Classification: Moderately Material
Section: Representations and Warranties of Seller
Negotiation Time: Minimal
Transaction Costs: Insignificant
Major Impact: Risk Management
What is This? The Representations and Warranties of Seller portion of the Agreement is used to save the Buyer time and money. Rather than require the Buyer to go through third parties to find certain information, the Seller provides the information and must reimburse the Buyer for any Losses it suffers if the information is false or misleading. Here, the Seller provides information regarding the financial statements of the Business.
The Middle Ground: The Seller represents that it has provided the Buyer with Financial Statements (i.e. Balance Sheet, Income Statement, etc.) for a specified number of years and for the most recently ended fiscal quarter (the latter being referred to as the “Interim Financial Statements”). The Seller also typically represents how the Financial Statements were prepared (e.g. based on GAAP), that they are based on the books and records of the Business, and they fairly reflect the Business’s financial performance.
Purpose: The purpose of the Financial Statements representation is to confirm that the Financial Statements delivered to the Buyer are, in fact, representative of the Business. This representation could rightly be described as either a deal driver or a moderately material term, the difference being a result of whether the inaccuracy in the Financial Statements is intentional or unintentional. Unintentional inaccuracies that constitute a breach of this representation are certainly undesirable, but they generally have no more than a moderate impact on the value of the deal (otherwise, they would’ve been flagged internally by the Seller). Intentional inaccuracies tend to be larger, thereby influencing deal value to a greater degree. The more troubling result of intentional inaccuracies is that they decimate trust between the parties, and at that point most buyers will walk away from the deal. Thankfully, unintentional inaccuracies are the much more common variety.
Buyer Preference: In the event that the Seller’s Financial Statements are not prepared in accordance with GAAP, the Buyer wants to see an explanation of the Business’s accounting policies and procedures, and will likely conduct a more rigorous due diligence review of the Business’s financial information. A more aggressive Buyer will resist a materiality qualifier as part of the representation that the Financial Statements fairly depict the financial condition of the business, and may seek to include language indicating that the statements are “true, complete, and correct.” A cautious Buyer may also request the Seller’s tax returns in order to confirm the accuracy of the internally-prepared company financials.
Seller Preference: The Seller will want to include a materiality qualifier and/or a “GAAP qualifier” that simply states that the Financial Statements were prepared in accordance with GAAP. Most sellers will settle for one qualifier or the other, but some may seek to include both if they want to rely on GAAP assumptions and are worried about minor inaccuracies or omissions.
Differences in a Stock Sale Transaction Structure: None.
We want The Middle Ground to be an ongoing dialogue for and resource to the lower middle market M&A community. The outline above is generally applicable, but there is always specific case law and nuance around certain industries that can be useful in helping buyers and sellers come together. If you are a lawyer or deal professional, we encourage you to add your perspective below.