Selling Your Small Business Part III- Does it come with a warranty?

By Rudman Winchell Attorney

By: Rudman Winchell attorney Brent A. Singer

 Does It Come With A Warranty?

 [1] In Part I, I discussed some of the most basic, preliminary points about selling a business, namely, “What are you selling?”, and what sorts of documents or records will you need.  In Part II, I discussed issues that arise depending on where the buyer is getting the money to buy the business.

 

            When we go to buy, for example, a new refrigerator that might cost, say, $900, one of the things we almost always want to know is “Does this come with a warranty?”  So why should it be any different if you are, for example,  buying a business that costs, say, $4,000,000?  The answer in many ways is that it’s not different.

            One of the issues, therefore, that comes up in every deal is the issue of “representations and warranties,” namely, what written representations is the seller willing to make about the quality or history of the business, and what warranties is the seller willing to give about the future performance of various aspects of the business?  The associated issue of “indemnity” also always comes up together with this issue of “representations and warranties.”  Although the word “indemnity” can mean other things, in this context it’s usually just a fancy word for the seller’s duty (if any) to pay money to the buyer if there is a breach of a representation or warranty.  Indeed, other than the most basic deal points (such as what, exactly, is being sold, and for how much), the most difficult negotiations over the final form of the binding purchase and sale agreement often involve the types and exact wording of representations and warranties that will be given by the seller, and the amount (or source) of indemnity (i.e., money) available to satisfy claims if there is a valid claim for breach of warranty or misrepresentation after closing.

            The dynamic is simple.  The seller would like to sell the business absolutely “AS IS, WHERE IS,” with no representations or warranties of any kind whatsoever.  That way, after closing, the seller just walks away with the cash and moves to a warmer climate.  The buyer, on the other hand, who is paying, say, $4,000,000, has other ideas.  For example, the buyer wants the seller to at least represent or warrant in writing that the financial statements provided by the seller to the buyer are accurate—or, that there is no, hidden toxic waste dump out back on the land that is being sold as part of the business; or that the seller is transferring good title to all of the business assets; or that the equipment in the manufacturing facility is in good shape and will not need to be replaced this year; or that tax bills have all been paid so that the IRS will not be slapping tax liens on the business property two months after closing; or that no one has recently slipped and broken his neck and threatened to sue the business for $20,000,000; or that that fancy logo that comes with the business isn’t really ripped off from someone else; or so on, and so on, as you can imagine, depending on the type of business and what is important for that business to succeed.

            To the extent the seller can be persuaded to give any warranties, the seller wants them to expire very soon—say, in a month, or a year—and to the extent the seller is making any representations, the seller wants the buyer to have only a limited amount of time after closing to bring a claim for misrepresentation.  That way, at least after a month, or a year, or what have you, the seller knows the seller is off the hook—the warranties and deadlines to bring claims for misrepresentation have all expired.  The buyer, of course, wants the warranties to last forever, and the buyer wants to be able to sue at any time in the future for any misrepresentation.  To close the deal, they need to find a middle ground.

            Another issue is how much the seller has to pay if there is, after closing, a breach of warranty or a valid claim for misrepresentation.  If the seller makes extensive, long lasting, detailed representations and warranties about everything in the business, including, say, a warranty that the business will make a fortune, but agrees to pay no more than $5,000, no matter what, for breach of warranty or misrepresentation, then what good are all those warranties and representations to the buyer?  The seller might as well just write the buyer a check for $5,000 after closing and be done with it.

            On the other hand, if the seller is selling the business for, say, $1,000,000, but might still be liable for, say, $1,500,000, after closing, for a breach of warranty, what good is that, maybe, to the seller?  It is therefore common for there to be a “cap” on the amount of indemnity that the seller has to pay.  Sometimes the cap varies depending on the culpability of the seller.  In other words, the parties might agree that so long as there was no fraud (i.e., no purposeful deceit), the seller’s liability is capped after closing at, say, $100,000.  But if the buyer proves fraud on the part of the seller, the sky is the limit.  Sometimes the caps vary as among the different subject matters of the different types of representations or warranties.

            Also, like in insurance policies, the parties often agree on something like a “deductible” (in this context often referred to as a “basket”), whereby, even if there is a breach of representation or warranty, the buyer still has to “eat it” if such breach results in a minor loss to the buyer.  The purpose of the basket is to avoid the possibility of claim after claim after claim by the buyer after closing for, say, $100, $200, $50, and so forth.  The idea is that if a claim (or set of claims in the aggregate) does not amount to at least, say, $5,000, or whatever the parties agree to, then it is not worth the parties’ time and effort—and especially not worth the time and effort of the seller—having to sort out whether it really is a valid claim.  Otherwise the buyer could “nickel and dime” the seller, and it would cost the seller less money just to pay the claim than to fight about it. 

            Finally, buyers worry about where the money will come from to satisfy valid claims for breach of representations or warranties.  What if in the month after closing, the seller loses all of the purchase price gambling in Las Vegas and goes bankrupt?  What good, then, is a promise to indemnify for up to $500,000 if it turns out there are hazardous wastes buried in the basement?  Or what if the seller is a corporation, and within a month after closing the corporate seller distributes all of the purchase price in cash to the shareholders and the corporate seller becomes an “empty shell”?  What good, then, is a promise by the corporate seller to indemnify the buyer for this or that after closing?  That’s why, sometimes, buyers will try to insist, if the seller is a corporation, that the individual owners of the corporation personally guaranty the continuing obligations of the corporation after closing.  Sometimes the buyer will insist even that the individual owners secure their personal guaranties with mortgages or liens on significant personal assets.  The individual owners, of course, would prefer not to. 

            Sometimes, if the buyer is especially nervous about a potential problem in the not-to-distant future, the buyer will insist that some of the purchase price be put into “escrow” (i.e., held by a neutral third party), for some period of time after closing, just in case, so that if something bad happens, the money will definitely be there to satisfy the claim.  The seller, of course, wants to limit as much as possible any escrow, and be able to “take the money and run,” so to speak.  If there is seller financing, often the buyer will want a clause in the buyer’s promissory note that the buyer can simply offset the buyer’s claims for indemnity against money that would otherwise have to be paid to the seller under the terms of the note.

            I have found, candidly, that except for the exhilaration that some of us feel in the accomplishment of a finely crafted set of representations and warranties, with associated caps, baskets, escrows, or other security for indemnities, the process of negotiating these things is not very enjoyable for the parties.  Sometimes clients look at it, or try to look at it, as so much dust being kicked up by the lawyers, especially when it involves so many hypothetical situations in the future that neither the seller nor the buyer hopes ever happens, much less either wants to think or talk about.  But usually, when the client understands what is at stake, the client will suddenly care very much whether the duration of the warranty is for a month or a year, whether money is put into escrow, and what are the caps and baskets.         

            One moral of this story is that even after the parties seem to have agreed on the purchase price, if a big dispute arises over the scope and limits of representations, warranties, and indemnity, that purchase price can suddenly, depending on the perspective of the buyer or the seller, look too low or too high.  For example, if the buyer is paying $1,000,000, but finds out that the seller is not willing to give any significant written representation or warranty, and not willing to back it up with any real security, that $1,000,000 can suddenly seem too high for the amount of risk being assumed by the buyer.  On the other hand, if the seller if being pushed around with respect to these issues, and having to continue to have significant exposure after closing, the purchase price begins to look too low to the seller.

            In the best of all possible worlds, together with the other things I discussed in the first two parts of this series, a seller will also give some thought ahead of time about what sorts of representations and warranties the seller is willing to give at closing.  To the extent neither the buyer nor the seller is surprised when these issues come up for discussion, the deal will go far smoother.    

           

[1] In Part I, I discussed some of the most basic, preliminary points about selling a business, namely, “What are you selling?”, and what sorts of documents or records will you need.  In Part II, I discussed issues that arise depending on where the buyer is getting the money to buy the business.

Disclaimer


These materials have been prepared by Rudman Winchell for educational purposes only. They should not be considered legal advice. The transmission of this information to you is not intended to create a lawyer-client relationship. Readers should not act upon this information without seeking professional counsel. You should not send any confidential or private information to Rudman Winchell until a formal attorney-client relationship has been established, in writing.