How to Buy a Small Business: What are Reps and Warranties in Closing a Deal

Buying a small business involves engaging with legal concepts like Reps and Warranties, which may be unfamiliar to most people. The purpose of this article is to shine a light on these integral concepts, particularly Representations and Warranties (Reps and Warranties, or R&Ws), which play an essential role near the end of the acquisition process, including during the closing of the deal.

R&Ws are formal statements or promises made by the seller to the buyer about the status of the business. “Representations” offer a snapshot of the business’s condition at the moment of closing the deal, while “Warranties” are forward-looking promises, safeguarding the buyer against potential post-acquisition issues.

Together, they form a safety net, ensuring that the buyer has a clear, accurate picture of the business they are buying. This article will help you understand the full importance of Reps and Warranties in the SMB acquisition process, including relevant information about R&W Insurance.

When do Reps and Warranties Come into Play

Reps and Warranties are integral during the negotiation of the purchase agreement, the final document governing the sale of the business. Reps and Warranties can include statements about:

  • The condition of the business’s assets
  • Its financial health
  • Its legal standing

These are vital assertions and assumptions upon which the purchase of the business relies.

Types of Representations in an SMB Purchase Agreement:

  • Fundamental Representations: Basic assurances about the seller’s legitimate ownership of assets and their authority to enter into the agreement.
  • Non-fundamental Representations: These may relate to various operational aspects of the business and despite their name, can still be significant.

Reps and Warranties play an important role at two stages of the acquisition process:

  • During the Pre-Closing Period: Between the agreement’s signing and transaction’s closing, R&Ws enable a buyer to reassess or withdraw from closing the deal if inaccuracies or breaches are discovered.
  • In the Post-Closure Phase: Reps and Warranties transition into a safety mechanism for the buyer, allowing them to seek compensatory damages from the seller if a misrepresentation or unfulfilled promise is found.

However, these protections are not everlasting. A “survival period” determines how long after closing a deal the buyer can lodge a claim about any breaches.

Understanding Indemnification

In cases of a breach in Reps and Warranties, the seller is typically required to indemnify the buyer, effectively bearing the financial burden of the breach. These situations could range from pending lawsuits based on pre-acquisition actions to unexpected tax liabilities from past missteps.

The indemnification clause also sets the groundwork for how a buyer can claim damages and outlines the dispute resolution mechanism. A common practice is to retain a percentage of the purchase price in an escrow account for a specified duration to offset potential breaches. This escrow amount is generally released after the survival period for non-fundamental Reps concludes.

The indemnification cap is also important in this context. It determines the maximum amount that a buyer can claim from the seller in the event of a breach. For instance, should a breach result in $750K of damages but the indemnification cap is set at $500K, the buyer can only seek compensation up to the cap limit.

To protect the seller from small claims related to normal business activity, reps and warranties typically include a deductible mechanism. A standard deductible ranges from 0.5% to 1.0% of the purchase price. Claims below this amount are the responsibility of the buyer. Sellers may employ a “tipping basket” at the higher end or a simple deductible at the lower end. Additionally, sellers might include a “de minimis” basket, which acts as a per-claim deductible. 

The Role of Legal Professionals in Crafting R&Ws

Reps and Warranties are more complex with larger and more complex business acquisitions. Experienced attorneys are invaluable in creating efficient R&Ws, as they can strike a balance between necessary protections and not overwhelming the seller. Their expertise helps manage complexities, survival periods, and indemnification provisions, like caps and baskets, providing buyers with confidence in the acquisition process.

When it comes to fundamental Reps, which include key aspects like rightful business ownership, buyers should advocate for an indemnification cap equivalent to the purchase price. This measure provides a safeguard for buyers, ensuring their right to claim full compensation in the event of significant misrepresentation. However, non-fundamental Reps can provide a greater level of flexibility. This is particularly useful since proving extensive damages from these breaches can be a challenging and complex process.

When buying a small business, the caps for non-fundamental Reps tend to range between 10-30% of the purchase price. This is a deliberate move to prevent disputes over minor damages, with a deductible usually included to discourage frivolous claims. To further incentivize sellers and streamline the transaction process, buyers often make their bids more attractive by offering to cover the costs of Reps and Warranties Insurance (RWI).

These suggestions are based on research on common elements of small business deals. For your own deal, we strongly recommend consulting a qualified attorney to support the crafting of your purchase agreement, reps and warranties, and any other legal documents. 

Reps and Warranties Insurance in SMB Acquisition

Reps and Warranties Insurance (RWI) is becoming increasingly common in small business M&A transactions. It brings a new dynamic to business acquisitions by reducing the need for escrow accounts and decreasing risks and liabilities for all parties involved. Employed by both buyers and sellers, RWI serves to reduce risks and provide additional coverage, thereby smoothing the post-sale transition.

Insurance can be particularly useful in more complex acquisitions where potential liabilities are more varied and numerous. The cost and beneficiary of the RWI policy are details to be negotiated as part of the deal. While the seller might bear the cost, it is usually recommended that the policy be issued to the buyer to protect against potential fraud from the seller’s side.

Though beneficial, RWI is not a panacea, as it doesn’t cover all potential claims: certain employee, healthcare matters, and specific tax claims are generally excluded.

The Importance of Tailored R&Ws and Their Role in Closing a Deal

Reps and Warranties are more than just contractual obligations. They are strategic tools for risk allocation, serving as the safety net in buying a small business. When carefully crafted, they offer substantial protection for both parties, ensuring a smooth transaction process and successful post-acquisition integration. Tailoring Reps and Warranties to your specific deal, aided by professional legal guidance and the right insurance, is vital for a seamless acquisition process. From understanding the importance of Reps and Warranties to leveraging insurance in SMB acquisitions, these insights pave the way to a well-informed buying decision.

Submit your response

Your email address will not be published. Required fields are marked *