UNDERSTANDING THE IMPLICATIONS:
REPRESENTATIONS, WARRANTIES, AND INDEMNITIES IN M&A DEALS
When a pest control operator decides to sell their business and actually start the process to achieve a signed contract memorializing the transaction, either an Asset Purchase Agreement (“APA”) or Stock Purchase Agreement (“SPA”) will be what is used.
However, long before a seller gets to the closing of an APA or SPA, a buyer will produce a short 5-6 page letter of intent (“LOI”) which is sometimes called a memorandum of understanding (“MOU”). Regardless of what it is called, the document reflects an offer from the buyer and contains material deal points as one would suspect concerning total purchase price, down payment, period of financing, assets included/exclude, liabilities assumed, deliverable net worth requirements, real estate lease terms, employment/consulting terms, customer attrition penalties, restrictive covenants, due diligence coordination, exclusivity periods, expected timing to close, etc.
While the above seems fairly complete to most people not used to doing a deal on a regular basis as is the case for most PCO’s, an LOI will always have a generic paragraph which seems fairly boilerplate and insignificant to a seller just focusing on the major deal points. However, what is covered in the LOI in one paragraph ends up being 10-20 pages in the APA and, more importantly, becomes an area that is hotly negotiated once a buyer concludes due diligence and hands over the first draft of the APA. A new negotiation on these 10-20 pages always ensues in any deal we have ever been involved.
The Transaction is subject to the negotiation, execution and delivery by the Purchaser and the Seller of a mutually agreeable asset purchase agreement (the “APA”) setting forth the terms of the Transaction and providing for (i) usual and customary representations, warranties, indemnities and other standard terms; and (ii) customary conditions to the Purchaser’s obligation to consummate the transactions contemplated therein, including approval of the Transaction by the Board of Directors of Purchaser.
Now ask yourself if you indeed know what “usual and customary means” and what “representations, warranties, covenants and indemnities” mean and the distinction between them in the context of a sale of a business reflected in the APA/SPA, as the case may be.
First of all, let’s explore these three different types of statements:
1. M&A Representation
Representation is an express statement regarding a particular fact or circumstance that serves to influence the consummation of the deal.
Warranty is a guaranty by one party that a particular statement of fact is true.
Covenant is an agreement to do or refrain from doing something prospectively.
Asset Purchase Agreement (“APA”):
Second, with the context of these 3 items that will be contained in the APA, here are the typical topics covered concerning the business that a buyer wants the seller to make representations and warranties about:
- organization and good standing
- authority and enforceability
- capitalization and ownership
- financial statements
- books and records
- accounts receivable and accounts payable
- related-party transactions
- tax matters
- brokers and finders fees
- full disclosure.
- customers and suppliers
- absence of undisclosed liabilities
- absence of certain changes and events
- real property
- intellectual property
- material contracts
- employee benefits
- employment and labor
- environmental, health and safety
- compliance with law
- legal proceedings
- product warranties
- product liability
With the above in mind, a seller now learns what the LOI intended by the phrase “usual and customary” in the context of doing an M&A transaction. Why scare off a seller early in the game? Of course, a seller is free to counter and refuse as many representations and warranties that a buyer asks for (per above example) but then a deal may not get done if a seller thinks they have all the leverage. In real life, the “golden rule” applies as in “he who has the gold rules.”
How long do the representations and warranties survive?
Can a buyer sue for breach 10 years after closing the deal? The survival period becomes another point of negotiation so there is no usual and customary once again. Some buyers want unlimited survival period in which to be able to sue whereas others will accept 2-3 years, while others want the applicable statute of limitations period to control.
From a practical perspective, why does a buyer need all this and how is it used as part of the transaction — is simple. If a seller ends up breaching any of the representations and warranties, then the buyer will sue the seller for breach of contract. In essence, the concept of “buyer beware” is a phrase with no utility in the M&A world and falls on deaf ears.
To make matters worse, after enduring due diligence where the buyer looks at all the above topics and relevant documents, the buyer then asks the seller to create “Disclosure Schedules” supporting each representation and warranty being made by the seller in the APA. Such Schedules will be actual Exhibits and made part of the APA in terms of any information being conveyed.
Not only will it seem like a redundant exercise given the process of due diligence covered the same topics, if something crops up after closing and the Disclosure Schedule did not properly disclose facts about some known and “murky” problem then the buyer’s lawsuit will point out, as proof, that the particular Disclosure Schedule was inadequate and therefore supports the buyer’s breach claim.
As stated earlier, Buyers want to eliminate all risk to the extent they can for as long as they can for any breach of representations and warranties. An indemnification provision, also known as a hold harmless provision, is a clause used in contracts to shift potential costs from one party to the other.
A seller understanding that an indemnification provision is a negotiated clause and there is no “usual and customary” standard because it depends on the sophistication of the seller in understanding the risk posture being forced on them.
Buyers, of course, want unlimited indemnification rights. Conversely, a seller should always seek a maximum limit of indemnification (commonly called a “Cap”) being given to buyer., which Cap may be equal to 30%, 50%, 100% of the purchase price. This ensures the seller can’t go out of pocket for anything in excess of what they received in the deal.
Think about why a Cap is crucial to a seller. For example, if a PCO owner was never going to sell and just keep running its business and then some huge wrongful death came about for $50 million and insurance was $10 million, what would the PCO owner do? They would not write a check for the $40M shortfall but instead just file for bankruptcy and protect their personal assets. So, given this context, why should a seller assume more exposure than they would face not doing a transaction. It is a compelling argument that, when made to a buyer, the buyer usually agrees to some level of Cap.
In addition to the Cap, a seller should also seek to not pay any indemnity claims until the buyer’s losses have reached a certain level (commonly called a “Basket”). Depending on the size of the transaction, it may be $20-$75K which losses the buyer is assuming before getting reimbursed form the seller.
So, in the end, a seller has to be very careful about representations, warranties, and indemnities and the consequences of improperly assuming that “usual and customary” is, in fact, harmless and unimportant clauses.
From a prior deal (out of the industry) we saw a client sell their business for $20 million with a holdback of $2 million to be held in escrow for 2 years to cover contingencies that of course seller had made representations and warranties about and provided Disclosure Schedules describing any potential exceptions. One year after the deal closed, the buyer decided they had overpaid for the company and then alleged breach of a representation about a certain matter set forth in the Disclosure Schedules. The buyer alleged that the disclosure made was vague and not fulsome enough to properly shift the liability for such matter, which surfaced after the transaction was consummated. Of course, the seller wanted to sue to get their $2 million being held by the buyer.
What happened? In the end, the cost and time effort to pursue litigation ended up in seller and buyer agree to split the baby and each gets $1 million. So, the lesson is that representations, warranties, and indemnities are serious risk points as well as Disclosure Schedules that should be thoughtfully prepared and not slapped together last minute before closing the deal as it leaves the door open for a buyer to use same as a weapon.
For the reasons and concerns set forth above, it is advisable that a seller prepare themselves to have a CPA and M&A attorney in your camp (preferably with pest control experience) or hire a PCO business broker that has in house counsel available to assist a seller if they don’t have the necessary resources looking at these specific risks to a seller during the due diligence phase as well as the APA contract stage.
Pest Control M&A Consultants
Daniel S. Gordon CPA
Daniel Gordon brings over 20 years of experience in accounting and managing high growth pest control companies. As an owner, manager, chief financial officer and industry consultant he has been involved with the development of several pest control companies from inception to the $15 million in annual sales levels and beyond.
John Corrigan, JD, CPA, MBA
Merger/Acquisition consultant John is a highly accomplished M&A specialist known for his ability to negotiate and structure both “Buy Side” and “Sell Side” transactions in addition to working with private business owners on internal matters including generational transfers and trust and estate planning strategies.
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