selling a business Tag

by Chris Swiecicki

What is the “Representations and Warranties” Section of a Purchase Agreement for, and Why is it Important?

When buying or selling a business, an accurate representations and warranties section of a purchase agreement is critical for ensuring a smooth transition. Any size entity, whether a small family business or larger corporation, is bound to the facts stated in the agreement in order to close the transaction.

Because there are so many legal details that could result in indemnification (compensation for loss and harm) for either party if not accurate, it’s always best to have a trustworthy attorney by your side who can explain what everything means during all contract negotiations.

What Are Representations and Warranties?

Representations and warranties are contractually binding statements assuring both parties of a sale that the business is what the buyer believes it to be. They give both parties legal recourse if the transaction does not go through as expected. Both the buyer and seller make representations and warranties, but the majority of them are made by the seller. 

Representations

A representation is an assertion that everything in a contract is true as stated. Especially in M&A transactions, sellers must include information about the target company or business and the stock or assets and liabilities being transferred. 

Warranties

A warranty can result in indemnification, or compensation, if the assertion is false. The seller will warrant information given to the buyer during the diligence process, such as that:

• The business is in compliance with all relevant government regulations.
• All financial statements are true and accurate.
• All property—whether tangible or intangible—is free of any encumbrances.

The buyer will need to make warranties as well, such as that:

• They have enough money on hand to pay the purchase price.
• They are a duly formed corporation with the power to execute the contemplated transaction. 

Exceptions 

Representations and warranties are drafted as general statements in most M&A transactions. The seller must disclose exceptions to those statements in a disclosure schedule attached to the purchase agreement. As long as the exception is properly disclosed, the buyer has been given official notice of the fact. If a seller fails to make a disclosure, it may result in a claim of fraud against the seller.

For example: Except as set forth in Section 1.1 of the Disclosure Schedule, the Company has no current litigation. Disclosure: A claim for XXX was filed in the Superior Court for Perry County on March 3, 2020, under Case No. 1234.

Remedies and Enforcement

The indemnification obligations of the parties, provided in the purchase agreement, is what enforces the representations and warranties. Indemnification language typically states that for a limited time after closing, the parties can indemnify each other for breach of or inaccuracy in the representations and warranties provided by that party.

For example, if a deal closes and the buyer discovers that the seller’s financial statements are inaccurate, the buyer can seek indemnification for losses incurred.

Because of the repercussions that can happen if any inaccuracies occur, it’s extremely important to have a lawyer help craft the deal at an early stage. A simple mistake made here can actually have larger ramifications on if the deal goes through, or whether a seller can get paid if it doesn’t.

Representation and Warranties Insurance

Insurance to protect both parties of an M&A transaction has become fairly common, although it is more often requested by the seller as protection from post-closing indemnity claims. Because the policies pay out claims that arise from breaches in the representations and warranties, those covered by insurance tend to be less concerned about deal friction and closing issues. 

The insurance issuer is involved in due diligence and negotiation of the representations and warranties. Every policy has different exclusions and conditions under which the policy will not cover indemnification claims. Exclusions are determined based on the insurance company’s due diligence review, and usually include issues the parties knew of prior to closing and other extraordinary risk issues.

What Information is Included in Representations and Warranties?

In general, the seller and target of the M&A will include the following information in this section of the purchase agreement. 

Financial Information

Financial Statements

This ensures that financial statements delivered to the purchaser:

• Are true and complete.
• Were prepared from the financial records of the target.
• Were prepared with sound accounting principles.
• Reflect actual transactions and have been maintained in accordance with sound business practices.

No Liabilities

This states that there is no debt or liabilities other than:

• Those disclosed in or reserved against in the aforementioned financial statements.
• Those incurred in the ordinary course of business since a particular date.

Tax Matters

This clarifies all information about taxes, stating that:

• The target has filed all required tax returns. 
• All tax returns are true, complete and correct in all material respects.
• All taxes have been paid in full and there are no liens or contests.

Ownership Issues

Authority

This states that the target and each seller party has:

• The full legal right and authority to execute the purchase agreement.
• Authorizations, consents and approvals required by law.

Corporate Power

This states that the target and each seller party has the power and authority to:

• Own, lease, operate and use its assets and properties. 
• Perform all its obligations under its contracts.

Ownership of Target Company; No Subsidiaries

This states that the seller owns the issued equity interests of the target and that:

• They are free and clear of all liens, encumbrances and rights of third parties. 
• There are no subsidiaries of the target. 
• All issued equity securities of the target were issued in compliance with federal and state laws.

Title and Sufficiency of Purchased Assets

This states that each seller party owns the goods sold, and that:

• At closing, the seller will transfer and deliver to the buyer all purchased assets.
• All goods and assets will be free and clear of liens and rights of third parties.
• Purchased assets constitute all of the material assets, properties and rights necessary. 
• The tangible personal property is in good operating condition and repair, except for with the exception of normal wear and tear. 
• All items of tangible personal property are located at the target’s premises.

Laws

Legal and Authorized Transactions

The purchase agreement constitutes the legal, valid and binding obligation of the target and each seller party. 

Compliance with Laws 

There are no violations by the target of any law relating to the target, its equity, assets or the transaction.

Licenses and Permits

The target has all required licenses and permits.

Litigation

There are no claims, lawsuits, investigations or judgments relating to the target.

Organization

The target and each seller party is in good standing under the laws of its jurisdiction of organization. 

Full Disclosure 

This explains that the purchase agreement does not contain any untrue statement or omit any information that would make the statements false or misleading.

Contracts

This states that except what is included in the disclosure schedule, the target is not bound by any contract or other agreement. The contracts set forth on the applicable disclosure schedule:

• Are a legal, valid and binding obligation of the target and the other parties.
• In full force and effect in accordance with its terms.
• May be assigned to the purchaser and will continue after closing.

Other Information

The representations and warranties section may also include information regarding:

• Product Warranties to Customers.
• Customer Credits.
• Intellectual Property and Confidential Information.
• Employee and Labor Matters.
• Environmental, Health and Safety Matters.
• Inventory.
• Real Estate.
• Insurance Matters.

A Knowledgeable M&A Attorney Should Be Involved in All Parts of a Purchase Agreement

Regardless of why you are buying or selling a business, it is best to have an M&A lawyer at the earliest stages of the deal. They should be the ones obtaining a valuation and crafting the agreement, along with ensuring the representations and warranties are complete and accurate. Instead of waiting until a deal is on the table and contracts are already drafted, contact  Swiecicki & Muskett, LLC to help you navigate your merger or acquisition.

Cover Image by tomazl by Getty Images Signature by Canva.com

by Chris Swiecicki

Selling Your Business? Find Out About Section 1202 to Avoid Taxes on Your Capital Gain

Investing in emerging fields like tech and software can have enormous tax advantages. When entrepreneurs sell their businesses, they may be able to exclude up to 100% of capital gain under Section 1202—up to $10 million or 10 times their investment, whichever is more. Both founders and their investors qualify for the exclusion after they have owned the company for five or more years.

If you want to position yourself for the Section 1202 gain exclusion when you sell your business, you may need to change the structure of your business to make an easy sale.  

Requirements for Claiming a Section 1202 Gain Exclusion

When selling a business or stock, having the wrong structure can be incredibly costly. For example, selling a business after changing the organizational structure from a C Corporation to a trust disqualifies the seller from the Section 1202 gain exclusion.

To qualify for the exclusion, a small business must meet the following requirements:

1. Its aggregate gross assets did not exceed $50 million at any time on or after August 10,1993, and before the issuance.
2. Its aggregate gross assets do not exceed $50 million after the issuance.
3. It is a U.S. C Corporation and will continue to be so when its stock transfers to a buyer.
4. The owner bought its stock with cash, property, or services.
5. Its stock must be stock as defined in the federal income tax code. Non-vested stock, stock options, and warrants are not Q.S.B.S.

While corporate stockholders are ineligible for Section 1202’s gain exclusion, stockholders of other business entities may qualify for the gain exclusion. This includes individuals, trusts, and pass-through entities.

Which Business Investments Qualify for Capital Gain Exclusions?

The capital gain exclusions in Section 1202 were designed to stimulate the economy. Thus, qualified trades or businesses are those creating jobs and/or knowledge including manufacturing, technology, research and development, and software.

Investments in service industries are not qualifying stock purchases. Section 1202 lists the following fields as not qualified for the capital gain exclusions:

A. Accounting, actuarial science, athletics, brokerage services, consulting, engineering, financial services, health, law, performing arts, or any other profession in which the main asset is the reputation or skill of employees.

B. Banking, financing, insurance, investing, or other financial services.

C. Farming.

D.  Oil and gas production covered under Section 613 or 613A.

E. Operation of hotels, motels, restaurants, or similar businesses.

In addition, property management is not a qualified business (Section 1202(e)(7)).

When you are structuring a business for easy sale and positioning yourself for capital gain exclusions, stay focused on its qualifying mission. You need to invest at least 80% of the corporation’s assets (by value) in qualified business activities to receive the Section 1202 exclusion.

How the Section 1202 Exclusion Became So Lucrative

The federal government sweetened the deal for investors following the Great Recession. Before 2009, Section 1202 allowed certain small businesses and start-ups to exclude 50% of capital gain in their gross income. The 2009 Recovery Act increased the exclusion to 75% of the capital gain of the sale of qualified small business stock (Q.S.B.S.) purchased between February 18, 2009, and September 27, 2010. The exclusion expanded to 100% of capital gain after September 27, 2010. Today, those selling a qualifying business receive:

• 100% exclusion from U.S. federal capital gain tax. (Sometimes the exclusion is a lower percentage. See below.) 
• 100% exclusion from the alternative minimum tax 
• Exclusion from the 3.8% net investment income tax

When you sell a business that does not qualify for Section 1202 exclusions, you probably will be responsible for paying the taxes on gains related to selling small business stock at the maximum rate of 28.7%.

Section 1202 Considerations for the Easy Sale of a Business

When you are ready to cash out on the successful launch of your business, pay close attention to whether your business is structured for easy sale AND for keeping you eligible for Section 1202 gain exclusions. To qualify for the exclusions, you must sell stock, not assets (deemed or actual). However, most buyers want to buy your company’s assets, not your stock. When you offer stock, and the other party is buying most of the shares, they will likely demand a discount. In this scenario, you may benefit from rolling over 20% to 30% of your equity as part of a structured deal. You will be allowed to defer gain, and be positioned to claim a Section 1202 gain exclusion, when the buyer eventually sells the rollover equity.

Many other ways to structure a business for easy sale are buried in the tax code. Here at Swiecicki & Muskett, we are experts at uncovering the opportunities lying just under the surface of the mountains of rules enforced by the I.R.S. and the court system.

Moves for When You Don’t Qualify for Section 1202 (Yet)

Suppose you want to take advantage of the Section 1202 exclusions but can’t because you have the wrong business structure. If you expect significant appreciation of your company’s stock and plan to sell your business or stock, changing your structure from an S corporation to a C corporation is a wise move. Capital gain after the conversion will qualify for exclusion on Section 1202.

The corporate tax team at Swiecicki & Muskett has many other solutions for structuring your business for an easy and lucrative sale. Based in St. Louis County, Christopher Swiecicki and his team serve growing businesses of all structures and sizes. Contact him at 636-778-0209 or email [email protected].