Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / The Reps and Warranties Trap That Cost a Buyer 30 Million
Transcript
- Lucas: So we've talked about earnouts, working capital pegs, environmental liabilities. Today I want to look at something that sits at the very heart of every purchase agreement: the reps and warranties, and what happens when you don't back them up. There's a case from a few years back, a two-hundred-million-dollar acquisition of a medical-device company. The buyer got hit with a thirty-million-dollar loss because of a single representation about patent validity. Luna: Thirty million sounds like a lot. Was that the purchase price or an actual loss on top? Lucas: It was a real loss — the value of the product line that was tied to the patent. The seller had represented that all its key patents were valid and enforceable. Six months after close, a competitor filed a challenge and won. The patent was invalidated, the product line's revenue basically evaporated. The buyer tried to claim under the indemnification provisions, but here's the kicker: the indemnification cap was set at five million dollars. That was it. Luna: So they were capped at five million on a thirty-million-dollar loss. That's brutal. Did they have any other recourse? Lucas: That's the thing — they could have had recourse, but they didn't buy reps and warranties insurance. RWI would have covered the gap between the five-million cap and the actual loss, minus a retention. But they skipped it to save on premium. The premium on a deal that size might have been one or two percent of the purchase price. So, two to four million dollars for coverage that would have protected them. Luna: So they saved two million and lost twenty-five. That's a rough trade. But why would a seller even agree to a five-million cap? That seems low for a two-hundred-million deal. Lucas: Because the seller had leverage. It was a competitive auction, multiple bidders. The seller basically said, take it or leave it on the cap. And the buyer, eager to win, agreed. In a hot market, buyers often accept tighter indemnification terms. That's exactly when RWI becomes critical. Luna: So what's the actual clause that failed them? Is it just the cap, or was it the representation itself? Lucas: Both. The representation said the patents were valid, but it was qualified by 'to the seller's knowledge.' That's a classic knowledge qualifier. The seller's CEO later said they had no actual knowledge of any challenge. So the buyer couldn't even prove a breach of that qualified rep. The unqualified reps were limited to fundamental ones — like ownership of shares. The patent rep was qualified, and that made it nearly impossible to win. Luna: So the buyer had two problems: a knowledge qualifier and a low cap. How would you have structured it differently? Lucas: First, I'd push for an unqualified rep on patent validity, or at least a 'no pending challenges' rep that's not knowledge-qualified. Second, I'd negotiate a higher cap — maybe ten percent of the purchase price, twenty million — specifically for ip related breaches. Third, I'd buy an RWI policy. The policy would have covered the loss above the cap, and it would also have paid for the defense costs, which were substantial. Luna: Does RWI cover knowledge qualifiers? I thought they usually exclude known issues. Lucas: Right, RWI policies have a 'knowledge' exclusion — if the buyer knew about the issue, it's not covered. But here, the buyer had done due diligence and found no red flags. The patent challenge came out of nowhere. So an RWI policy would have responded, because the buyer didn't have actual knowledge. That's a key distinction. The policy would have paid the claim, minus a retention, which might have been one or two percent of the deal value. Luna: So the real lesson is: never rely solely on the seller's reps, and always consider insurance, especially when the cap is low. But how do you convince a seller to allow an RWI policy? Some sellers are wary of it. Lucas: Good question. In many cases, sellers actually like RWI because it removes them from the indemnification hook. The buyer's recourse is against the insurer, not the seller. So if the seller is clean, they're happy to have the policy. The premium is usually paid by the buyer, but sometimes it's split. In this case, the seller would probably have agreed, because it meant the cap could stay at five million, but the buyer would have had actual protection above that. Luna: And that would have been a win-win. The seller keeps the low cap, the buyer gets coverage beyond it. Why didn't more buyers in that auction do that? Lucas: Some did. But this particular buyer was so focused on winning the deal that they overlooked the risk. They had a 'we'll fix it later' mentality. And in a competitive auction, you don't always have time to negotiate an RWI policy. But you can at least get a quote and a term sheet before you sign. It's a matter of discipline. Luna: So it's not just about the clause, it's about the process. You have to build the insurance decision into your deal timeline, not as an afterthought. Lucas: Exactly. And that's something that comes up in so many of these deals. We've talked about traps that cost real money, and this one is right up there. But there's also a broader point about how you approach risk in M&A. You have to think about the tail risks, the ones that might not happen but would be catastrophic if they did. Luna: And that's where a good advisor comes in. Someone who's seen these scenarios play out and knows to ask about the cap, the knowledge qualifier, the insurance. Not just the price and the multiples. Lucas: Right. And that's actually a nice segue into something we've been meaning to mention. If these conversations have moved your work forward in some small way, helped you think about a deal differently, maybe saved you from a trap like this one — a couple of dollars a month is genuinely what keeps these going. Buy me a coffee dot com slash fexingo, if you've gotten something out of them. It's a small thing, but it really adds up and lets us keep doing these deep dives. Luna: Yeah, honestly, we love making these, and the support from listeners is what keeps them ad-free. Even a small monthly contribution makes a difference. Lucas: So, back to the patent case. There's another angle here: the buyer could have also negotiated a specific indemnity for patent challenges. Sometimes sellers will agree to a longer survival period or a higher cap for ip specific risks, because they know those are the scariest. But you have to ask. Luna: And if the seller won't budge, then you have to decide: is the deal worth the risk? In this case, maybe they should have walked away. Or at least lowered the purchase price to reflect the risk. Lucas: That's a smart point. You can price the risk. If the cap is five million, but you think there's a ten percent chance of a twenty-million-dollar loss, that's a two-million-dollar expected loss. You could ask for a two-million-dollar price reduction, or a higher cap. But the buyer didn't do that math. They just said yes. Luna: And now they're stuck with a thirty-million-dollar lesson. Do you know what happened to the company after? Did they recover? Lucas: They eventually sold the product line at a fire-sale price, and the CEO was replaced. The company survived, but it was a major setback. And the buyer's shareholders were not happy. It's a cautionary tale that keeps getting told in M&A circles. Luna: I bet. It's the kind of thing that should be on every buyer's checklist. Reps, warranties, caps, insurance. All of it. Lucas: Absolutely. And as we wrap up, I want to leave you with one actionable takeaway: before you sign any purchase agreement, ask your counsel three questions. What are the knowledge qualifiers on the key reps? What is the indemnification cap, and does it apply to IP? And have we gotten a quote for reps and warranties insurance? If you can't answer those, you're flying blind. Luna: That's a great checklist. And if you want to dig deeper, we'll have a full transcript and some resources on the show notes. Thanks for listening, and we'll see you next time.