Buying a Business: Risk Allocation
What is “risk allocation” and how does it pertain to and figure into the negotiations when buying a business?
Risk allocation is an attempt by the buyers and sellers of a business to identify known risks – as well as acknowledge that there may be some unknown risks – and allocate those risks and the liability they may pose to one party or the other. Risk allocation is a critical issue in private company mergers and acquisitions. The buyer and seller – and their respective advisors – would be wise to spend a lot of time on the process of identifying and fairly allocating the risk for for potential liabilities. The portion of the purchase agreement where this task begins is in the seller’s representations and warranties.
Among the most obvious possible risks are unpaid taxes and undisclosed potential disputes that could arise out of a contract disagreement. In the case of the former, the most concerning would be employee withholding taxes. While this concern can usually be eliminated during the due diligence period by requiring the seller to provide proof of payment, we advise our buy-side clients to insist on a seller’s warranty in this regard. Though reason would dictate that the seller would be liable for any such unpaid taxes and that the tax authorities would look to the seller to satisfy this obligation even after the sale, the Feds cast a wide net in these circumstances and also look to the business and the current owners, the buyers.
Because of these potential eventualities, arguably the most important and fraught provisions of the definitive purchase agreement are the ones detailing the seller’s covenants, representations and warranties. The recent development and availability of representations and warranties insurance* provides some protection but such insurance is most suited to larger, more complex deals.
* Representations and Warranties Insurance is a form of coverage designed to guarantee the contractual representations made by sellers associated with corporate mergers and acquisitions. For example, the seller of a company may represent that the company’s underground storage tanks are in good repair. If a serious leak is discovered following the purchase, the buyer can seek recovery for repair and clean-up costs from the seller’s representations and warranties insurance policy. The key benefit of the policies is that they provide a viable alternative to escrow funds, which have traditionally been used to satisfy claims associated with representations and warranties contained in merger and acquisition documents.
As a general rule, the buyer wants the seller to indemnify the buyer for any claim regardless of whether the claim is made by the buyer itself or if it is a claim against the buyer by a third party – such as a vendor, customer or government agency – arising out of any breach of either the representations and warranties made by the seller or any covenant of the seller.
However, some buyers push for the seller to indemnify the buyer for any liability relating to the operation or conduct of the seller’s business prior to the closing. But this is unrealistic. For example, the seller cannot reasonably and without limits indemnify the buyer for liability for product warranties. If the business manufactures toasters, a certain portion will likely be returned and the buyer cannot go after the seller for each one. Reasonable parties are typically able to agree on an equitable, sensible and prudent set of representations and warranties appropriate and germane to the business in question and that fairly allocate between the parties the risks of owning and operating a business. In the case of a bunch of bad toasters, the parties ought to be able to agree to a reasonable return or warranty/repair factor that is applied to the purchase price. (See, “Indemnifications with Monetary Limitations”, below.)
That said, it is possible that the buyer, during its due diligence investigation, becomes aware of some liability that, because such liability was undisclosed or not known beforehand, was not reflected in the purchase price that the buyer offered for the business. In such a situation, the buyer might reasonably require a specific indemnity for any future loss associated with this newly-discovered liability. Other specific indemnifications that are fairly common include those for tax liabilities and other debts as they pertain to the business prior to the closing date, as well as transaction expenses such as brokerage and legal fees.
Are There Any Limitations to Risk?
As a rule, most M&A transactions will also include limitations on certain indemnification obligations of the seller because without such limitations, the seller would on the hook for any unknown liabilities of the business indefinitely. As an example, we can look to the underground storage tanks used in the insurance definition, above.
If the seller avers during the pre-closing process that the tanks are in good condition, it would be reasonable to assume that such tanks will not cause any major problems for some reasonable, negotiated time. It would not be reasonable to assume that they would not cause any problems for the rest of time. Therefore, the parties might agree that the sellers will indemnify the buyers in this regard for a certain period of time after which tank issues belong to the buyers.
Two factors that help to eliminate lopsided liability risks and in more equitably allocating such risks are certain monetary and/or time limitations (such as the above) in which the parties agree to sunset clauses and monetary caps on the seller’s indemnification obligations.
Time Limits or “Sunset” Clauses
Representations and warranties are made as of the date of the definitive purchase agreement and are generally reaffirmed as of the closing date. They are meant, of course, to assure the buyer that, to the best of the seller’s knowledge, certain conditions affecting the business obtain both when the purchase agreement is signed as well as at the time that the transaction closes. As with our underground tank example above, they typically survive the closing for some defined period of time after which the buyer no longer has recourse.
For representations that are more operational in nature, such as territorial limitations or the protection of certain key personnel, the survival period might be between 12 and 24 months after the date of closing. For issues relating more to the structure or condition of the company, such as the organization of the seller, authority to complete the transaction, title to assets and transactional (i.e., broker and legal) obligations such as expenses, the survival period is usually longer or, in certain instances, there may be no sunset provision at all.
For still other other representations – such as those relating to government or existing laws (i.e., zoning, environmental, etc.) – the survival period is often tied to legislation and whatever limitations such legislation contains.
Indemnifications With Monetary Limits
According to Tony Kuhel, a partner in the corporate transactions and securities practice group at the Cleveland, OH-based law firm Thompson Hine, there are three standard monetary limitations.
- First, the parties may agree to a minimum claim threshold on the premise that neither should be bothered with small claims.
- Second, the parties typically negotiate a “basket,” or a threshold amount after which the seller’s indemnification obligations kick in. Baskets usually come in one of two forms: a deductible basket, similar to an insurance policy, where the seller’s indemnification obligations only apply once the deductible is met, and then only to the extent liability exceeds the deductible; or a “first dollar” or “tipping” basket, where the seller’s indemnification obligations cover the entire amount of liability once the basket has been met.
- Finally, the seller usually negotiates a monetary cap on its indemnification obligations.
The Bottom Line
Unless a great deal of thought is given to risk allocation during the negotiating process and again during the due diligence phase, the parties are really rolling the dice on what the potential downside is from potential liabilities that might be unknown at the time of closing and that could come back to haunt one or the other at some point down the road. A qualified business broker or M&A professional will prove invaluable when negotiating indemnification provisions that clearly and fairly allocate economic and legal risk for both known and unknown liabilities between the parties.
If you’re a buyer, we’ve put together a lengthy document listing and describing many of the warranties you will want the seller to give and many of the covenants you might reasonably want the seller to make. If you’re a seller, you might want to review this list yourself – both to be prepared for the buyer’s request and to see what kinds of representations and warranties you might want the buyer to make. If you’d like to receive a copy of that list, let me know where to send it and it’ll be on its way.
If you have any questions, comments or feedback, I want to hear from you. Put them in the Comments box below. I’ll get back to you with answers or my own comments. If I get enough on one topic, I’ll address them in a future post or podcast.
I’ll be back with you again next Monday. In the meantime, I hope you have a profitable week!