can claim indemnification from the breaching party. The process and impact of the R&Ws are governed by certain key considerations in the purchase agreement agreed upon in the negotiation stage:
Indemnification Baskets: An indemnification basket, also known as a deductible, is a dollar threshold that must be exceeded before the counterparties can claim indemnification. The aggregate losses and damages must surpass a specified amount to trigger the indemnification process. There are two common types of baskets: (1) Tipping Basket - If losses exceed the threshold, the claimant can recover all losses; and (2) True Deductible – The claimant can only recover losses above the threshold. We see both types of indemnification baskets used in M&A transactions, and it is typical for the threshold amount to equal ~0.5% of the total transaction value. From a seller’s perspective, a true deductible, high indemnification basket is viewed as most favourable.
Indemnification Caps: Indemnification claims are typically subject to a maximum amount, which is known as the indemnification cap. For Fundamental R&Ws, this cap may be set at the purchase price while for General R&Ws, it is usually lower. General R&Ws are typically 10% to 25% of the purchase price, and the seller’s liability can vary for each General R&W based on the importance of the representation.
Survival Period: The survival period limits the timeframe within which the parties can make indemnification claims. Fundamental R&Ws generally have a longer survival period, typically lasting up to 7 years. In contrast, General R&Ws usually have a shorter survival period, ranging from 12 to 24 months.
Representations and Warranties Insurance: A Financial Safeguard
One option to mitigate the uncertainty resulting from R&Ws from a seller’s perspective is to purchase Representations and Warranties Insurance (RWI). By transferring some of the risk to the insurance policy, the seller can expedite the transaction process and unlock liquidity without the need for setting aside substantial escrow amounts or facing prolonged negotiations over indemnification provisions. It allows the seller to pursue a clean exit from the business, knowing that unforeseen future claims won't jeopardize their financial security. RWI policy coverage is typically an amount equal to ~10% of the total transaction value and often includes standard exclusions to encourage thorough seller disclosure. Overall, RWI insurance provides peace of mind to sellers, and it has become far more popular in recent years.
In M&A transactions, R&Ws are vital components that help ensure a successful deal. Without R&Ws, the due diligence process would become far more onerous. Buyers would need to attempt to determine the authenticity and accuracy of all provided information, rendering the process slower, more expensive, and more cumbersome. R&Ws serve as both preventative and remedial – helping to identify hidden risks and promoting diligent fact-finding, while also providing an obligation to compensate in the event of a breach.
By understanding the distinctions between the different classifications of R&Ws and considering key factors such as indemnification baskets, indemnification caps, and survival periods, parties can navigate the transaction process with greater confidence and transparency. These legal safeguards enable both buyers and sellers to mitigate risks and build trust in the accuracy of the information exchanged, laying the groundwork for a fruitful post-transaction relationship.