What are Representations and Warranties?
Representations and Warranties are standard clauses in any business or practice purchase agreement. 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 that this article is not to provide legal advice, but rather to help you avoid 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 consider whether they will remain in the European Economic Community. European leaders are telling Greece to pass laws to implement the changes they are offering, or there will be 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 were to lend Greece billions of dollars.
It’s no different from 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 it does not become part of the contract. It is also typically before any contract. For example, the seller of a business can represent that, in the last 12 months of operation, 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 request that the seller provide copies of bank and credit card statements, as well as accounting journals, to verify that $7,560,000 is the correct amount.
The gross sales are a crucial number for the buyer, as they encourage or induce them to purchase the business.
What is a Warranty?
A warranty is a statement of fact. It is typically 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 doesn’t happen, the buyer has the right to terminate the contract and may also claim 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 generates income for the business, make that disclosure. If the seller knows a piece of equipment is broken but may still be usable if the buyer repairs it, then make that disclosure.
What do Representation and Warranties mean to the buyer?
A buyer is purchasing a business for its potential to generate income. Their interest is to maximize that income, and they rely on the seller’s 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 all relevant information. 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.
Suppose the sale of a business becomes complex or contentious. In that case, a lack of disclosure about a representation or warranty can be the trigger that escalates all the frustration into a lawsuit. This then creates a situation that neither the buyer nor the seller truly wants, resulting in a loss of time, control, and money.
Once again, the purpose of this article is not to provide legal advice. Its purpose is to remind buyers and sellers that their time and money are their most valuable assets, so they should make wise decisions on how they are 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 the information you need from the drop-down menu.
For more immediate assistance, you are welcome to send an email to Andrew Rogerson or call me at 916 570-2674.