Representations and Warranties
Representations and warranties serve two functions. They are part of the due diligence process where the private equity buyer looks at all material information about the target’s business; representations and warranties reflect the results of this investigation. They are also the insurance policy that the seller gives the private equity buyer about the truth and accuracy of the business information. The “representations” are assertions that the information furnished is correct and the “warranties” are legal obligations to stand behind the statements financially.
The subject matters of the representations and warranties cover all major facets of a business. Although the representations are worded in absolute terms, in practice the seller creates a schedule of exceptions and attaches them to the purchase agreement. These exceptions contain information about the company’s business and assets that deviate from the standard representations. Accordingly, these exceptions are important to the private equity buyer and their disclosure often provokes further negotiations.
Many representations overlap one another. For example, a representation that the seller has no liabilities other than those disclosed in its financial statements overlaps with the representation that there is no litigation pending against it, since the litigation may be treated as a liability required to be disclosed in the financial statements. Also, some representations are more important than others, such as those involving the seller’s financial statements. Finally, special attention will be devoted to representations in areas of special importance to a seller. For example, a seller with extensive real estate holdings will give representations on these matters that are far more detailed than sellers whose only real estate is rented office space. In the end, the seller must give detailed representations in every area remotely relevant to its business, with special focus on those areas where the seller generates its revenues.
Sometimes, a representation is qualified “to the knowledge” of the seller, meaning that seller is only responsible for a breach if it knew that the representation was false. Because it is difficult to prove whether a company knew a fact or not, the “knowledge” qualification is granted sparingly.
The following outlines the principal representations made by a corporate seller of business assets, the subject matters covered by the representation and a comment on why the representation is included in the purchase agreement.
2.1 Valid and Binding.
| The purchase agreement is a valid and binding agreement of seller, enforceable in accordance with its terms | This confirms that all internal approvals (board of directors and shareholders) have been given for the deal. Seller has no legal defenses to enforceability of the contracts. This representation is typically confirmed through a legal opinion from seller’s attorneys. |
2.2 No Consents.
| No consent or approval is required to be obtained by seller in connection with its execution or performance of the purchase agreement. | This identifies any third party consents that may be necessary to complete the deal. |
2.3 Financial Statements.
| The financial statements of seller identified and furnished to buyer are accurate and complete in all material respects, are consistent with the books and records of seller (which have been maintained in all material respects in accordance with good business practices), have been prepared in accordance with generally accepted accounting principles consistently applied and fairly present in all respects the financial condition and results of operations of seller as of the dates thereof and for the periods covered thereby. | This is the most important representation, as financial statements are the lynch pin of private equity transactions. |
2.4 No Undisclosed Liabilities.
| Seller has no liabilities or obligations except as identified in a schedule, disclosed or reserved against in its latest balance sheet, or incurred in the ordinary course of business consistent with past practice since the date of the latest balance sheet. | This is an important catch-all representation on liabilities. It forces seller to specifically identify any liabilities not properly reflected in its financial statements. |
2.5 Taxes.
| Seller has filed all tax returns required to be filed and has paid all amounts required to be paid on such returns. | This provides specific verification that taxes have been reported and paid. |
2.6 Title to Assets.
| Seller has good, valid and marketable title to its assets; seller owns its real property free and clear of liens; and the assets being conveyed to buyer constitute all of the assets (tangible and intangible) used in connection with the operation of the business as presently operated by seller. | The last part of the representation confirms that seller is transferring all of the assets used in its business, and there are not other assets held by other parties that are used in the business. |
2.7 Intellectual Property.
| Seller owns or has the right to use all of its intellectual property; the transfer of this property will not alter or impair any such rights or require any consent or approval; the intellectual property is subsisting, in full force and effect, has not been canceled, expired, or abandoned, and is valid and enforceable; and seller’s business does not infringe upon, misappropriate or otherwise violate any intellectual property rights owned or controlled by any third party. | Intellectual property is a unique class of assets that gets its own set of representations. Buyer can independently verify the validity of patents and trademarks, but not even seller may know whether its business infringes the intellectual property of others. |
2.8 Contracts.
| None of seller’s contracts are in default and the transactions contemplated by the purchase agreement will not require the consent or approval of any other party to the contracts. | This identifies all of seller’s contracts and certifies that the contracts are enforceable and no consents are required to transfer them. Consents can be time-consuming and expensive to obtain. |
2.9 Employee Plans.
| Seller’s employee benefit, savings, welfare and pension plans comply with law and there are no unfunded pension liabilities. | Benefits have their own federal laws and regulations and it’s customary to break benefit plans out into their own section. |
2.10 Labor Relations.
| Representations about seller’s relations with labor unions and the existence of organized labor activities at seller. | This is the place for seller to identify any union activities at its plants, even if no union has been formally recognized. |
2.11 Litigation.
| There is no litigation pending or, to the best knowledge of seller, threatened against seller or any of its properties. | Pending litigation is easy to identify and has usually been reserved against on the balance sheet. A buyer is interested in learning if any litigation has been threatened, which may not be reflected in the balance sheet. |
2.12 Compliance with Laws.
| Seller has complied with all laws applicable to its business. | The representation is generally easy for the seller to give. Issues can arise where the business operates in a heavily regulated area. |
2.13 Absence of Changes.
| Since the date of the last balance sheet, the business has been conducted in the ordinary course consistent with past practices and there has not been any unusual transaction. | This brings disclosure about the business current since the last balance sheet date and requires the seller to identify any transactions outside the ordinary course since that date. |
2.14 Inventory.
| Seller’s inventory consists of merchandise of a quality and quantity usable and saleable in the ordinary course of business consistent with past practice, except to the extent of normal obsolescence or to the extent written down or reserved against in accordance with GAAP, and is fit for its intended purpose. | This ensures that the quantity and quality of seller’s inventory is acceptable. The representation implies many subjective determinations about obsolescence and GAAP reserve policies that are more art than science. |
2.15 Suppliers.
| Identifies the top suppliers to the business and represents that none of them changed its method of doing business with seller nor indicated that it intends to do so. | Buyer wants to know that it will continue to have a stable source of supply from the key suppliers to the business. |
2.16 Accounts Receivable.
| Seller’s accounts receivable arose in the ordinary course of business, are legal, valid and binding obligations of the respective debtors enforceable in accordance with their terms, are not subject to any counterclaim, set-off or defense and have been accurately and fairly reflected in the latest balance sheet. | This representation is a statement that the receivables are collectible in full at their stated amount subject to any reserves established in the most recent balance sheet. |
2.17 Related Party Transactions.
| No affiliate of seller is, or in the past has been, a party to any transaction or contract with seller or the owner of an interest in any person which is a competitor or supplier of the business. | An important representation that identifies any transactions or relationships that may not be at arm’s-length. |
2.18 Environmental Matters.
| Seller has complied with all environmental laws and has not treated, stored, disposed of, arranged for or permitted the disposal of, transported, handled, released, or exposed any person to, any hazardous substance | Environmental law compliance is typically treated in a separate section, even though it is covered under the representation that seller has complied with all laws. |
2.19 Disclosure.
| All information furnished by seller has been true and correct in all material respects. | This is a catch-all representation saying that the materials and disclosures furnished by seller during due diligence have been accurate in all material respects. |
