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The Game of Risk (Allocation)

According to Benjamin Graham in his book, The Intelligent Investor, "Successful investing is about managing risk, not avoiding it." This same concept holds true and can be applied to transactions involving the purchase or sale of a small to medium sized business. Even with unlimited resources to conduct due diligence, there will always be risk for both the buyer and the seller in any business transaction. One of the most significant sources of risk in a business transaction is the risk of the unknown: in all cases, the buyer or seller "does not know what he or she doesn't know".

Allocating Risk in the Purchase or Sale of a Business

The risk associated with a business transaction is allocated between the parties within the negotiated purchase agreement. The risk allocation is primarily managed through representations and warranties which are standard components of all transaction purchase agreements. The terms "representation" and "warranty" are often used together.

A representation is an assertion as to a fact, true on the date the representation is made, that is given to induce another party to enter into a contract or take some other action. If a representation is not true, it is inaccurate.

A warranty is a promise of indemnity (legal or monetary protection) if the assertion in a representation is false. If a warranty is not true it is breached.[1]

The parties to a business transaction are agreeing to enter into the transaction based on the representations and warranties made by the other party. If a representation is false and the relying party suffers damages because of the falsehood, the damaged party can seek relief based on the warranty given with the false representation.

Types of Representations

Representations are generally categorized in two groups. Fundamental representations are ones that are so essential that a party would likely not enter into a transaction if they were not true. Examples of fundamental representations include; (i) a seller's unencumbered ownership of the business that is being sold, (ii) each party has the authority to enter into the transaction that is being contemplated, and (iii) all taxes for the entity being sold have been properly accounted for and filed with the applicable taxing authority. Non-Fundamental representations, while important, may not necessarily lead to a termination of the transaction, but may impact the purchase price a buyer is willing to pay. Examples of non-fundamental representations include; (i) all accounts receivable and inventory on the balance sheet of the business are accurate and have been acquired in the ordinary course of business, (ii) there are no lawsuits pending against a party and (iii) there are no known environmental conditions existing on the property of the business being sold.

Survival of Representations

The amount of time that a party is obligated to warrant a representation is negotiated in the purchase agreement. It is not uncommon for fundamental representations to be warranted for their applicable statute of limitation. Non-fundamental representations generally survive for a period of one to three years depending on the character of the representation. A party making a representation is generally not liable to the damaged party in the event that the claim for damages arising from a false representation is made after the applicable survival period.

Capping the Amount of Warranty Claims

The amount of monetary indemnification that a party can seek in the event of damages arising from a false representation is negotiated in the purchase agreement. While the amounts will vary, it is not uncommon that the cap on damages arising from a false fundamental representation would be the purchase price of the transaction. Claims for damages arising from a false non-fundamental representation may be capped at a value between 5% and 30% (or higher) of the purchase price, depending on the risk associated with any particular non-fundamental representation. In some transactions, claims for indemnification are subject to a basket amount (or deductible amount in insurance parlance). A party cannot seek monetary indemnification against the other party until the amount of damages exceeds the basket. The basket is a negotiated amount.

Summary

All transactions involving the sale of a business include some level of risk for both the buyer and the seller. The negotiation of representations and warranties is a critical component in allocating inherent risk in a business transaction among the parties.

This information should not be considered a comprehensive discussion of transactional representations and warranties, legal advice, or all that parties should consider in a business sale and purchase. Should you wish to discuss selling or purchasing a business and its implications, contact an attorney who can provide guidance tailored to your specific situation.


[1] Westlaw Practical Law - Glossary of Terms

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