Selling your business can have significant consequences, both monetarily and emotionally. Your transaction will involve the signing of a purchase agreement that will usually be drafted by the buyer, in the buyer’s favor. As a seller, you might intuit that the most important terms in the purchase agreement are those that specify what combination of cash, assets, equity, debt, or other compensation (known, collectively, as the purchase price or the seller’s consideration) you will be receiving at the closing of the sale.
However, one must always keep in mind that the remaining terms of any well-drafted purchase agreement submitted by the buyer are purposefully designed to chip away at the purchase price in a variety of ways. Primary among these terms are the indemnification provisions, which work hand-in-hand with the section of the purchase agreement dealing with the seller’s representations and warranties. This article will advise you on how to minimize your risks of having your purchase price lowered or having any portion of it returned to the purchaser in any way.
The seller’s representations and warranties (reps) are a series of declarative statements made by the seller in a purchase agreement. Note that (depending on the terms of the agreement negotiated between the parties) references to “the seller” in a purchase agreement can refer to the company; the company’s board, management, employees, or other representatives; the company’s equityholders; or any combination of the foregoing. You should think about reps as analogous to your raising your right hand (as the seller) and pledging under oath that certain statements you’ll be making about the business are completely true and correct. For example, here is a simplified version of a standard rep that would appear in a purchase agreement regarding the company’s litigation issues:
Section 2.10. Litigation. There are no criminal, civil, or regulatory claims or orders (collectively, “Claims”) involving the Seller relating to the Business. Except as set forth on Schedule 2.10 hereto, there is no Claim relating to the Business threatened against the Seller, nor is there any reasonable basis therefor.
You, and all the managers who would have relevant knowledge regarding any specific reps, should read all the reps extremely carefully so that the seller (however defined) is 100% certain of their accuracy. The reason for this is that the purchase agreement’s indemnification provisions will provide penalties for any misstatements in the reps. These penalties typically involve reimbursements of all or portion of the purchase price, which you will clearly want to avoid. In the sample litigation rep above, the buyer is seeking a factual, comprehensive assessment of any threatened or pending litigation to which the company is or may be subject, because these matters could become the buyer’s continuing liability following the acquisition. The purpose of the indemnification provisions (as discussed below) is to provide ways for the buyer to mitigate these potential risks.
Sometimes reps can be worded broadly enough or require such conjecture that the seller is not able to confirm the statement with absolute certainty. In these cases, you should make every effort to insert language that softens the rep enough so that you can confidently make the statement. One way to accomplish this is with the use of a materiality qualifier. By adding the phrase “material” or “in all material respects,” then the rep will only apply to statements that have a relevant effect on the business. Another approach is to qualify certain representations with the “knowledge” of the seller, which puts the burden of the purchaser to prove that the seller actually knew the applicable rep to be inaccurate.
In addition, you can also add the phrase “other than in the ordinary course” to make certain reps generally true with respect to the way that the company conducts its business on a daily basis. For example, if a rep were to ask the seller of a grocery store to list all inspection violations, then adding ordinary course language would remove the burden of listing minor infractions and instead limit the seller’s disclosure to that one time when an inspection resulted in the store shutting down for a whole week until the violations had been remedied.
Another tool for making sure that your reps are 100% true and accurate is to list any exceptions on a corresponding schedule to the purchase agreement. Using the litigation rep above, if there were any threatened or outstanding Claims that would make the representation untrue, then you could fix that inconsistency by listing those Claims on Schedule 2.10. To be clear, any given rep from the seller, when read as a whole (including whatever is listed on the schedule) should be 100% factual. This simple rule will limit any future indemnification claims by the buyer against the seller.
In a word, indemnification is payback. If the seller provides either a false, misleading, or incomplete statement in the reps that results in a liability for the buyer, then the indemnification provisions govern how the buyer is to be made whole. This puts your purchase price at risk. The last thing that a seller wants to worry about after celebrating a successful closing is that any portion of the consideration might have to be forfeited to the buyer at some point in the future.
Indemnification can be structured in various ways. The simplest way is for the purchase agreement to provide that the seller must repay any losses suffered by the buyer as a result of any inaccuracies in the reps within a certain number of days after the seller receives an indemnification notice. A more common approach is to stipulate that the buyer will not seek any indemnification from the seller until the aggregate dollar amount of indemnification claims exceeds a certain threshold called the “hurdle” or the “basket” (for example, the basket could be $100,000). Once the basket has been exceeded, the parties can further agree that any indemnification payments to the buyer will either include the dollar amount of the basket (called a tipping basket) or exclude that dollar amount (called a deductible). Also, the parties can agree to an upper limit on the aggregate dollar amount of indemnification claims that the buyer can make (called a cap). Including a cap in the purchase agreement limits the seller’s exposure and allows the seller to calculate how much of the purchase price is safe from forfeiture.
The parties also have the option of setting up an escrow to cover potential indemnification claims. The escrow would be made up of consideration otherwise payable to the seller, subject to any indemnification claims, and based on distribution terms to be agreed upon by the parties. For additional information on how escrows work, see Using an Escrow to Solve Your Business's Payment Dilemmas.
In the purchase agreement, the parties will also have to state a time period for which the buyer is permitted to bring indemnification claims. This could either be a set number of years, or could vary based on the representation or warranty invoked. For example, you could legitimately argue that the seller should only be exposed to indemnification claims relating to the litigation rep for up to two years after the closing. However, a buyer could reasonably contend that it should forever be able to bring indemnification claims for any breaches of the seller’s reps regarding the company’s formation, good standing, ownership, or authorized officers because of their critical importance to the legitimacy of the transaction.