The Handshake Deal

Today’s business transactions are more complex than deals of the past, requiring the need for extensive buyer representations regarding the state of its business.

For companies in San Jose and elsewhere in the Bay Area, even with the recent recession, deal-making never really left Silicon Valley.  Gone are the days when businessmen sealed a deal with a handshake. A shareholder of one of my clients in Cupertino once wondered why he was receiving such a large stack of paper to help him approve a proposed merger.  He told me that when he sold a company he had owned “back in the day”, he rarely called his corporate attorney and closed the deal with a handshake and “cash over the barrel”.  When companies were sold to buyers running the same kind of business as the seller or for whom the seller’s relationship was formed and tested over time, a handshake often did the job, and no mergers and acquisitions attorney was required.

With the rapid speed of today’s transactions, the rising complexity of the legal and business environment, and the need to work with buyers and sellers who may not know each other for a period longer than the deal’s term sheet, the need for extensive acquisition documentation has grown.

One of the most extensive portions of an acquisition agreement is the seller’s representations and warranties.  This portion of the agreement serves two functions.  First, it describes the shape of the seller.  Second, for those items of the seller not acceptable to the buyer, the representations and warranties can shift the risk of any loss associated with the item back to the seller.

In describing the seller, representations and warranties will fall into four categories.  The first category discusses legal aspects of the seller.  This includes commitments regarding entity structure, stock structure, locations in which the seller is authorized to do business, and similar matters.  The second category concerns commitments and disclosures related to the business itself.  These discuss items of the seller, such as the presence of any security interests, the state of the seller’s financial statements, occurrences following the date of the seller’s financial statements, and the state of the company’s assets, including its intellectual property, insurance coverage, and employment and benefits issues.  The third category describes the seller’s relationships with others, including the seller’s material contracts, supplier and customer relationships, loans to third parties or company insiders, guaranties, indemnities, and other commitments, and whether any litigation exists.  The fourth category pertains to the seller’s regulatory matters, including compliance with tax matters and regulatory filings, and the dreaded environmental law representations.

To add greater detail to the representations, a schedule is typically attached to the acquisition agreement.  Sometimes referred to as a disclosure schedule, this attachment will contain lists of the seller’s assets, intellectual property, material contracts, liens, employees, and insurance policies.  Documentation and information listed in the schedule often reflect materials made available to the buyer as part of its due diligence investigation. 

Representations are highly stylized, and crafted to broadly describe the matters to which they pertain.  As such, they can act as “fishing expeditions” to help ensure that the buyer has not missed anything in its investigation.

What happens if the representations are wrong?  If a representation turns out to be false, and the buyer is harmed as a result, the agreement could allow the buyer to sue the seller for that damage.  As discussed in prior blogs, buyers often hold back purchase price funds to act as a source of compensation to the buyer for these types of damages.  The extent to which the buyer can access these heldback funds depends on the terms of the indemnification provisions found later in the agreement. 

What happens if a representation is wrong, and the seller knows it is wrong when the agreement is first prepared?  The seller can then disclose to the buyer in the agreement those items that make the representation incorrect.  If the disclosure is contained in the Agreement, such as in the disclosure schedule discussed above, the seller can escape liability for claims arising out of that disclosure.  The extent to which the disclosure can be made, and its use to shift risk, is a matter for the next blog.  Stay tuned!