Trends for M&A Warranties and Indemnities
In this video, third in our M&A Deconstructed series 3, Justin Levine and Nick Davies discuss further the current trends of warranties and indemnities (W&I) in the context of M&A transactions. They recap that warranties are statements of fact given by a seller to a buyer to provide reassurance about certain matters affecting the company being sold. Warranties are typically found in the share sale and purchase agreement (SPA) and are heavily negotiated. Warranties can also be given as representations, which provide the buyer with additional remedies if the warranty is untrue or misleading. Indemnities, on the other hand, are specific obligations to compensate the buyer for identified risks, such as tax claims or issues.
Nick and Justin emphasise the importance of sellers conducting pre-sale due diligence to address any issues upfront which not only mitigates the need for warranties and indemnities but minimises risks of an aborted sale. They also discuss the limited occurrence of warranty claims and the potential use of warranty and indemnity insurance. Overall, they stress the need for sellers to have knowledgeable and experienced support.
Take a look at this in-depth discussion in the video:
Quick find timeline:
00:00 – Introduction: Trends for M&A Warranties and Indemnities (W&I)
00:13 – What are warranties in M&A?
01:09 – Examples of M&A Warranties
01:23 – Where are warranties found?
01:57 – What are Representations in M&A?
02:17 – Recession as a remedy for misrepresentation
02:58 – Buyer trends UK vs US
03:10 – What are Indemnities?
03:20 – How Indemnities are triggered
03:56 – Disclosure impact on warranties / indemnities
04:46 – Why a seller has to give warranties & indemnities
06:46 – Typical Indemnities
07:43 – Claims for warranties and indemnities
09:10 – What are de minimus claims?
10:00 – Limitations, negotiations, challenges and court
11:08 – What can a seller do up front?
11:47 – Mitigating warranties and indemnities
12:43 – Expectation of numbers of warranties in an SPA
13:14 – How early should sellers consider potential due diligence questions?
13:47 – Typical due diligence questions
14:35 – Get match fit for an exit
15:08 – Are indemnities time limited?
15:19 – Timescale for warranties
15:54 – Likelihood for W&I claims
16:31 – Data from W&I insurance companies
16:42 – Accounts warranties most frequent claim
17:17 – Other frequent warranty claims include material contracts
18:08 – W&I insurance
20:23 – Summary W&I trends
22:17 – Cost known upfront vs unknown exposure
23:10 – Customer due diligence trend
Series 3 – Topics
- Pre-Sale Due Diligence in M&A transactions
- Property in M&A transactions
- Trends for M&A Warranties and Indemnities
- Looking to Sell Your Business – Where to Start
In case you missed our first two series you can watch the videos on catch up below:
Series 1 – Topics
Discussions to learn M&A basics in our first introductory series of videos, include:
- Introduction to the M&A Deconstructed series of videos
- What is EBITDA?
- What are Heads of Terms?
- Equity Share vs Asset Sale
- Completion Accounts vs Locked Box
- What is Due Diligence (DD)?
Series 2 – Topics
The conversations in the second more technical series of videos include:
- What is a Sales & Purchase Agreement (SPA)?
- M&A Warranties, Representations & Indemnities
- Getting Paid: Earn-Outs, Deferred Payments & Vendor Loans
- What could Derail a Company Sale?
- How much does it Cost to Sell a Company?
- 5 Insider Tips: A Successful Company Sale
Meet your M&A experts
Nick Davies, Partner | M&A Solicitor, Steele Raymond LLP Solicitors
Nick acts for a wide range of business clients across various sectors, advising on complex corporate transactions including company sales, purchases and mergers. Nick also advises on on mergers, de-mergers and re-organisation.
Justin Levine – Managing Director, TheNonExec M&A Boutique
Justin leads a boutique exit advisory firm specialising in manufacturing, technology, IT, digital, healthcare, wholesale and distribution markets. With the support of a 15-strong virtual team of analysts and researchers, he helps private business owners with growth and exit strategies.
CONTACTS:
TheNonExec Limited
Contact us here to chat about your business exit.
Steele Raymond LLP
Richmond Point, 43 Richmond Hill, Bournemouth, BH2 6LR
steeleraymond.co.uk
Transcript for video: Trends for M&A Warranties and Indemnities
Introducing Trends for M&A Warranties and Indemnities (W&I)
Justin Levine:
So Nick
Nick Davies:
Morning
Justin Levine:
Welcome to series three.
Nick Davies:
Thank you very much.
Justin Levine:
Yeah. Today is the topic of warranties and indemnities.
Nick Davies:
Indeed.
What are warranties in M&A?
Justin Levine:
So a phrase that most people, one of those words, people are familiar with warranty. So you go buy your mobile phone, it comes with a warranty. So there’s something that people are familiar with, but of course it means very little to an M&A transaction. Indemnities is probably a new phrase, but with my clients, very rarely do they have an idea of what warranties and indemnities are. So perhaps just a quick recap from the beginning of what are warranties and indemnities and when do they happen when a company’s being sold?
Nick Davies:
Yeah, sure. So warranties in this context, in the context of M&A transactions are statements of fact, which are given by a seller or sellers to a buyer to give the buyer comfort and reassurance about certain matters affecting the company being sold.
Examples of M&A Warranties
So an example might be employment and a warranty might say there are no employment claims. One might be litigation, and it might say there is no litigation in the company. So those are two examples of very simple warranties.
Where are warranties found?
Where are those warranties found? They’re found in the share sale and purchase agreement, which is typically drafted by the buyer’s legal team. It’s heavily negotiated. The warranties themselves are negotiated, but they will form a considerable schedule in that document. There are variations on warranties because we often hear warranties also being described as representations, which is unhelpful because there’s then a further layer of terminology, and you’ve also mentioned indemnities.
What are Representations in M&A?
Representations, if warranties are also given as representations, they give a buyer a further range of remedies in the event that the warranty and representation proves to be untrue, inaccurate, or misleading.
Recession as a remedy for misrepresentation
And what that means is that as well as a traditional claim for damages for breach of warranty, if the warranty is also a representation, then the buyer may be able to say, you misrepresented the position to me, and therefore I have a wider range of remedies, one of which can include rescission. And rescission will mean undoing the contract and taking you back to the position as if the contract that in this case, the share sale and purchase agreement had never been signed. So that’s quite an important distinction to make. Typically, in the UK, sellers would resist giving warranties as representations, and that’s I would say, a fairly well accepted market position. All the solicitors watching this who act for buyers will disagree and say, well, no, of course we always want representations as well, but that’s my own experience.
Buyer trends UK vs US
Where you’re dealing with US buyers, they will typically want representations as well. And in my experience, that’s more common. So there are some geographical differences in terms of what’s common.
What are Indemnities?
Indemnities are different. Again, indemnities are typically for specific risks which have been identified in due diligence. So let’s say for example, there is a tax claim or issue ongoing in a target company, the buyer will say, we know that you are potentially on the hook here for a hundred thousand pound tax fine. Therefore, we want a specific indemnity which says, in the event that HMRC say X, Y, and Z, you will pay us the cost of that fine.
How Indemnities are triggered
And that really is a pound for pound adjustment to the price, because if the indemnity is triggered, the seller pays or should pay, or has to pay that amount of money to the buyer.
Disclosure impact on warranties / indemnities
Uou can’t typically disclose against indemnities. Whereas with warranties, you have an opportunity to prepare a disclosure letter. So if we look back at my example where I said there are no employment claims in the company, a valid disclosure might be Mrs. Goggins is bringing a claim against the company for age discrimination. So if that were a scenario that were happening in the company, the sellers could reduce and manage their risk by setting that out in the disclosure letter.
Justin Levine:
Yeah, thanks Nick. I’m thinking, so we talked with Shaun Guppy a little earlier about pre-sale due diligence. We have a separate video on due diligence. So of course is that when a buyer has finished or largely finished the due diligence, the Sale and purchase agreement, the SPA is constructed, it contains the warranties and indemnities
Why a seller has to give warranties & indemnities
I’m thinking like a seller, I’m thinking like an obstreperous seller that sits here and says, listen, my business has been examined to death. You’ve had teams and teams and teams of people doing financial, tax, legal due diligence for months. I’ve given you everything and more. Why do I have to have warranties and indemnities? Surely you’ve seen everything. Why do I have to sign up to something else?
Nick Davies:
Well, I suppose the buyer’s argument is, you’ve shown us what you’ve shown us, we don’t know what you haven’t shown us. So the warranties are a layer of protection for the buyer, such to encourage, I suppose, the seller to be full and frank in the disclosure process. If a seller is not full and frank and they sign up to certain warranties, they are taking on more risk as a seller than would be sensible for them to do. So, the warranties are there as those statements of fact to the buyer, to induce the buyer to enter into the contract in reliance on what the warranties say. So yes, you have due diligence, and that’s one step in the process in terms of flushing out information, allowing the buyer to undertake a full analysis of that information. A well constructed SPA should follow the due diligence in that the warranties, and more specifically the indemnities should be designed depending on what the due diligence has said.
If the due diligence has gone swimmingly and it’s a squeaky clean, shiny company, there may not be any indemnities, and the warranties may be more proportionate. If a buyer says, we haven’t been able to get the information from you that we’ve asked, we don’t really know what’s going on with A, B, and C, we want all the warranties under the sun, and we want specific indemnities in respect of A, B, C, D, and E.
Typical Indemnities
And you might see there’s some fairly typical indemnities that come up quite often. There are often indemnities around calculation of holiday pay because a target business may not have done that in a certain way, which the revenue are now hot on. We are seeing indemnities more regularly for companies that do a lot of R&D claims because HMRC are having a real focus on R&D claims at the moment. If we’ve got a company which had some enormous CGRS or furlough claims years ago, and the buyer thinks there’s a vulnerability in respect of some of those claims, you might see an indemnity and respect of that. That’s probably falling away now as we’re moving quite far on from furlough, but certainly post pandemic, that was very topical. Yeah.
Claims for warranties and indemnities
Justin Levine:
Yeah, so I think from my side, a layman’s perspective, a warranty is a statement of fact about the business, and if downstream the buyer acquires the company and finds out the statement of fact is incorrect, it has to basically go to court, I think to actually challenge whether it was right or wrong. In other words, if it wants to make a claim to saying you said this was a fact, it turns out to be untrue, then it has to have some legal remedy as it were to go and basically potentially recover its monies. Whereas an indemnity is simply a pound for pound, there’s an immediate compensation for a known issue if it crops up, have I understood that correctly?
Nick Davies:
You have, yeah. The indemnity is an immediate obligation on the seller to make good that loss. If it’s crystallised the loss and it can be evidence that it’s crystallised, then the indemnity will require the seller to pay that amount. The seller can of course resist that, and there may be some litigation or mediation or whatever else depending on the sums involved. But that is the mechanism that you’ve described. For warranties, what the SPA will typically say is in the main body of the agreement, the warranties are true, accurate, not misleading as at the date of this agreement. So if a buyer can subsequently that the warranty was untrue, inaccurate, or misleading, they may have the basis for a claim.
What are de minimus claims?
A well-constructed share sale and purchase agreement will contain some limitations on liabilities for sellers. And that is to say that certain claims, we call them de minimus.
Let’s say a claim is, I dunno, there’s been a breach of warranty and the loss is 50 pounds on a transaction of 10 million pounds, a seller is going to say, come on, you’ve got to take that on the chin. It’s not material as well as the day minimus threshold. We have what we call a basket threshold, and that’s that you have to have so many claims which are qualifying for day minimis, get into the basket, tip the basket over before you can bring those claims.
Limitations, negotiations, challenges and court
There are lots of other limitations. A buyer shouldn’t be able to have double recovery if they’ve already recovered under an indemnity. They can’t also recover under a warranty. They shouldn’t be able to recover for anything that’s detailed in the accounts, anything which is detailed in the management accounts, anything in the disclosure letter, changes of law and so on.
So there’s lots of limitations available, and these are negotiated, but a seller is trying to achieve as many of those as possible. But in terms of if a buyer brings that claim, it’s not sort of bring the claim off into court. It’s particularise the claim, set it out, send it to the sellers, the sellers will look at it and they may say, yeah, actually you’ve got a bang to rights there and will send you the check. More likely, I suspect is the seller would challenge it and say, well, actually you’ve either misunderstood that or there’s some other reason, or actually we did tell you that it was disclosed. And so you will have some negotiation on the claim that may develop into some mediation if the parties don’t agree, and there may be a mechanism for that in the share sale and purchase agreement. If you go through that process and ultimately people can’t agree the time of day, then it’s going to reach a point where the buyer is going to issue the claim at the court, and at that point you enter the court process and the outcome will be the outcome.
What can a seller do up front?
Justin Levine:
So hopefully it doesn’t happen. We’ll come to how often this happens, but we’ll just park that question for a second. And I’m thinking a little bit about what a seller can do upfront. So I mean, I’m not saying I win this argument all the time, I don’t, but my advice to anybody selling a company is to have a professional appraisal, either a vendor due diligence or a form of due diligence, especially on the legal side and tax on the company before you go to market. Because of course, what we’re talking about is if that isn’t done, issues come up in due diligence and there’s warranties and indemnities that’s there to protect the buyer about all those issues that bubble up during due diligence.
Mitigating warranties and indemnities
So the more that can be done upstream by a seller to mitigate that, fix it, put it right, the more chances are is that those warranties and indemnities soften or disappear.
And that seems like a sensible approach. Now, I don’t win the argument often because sellers don’t see the value at that moment in time. And I think I’m always fascinated by the psychological change that happens taking a seller through the sale process, because by the time we’re finished, I can say a hundred times at the beginning saying, you need to spend some money, do this upfront. It usually hits a brick wall. At the end of the process. Normally the penny drops and the seller says, gosh, now I understand. And sometimes, and I think maybe doing these videos might be helpful to saying actually spending a modest amount of money upfront is probably a very wise investment because I mean, ultimately a seller’s got to sleep, right?
Expectation of numbers of warranties in an SPA
You sell the company for 20 million you know and suddenly you’ve signed 150 page SPA to sell your business, and in it are hundreds, possibly
Nick Davies:
There will be hundreds of warranties.
Justin Levine:
Yeah, hundreds of warranties and indemnities, the seller wants to go off and buy the Sunseeker yacht, a terrible promotion for Sunseeker there, but they are local and enjoy their monies and not have to worry that the buyer’s going to come and basically make a claim. Right?
How early should sellers consider potential due diligence questions?
Nick Davies:
Yeah, absolutely. I mean, everything that you say there is, right? And like we encourage clients who are considering an exit 1, 2, 3 years down the line to start looking at the sort of questions that would be asked in due diligence.
Typical due diligence questions
Now, I met a new client yesterday who wants to sell his business. I’ve given him a due diligence questionnaire, a sample one, and said, these are the sort of questions any prudent buyer is going to ask you. So go away and read it and think, can you answer those questions? And if you can’t, we need to rectify that now before you get into the process. And it’s things like statutory books and records, it’s things like employment contracts. Are they up to date a big one these days? Is GDPR and data protection? Is your business compliant? How it handles personal data? You’ve got key contracts with customers.
Have they expired? Do you have any contractual right to continue supplying that customer? If not, what’s the buyer going to think about that? What about your intellectual property? Has that expired? Do you even have protection over your name? Who owns your website? Does the website designer own it? So there’s a long list of things which any prudent buyer will identify.
Get match fit for an exit
Far better to have identified it before the buyer does, and given yourself the chance to remedy and rectify that before you get into the process. As you say, people have to commit a little bit of expenditure to doing this. What I would say to people is, what’s your worst case scenario? If you spend the money and you end up not selling? What you’ve got is a really organised and well governed business because you’ve dealt with all of this stuff. And it means that if you do come back to the market, actually you know are in match fit shape to be able to move forward.
If you don’t do it, the problems aren’t going to solve themselves. And the worst case scenario I always think is that things don’t get dealt with, and then a buyer will say, you haven’t dealt with this. There’s a problem. We want an indemnity.
Are indemnities time limited?
Indemnities are a worst case scenario for a seller, really, because they’re not typically limited by time. They’re not typically limited by value. So they could be an unlimited amount.
Timescale for warranties
With warranties, they will expire after 18 months or two years. So your point about being able to sleep at night, once you get to that point, most of your risk has fallen away, but with an indemnity, it may remain at infinitum. You clearly try and negotiate it down from that. But to have had the opportunity to fix a problem so the indemnity doesn’t arise is always a preferable outcome.
Justin Levine:
It’s a key point, isn’t it? It’s key. It’s really, it’s really important point that because some of the companies we take to market have been running for decades and sometimes even longer. So there’s a lot of stuff that’s a lot of history wrapped up in that business.
Likelihood for W&I claims
Let’s just briefly talk actually, after the deals are done, Steele Raymond as a law firm, your prominent law practice across the whole central south, how often do you get involved in legal issues, either for buyers or for sellers, basically making claims against warranties and indemnities?
Nick Davies:
We don’t see it that often. Probably in my career, over 18 years of doing these deals, I’ve probably seen three or four warranty claims. We typically do a lot of sell side work, so we know if there is a claim because the sellers are notified.
Data from W&I insurance companies
What’s been really interesting in recent years is lots of the warranty and indemnity insurance companies now release data about the areas in which claims arise.
Accounts warranties most frequent claim
And the data is that more often than not, warranty claims are under accounts warranties. And that’s often because a buyer is misunderstood. Certain accounting standards or policies or accounting standards that are used or the accounting warranties go much further than the seller has a full appreciation for. It’s really important to get the proper advice on those accounting warranties from your accountant, from your lawyer, and from your tax advisor as well. So that’s one key area in which claims can arise.
Other frequent warranty claims include material contracts
The other one is material contracts. I mentioned that a moment ago. If a buyer’s buying your business in the belief that they can continue supplying your customers for five years and adding to the price every year, and actually there’s a problem in that contract. Somebody hasn’t spotted a change of control provision, for example, and that customer disappears the day after completion. The buyer is quite understandably going to be a bit miffed about that. If you have warranted the position that all material contracts are valid for a minimum of three years, you can see where the claim arises. And in that case, it’s fairly easy for the buyer to quantify their loss because they would say, well, actually under that contract, if you retain the customer, it’s X, Y, Z per year and there’s our claim. So those are two key areas, which the data coming out of W&I insurance tells us claims do arise.
W&I insurance
Justin Levine:
Yeah, and that’s a good point. I mean, from my side, you talk about warranty indemnity insurance, we don’t see it. I have not seen it in the 15 years we’ve been doing this type of business. A client wanting to pay the kind of premiums that are required to insure themselves against the risk of a claim against the warranty indemnities within the SPA. What’s your view? Do you see this? I know that’s a popular discussion point with corporate finance, with lawyers in terms of W&I insurance. Do you see it often?
Nick Davies:
We don’t see it often. I mean, I think historically it was very much in the kind of mega deal range, a hundred million and above. I think it is filtering down into the SME level a bit more. I think the insurers have caught on that it’s a good product for them. There is certainly more availability now than there ever used to be. We’ve done a few deals where W&I has been involved in one matter I can think of the buyer wanted it and the buyer wanted it so that if they had to bring a claim, they could claim against the insurer and not the sellers, so as to not sour the relationship. So that policy was buyer funded and put in place by the buyer, no claim arose, so it was null and void. Another matter I can think of was recently a selling shareholder who had inherited shares from who was the majority shareholder in the business.
The beneficiary who had inherited shares, knew nothing about the business, which was just owner of shares. The company was being sold. I think she had 49%. And the buyer said, you’re giving warranties, or the requirement is you must give all operational warranties about employment, about insurance, about property, and says, well, I just simply don’t know. So it was agreed in that case that we would have a comprehensive W&I policy, which came at some cost, but it gave the seller the peace of mind that actually after she’s paid the premium for the policy, the net proceeds are actually hers and not vulnerable. That goes to the seller sleeping at night point. So I think that it does have a place, I don’t think it’s suitable for every deal. The costs are off, off-putting to most people, but it’s a good product potentially in some cases and worth looking at.
Summary W&I trends
Justin Levine:
Thanks, points that come to mind in terms of summarising that discussion. In no particular order, you clearly need a good team advising you in terms of particularly the legal side, because I think it’s the realisation that the seller has, and they all have it at the end that, gosh, what have they signed up for? They’ve sold the business, but there’s a ton of stuff that they’ve agreed to stand by warranties and indemnities. So there’s a very strong argument there to have really a very seasoned and experienced legal team behind you to help me negotiate that because it’s a negotiation. It’s not as a seller, you don’t have to take it on the chin that the buyer’s first presentation of that draft is the de facto standard. You have some flexibility in negotiating, and that’s where that experience comes in. I think the other aspect that really comes to mind is that spending some money up front and doing some pre-due diligence on the business, which is, I probably won’t win the argument.
I don’t pretend I will. And people listening to this might think that, well, I’m just flying the flag for spending more money with professional firms. Actually, it’s not. A long time ago, I stood behind a purchase of a very expensive company and saw it from the other side. And in a sense, the lack of professional input on that particular deal some 18 years ago. And I remember reflecting on it many years afterwards going, gosh, knowing what I know now, having professional advice would’ve saved millions, literally millions of pounds. And I didn’t know that that advice was necessary at the time, and so I just didn’t do it and I didn’t see the value in it. So I’m the poacher turned gamekeeper. Now this is what we do professionally for a living and do it quite successfully. And you’re saying, yeah, spend some money. If you’re spending 50 grand of money upfront on a 10 million deal to get the thing clean, spend the money, spend the money.
Cost; known upfront vs unknown exposure
Nick Davies:
I think the point to make as well, if you pay now, it’s a certain amount because you pay a certain amount to fix the problem. If you don’t fix it, you don’t know what the cost might be later, but you could still be on the hook for it. And like you, I’m not trying to create work here. A lot of companies which will come in are really well run. They really don’t need a great deal of expense, but still have the audit, still have the check. I think the challenge that people often don’t grasp or appreciate is the time intensive nature of once you’re in a transaction of the due diligence requests, a due diligence request on a 10, 15 million pound sale might be 40 pages of legal questions. Then there’s FDD financial due diligence, there’ll be tax due diligence, there will be commercial data protection, employment property potentially, which could be pages and pages with some buyers.
Customer due diligence trend
Now we’re seeing a trend toward what we call customer due diligence, where they want to have meetings with key customers. They want to have phone calls, they want to have things like this. So the sheer organising and collating of all of the responses to that is enormous. It’s a full-time job in and of itself. At the same time, you’ve got to continue running the business because you still own it. You’ve got to continue managing the transaction with the buyer. So the time demands are vast and often underestimated. So I think that anything you can do prior to clean things up, get them put away, you are saving yourself time later as well as money.
Justin Levine:
It’s funny, when I hear about all of that work, I feel like putting my fees up, that’s what I think about. So Nick, I think that was a great piece on warranties and indemnities. I think we’ve covered off some of the basic terms that hopefully have educated people a little bit as to what goes on behind the scenes when constructing that sale and purchase agreements. So thanks.
Nick Davies:
Absolutely. Yeah, I hope it was useful to viewers and people find it interesting. And yeah, we’re here to help if we can in any way. Thanks, Justin.
Justin Levine:
Thanks.
Nick Davies:
Cheers.
