How to manage the warrant and indemnity claims in the acquisition process

There are various complexities inherent in the sale and acquisition of businesses, which, if not properly managed, can often lead to missed opportunities on either the sell or the buy side.

Accordingly, the processes involved in the disposal of a business must be appropriately attended to, to ensure that the maximum potential value is realised.

One of the most important aspects of the disposal of a business is the accompanying due diligence that the acquirer must undertake. The due diligence process has multiple purposes, but is primarily focused on determining the inherent risks for the acquirer, which may impact the purchase consideration. Typically, the due diligence process is handled by creating virtual data rooms (DD rooms), where the seller provides the acquirer with relevant information about the business. However, key information is also often shared outside of the DD room, either in ad hoc email correspondence or desig-nated meetings. From the seller’s perspective, it is prudent to ensure that the ad hoc correspondence is transferred to the virtual data room. This can be done, for example, by ensuring that all the acquirer’s ad hoc questions are encapsulated in a single document, with the corresponding responses from the seller.

The DD room is also critical to the disclosures of the purchase agreement. To this end, the seller would want the DD room to be annexed to the disclosure clauses as part of the purchase agreement. This practice aims to prevent unnecessary warranty and indemnity claims for the seller as a result of non-disclosure. In such a case, the buyer would need to be confident in their due diligence process, to ensure that the relevant risks are identified and adequately addressed as part of the purchase agreement.

From a buyer’s perspective, one protection measure that could be implemented is a holdback on the purchase consideration until certain perceived risks have lapsed; i.e., the buyer would withhold the payment of a portion of the purchase consideration until holdback provisions have been satisfied. These holdback provisions can be either suspensive or resolutive. In certain instances, a seller may request that the cash portion subject to the holdback be placed in an escrow account; however, using an escrow account does result in the unproductive use of funds for both parties.

To avoid unproductive cashflow consequences, the parties could consider obtaining warranty and indemnity insurance, should certain hold-back provisions not be met. The downside of such a solution is that it is typically quite costly for both parties. Alternatively, where the seller does not outrightly divest from the business, and therefore maintains an interest in it, a portion of the shares that it maintains in the business could be offered as security for any warranty and indemnity claims.

The disposal or acquisition of a business interest can be notoriously complex, particularly when there is an air of scepticism amongst the parties, which typically leads to extensive due diligence processes and complex warranty and indemnity provisions. These complexities can be overcome by finding nuanced solutions to satisfy the needs of both parties. Ultimately, no two merger and acquisition processes are alike, and understanding the options that are available to solve these potential deadlock situations is the key to concluding a successful transaction.

Bobby Wessels is a Manager: Corporate and International Tax, and De Wet de Villiers a Director: Private Clients | AJM.

This article first appeared in DealMakers, SA’s quarterly M&A publication.

DealMakers is SA’s M&A publication.
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