The M&A Playbook (Part 9): The 'What If You Lied?' Clauses
Table of Contents
- Introduction
- Step 1: Representations & Warranties ("Reps & Warms")
- Step 2: Indemnification (The "Remedy")
- Step 3: The Negotiation Battleground (Caps, Baskets & Survival)
- Step 4: The "Hostage" – The Escrow Account
- The Indemnification Toolkit: At a Glance
- The "Modern" Escrow: R&W Insurance
- Conclusion: Your Post-Closing Insurance Policy
Introduction
In Part 8, we forged the Purchase Agreement, which protects you before the deal closes. Now we come to the most contentious part of the entire legal negotiation.
This section is all about post-closing risk. It answers one simple, brutal question: "If I discover a skeleton in the closet 6 months after I've paid you $100 million, who pays for it?"
This is the "risk allocation" section of the deal. It's a three-step process: the promise, the remedy, and the security.
Step 1: Representations & Warranties ("Reps & Warms")
What they are: "Reps & Warms" are a long list of legally binding statements of fact from the seller about the business. They are the foundation for any post-closing claim you might have.
Examples:
- "The financial statements are true and correct."
- "The company has paid all of its taxes".
- "The company owns 100% of its intellectual property".
- "There is no pending or threatened litigation (other than what is disclosed)."
The Negotiation: The seller's lawyers will try to water these down with "knowledge qualifiers" (e.g., "To the best of our knowledge, we have paid all our taxes"). Your counsel will fight to make these statements "flat" and absolute (e.g., "Seller has paid all taxes."). Why? Because if it turns out taxes weren't paid, you want your money back, regardless of whether the seller "knew" about it or not.
Step 2: Indemnification (The "Remedy")
What it is: This is the "so what?" Reps & Warms are just nice words without a remedy. The indemnification clause is the seller's promise to pay you back (indemnify you) for any losses, damages, or costs you suffer if one of their Reps & Warms turns out to be false.
Step 3: The Negotiation Battleground (Caps, Baskets & Survival)
This is where the real fight happens. The seller has made a promise (the rep) and agreed to a remedy (indemnification). Now they will fight to limit their liability.
1. Baskets (The "Deductible")
The seller will argue, "We won't pay for petty, immaterial claims." They will demand a "basket," which is the minimum amount of losses you must incur before the seller has to pay for anything.
Deductible Basket: Like car insurance. If the basket is $1M and your loss is $1.1M, the seller pays only the $100k excess.
"Tipping" Basket (or "Dollar-One"): This is more buyer-friendly. If the basket is $1M and your loss is $1.1M, the basket "tips," and the seller must pay you the entire $1.1M (starting from dollar one).
2. Caps (The "Ceiling")
This is the maximum amount the seller can ever be forced to pay you, even if your losses are higher.
Market Rate: A typical cap for general reps is approximately 10% of the total transaction value.
Carve-Outs: As the buyer, we must carve out certain "Fundamental Reps" (like "we actually own the company stock" or "we paid our taxes") and fraud from the cap. For these critical issues, the seller should be liable up to the full purchase price.
3. Survival Periods
This is how long the reps "survive" post-closing. The seller wants this period to be as short as possible (e.g., 12 months). You want it to be 18-24 months, so you can get through two full financial audit cycles to find any problems.
Step 4: The "Hostage" – The Escrow Account
A seller's "promise to pay" is useless if they've taken your $100M, dissolved their entity, and moved to a non-extradition country.
To solve this, you don't give them all the money at closing. A portion of the purchase price (typically 10-20% of the deal, or an amount equal to the indemnity cap) is "held back" and put into an escrow account managed by a neutral third-party bank.
This money is your security. It is the "hostage" that will be used to pay for any indemnification claims that arise during the 12-24 month survival period.
The Indemnification Toolkit: At a Glance
| Term | Definition | What It Does |
|---|---|---|
| Reps & Warranties | Legally binding statements of fact about the business | Creates the basis for a future claim (e.g., "Seller promised the taxes were paid") |
| Indemnification | The remedy. The seller's promise to pay you back if a rep is false | Gives you the right to recover your losses |
| Basket (The "Deductible") | The minimum loss you must incur before the seller has to pay | Protects the seller from small, nuisance claims |
| Cap (The "Ceiling") | The maximum liability the seller has for a breach | Protects the seller from catastrophic, "bet-the-company" liability |
| Escrow (The "Hostage") | A portion of the purchase price held by a third party post-closing | Provides a "pot of money" to ensure you can actually collect on your claims |
The "Modern" Escrow: R&W Insurance
This entire process is, by nature, deeply adversarial. Sellers (especially private equity firms) hate leaving 10% of their money locked in escrow for two years.
In the last decade, "Representation & Warranty Insurance" (R&W) has taken over the market. Instead of fighting over a 10% escrow, the buyer (or seller) purchases an insurance policy. If a rep is breached, the insurer pays the claim, not the seller.
This "streamlines negotiations", allows the seller to get all their money at closing, and gives the buyer a (supposedly) easier path to recovery. It has its own costs and complex exclusions, but it is now a standard, and often required, tool in the M&A toolkit.
Conclusion: Your Post-Closing Insurance Policy
These clauses are your primary insurance policy against post-closing surprises. Your lawyer's job is to build a tight remedy. The seller's job is to limit it. The final landing spot is a pure reflection of each party's negotiating power.
The contract is signed. The money is ready. The final, marathon negotiating session is over.
Continue to Part 10 where we'll cover the final 'Close' and the real start of the marathon: Post-Merger Integration.
Previous: Part 8: Forging the Purchase Agreement
Next: Part 10: Closing the Deal & The First 100 Days
