Below is a dude that wrote a thesis on reps and warranties. Let us all prevent this.
Re-Visiting Robert Bruner’s Applied Mergers & Acquisitions on the last weekends. The part on due diligence made me think again about how soft and easy things work in the early stage VC world. Certaintly, there are some reasons there why people don’t spend $300.000 DD on a $500.000 deal, but then, it should still be worth to revisit the task.
First one has to understand the relationship between material provided by the company in the data rooms and pitch information, material requested and reviewed during due diligence and the legal clauses in the investment contracts that protect against assymetric information or moral hazard issues. Something this post will also address.
Ideally, your legal clauses or Reps, Warranties, Indemnifications are designed t cover the risks you were not able to look into during due diligence. In VC practice, it often looks more like a big standard list of clauses slammed on every deal “just in case”. Yes, that is somewhat cool. Especially in young start-ups this leads a big impression. And as said before, maybe that is the right approach to keep the cost of diligence low.
But then there is this general feeeling that tells you that anything in a contract that is non-enforcable doesn’t belong into the contract. And even more important, anything that is enforcable, but which is not enforced or intended to be enforced, belongs out of the contract. Why? Because every clause in a contract that is violated consistently is watering down the entire contract. It makes all agreeing parties look like they do not know what they are doing. Everyone is forced to be in steady non-compliance with a well-thought out contract. It destroys trust and in the worst case enforcability ofthe entire contract.
But, let’s revisit what Bruner had to say to give some coloring.
Due Diligence is about risk … AND REWARD
Bruner makes some interesting observations which were new to me, but make sense:
- Markets pay for clarity and accuracy.Uncertainty is a big thing in markets. Just think CAPM.And clearly, ambiguity of information caused by lack of clarity increases uncertainty. Which leads to higher perceived risk for same perceived reward. And hence leads to lower valuations.
Accuracy is another driver. Accuracy goes down if there are omissions that are misleading. Omissions in general are to larger part deemed inaccuracies from lack of competence, or neglicence or deliberate omissions.
Same for misfacts or claims on false facts. Or Misrepresentations as false claims on accurate facts.
But even if information provided is complete, it may be insufficient or insufficiently clear information. Also bad.
All adds to risk of the investments. Any misrepresentation adds to a pattern of misrepresenting and makes everything disclosed less plausible and certain or reliable and hence more risky.
- Mitigate the uncertainty of returnThere is a massive amount of uncertainty in any venture investment. But that does not mean that it cannot be controlled at all. Again thinking CAPM.Operational risk: There is market risk, possibly hedged against to certain extent. There is operational risk to be properly measured and controlled. Documented lack of awareness or willingness to deal with risks or the lack thereof can be indicators of risk on operational side.
Execution: Solid planning that matches best practices is one thing. Commitment to and ability to execute against plan another thing. And the plan’s accuracy to win in the market is another thing.
Governance, compliance, regularity of the business: Is everything legal, is the best effort being made to run a regular and compliance business? Is the prudence, the level of care, and so forth all in place?
Behavioural risk: Post hoc ergo propter hoc: The past isn’t a predictor of the future when it comes to success. But a predictable pattern of misconduct and negligent behaviour is a good predictor of those patterns in the future.
Success Predictors: The perceived ability of accurately prediciting revenues and costs under growth can if at all best be measured by the ability to do it in the past. Looking at all business plans and execution against it might be a best predictor of performance against plan in the future. Clear failure in forecasting and budgeting in the past are for sure a good predictor of failure re-curring.
Using risk measurement: Both buyers and sellers, or investors and start-ups, have to build and use framework to visualize and materialize risk-related information in order to discuss and control the underlying risk. If this is not happening, valuations need to reflect worst case assumptions and valuations drop. Reps and warranties increase.
Understanding the interplay of risk and valuation and how ability to see and price risk is guiding diligence work, questions asked by VCs and what they write into their investment memos is key to understanding why negotiation reps and warranties is something useful to understand who you are dealing with. Hence this article.
If due diligence and reps and warranties are about risk management, and reducing risk means increasing value, then this is at the core of the question. Are both parties interested in de-risking and value-optimization? Or do both see the exercise as a hassle and do they lack an understanding of investments and running businesses?
Furthermore, coming back to accuracy and clarity: representations are meant to be clear and accurate. Unclear representations are increasing uncertainty. Misrepresentations in representations are sanction and further increase uncertainty. And lower price.
[In Theory] This implies that unclear language in your reps and warranties, overly generalistic statements and the inclusion of reps and warranties that are violated at the moment of drafting by all parties are all indicators that people do not know what they are doing or they are justifying a lower price.
Sidenode: This also reflects how serious investors take their job. If you are doing an LBO at a 10 billion valuation and you are missing out a part in diligence and you are not putting that risk into the reps and warranties, chances are there will be a lawsuit if things go wrong. Which is why you are not doing it. But of course, investing 5 million of family office money into a fraudulent start-up is something that does not warrant such care. With investment contracts shared with investment committees, and LPs covering wider portfolios from early- to late-stage investments, it becomes another indicator – at least to me – why fund volumes and tickets in Europe are so small-ish. The fact that early stage investors do not take this serious is then probably again supported by the fact that Germans do not go to court aggressively. And maybe because GmbH law and jurisprudence is not the most aggressive one.
So again. If a start-up provides incomplete or shady information to investors, it lowers the price. Investors do some diligence, and cover some risks and ignore a lot of other risks. This reduces the price. They then slam a large reps and warranties standard list on the table. Which both increases the price for covering some risk, and reduces the price for assuming risk where it might not be and for watering down a contract with non-enforcable clauses or having clauses in there that are not enforced when violated which increases risk of future investors invoking the clauses and lowers valuations down the line. Etc.
The money saved on due diligence and legal drafting is going to bite back all participants. On valuation, on perceived professionalism and by tanking the overall governance and cleanliness of the business.
Reps, warranties, covenants, indemnifications, agreements?
So what are representations and warranties? Let us dive deep into the philosophy of uncertainty and ignore the legal context for a second.
Let’s start with indemnifications. There are basically two types of indemnifications. The first type takes away all liability from the indemnified person. If you sell me a black pen and call it a grey pen and I indemnify you from it being potentially not a black pen, then that’s that. Done. The first type of indemnification is a statement by the “buyer” that he accepts and assumes all risk without the right for damages on a particular item. A more realistic example could be that the buyer holds current management and the seller harmless for any financial errors in audited statements.
The second type of indemnification is of the type that regulates the damages for a breach of representations and warranties. So assuming that a seller warrants that tomorrow he will close a 1 million USD deal, and the deal does not come through, then an indemnification clause could have said that if this deal does not come through, the seller has to pay damageds of 200 thousand USD to the buyer. Apart from such indemnification clauses for specific warranties or representations, there can also be lump sump elements or statemetns such as if any warranty was broken there is a reduction of pruchase price. etc.
A representation is a statement that something is true. And it is known at 100% certainty to the seller that the statement is either true or false. or as this guy says: statements on past or present facts of circumstance.
A warranty is a statement that something is true. Only this time the seller does not know at 100% certainty if it is true or false. This can be the case when the seller is simply not able to judge, or does not have the right information, or he is simply talking about something in the future. Let’s say again, the seller warrants that he will close a 100 million USD deal in 3 months. And while he does not know the certainty, he will assume the full risk for this and will make the satement he wants to be held liable for any damages arising for this, because he wants to be treated as if he knew it was or will be true. Somewhat like a guarantuee. But the uncertainty comes from lack of information at the time t. So in essence, a warranty is something where the seller wants to ensure to the highest level possible that the buyer will be treated no less than how he would be treated if what he warrants was true. And the warranter acknowledges that he is in power and fully responsibility of what he warrants.
or as the othe guy said: Statements or promise of current and future condition including the fact that if condition is not met it will be made met.
Now we also have a guarantee. A guarantee is typically something similar to a warranty. One way to read it is that the guarantor is guaranteeing irrespective of his ability to control or not that he is by his guarantee ensuring full control. So a warranty might break if external force or something similar results in a loss. A guarantee doesn’t care about it. Hence also a title guarantee in a share deal that the seller owns the shares he sells. It doesn’t matter if he owns them – only in representation – or he cannot buy them any more because the physical shares were burned – only in warranty -, but that he makes the intended result materialize – that the ownership is moving as expected. Somehwat like a warranty + a promise to make any and all statements and actions to make the warranty work. So maybe this is a bit stricter than a warranty and damages should be higher.
Oh, and covenants as promises of future action or inaction. The company management will make any and / or all statements to …. The company will issue a press release.
All of the above from guarantees, covenants, warranties can be limited and restricted by including catch all indemnifications or having a time limit. If a warranty is breached but it only comes to light after the time limit, no damages will be paid and covered for again.
Makes all sense? Good. So coming back to law, we could say that a representation should bear highest damages. Followed by warranties. Followed by guarantees. And here you can read a commentary on this for the UK. Just without the guarantee. Since the term isn’t so common lately. In the US, as this guy claims, reps and warranties are treated as the same.
Another way to look at it is that lying or misrepresenting under oath is a criminal offense. While miswarranting isn’t a thing. So, makes sense to sanction a lie harder than a bet in good faith (warranty). And the fact why we probably have people claim that both are the same in the US is derived from them not being listed seperately, but their nature being clearly differentiated.
Summing this section up, and following this article, and Bruner, the reps and warranties are used to structure exposure of the buyer to risks that he was not able to fully understand and/or control using his due diligence. The indemnifictions are used to protect the seller from risks he might not be willing, able or asked to bear. Either by indemnifying from the risk completely or by specifying damages for breaches of the reps and warranties and hence making the capped amount of damages known and managable. The more specific all this is, the easier it also is to go into arbitration and settlemtn quickly, instead of going the litigation route. Simple.
Recitals, Conditions: Recitals are general statements that have no legal meaning apart from clarifying context and intent of contract. They are like comments in a software source code. Conditions or conditions precedent or precent conditions are things that are agreed to be not true as of yet, but need to become true for teh entire contract to come into full effect.
Oh, and there is an agreement. In principle, if the buyer indemnifies the seller, there is likely a risk left, which the buyer is willing to accept. What if there is no risk? When the diligence proved something is the case. And the seller is willing to represent knowing the statement is true. And the buyer is willing to indemnify knowing the statement is true. Then both parties have an agreement that something is the case. Having an agreement in the contract is signalling and derisking. Leaving it out would have the item unregulated. Putting it in would say the item is regulated. And having an agreement means that there is also no risk of the buyer to violate his duties by indemnifying the seller. And the seller has no risk by representing. Perfect.
I hope this was as interesting to the reader as it was to me when I read about it in the M&A literature. But the big questions is, how to use this in the negotiation?
In some sense, the answer is, you probably don’t. Because you don’t want to ruin your relationship with your new investor by negotiating reps and warranty details. Your investor most likely doesn’t get it that much and doesn’t care that much.
So step 1 in negotiating reps and warranties: let your lawyers do it. Lawyers like this a bit more and they like the billable hours even more. If you share cost on legal fees, good strategy. It’s your equity in the end. And you way to get to know the investor.
The next step is to acknowledge that you are not negotiation new representation for a higher price. Trying to add a new representation is only starting alarm bells. No, usually the due diligence process should yield a set of reps. Or there is a standard rep. And for the sake of getting waste out of your investment agreements, you should try to slash every one of those representations. And for every representation you cannot slash out, you should try to get the valuation increased. Or some other term added.
So step 2, negotiate them away or ask for something if they stay.
The next big insight here is the kind of answer you get. If your counterpart is not moving on anything even the clearly nonsensical representations that you know he will not use, and you can not meet and it makes both of you vulnerable, an the answer is that it is a standard term they always use and that is not negotiable, then you know that the negotiation and legal prowess of your investor is … well, (a) not existing, (b) existing, but there is an ego problem, (c) existing, but there is an authorization problem. In all three cases, you can make a bet that although your valuation is not affected by your arguments on the representations now, the skill and quality and mindset of this investor will hurt your valuation in future financing rounds. And that is where you have to be careful. And where you kill the deal – if you have alternative bidders and you don’t have an exclusive or break up fee and you are “pre-Termsheet”.
So step 3, you get to know your investor. His skill level. And leverage over him. If he negotiates a term he is not going to enforce but you have evidence that he should, you can use it by informing your minorities about him not meeting his fiduciary duties. Which would probably hurt you, too, but which you can use to show character of the investor and win over other shareholders for your proxies. Or worse, it is something a future majority investor can use to bully your old investor and make more concessions. Many ways this can backfire to your investor.
And finally, step 4, how do we use all this in a process perspective. Well, investors does diligence. Defines risks he could not resolve and comes up with reps and warranties. His perceived understanding of the risk in this reduces purchase price. Seller tries to negotiate away. Back and forth going on. Finally, seller talks indemnifications and caps to damages come into play. In a start-up world where the “sale” is basically the creation of new shares and the sale of those and the old shareholders and investors are not really “selling” shares, but selling fully diluted ownerhsip, it also makes sense structuring how those damages are to be paid. Less common here probably the use of escrows or guarantors. More common the change in purchase price triggering a higher dilution and hence the right to pruchase more shares.
Moving from the founder to the investor side. If you as investor slam a representation that you know will be given but will also not be true, you know that you are dealing with someone that is either not able to understand the risk and situation he/she is in and it can be leverage later, or you are facing a deliberately dishonest individual that will misrepresent in the future, too. In any case, once you introduce such a term and it is accepted, there should be some major effort spent on assessing which of the above cases are true. And if the lawyers of this target are nto highlighting an obvious representation that cannot be true to their founders or in the negotiation, they are in a bad boat.