The time for Full Disclosure
Through all the exhilaration, stress and the emotional rollercoaster of a sales process in which the entrepreneur works towards handing over the keys of his life’s work, there comes a point in every disposal transaction that the seller needs to clearly understand the contractual representations they will make and their implications. To use a car-analogy - this is essentially when the “rubber hits the road”, and things get serious. This point arises near the end of the exhausting marathon of diligence and SPA negotiations, when the seller and his lawyer will often prepare a “disclosure letter”, which forms a key part of the contractual process. The “disclosure letter” is an opportunity for the seller to fully clarify any defects or issues which exist within the business, so that the buyer can complete the transaction with a full knowledge of any risks. If however the seller fails to make adequate disclosures, they may well find themselves at some time in the future receiving a breach of warranty claim, which will attack the very sales proceeds they had fought so hard to achieve.
What's a warranty and what should be disclosed?
In previous articles we have taken the liberty to equate the process of selling your business with the selling of your private vehicle. Both are effectively “sales processes”, where you seek to polish and enhance the appearance of your asset in order to seek a premium value. Another interesting similarity is that both asset-sales rely on the legal principle of “buyer beware”, since there is little alternative statutory or common law protections for the buyer. In order to overcome this weakness the buyer’s lawyers set out extensive contractual statements in the form of “warranties” within the sales and purchase agreement (“SPA”), for which the seller is required to provide the buyer. While we will be familiar with warranties when buying a new TV, where the seller guarantees the quality of their product, the warranties sought on a business disposal unfortunately reflect the complexity of a company with a myriad of corporate, employment, regulatory, financial, property and tax exposures which can easily take up to 50 pages of the SPA. It is vital however to understand the important connection between “warranties” and “disclosures”, since if a warranted fact is later found to be false, the seller may face a claim of breach of warranties to compensate for any loss. If however the facts which give rise to the breach were fully disclosed, then such a claim can be defeated. Simply put - the seller can avoid future exposure (and indeed sleepless nights) if they fully disclose to the buyer any pertinent facts or risks relating to the warranty being requested.
The disclosure letter as seller protection
It should however be highlighted that claims for breach of warranty are very rare, and indeed most M&A professionals will unlikely come across them. Their rarity is usually down to the high cost, time and disruption of the buyer pursuing any formal litigation. Also while there is a requirement for buyers to demonstrate their suffered loss, warranties are usually subject to a range of limitations, including a time-limit within which claims can be brought, a de minimis threshold for any single claim and total basket cap which has to be exceeded for cumulative claims before any action can be taken. The other key reason as previously noted is the protection that the sellers will have against any claim to the extent that the nature of the claim has been disclosed to the buyer within the disclosure letter. Given the relative importance of the disclosure letter, it is however a curious fact that most of the legal discussions (and indeed extensive legal fees) are engaged earlier in the process during the negotiation of the intricate terms of the warranties, rather than in the consideration of the disclosure letter which often comes at the last gasp of the deal.
A full and proper disclosure letter is in everyone’s interests
To better understand this, one must look however beyond their primary purpose as being an arrangement to provide some compensation, to the extent that unknown liabilities arise. It is their secondary (and arguably more important) purpose they play in encouraging sellers to fully disclose any potential such risks, since the failure of such disclosure will open the sellers to future risk of a claim. The resultant disclosure letter thereby not only provides protection for the seller (as already noted), but ensures that arising issues are discussed sensibly by parties before the completion of the sale. While a buyer when faced with a disclosed risk may well desire to obtain a late price adjustment or an indemnity from the seller, it is common in competitive bids that buyers may be forced to accept certain risks without recourse, to avoid losing the deal to a competitor. A full and proper disclosure letter is therefore in both parties’ interests. For the seller, it provides protection from a future breach of warranty claim, where for the buyer it supplements the due diligence exercise in giving it a full picture of the target company or business.
At Red Swan Partners our team have extensive experience from growing and selling their own businesses, being TIC corporate’s M&A executives, as well as working with a wide range of TIC business owners to support them in the development of their own exit strategy. This wealth of relevant market experience allows us to best advise seller and advisors through preparing for the due diligence and disclosure process and support you to secure a premium value that is not at risk from future claims. Red Swan recommends that it conducts an early risk assessment of your business to identify areas which may cause an issue during the disclosure process. Once identified Red Swan will assist you to determine how best to deal with or overcome this risk in the context of a divestment. As previously discussed in our earlier July-21 article “Honesty is the best Policy” such an early assessment will allow consideration as to how best to deal with the issue in order to preserve competitive tension and still deliver a premium value.