Representations and Warranties and Why They Matter
Representations and Warranties are standard clauses in any purchase agreement for a business or practice. It’s not something the buyer and the seller tend to spend too much time on; until something goes wrong. Once it goes wrong, the conversation quickly turns to hiring an attorney and taking legal action.
Perhaps a little knowledge may help. Bear in mind this article is not about providing legal advice but hopefully avoiding the need to spend money on legal advice. To get legal advice, please consult your attorney.
The capitalist system is built on trust. Not sure this is true? Simply look at what is happening in Europe right now with Greece and whether or not they stay in the European Economic Community. The European leaders are telling Greece to pass laws to implement the changes they are offering or there is no interest in helping them. That is, the European leaders are not trusting that the Greek politicians will do what they said they would do if Europe was to lend Greece billions of dollars.
It’s no different to the quote from President Reagan who said “Trust but verify.”
What is a Representation?
A representation is an inducement to a party entering a contract but does not become part of the contract. It is also normally before any contract. For example, the seller of a business can represent that in the last 12 months of doing business the gross sales were $7,560,000.
The seller will rightly say to the buyer, I cannot guarantee that if you buy my business your gross sales will be $7,560,000 or more as the seller has no way of either predicting the future or how well the buyer will run the business.
The buyer however can ask the seller to provide copies of bank and credit card statements as well as accounting journals to show that $7,560,000 is a correct number.
The gross sales are an important number to the buyer as its encouraging or inducing them to buy the business.
What is a Warranty?
A warranty is a statement of fact contained in the purchase agreement. It is unusual for a purchase agreement to state the seller’s gross sales in the previous 12 months were a certain amount however the purchase agreement may state the buyer will achieve a minimum level of sales. If that then doesn’t happen, the buyer has the right to terminate the contract as well as a claim for damages.
What do Representations and Warranties mean to the seller?
It means the seller should only disclose or represent things they know to be correct. Equally, the seller should disclose things that the buyer will rely upon to make decisions in the future. For example, if the seller knows a piece of equipment is broken but is obsolete and no longer used to generate income for the business; make that disclosure. If the seller knows a piece of equipment is broken but may have some use if the buyer gets it repaired then make that disclosure.
What do Representation and Warranties mean to the buyer?
A buyer is buying a business for its income generating potential. Their interest is to maximize that income and they rely on the sellers disclosures to form their decisions.
Read More: Here is more information about valuing a business.
Disclose, Disclose, Disclose
The simplest and safest path for both buyer and seller is to disclose everything. Yes; the buyer needs to make disclosures about their ability to buy, own and operate the business just as they expect the seller to do the same.
If the sale of a business becomes difficult or highly charged, a lack of disclosure about a representation or warranty can be the trigger for all the frustration to flow into a law suit. This then creates the situation neither the buyer nor seller truly want which is a loss of time, loss of control and a loss of money.
Once again, this article is not designed to provide legal advice. Its purpose is to remind buyers and sellers that their time and money are their most important assets; so make wise decisions on how it is spent.
If you would like more information about selling a business, buying a business, buying a franchise or a related service such as valuing a business, please visit my webpage Services and choose from the drop down menu the information you would like.
For more immediate help, you are welcome to send an email to Andrew Rogerson or give me a call on 916 570-2674.
