Representations and warranties and liability regime in share exchanges
Published on 23rd Nov 2021
Reciprocal representations and warranties and liability regime as a negotiation tool in the acquisition of companies where the purchase price is paid in shares.
Representations and warranties, and the liability regime related to any potential breaches thereto, play a key role in company acquisition mechanisms. The seller makes certain statements about the company's general situation (e.g. financial, tax, employment, regulatory matters) and undertakes to indemnify the buyer in the event of damages resulting from untruthfulness or inaccuracy of such statements.
The main purpose of this mechanism is to address information asymmetry and allocate risks. The seller assumes the obligation to hold the purchaser harmless from any potential liabilities whose origin is previous to the acquisition of the company by the buyer (without prejudice to the different possibilities to regulate buyers knowledge of such liabilities).
This usual scheme becomes less apparent when all, or a substantial part of, the purchase price is paid to the seller in shares of the acquiring company. The roles of buyer and seller become, then, interchangeable since both parties acquire shares from the other party. Therefore, there is a need to address the information asymmetry and risk allocation in both directions.
This, which might seem obvious when it comes to mergers between companies of similar size, is sometimes ignored when a significantly larger company acquires a smaller one and takes advantage of its bargaining power.
These kind of transactions are frequent among tech start-ups, when a company decides to drive its growth inorganically through acquisitions and, due to lack of liquidity, payment is (fully or partly) satisfied with shares of the buyer.
Suppose the sale and purchase agreement only regulates the granting of representations and warranties by the seller. In that case, the seller receiving shares of the buyer may be exposed to the risk of possible liabilities or hidden contingencies that the buyer may suffer because of acts or omissions occurring prior to closing. Therefore, the seller who has received shares from the buyer will see the value of such stock diminished without being able to seek any compensation, save in cases of fraud or wilful misconduct.
If the buyer is a listed company, this is less of a problem since the shares are liquid, and the seller may be able to sell them in the market after closing the transaction. However, in the case of private companies, due to the lack of liquidity of the shares received as payment, the seller must keep them until there is a liquidity event, thus being exposed to any loss in value in case of hidden liabilities.
A possible solution would be the buyer and seller granting themselves reciprocally the same representations and warranties, and share the same liabilities against possible damages resulting from inaccuracy or untruthfulness. By doing so, both parties are protected against potential risks in the company each of them is acquiring. In acquisitions (or technically speaking, in swaps) where the full price, or part of it, is paid in shares, each party acts both as buyer and seller in relation to the other party.
This option is not only fairer but also gives an incentive to the parties (and their advisors) when negotiating fair and well-adjusted liability regimes. Since both parties might find themselves acting as both the indemnifying and the indemnified party, incentives become aligned and none of the parties would impose a condition on the other party that it would not be willing to accept for itself. Finally, this scheme fosters a more fluent and efficient negotiation.
This approach should be brought up at the beginning of the negotiations, when payment terms are discussed and the buyer suggests its company shares as means of payment. To the extent possible, it should also be reflected on the documents where the initial conditions are described (letter of intentions, term sheet or similar).