When drafting and negotiating transaction documentation, the focus is primarily on risk allocation. For example, how are risks identified by a buyer during the due diligence process (‘DDO’) incorporated into the share purchase agreement (SPA)? But also, who bears the risk for matters unknown to both the buyer and the seller? This is where warranties and indemnities come into play. A risk allocation may also apply with regard to the purchase price in the form of a potential supplementary payment, known as an earn-out.
Warranties and indemnities
Warranties are representations made by the seller regarding the condition of the company being sold (the ‘Target’) at the time of closing. Indemnities relate to specific, known risks, whereby it is agreed that the seller will bear the consequences should those risks materialise. For example, the DDO reveals that the Target is involved in legal proceedings. Any resulting loss to the Target is at the seller’s expense and risk. The allocation of risk with regard to other, unidentified risks is set out in the warranties.
The seller provides representations regarding all aspects of the business in question and warrants that these representations are accurate, unless the seller has informed the buyer otherwise. Through these warranty representations, the parties set out the characteristics of the business and, consequently, what the buyer may expect. For example, ‘The Target has taken out all insurance policies customary within the industry, providing adequate cover’. If it subsequently transpires that this warranty statement is incorrect and the seller has not (accurately) informed the buyer of this, the seller is liable for the loss suffered by the buyer.
Limitations of liability
A seller will seek to limit their liability in respect of the warranty statements as much as possible. After all, a buyer should not be able to make unlimited claims. There is often a time limit (usually 18–24 months). A buyer can therefore generally approach the seller up to a maximum of two years after the transfer of ownership if a warranty statement has proved to be incorrect and the buyer has suffered loss. A financial limit is also always agreed. A claim may not exceed a certain percentage of the purchase price (the cap). In addition, individual claims must meet a minimum threshold (for example, €10,000, the ‘de minimis’) and all claims taken together must exceed a certain value (for example, €100,000, the ‘basket’). Claims that fall below these so-called ‘no-fuss thresholds’ are not classified as ‘material’. In other words, the claim must be of a certain significance for a buyer to be able to make a claim. If the amount of the claim remains below these ‘no-quibble thresholds’, this falls within the buyer’s (business) risk. The levels of the de minimis and basket depend on the purchase price. Specific indemnities (other than the general tax indemnity found in every SPA) are usually not limited in terms of time or amount, though this is possible.
Furthermore, the SPA often stipulates that, with regard to both warranties and indemnities, account must be taken of, for example, taxes and insurance. If the event giving rise to the damage also results in a return of equity or an insurance payout to the Target, the seller is generally not liable for that portion.
Finally, a seller may also attempt to negotiate that certain warranty statements be qualified as being ‘to the best of the seller’s knowledge’. For example, ‘To the best of the seller’s knowledge, no third parties are infringing the company’s IP rights’. If that warranty statement proves to be incorrect, it becomes very difficult for a buyer to make a claim under this warranty. After all, the seller will defend themselves by arguing: ‘I did not know’. This places the buyer in a rather unenviable position (in terms of the burden of proof). A buyer must therefore be critical when accepting these so-called ‘knowledge qualifiers’.
Earn-outs
An earn-out is an arrangement whereby the buyer is only required to pay part of the purchase price once one or more specific results agreed between the parties (the ‘earn-out conditions’) have been achieved within a specified period following the acquisition (the ‘earn-out period’). The earn-out conditions are usually financial in nature. For example, during the earn-out period, the Target must achieve a certain minimum operating profit. However, these conditions may also be of a non-financial nature, such as the acquisition of an essential licence. Preferably, the earn-out period is limited to two or, at most, three years following the acquisition.
Earn-outs have both advantages and disadvantages. On the one hand, earn-outs are, for example, a suitable tool for bridging the gap in valuation (and thus the purchase price) between the minimum the seller wishes to receive and the maximum the buyer is willing to pay. This difference in opinion may arise for the following reasons. At the start of an acquisition process, the seller’s financial adviser usually draws up an information memorandum (‘IM’). This provides an overview of the company. The IM provides, amongst other things, (detailed) information about the company’s products and services, its employees, customers, suppliers, etc. A financial section is also a standard part of the IM. This section not only focuses on the Target’s historical results but also – or rather, primarily – on future prospects. The IM often paints a rosy picture of the future. A buyer is often more sceptical and will say to a seller: ‘Prove that those future expectations are realistic’. If the purchase price includes a potential earn-out payment – which has often been the case in SME transactions in recent years – the seller usually remains associated with the Target for (at least) the duration of the earn-out period.
A disadvantage of earn-outs is that they often give rise to disputes between the seller and the buyer. Not just after the event. For example, has the earn-out been calculated correctly (in line with the Target’s applicable accounting standards)? But also beforehand. For example, how are one-off financial windfalls or setbacks during the earn-out period (the so-called ‘normalisation adjustments’) dealt with? This often leads to protracted contract negotiations on this point.
Furthermore, there are, in a sense, conflicting interests between the seller and the buyer. For the seller, for example, it is important that the buyer does not take any actions during the earn-out period that would undermine the Target’s earning capacity. The buyer, on the other hand, will require freedom and flexibility with regard to the Target. As the new owner of the Target, the buyer will want to be able to intervene whenever and in whatever way they deem necessary.
Finally, in the context of warranties, indemnities, earn-outs and risk allocation, it may be agreed that, should a seller be liable for damages because a warranty has proved to be incorrect or an indemnity claim has materialised, the buyer may set off those damages against the (potential) earn-out payment. Set-off is generally only possible once the buyer and seller have reached agreement on the amount of the damages or once a court has ruled on the matter.
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For a balanced allocation of risks relating to an acquisition process, please contact Onno or one of the other professionals from the team.
