The goal of many entrepreneurs is to seek venture capital financing or ultimately sell their company in an “exit” merger or acquisition. In each case, the company’s historical operations come under onerous pressure through the representations and warranties the seller is asked to make, and the related due diligence the seller must produce. To a small business, this can be extremely uncomfortable and/or challenging. To a big business, it may be more comfortable but nonetheless more demanding.
So why are they expected?
Representations and warranties are often a glimpse into the business and its history of performance. To a buyer, these validate value and allocate risk. If you were buying a pharmacy, for example, wouldn’t you want the seller to represent and warrant that its financials are true and correct (validating the value), and that it is and has been licensed to sell pharmaceuticals (minimizing any risk of noncompliance or violations)? If the seller represents and warrants to these items and it turns out they are false, the buyer now has recourse against the seller (which reduces upfront risk and may make them whole).
Representations and warranties also facilitate fact-finding, as the buyer can rely on the seller’s representations and warranties, caveated by disclosure. For example, if the seller represents that it has provided the buyer with all of its material contracts (which is common) except for those disclosed, the buyer can review those contracts as part of its due diligence process of evaluating value, risk, and outstanding or potential liabilities.
Representations and warranties serve a good purpose for both parties to a transaction. Few businesses are sold “as is” for, among others, the above reasons. It is important to remember, however, that reps and warranties, like everything else in the transaction, are always subject to negotiation.