M&A Issues: Reps, Warranties, Indemnities, and Escrows

Yet another post on issues in M&A. This one is about the things you will sign up to when you sell your business and the money you will set aside to cover them.

First things first. I am not a lawyer. And this post is about legal stuff. I barely know how to spell indemnities. I had to double check that I was spelling it correctly. So I am going to put a bunch of stuff on the table but if you really want to understand this, talk to a lawyer. This kind of stuff is why you have a lawyer and why they are valuable. That said, here goes.

When you sell your business you will make a bunch of representations to the buyer (reps). You will tell them you own all of the assets you have on your balance sheet. You will tell them that you have no more liabilities than you have listed on your balance sheet. You will tell them that you own all the intellectual property you claim to own. You will tell them that you have all the contracts with customers you claim to have. I could go on and on. The list of reps in a purchase agreement is long.

This is a contract. You need to take this stuff seriously. If you are repping to something, you should be very careful and read every rep and make sure it captures the situation accurately. There will be schedules for most, if not all, reps. Read them too. You are making promises to the seller. Make sure they are correct.

Reps are about what is true today. Warranties are about the future. You will also be asked to warranty a number of things in a sale contract. Read them carefully as well. Make sure you are confident of them. Lawyers write these contracts but people have to live up to them. So don't just treat a contract as a piece of paper to be signed. Understand what is being agreed to, take the time to understand it. If you don't understand it, make your lawyer walk you through it, line by line if need be.

An indemnity is the amount of money that is to be paid from the seller to the buyer if any of the reps and warranties turn out to be false. They will be set up in the contract. Understand how much liability you are taking on for the reps and warranties.

The buyer will require a percentage of the purchase consideration be set aside to back up the indemnities, usually for one year. The percentage is most often 10%, but can be more or less depending on the type of deal it is. The escrow is the money the buyer can come after based on the indemnities without having to sue the seller.

There will be an escrow agent represeting the selling shareholders. It is most often the lead investor. Our firm has done this many times. It is a thankless task, but an important one. If there is a fight over the escrow amounts or a larger claim, the shareholder representative will be the one dealing with the buyer.

One area that has been particularly problematic in M&A for tech startups is IP reps, particularly patent issues. An announcement of a large purchase of a tech company is a big fat target for patent trolls. The patent infringement suits will come out and the seller's escrow will be the target. My partner Brad has been dealing with one of these for years. It is ugly.

Most of the time, the escrow is paid without much haggling by the buyer on time (usually a year later). But sometimes the buyer has legitimate claims and the escrow is used up paying the indemnities. It is rare (at least in my experience) for the buyer to come after more than the escrow. That is most common in outright fraudulent transactions.

In summary, you will be asked to make a bunch of statements of fact and future performance to the buyer when you sell the company. Take them seriously and make sure you understand what you are signing up to. Be prepared to set aside at least 10% of the purchase price to back up these statements. And if things go wrong, expect to lose some or all of that 10%.

#MBA Mondays

Comments (Archived):

  1. awaldstein

    ‘Lawyers write these contracts but people have to live up to them.”Wise words. Nothing could be more true or more important to state.The only thing I would add is to spend the time and find a lawyer you trust. Your attorney and your accountant require a trust bond for you to be comfortable with. If you are, you will sleep better.

    1. fredwilson

      this is one of the many things we help entrepreneurs with (including many we never invest in)we know a bunch of really strong venture lawyers and we advise that the entrepreneurs meet with all of them and pick the one they have the best personal chemistry with

      1. awaldstein

        This is a great value add Fred.

  2. bfeld

    We used to be shareholder reps also. We’ve decided never, ever to do it again. My partner Jason Mendelson helped create a company called SRS to do this – http://www.shareholderrep.com/. We now use them for all our deals, as do many other VC’s and VC-backed companies. I encourage you to consider them so you don’t have to spend your time on this.

    1. fredwilson

      wow, wow, wowthat is so good to knowi wish i had known this last weeki just signed up to do it again, signed the escrow agreement this morningugh

    2. Dave W Baldwin

      Good move.

      1. Senith @ Finance Ttutor

        Thanks for the SRS tip Brad!

    3. feddkraft

      sorry, then i couldn’t get if a ‘rep’ is a piece of paper or a person/organisation…

  3. mike gilfillan

    And what about the “give and take” of picking which Reps to argue for/against? At some point both buyer and seller have to agree to “lose the battle to win the war” so to speak when it comes which Reps you want to have in the agreement.

    1. fredwilson

      i rely on our laywers to help us through that give and take

      1. mike gilfillan

        Yeah, and hopefully the lawyers at that level also have good business sense. BUT, I remember having a room full of lawyers arguing over some minute detail (running up their hourly fees), until buyer and seller (me) took the conversation offline and said “look, we both need to reign in our lawyers on this one”.Somewhere there needs to be a legal crash course for technology founders so they don’t have to learn too many lessons the hard way…

        1. Fernando Gutierrez

          People billing by the hour can be dangerous!I always prefer to negotiate closed fees with professionals to avoid paying for inefficiencies. I understand that this is not always possible because the scope of the task doesn’t always let you budget accurately, but I try. Also when it’s me who is billing I prefer that my client knows exactly how much he’ll have to pay. If it takes me more time to get there that’s my problem, not his… unless it’s his fault, in which case he should have some kind of penalties.

    2. JLM

      Actually reps and warranties are easy to negotiate if you simply remember that each party likely wants something that the other party does not really care about.Never make any concessions until the entire list has been simmered sufficiently that it has reduced to just a handful.You will find that you don’t really care about a few that the other side is apoplectic about.You will also find that there are a couple you can live with.You will find there are some that you will be OK with if you can strangle them at the closing.You will find that there are some that you can live with if you can cap the damages or agree to liquidated damages.Then just go through them methodically.Concede one you can live with in return for one that really upsets you. Easy trade. Work through this portion of the list.Give up — but bank the goodwill — on a couple you can live with as long as they don’t survive closing.Trade the goodwill for some other similar things on the other side with an eye toward getting more bang for your money even on an otherwise unrelated deal point.Then cap damages. Put a liquidated damages amount on a couple more.Negotiate the hold back as part of this deal.Kiss the babies, squeeze their mommas and go have a drink.Works every time.

      1. mike gilfillan

        Thanks JLM. That is terrific advice and a great guide to follow. Every thing you said is spot on with my experience in closing my first sale. Your comments in this post are a goldmine. Thanks again Fred for making this available to everyone.Would love to see a thread on “Material Adverse Effects”….

  4. Quizotic

    Wow, great post. Particularly about the possibility of patent litigation. When the trolls claim the seller is infringing their patents, is it more commonly the seller’s patents that are infringing or the seller’s unpatented technology? I would have thought that if the seller’s patent claims were allowed, that would provide protection. And I would have thought the trolls would have no basis for knowing anything about the seller’s unpatented technology, without a fishing expedition. I guess I’m surprised to hear that the trolls can find a basis for litigation!

    1. fredwilson

      there is no basis for trolls other than to be a tax on society, innovation,and capitalism

      1. bfeld

        I strongly support this sentiment!

      2. Quizotic

        too easy a write off. if patents are an asset, why shouldn’t they be bought and sold and protected? if the limited monopoly grant isn’t an asset, what’s the motivation to share methods that make money? even if one views trolls as nothing more than bottom feeders, they serve the same function as any bottom feeder in an ecosystem – recycling the dead and dying.if anyone has experience with fending off trolls, do they most often after your patented technology or your unpatented technology? knowing that would help inform how much patenting (and disclosure) to do. at the moment, i’m pursuing ‘lots’ of patent protection. but if that just serves to attract trouble later, i’d want to rethink it.

        1. fredwilson

          i don’t think software patents should exist

          1. GraemeHein

            Patents are good and necessary for situations that require substantial capital to derive value from and where the patent can be specific.Drugs require huge investments of time and money and are for one chemical structure only. You can’t patent the idea of SSRIs, only YOUR SSRI.Software is very, very fast moving and the patents are general. One-click being a great example. On top of this, innovation in software isn’t as innovative as it’s claimed. Most work is obvious and it’s simply who faces the issue first or who has the largest patent staff churning out submissions. That they then get to control whole classes of algorithms is absurd.Software is something that should be copyrightable, not patentable.

          2. ShanaC

            I have genes in me that are patented (or possibly). I really don’t like that.

          3. GraemeHein

            Patents on the existence of genes is fairly ridiculous. It’s sequencing with no work.Patents on the OncoMouse or RoundUp Ready plants are useful and worthwhile.You should have to do something actually novel and creative to get a patent.

      3. JLM

        This is true for most classes of litigants dealing with large pools of capital, money changing hands at the closing table and public/quasi-public funds.It is typically the lawyers who are driving this through class action type thinking — law as an entrepreneurial and financial endeavor rather than as a service to clients.If you let lawyers take cases on contingency, you are in effect putting them into business but they buy their services wholesale and do not have to pay for losing.We have allowed this to happen by the absence of tort reform, loser pays and the aggregation of trial lawyers into a political class.If we had loser pays, then everybody would be on their toes particularly if you had to post something like a supersedeas bond to ensure payment in the event of a loss.This is routinely done at the appeal level and it has the desired impact.

        1. fredwilson

          i totally agree JLM

        2. Fernando Gutierrez

          I’m a big fan of systems in which the loser in a trial pays for the legal costs of both parties. They are great to reduce disputes, but they also have flaws.In Spain we have a mixed system (loser pays when he has made the process longer or more expensive than necessary, or when he’s proved completely wrong in everything) and it prevents some legitimate claims to be made to avoid risk.Also, it’s difficult to deal with the different prices of lawyers: should the loser pay for any legal bill presented, no matter how expensive? or just for an average bill? The first case is great for the winner, but it increases risks a lot and puts even more power in the hands of judges (who, btw, are human, and thus, fallible). The second takes some risk off the table, but then it doesn’t completely solve the problem because the winner may still have some legal bills to pay.

          1. ShanaC

            I like this system

  5. Nate Quigley

    I like the last paragraph best. Helpful to go into the process with realistic expectations. We had a 10% “hold back”, and 12 months post sale our buyer did in fact hold some back. They pointed at an implementation project that had gotten complicated i.e. expensive. They also grumbled about the pipeline. I wanted to argue, my more experience partner said life’s too short. In the doubling revenue every year stage of growth, there will always be something messy to point at. Looking back I’m glad we just moved on.

    1. fredwilson

      good decision

  6. JLM

    Ahh, a great subject and one I could write on for days.Here are a couple of pragmatic tips as I have dealt with these type of issues forever.Know the difference between a rep and a warranty and when they are used and what the knowledge standard is for each one because it is typically different.A rep is typically to the “best of your knowledge” meaning it is only what you really know and does not require any inquiry on your part.A warranty is typically “absolute” meaning it doesn’t matter whether you know it or not. You are responsible for the truth.A rep is typically in a Purchase and Sale Agreement while the same issues are typically warranted in a Stock Exchange Agreement. One is thought of as being “contractual” while the other is more of a “securities” issue.Classic example — street is wet in front of the building. Why?Rep — “it rained” — ooops, street sweeper came by. No problem as you did not have actual knowledge. You are off the hook.Warranty — “it rained” — ooops, street sweeper came by. Big securities problem because you do not get a pass based upon knowledge standard. A warranty is absolute.Big idea: never, ever, ever rep or warranty anything a buyer could find out through his own due diligence. If you give the buyer the unfettered opportunity to satisfy himself on the issue, then you should not be bending over backwards to rep or warrant anything he can find out or otherwise satisfy himself on. At the very least, make damn sure to create an exhibit showing what the buyer did for his own due diligence so that if there is a future issue you can at least argue that he investigated it himself at the time and did not object.They will not send you more $$$ if they surpass their own financial projections. I promise you that.

    1. andyswan

      “Big idea: never, ever, ever rep or warranty anything a buyer could find out through his own due diligence”…..Came here to say just this. It’s the only rule of reps/warranties you need to know.Well that and make damn sure a really really thorough and smart attorney has verified that everything you are repping is 100% true.You’ll be shocked how much better the other side is at due diligence AFTER the deal goes bad….

      1. doctoral thesis

        […] “Big idea: never, ever, ever rep or warranty anything a buyer could find out through his own due diligence”[…]great words. sometimes we are not attentive and can not do what ou say – i mean […] make damn sure … that everything you are repping is 100% true […]agree that it is just impossible to do that every single time! from time to time you are going to miss something anyway

    2. Tom Labus

      That was excellent, thanks JLM.Fred, how the did the WM7 phone do in your office?

    3. davidthomas8779

      It is impossible to have these two positions at the same time:1. Fees for transactions should be fixed and low.2. Anything discoverable through due diligence should not be repped to.Fundamentally, buyers rely on sellers to provide accurate and complete information so that they can assess their potential risk and determine how it affects perceived deal value and without representations from the seller, a buyer would be be forced to spend hundreds of hours investigating every aspect of a business or discount the value of the business to take into account uncertainty.[I feel obligated to point out that even if you’re my client, my blog comments are not legal or tax advice. More information at http://tinyurl.com/blogdisc…]

      1. JLM

        I am not sure I completely understand your premise but the two statements are not really in conflict.As it relates to the costs and fees for transactions, in great measure that is a function of the real cost of doing deals in a real world in which the documents are sitting in your attorney’s computer, are not “one off” docs and the real cost is one of tailoring them to the actual deal.Frankly, not a skill worth $400/hr unless something goes terribly wrong which is why you don’t want those reps and warranties to survive the closing if you are a seller or you want to have liquidated damages, at least.This is like Charles Schwab turning the brokerage business on its ear making the pricing a function of order entry and execution rather than the bullshit standard of your stockbroker’s country club.Any buyer worth his salt is already doing the kind of due diligence I am suggesting is the basis for allowing reps to die at the closing table. Reasonable and painstaking but still much less expensive than just a few years ago. If you are investing OPM, you better be doing this level of DD.You can do a background investigation — a very comprehensive one — for about $150.The banking industry has to do these type of background investigations because of the implications of recent law which does not allow any person who has a fraud or financial dishonesty conviction or deferred adjudication in lieu of a conviction or pre-trial diversion (read fake ID when you were a college freshmen in SAE at UT all those years ago) to touch money. Not a big fan, just reporting the news.So, yes, I think you can get both and I have done it quite a few times myself. But, hey, that’s just me.BTW, I love your movie — cartoon. It is great. A sign of the times.

    4. ShanaC

      Why are warranties absolute – you can’t know the future…

      1. feddkraft

        i guess, you can’t know, but you can promise. if you manage to promise, you get better valuation. if promised happens, you’ll get the escrow. isn’t it good? 🙂

  7. brianmgordon

    Great post which shows the value of counsel with expertise and experience in selling venture-backed companies. The interplay between reps and indemnities, as well as the bargaining over escrows, holdbacks, etc. is where there is significant overlap between so-called “legal” issues and so-called “business” issues, and so it is important to have an attorney which the business side trusts implicitly.

  8. Rob W

    Two thoughts:(1) I would expand the discussion of “reps” and “warranties” to “reps”, “warranties” and “covenants”. In many instances you will see “reps and warranties” lumped together and “covenants” in a separate section. As JLM comments correctly, reps are about things that are true as of the closing date, while warranties are about things that are/will be true. Covenants are different but no less important – they are promises by the sides to do (or not do) certain things during the term of the agreement. (For example, if you have obtained bank financing, you will quite likely have a “negative covenant”, i.e., a promise, not to dispose of collateral.) This is lawyer territory, but make sure you understand correctly what’s going on (and what you’re promising!).(2) It is critical that your lawyer educate you on how these things work. It is *at least* as important that you educate your lawyer upfront about how your business works and what things you know and do not know in the conduct of your business. This will (a) get you a better outcome and (b) keep your legal costs down. with lawyers, as with life, an ounce of work up-front will save a pound of effort fixing issues in the back.Great post, Fred – really important stuff!

  9. Scott Edward Walker

    One of the most important terms from the sell-side is the “cap” on liability, which ideally should be negotiated as part of the letter of intent (when the seller has the most leverage and prospective acquirors are played off of each other).A cap basically means that if something goes wrong post-closing and it turns out, for example, that the seller has breached a representation and warranty in the agreement, the buyer can only recover up to a certain amount.Sellers should push hard for a cap of 10-20% of the purchase price; and, if there is an escrow, Sellers should push hard to make the escrow the buyer’s exclusive remedy (and should minimize any buyer carve-outs). The message to the buyer is simple: inherent in any business are certain ongoing risks; thus, once the business is sold, the buyer should only be able to recover a limited amount of the sale proceeds (absent fraud).I discuss this issue in detail in paragraph #5 in my post “5 Biggest Mistakes Entrepreneurs Make in Selling Their Company” (see http://bit.ly/duvg53).Thank you.

    1. JLM

      The entire concept of damages caps or liquidated damages — particularly including legal fees — is one of the most important concepts in business today.I don’t ever mind taking on a liability if I can quantify it.It removes the Irish Sweepstakes ticket element from the issue.And that is a good thang!

  10. Shurtleff

    A post on each of these topics would be useful. One warning on Escrow’s this was once an area where if things went reasonably well a year in the escrow would just be released. From talking with M & A lawyer friends, this area is becoming super contentious. It about money after all… One personal example was a purchaser held back escrow funds when outstanding invoices did not come in within 60 days as specified in the purchase and sale document (mistake, make the window bigger). The outstanding invoices ultimately were paid, but not ine the specified window. The purchasing CFO played the ‘fine print card’ and essentially double dipped, keeping both the revenue and matching escrow funds.

    1. JLM

      We call that “unjust enrichment” and that is frowned upon.This is exactly why dueling should never have been outlawed.

    2. JLM

      I cannot tell you the number of times I bought something and a bill came in thereafter. If it was applicable to the pertinent time period, I just paid it.Why be a shit and try to get out of something because it was late. Karma.On the other hand, I came to know that if the lawyers send you a 3 page letter it is ALWAYS because they are trying to get around something.I am involved with a very simple matter just now pertaining to a very, very, very, very lucrative cell phone tower. It came along in a deal for free and I never thought a thing of it counting my lucky stars and collecting what was a modest rent.Then they trespassed on my property and just installed an underground cable outside the easement. I asked them to fix the encroachment and they told me to piss off.Then I learned they had sublet space on that cell phone tower to every Tom Dick and Jane in the free world thereby making a shit pot of money but conveniently overlooking the necessity to obtain my permission. Or to give me even a touch of their good fortune.I have not had as much fun in years as I am having screwing with these guys. If they had just come to me and said — ooops — I would have told them to clean up their mess and go buy me a Honey Baked Ham but noooooooooooooo — they wanted to teach me a lesson.Their law firm has an office in Hong Kong and London and they have it on their letter paper. I on the other hand am skilled in providing barbed wire enemas. We shall see.

      1. Dave W Baldwin

        So you can’t put a little electric zing to the fence?By the way, here is an interesting announcement re towers-http://www.linkedin.com/new…

    3. mike gilfillan

      In the end it’s all about trust. I think it’s possible to gain a keen sense of who you are dealing with by how they negotiate the details of the deal.The rep on outstanding invoices is one in which we went round and round, eventually I proposed that the seller has the option to recover bad debt instead of hitting the escrow; basically saying, “if you can’t collect it, I WILL”. Of course, the buyer didn’t want the seller contacting customers post-deal, so it boxed them in and showed that I was confident in our clients, contracts and ability to collect.

  11. JLM

    One other thought as it relates to reps and warranties — the applicable time period.There are many reps and warranties that should die a graceful death at the closing. In this instance, it should be specifically noted what reps and warranties survive closing.It is not the least bit unreasonable to eliminate virtually all reps and warranties that are no longer germane after the closing and for which buyer due diligence can be substituted.As an example, there is no good reason to opine about anything related to the lease of the premises when a formal lease assignment has been executed.Same can be said for the wisdom of identifying specific liabilities to be assumed and denying all others not on the exhibit.

    1. fredwilson

      yes, when they expire is critical. i can’t believe i left that out. thanks for raising it JLM

  12. MartinEdic

    Wow, this post and the comments is incredibly valuable. A whole set of issues I was not familiar with. Keep it coming Fred…

  13. PhilipSugar

    My comment comes from selling my house versus selling companies (2)My realtor (good friend) said list everything wrong with your house. Nobody ever backs out because of the reps. Its when they have “buyers remorse” they want to come after you.I listed everything. He asked again…everything?? We went over and added some stuff.Sure enough when the bubble burst, the buyer wanted out of the deal…..everything she complained about was listed.To JLM’s point, the real estate company paid a down and dirty settlement rather than spending money in court. That kills me about our system.

    1. fredwilson

      list everything is good advice

  14. davidgeller

    Great post. Perhaps the most important part of a sale agreement. It’s why the lawyers make the big bucks.

  15. paramendra

    Hefty stuff.

  16. Ilias Chelidonis

    FredMaybe you want to do a post about whether acquisitions make sense or not and under which conditions, what to look for when identifying a target and how to make an acquisition as smooth as possible. An expert advice on this would enlighten us all.Elias

    1. fredwilson

      that’s what i am attempting to do with this whole series on M&A

      1. Ilias Chelidonis

        Alright, looking forward to it.

  17. TedHoward

    “The seller will require a percentage of the purchase consideration …” should be “The buyer …” right?

    1. fredwilson

      yes, will fixthanks

  18. J.R. Sedivy

    Do you have any advice on how to build your business and IP strategy to strengthen its position against potential patent trolls? That would make for an interesting future article.

    1. fredwilson

      get patents and cross license them with others to create a strong defensiveposition

      1. J.R. Sedivy

        Thanks Fred. I did some brief reading and found an example of Microsoft and JVC cross-licensing. If you have an example readily available and it fits within your blog schedule I would be interested in seeing a case study from your experience where this worked well. If possible, from two early stage companies.

  19. Mark Vogel

    For those of you interested in this topic , SRS has a free book on its website that provides details of post-closing issues and what you can do when negotiating the merger and escrow agreements to mitigate risk. http://www.shareholderrep.c….

  20. JLM

    Directors of public companies enjoy a general indemnification under Delaware law for all actions they take as “prudent” men.Since Berkshire IS an insurance company at its core, they are simply self-insuring and thereby indemnifying their Directors directly. Probably a pretty damn good indemnification.I would never contemplate serving on the Board that did not have a D & O policy of some considerable magnitude as a claimant could proceed against a Director as easily as the company.It is not just the claims you lose, it is also the ones you win and still have to pay huge legal fees for that will kill you. Nothing in America is more expensive than being right.That is why we so desperately need tort reform.Anybody with $25 can sue you and every lawsuit has a headache factor which can be an expensive proposition to say nothing of the time, energy and brain cells lost in the process.

  21. fredwilson

    we have it at USV

  22. JLM

    I actually don’t see any conflict. Read it carefully.While Buffet is beating his chest saying the Directors do not receive the protection of liability insurance, he is not saying they are not indemnified. I think this is a simple matter of law and not some arbitrary election by the company.I cannot imagine a scenario in which BH and its Directors would be subjected to a claim and the company would not defend its Directors if for no other reason than to prevent them from settling something the company would have to fight.While it is fairly difficult to separate a company, its officers and Directors from the same liability or claim, it could arguably be done if the claim was based solely upon the actions of a handful of Directors.Even then the company would have a vested interest in defending its Directors.Not bloody likely but surely law school class theoretically possible.As to losing money, that is a reference to their shareholding not their role as a Director.

  23. David Semeria

    Nothing in America is more expensive than being right.Well said – and it’s not only in America.Legal cases should be like football games: if it’s a close call then it’s right that costs be shared, but if the other side doesn’t even score a point then they should pay for the whole party….

  24. fredwilson

    yeah, i see that all the time. it sucks