By James Forrest and Jeff Wolfe

At the Forrest Firm, one of our central practice areas is advising companies with respect to mergers, acquisitions and divestitures. As a buyer looks to acquire a target company, the process typically begins with drafting and negotiating a letter of intent, which outlines some of the material terms of the transaction, such as the consideration (purchase price), an exclusivity period for negotiation, and agreements on post-closing employment.

After the letter of intent is signed by both parties, the next step is usually drafting and negotiating the definitive asset purchase agreement, stock purchase agreement, or merger agreement (depending on the transaction structure), which we’ll refer to generically in this article as the “Purchase Agreement.” The purpose of the Purchase Agreement is to finalize all of the terms and conditions of the purchase transaction, which should be consistent with the letter of intent but will include important legal considerations not covered in the letter of intent. Whereas letters of intent are typically 1-3 pages long, Purchase Agreements are commonly 50-100 pages long.

One topic that is not typically addressed at the letter of intent stage but is heavily negotiated in the Purchase Agreement is the “representations and warranties.”  The letter of intent will typically stipulate that the seller will make customary representations and warranties to the buyer, and the Purchase Agreement contains the full text and scope of such representations and warranties. Often for a typical Purchase Agreement, the Representations and Warranties can be the largest portion of the document (often15-30 pages themselves!).

By definition, a representation is to assert as fact any circumstance that is true on the date the representation is made to the other party. If there are separate signing and closing dates for a transaction, the representations generally need to be true on both dates. 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 target company and the authority to execute the transaction, as well as affirmations regarding litigation, title to assets, and compliance with laws and tax obligations. Depending on the operations of the target company, the representations may also address intellectual property, customer contracts, human resources, regulatory, and environmental matters.

Below is an example of one particular representation/warranty typically given by sellers:

“Seller is not in violation of any laws, governmental orders, rules or regulations, whether federal, state or local, to which Seller or the Assets are subject. There is no liability or non-compliance with law arising prior to the Effective Date which impacts the Assets or the Business.”

In a nutshell, the representations and warranties give the buyer more comfort to move forward with the transaction because if any of them turn out to be incorrect after the closing, the buyer will have a contractual remedy against the seller in the future. The seller of course desires that the “reps and warranties” be narrower in scope, as this reduces their liability related to the transaction post-closing (i.e., reduces the likelihood they will be sued by the buyer).

Although the seller’s representations are the more critical component of the Purchase Agreement, sellers also generally request that the buyer make a limited set of representations (e.g., the authority to execute the transaction), which are typically reciprocal to the seller’s similar representations.

In addition to determining what types of representations will be included in the Purchase Agreement, another key area of negotiation centers around narrowing the scope of the representations and inserting qualifiers. For instance, a representation may be qualified to the knowledge of the seller or exclude items that would not have a material adverse effect on the target company (i.e., the seller is not in breach of the agreement if the misrepresentation is immaterial). These qualifiers are typically negotiated line by line by counsel for the respective parties.

Here is what the example rep given above may look like with qualifiers:

To the knowledge of Seller, Seller is not in violation of any laws, material governmental orders, rules or regulations, whether federal, state or local, to which Seller or the Assets are subject, except where such violation does not result in a Material Adverse Effect. To the knowledge of Seller, there is no liability or non-compliance with law arising prior to the Effective Date which materially and negatively impacts the Assets or the Business.

If you and your business are gearing up for a sale or purchase, it’s important that you work with legal counsel to determine the appropriate scope of representations and warranties to be included in the Purchase Agreement.