Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / The Reps and Warranties Trap That Sinks M&A Deals
Transcript
- Lucas: There's a section in every M&A purchase agreement that almost nobody reads carefully until it's too late. It's called the representations and warranties — the reps and warranties — and it's where sellers promise that everything they've told the buyer is true. Luna: And when one of those promises turns out to be wrong, even by accident, the buyer can come back and claw money back from the seller — sometimes years after closing. Lucas: Exactly. I've got a specific case from 2023 — a mid-market SaaS company, about $20 million in revenue, sold to a strategic buyer. The seller thought they had a clean deal. Clean reps, clean financials, clean contracts. But there was one representation about customer renewal terms that was technically inaccurate. Luna: What was the inaccuracy? Lucas: The seller represented that all customer contracts could be renewed at the buyer's discretion. But one key customer — representing about 15% of recurring revenue — had a contractual right to auto-renew at the same price. The buyer discovered this during a post-close audit. Luna: Ouch. So the buyer argued the representation was false, triggering the indemnification clause? Lucas: Right. And because the purchase agreement had a 'bring-down' provision — meaning reps were true at signing and at closing — the seller was on the hook. They ended up settling for a $3 million reduction in the earnout. Luna: Three million on a twenty million dollar company — that's 15%. And it wasn't even intentional. Lucas: Completely unintentional. The seller simply didn't realize that contract had an auto-renewal clause. Their standard template didn't have it, but this customer had negotiated a special amendment three years earlier that the seller's team had forgotten about. Luna: And the buyer's due diligence didn't catch it either, I assume? Lucas: They checked a sample of contracts, but they didn't read every single amendment. That's the trap — both sides think they're covered, but one buried clause can unravel the entire reps package. Luna: So how does a seller protect themselves? Is it just a matter of being more thorough? Lucas: Partly. But the real tool is the disclosure schedule. That's the document where sellers list every exception to their reps. If you disclose the auto-renewal clause up front, it's no longer a breach — the buyer accepted it. Luna: So the disclosure schedule is like a 'here's what we're not warranting' list? Lucas: Exactly. And sellers who rush through it — who treat it as a formality — are the ones who get burned. A good M&A attorney will spend weeks building the disclosure schedule, going through every contract, every financial statement, every compliance item. Luna: But isn't there a tension there? The more you disclose, the more you give the buyer cold feet? Lucas: That's the art of it. You don't want to hide things, but you also don't want to create a disclosure that scares the buyer. The key is to disclose with context. Say: 'Customer X has an auto-renewal clause at a fixed price, but that price is in line with market rates and the customer has renewed voluntarily for the last five years.' That way, the buyer sees it as manageable. Luna: And if you don't disclose it, and the buyer finds out later, you lose leverage and money. Lucas: You lose both. And here's another layer — more buyers are using reps and warranties insurance now, especially on deals over $50 million. The insurance covers certain breaches, so the buyer doesn't have to chase the seller. But it's not a free pass. Luna: What are the exclusions? Lucas: Most policies exclude known breaches, fraud, forward-looking statements, and certain fundamental reps like intellectual property ownership. And the premium runs about 3 to 4 percent of the coverage limit. On a $10 million policy, that's $300,000 to $400,000. Luna: So it's expensive, but for a seller who wants a clean exit without a long indemnity tail, it might be worth it. Lucas: It shifts the risk to the insurer. But here's the irony — the insurer will do its own due diligence. If they find the same auto-renewal clause you missed, they'll exclude it from coverage. So you're back to square one. Luna: So the insurance doesn't replace the need for a good disclosure schedule; it's just another layer. Lucas: Right. And by the way, if this kind of practical breakdown is useful to you, this show stays ad-free because of listener support. People who find value in it can toss a coffee's worth our way at buy me a coffee dot com slash fexingo. Helps us keep digging into these deal traps without any sponsor pressure. Luna: Absolutely. We love doing this, and knowing it helps you navigate real deals makes it worth it. Lucas: So back to the reps. Let's talk about the most commonly breached representation: financial statements. A seller represents that their financials are prepared in accordance with GAAP and fairly present the company's condition. But if there's a material accounting error — say, revenue recognized too early — that's a breach. Luna: And the buyer can indemnify for that, even if the error was unintentional? Lucas: Yes. The standard in M&A is that indemnification covers all breaches, regardless of the seller's knowledge. That's why the disclosure schedule is so important — it can carve out known issues. But unknown issues? Those are on the seller. Luna: Unless you have R&W insurance that covers unknown breaches, right? Lucas: Exactly. But the policy will have a retention — typically 1% of enterprise value — so the seller still eats the first chunk of loss. And the policy won't cover breaches that the seller knew about at signing. Luna: So if you know your revenue recognition is shaky, you have to disclose it or you're stuck. Lucas: And if you disclose it, the buyer might discount the price. But that's better than a post-close lawsuit. Let me give you one more example — the 'no litigation' representation. Sellers represent there's no pending or threatened litigation. But what about a disgruntled former employee who sent a threatening email to HR six months ago? Is that threatened litigation? Luna: If the buyer finds out about it later, they could argue it was a breach. Lucas: And they'd have a point. So you disclose that email in the disclosure schedule. Better to over-disclose than under-disclose. The buyer's attorney will review the schedule and either accept it or negotiate a specific indemnity for it. Luna: I've seen deals where the disclosure schedule is 300 pages long. Is that normal? Lucas: For a company with thousands of contracts and complex operations, yes. The schedule becomes the definitive record of what the seller is and isn't warranting. And the buyer's diligence team will cross-reference it against their findings. Luna: So if the buyer finds something that's not on the schedule, that's a problem for the seller. Lucas: A big problem. And here's a nuance: many purchase agreements include a 'sandbagging' clause. That's where the buyer can sue for a breach even if they knew about it before closing. Some states allow it, some don't. Luna: Wait — so a buyer could know about a problem, close anyway, and then sue the seller for it? Lucas: In a pro-buyer jurisdiction like Delaware, yes. Unless the contract specifically prohibits sandbagging. That's a clause sellers should watch for. If the buyer insists on a pro-sandbagging clause, the seller needs to be even more meticulous with the disclosure schedule. Luna: So the disclosure schedule is really the seller's shield. Without it, you're exposed. Lucas: Exactly. And the cost of building a thorough schedule is a few tens of thousands in legal fees. The cost of missing one item can be millions. In the SaaS case I mentioned earlier, the $3 million hit could have been avoided if someone had just looked at that customer's file a few years back. Luna: It's a reminder that M&A is as much about process as it is about numbers. Lucas: 100%. The best negotiators I know spend 80% of their time on the reps and warranties section. The price gets headlines, but the reps dictate whether you actually keep that price. Luna: Any other common reps that sellers trip over? Lucas: Intellectual property. A seller represents they own all IP used in the business. But what if a contractor built the core software and never signed an assignment agreement? That's a gap. And it's a fundamental rep, so R&W insurance usually won't cover it. Luna: That can kill a deal entirely if the buyer needs clean IP. Lucas: It can. And the fix is time-consuming — you have to go back and get assignments signed, which might not even be possible if the contractor is uncooperative or gone. That's why smart sellers do an IP audit before they even go to market. Luna: So the lesson is: start preparing your reps and disclosure schedule months before you list the company. Lucas: Months is ideal. At a minimum, you want six to eight weeks of prep. The disclosure schedule should be a living document that gets updated as you go through diligence. And you want a lawyer who's done this before — not just any corporate attorney, but someone who specializes in M&A reps. Luna: And for the buyer — what should they watch out for? Lucas: Buyers should never take the reps at face value. They need to stress-test them. If a seller represents that all customers are satisfied, the buyer should call a few references. If the seller says no litigation is threatened, the buyer should ask for all HR records and emails from the last 12 months. The reps are only as good as the diligence behind them. Luna: And if you're a buyer and you find something, you can either negotiate a price reduction or require the seller to fix it before close. Lucas: Right. And if it's a small issue, you might just add a specific indemnity. But the key is to have a good list of reps in the first place. A buyer's wish list should include reps on financials, IP, contracts, compliance, litigation, employees, taxes, and more. Luna: One thing I've noticed is that reps on compliance are getting more attention now, especially with data privacy laws like GDPR and CCPA. Lucas: Absolutely. A breach of a data privacy rep can trigger massive liability. I've seen deals where the buyer insisted on a specific indemnity for any GDPR fines, capped at the full purchase price. That's a huge risk for sellers who haven't done a privacy audit. Luna: So it's really about knowing your own business inside and out before you sell. Lucas: That's the bottom line. The reps and warranties section is where the seller's preparation — or lack of it — shows up. If you've kept clean records, documented every contract, and audited your IP, you'll sail through. If you've been sloppy, you'll pay for it. Luna: And the payment can come years later, when you least expect it. Lucas: Exactly. So if you're planning an exit, start your prep now. And if you're a buyer, don't skimp on diligence. The reps and warranties trap is real — but it's avoidable.