13 Things to Look for In the Seller’s Representations and Warranties.

13 Things to Look for In the Seller’s Representations and Warranties. February 16, 2020
Mergers & Acquisitions representations and warranties

My name is Joe Whitcomb coming to you from Whitcomb Selinsky PC. We are a Denver-based law firm in the South Metro portion of Denver Colorado. It is April 6, 2020, and we are in the throes of the COVID 19 crisis. I am bringing you another episode of Vetbizlawyer podcast and video. Today I'm going to speak to you about representations and warranties which are documents that normally accompany the purchase or sale of a business. For most of today's discussion I'm going to be bringing you items you would be looking for as a buyer in the seller's representations and warranties.

The Company that you as the seller are acquiring is usually referred to as the target company. The representations and warranties are normally presented to you during the course of the transaction but before you actually close on the purchase of the company. The name representations and warranties, does a good job describing what the documents are. Representations are issues that the seller of the Company is informing the buyer about before the purchase. Warranties go farther than that in that they are more akin to a guarantee. Normally, as a buyer, if a seller meaningfully misrepresents a warranty, you would have the option of withdrawing from the purchase or getting a portion of your money refunded by the seller.

Today I'm going to give you a list of elements that you as the buyer would be looking for in those representations and warranties. We will be addressing these issues from a 30,000-foot view.

20200406 13 Reps & Warranties issue

1. Basic representations

 As the buyer, the first thing you will be looking for in the seller's representations and warranties are known as the "basic representations."

Falling under basic representations is the organization. In other words, what is the Company's name and where is it organized?

If we were talking about my law firm Whitcomb, Selinsky, P.C. that would be the legal name of the corporation. The company would be listed as a for-profit corporation and it is organized under the laws of Colorado. This means that the seller has at least gone to the trouble of filing articles of organization with the home state’s Secretary of State's office.

2. Authority 

The second issue to be covered under basic representations is "authority." The question this section answers is “does the seller have the authority to make the transaction?” If so, what corporate governance document gives the individual with whom you are negotiating the right to execute the sale and sign all of the necessary documents?

Again, using the example of Whitcomb, Selinsky, P.C., as a majority shareholder, in theory, I would have the necessary authority to sell the company. However, minority shareholders in my company may also have ownership rights and a vote in the sale of the company. As a buyer, you would want to examine the selling company's bylaws, shareholder agreements, and any other corporate governance documents that could encumber the rights of majority shareholders to sell the company or its assets.

In the future, I intend to produce videos that will detail the difference between an asset purchase and a stock purchase which are the two main categories of sales. However, for today's discussion, we are primarily dealing with a stock purchase and you want to make sure that the individual with whom you are negotiating and who is signing documents has the authority to do so under the laws of the State in which the company is organized and according to the documents that govern the company.

3. No conflict

The third piece of information you want to uncover before moving forward with the sale is that there is no conflict or violation. In doing so, you want to make sure, as the buyer, that the seller has the necessary documentation and that there aren't any other buyers that believe that they have an interest and that the seller owns the shares clear of any other interest.

You will also want to make sure that the seller is not violating any local laws or regulations. For example, if there is a lien against the company's assets, you would want to know about that.

4. Consents and approvals 

In this section of the representations and warranties, you would want to identify written documentation that the company's board of directors has authorized the sale of the company.

If the Company is a for-profit corporation, then you as the buyer want to make sure that the Board has convened, taken a vote, and that the necessary shares required to approve the sale have voted and have signed off on the amount of money that you as the buyer are authorized to spend. As an extreme example, it would do you no good as a buyer if the selling company has authorized the sale of $1 billion and you only have authorization to purchase for $1 million.

You also want to make sure that there has been stockholder approval if the bylaws require this for the sale of the company. The bylaws may state that it is only required that the board inform shareholders or stockholders of the sale. The corporate governance documents may not require a shareholder approval of the purchase. Again, it is important to check bylaws, stock purchase agreements, and shareholder agreements.

Do not assume that because 50% of shares have voted in favor of the purchase that you have satisfied the corporate or legal requirements for the purchase.

This is the place where you may want to involve corporate counsel. Having corporate counsel review the purchase agreement, the target company's bylaws and shareholder agreements, as well as any other corporate government governance documents may help avoid having the sale unwind at closing.

A lawyer might also be able to help you determine that the sale passes muster with state laws.

5. Foreign entities

If you are purchasing a company that is a foreign entity, a company that is organized outside of the United States, then there may be separate legal issues related to the purchase of that company. Our firm always recommends that our clients authorize the engagement of local counsel in the country of organization in order to make sure that you are navigating the foreign country's laws relating to the purchase of the target company. For example, it may not be legal for U.S. based company or residents of the United States to own 100% of the shares of the foreign corporation. Local counsel could help you determine whether your purchase is legal under the country of organization’s laws.

6. Charter documents

In the third major section of the representations and warranties, you will want to be able to review the selling company's corporate documents and organizational structure. The list of those documents includes articles of organization, articles of incorporation, bylaws, shareholder agreements, stock purchase agreements, or any other document or contract that may affect ownership. Some documents that you require will be available on the Secretary of State’s website for the state in which the company is organized. The value in looking at all of these documents is to make sure that there are no other claims to the company that you are attempting to purchase. If we were analogizing this to a home purchase it is similar to ensuring that you are getting a clean title.

7. Subsidiaries

Another issue you will want to check in the representations and warranties relates to the selling company’s subsidiaries. For example, if you are purchasing a parent company you will want to make sure that the seller's written representations and warranties list all subsidiaries to the parent corporation. This is because you could be buying all of the assets or liabilities of those subsidiaries, so you want to make sure that this paragraph is covered and that your subsidiary relationships are disclosed.

8. Books and records

As a buyer, you will also want to make sure that your books and records of your target company are included in the representations and warranties. Most of these items, you should be familiar with. You will want to make sure that you are reviewing the target company's profits and losses and that the representations and warranties you are reading represent and/or warranty that the profit and loss, balance sheet, and general ledger are all accurate at least up to the date that they were created and presented to you. As a buyer, you should consider it your privilege and your right to make sure that you are reviewing both cash and accrual basis profit and loss and any other financial documents you desire on the target company.

9. Security matters

The next item of concern for the target company is security matters. This item has largely to do with companies that are publicly traded, but there are state regulated securities as well as federally regulated securities to consider. You, as the buyer, want to make sure that the seller's representations and warranties demonstrate that the requirements for any securities that are being purchased or sold or legal in the State in which they are purchased. If it is a publicly traded company, then you will want to make sure that all SEC filings are timely and accurate. You will also want the representations and warranties to record for you that those documents have been filed and that they are accurate. Any material misrepresentations related to SEC filings in the representations and warranties could allow you as the buyer some recourse after the close of the sale.

Included in this paragraph in the representations and warranties should be some language related to adequate capitalization. This paragraph may state for example that the purchase of the target company will be executed entirely in cash or include equity in the buying company. This section of the representations and warranties could contain recently filed SEC reports which will help in determining those reports were both timely and accurate and that the filings for the company are up to date.

10. Financial matters

An important section of the seller’s representations and warranties should fall under the heading of financial matters. You will also want to make sure that the section is true, accurate, and up to date. This is the section in which you will want to define what is a "material misrepresentation" and what the recourse is for such a misrepresentation. We will want to make sure than any financial documents that you require to validate the seller's representations and warranties are current and up to date.

One example of a particularly sticky point is the accuracy of the accounts receivable representation. You do not want to purchase a company and learned three months after closing that the selling company had a large number of stale and uncollectible accounts receivable. This is another reason to ask for both a cash basis profit and loss as well as and accrual basis profit and loss. These two reports together show what the companies actual cash flow looks like and how much outstanding receivables the company carries on its books.

There are even reasons under this section to call the company's creditors to make sure that the company has paid or is in the habit of paying its creditors on time. You do not want to inherent a host of bad business relationships soured by years of negligent payment history. Or, if you do inherent such relationships, you will want to do so knowingly.

11. Intellectual property

In the target company's list of assets should be included a list of its intellectual properties. The most obvious of these include patents, but they may also include trademarks, logos, and trade secrets. If the company lists trade secrets on its list of intellectual properties, then you as the buyer will want to see nondisclosure agreements and investigate the pains that the selling company has gone to in protecting those trade secrets.

Of course, reviewing the US patent and trademark offices registered trademarks for the company will be essential, but also reviewing foreign registered trademarks and patents will be equally important if you are paying value for that intellectual property. Many foreign countries require regular updating of patents and trademarks in order to maintain their validity. It would be a good idea to hire an intellectual property firm to investigate the validity of the intellectual property that you are purchasing in order to make sure that it is adequately protected and that you are getting the full value of the IP for which you are paying.

12. Contracts and leases

The seller’s representations and warranties may include contracts and leases on the list of company assets. This list of contracts and leases could include real property as well as machinery. It might also be a good idea to obtain that list of assets to have those assets appraised. You are always within your rights to hire a third-party appraiser to validate the value for which you are paying for these assets. However, if you do hire a third-party appraiser, it is likely that the buyer will be required to pay the cost of that appraisal, unless it is negotiated into the closing costs of the sale. It may be equally important to seek a third-party appraisal of the target company. However, if the company is publicly traded, then there should be a history that will be informative as relates to the value of the stock you are buying.

13. Reputation matters

The last piece of information that you as the buyer will be interested in learning from the representations and warranties is a statement of the target company's reputation. In nearly every negotiated purchase price there is some element of goodwill. You will want to answer the question, "where does the company stand in its reputation within the community and within its industry?"

If, for example you were purchasing a financial services company, what is that company's reputation within the industry. Also, you will want the seller to make a written representation as to that reputation. You may also independently seek out the company's reputation within the community and within the industry. Make sure before doing so that this investigation will not violate any nondisclosure agreements that you may have signed at the beginning of the purchase process.

If the company is part of a regulated industry like lawyers, doctors, or accountants, then you can always look for any sort of disciplinary information, but failing to find any sanctions does not mean that the company's reputation is pristine within the industry. It may be valuable to interview some of the selling company's customers and clients to find out whether those relationships are happy and healthy or whether they are strained.

Conclusion

If you are currently asking yourself, "why go to the trouble of getting all of these representations and warranties in writing?" It may be because your planning on doing a thorough due diligence investigation before closing. However, that process will be time-consuming and expensive. Getting the seller to make meaningful commitments in its representations and warranties, could make the costs of unearthing negative information expensive for the seller.

Put differently, if the seller knows that you have the authority to not only pull out of negotiations but also the authority to charge the seller money for your time and financial investment then it may incentivize a more truthful disclosure from the outset. Also remember, most Letters of Intent come with exclusivity provisions, which means that while you are negotiating the purchase of this company you will be foreclosed from purchasing one of the seller’s competitors. This means you are effectively "out of the market" the entire time you are performing your due diligence on the target company. Of course, the same is true for the seller, but they may not have the same urgency that you do in the transaction. Therefore, a great way to save you time, money, and aggravation is insisting on thorough and accurate representations and warranties covering the above 13 items.

This is all for this week’s Vetbizlawyer video and podcast. I hope that you and yours are safe and secure during this COVID crisis.

 

Tags: Mergers & Acquisitions