As any experienced merger and acquisition (M&A) professional can attest, some deal points get negotiated in virtually every M&A transaction. Sure, every transaction is unique. But M&A transactions are like love songs; as Randy Travis tells us: “Every one is different and every one’s the same.”
An M&A transaction involves the buyer and the seller entering into a purchase agreement. As part of the purchase agreement, the seller will make a series of representations and warranties about the condition of the seller’s company and its assets.
If those representations and warranties are not true, the buyer may make a claim against the seller for a breach of contract. That’s called seeking indemnification. The purchase agreement may limit the buyer’s ability to seek indemnification claims against the seller.
The tension between the buyer’s desire to know exactly what it is buying (and be protected if the seller’s company does not live up to the buyer’s expectations) and the seller’s desire to limit its exposure to post-closing indemnification liability is the source of many of the frequently negotiated deal points.
How long after the closing should the buyer be able to seek indemnification from the seller for an alleged breach of one or more of the seller’s representations or warranties in the purchase agreement? That time period is called the survival period. As you might expect, sellers would like the survival period to be as short as possible (ideally, none). The buyer wants the survival period to be as long as possible.
After the closing, the seller does not want to hear about every tiny issue that the buyer may have with the company. Often, the buyer and seller will agree that the buyer cannot seek indemnification from the seller for an alleged breach of one or more of the seller’s representations or warranties until the buyer’s damages for such breaches exceed an agreed-upon dollar amount. That’s called an indemnification basket.
Similarly, the seller will seek to have the purchase agreement include a limit on the seller’s maximum exposure for potential indemnification claims from the buyer. That is called an indemnification cap.
The buyer may be concerned that the seller will be unwilling or unable to pay indemnification claims after the closing – or that pursuing such an indemnification claim will be prohibitively expensive. If so, the buyer may seek to have the purchase agreement include a provision that the buyer will hold back a portion of the purchase price for a period of time until the buyer confirms that the seller’s representations and warranties were correct. If the seller agrees not to accept all of the purchase price at the closing, the seller might insist that rather than holding back a portion of the purchase price, that amount should instead be delivered to an independent third party that will hold the funds in escrow.
While the buyer will want the seller’s representations and warranties to be as broad and unqualified as possible, the seller will prefer for the seller’s representations and warranties to be qualified so they only apply to matters that are “material” or to matters of which the seller has actual “knowledge.”
What if the buyer knew that the seller’s representations and warranties were not true before the purchase agreement was ever signed or the deal was closed? That’s called “sandbagging.” The seller will seek to include an anti-sandbagging provision in the purchase agreement that provides that the buyer cannot seek indemnification from the seller for representations and warranties that the buyer knew were untrue. The buyer will resist including an anti-sandbagging provision.
There are no right or wrong answers to how any of these issues should be addressed in the purchase agreement – it depends on the relative bargaining power of the buyer and the seller and how willing each side is to fight for its preferred position. Regardless, it is helpful to know the landscape of the issues that will be addressed. And it is helpful to have experience dealing with these issues and with how other buyers and sellers in the market have ultimately reached agreement on these frequently negotiated issues.
Douglas W. Clayton is a corporate and securities partner with the law firm of Cantey Hanger LLP, where he is the chairman of the firm’s Business Transactions Practice Group. He is a graduate of Harvard Law School and Texas Tech University. Clayton focuses his practice on mergers and acquisitions, corporate finance, securities offerings and other business transactions. For more information call 817-877-2890 or visit www.canteyhanger.com or his blog at www.NorthTexasSECLawyer.com.
This article is for information purposes only and is not intended to be legal advice or substitute for consulting an attorney. We recommend that you discuss your particular situation with your attorney when you need legal advice.
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