The definitive purchase agreement is where the deal becomes binding. For a private company it is usually a stock purchase agreement (SPA) or, where the buyer takes only selected assets and liabilities, an asset purchase agreement. For a public target, and for some private deals with many shareholders, it is a merger agreement, under which the target merges with a buyer subsidiary and the shareholders receive the price. The agreement sets the price and its adjustments, but most of its pages allocate risk: what the seller promises about the business, what happens if those promises prove false, and what must be true before either side has to close.
For a buyer, the agreement is the second line of defence after diligence. Diligence finds what it can; the representations and warranties, backed by indemnities, escrows or insurance, cover what it could not find. For a seller, the same clauses determine how much of the price is truly final. The negotiation over them is often as long as the negotiation over price.
This topic covers the structure of the agreement, reps and warranties and the disclosure schedules, fundamental and general reps, the indemnity package (baskets, caps, survival and escrow), representations and warranties insurance, material adverse change clauses and closing conditions, with a worked indemnity claim.
Key takeaways
- Reps and warranties are statements of fact about the business at signing and closing; disclosure schedules list the exceptions, which shift the risk of disclosed matters to the buyer.
- Fundamental reps (title, authority, capitalization, often tax) survive longer and are capped at or near the purchase price; general reps survive for months and are capped at a fraction of it.
- A deductible basket makes the buyer bear losses up to the threshold; a tipping basket lets the buyer recover from the first dollar once the threshold is crossed.
- R&W insurance shifts most breach risk from the seller to an insurer, so the seller can take its proceeds with little or no escrow, but it excludes known issues.
- A MAC clause lets a buyer walk only in rare cases; US courts have set a high bar, so buyers should not rely on it as a general escape.
The agreement and how it is structured
A stock purchase agreement transfers the shares of the target, so the buyer takes the company with all its history, assets and liabilities, known and unknown. An asset purchase lets the buyer choose what it takes, which limits inherited liabilities and can give a tax step up in the asset base, but requires transferring contracts and permits one by one. A merger agreement achieves a stock acquisition through a statutory merger, which binds all shareholders once the required approval is obtained and so avoids needing every holder to sign.
Most US agreements follow a familiar structure: the purchase price and its adjustments, representations and warranties of the seller and of the buyer, covenants governing conduct between signing and closing, conditions to closing, indemnification, termination rights and general provisions. In a public company merger agreement the reps generally do not survive closing, because there is no one to claim against after the shareholders are paid out; protection comes from diligence, the conditions and the price. In private deals the indemnity, or insurance, carries the reps past closing.
| Feature | Stock purchase (SPA) | Asset purchase | Merger agreement |
|---|---|---|---|
| What transfers | Shares of the target | Selected assets and liabilities | All shares, by operation of law |
| Inherited liabilities | All, known and unknown | Only those assumed | All |
| Who must sign | Every selling shareholder | The selling entity | Board and required shareholder vote |
| Contract transfers | Usually automatic, except change of control clauses | Assignment often needs consent | Usually automatic, except change of control clauses |
| Typical use | Private companies with few holders | Carve outs, distressed sales | Public targets, private targets with many holders |
| Reps survive closing? | Usually | Usually | Public: usually not; private: often |
Reps, warranties and disclosure schedules
Representations and warranties are statements by the seller about the business: that the financial statements are fairly presented, that there are no undisclosed liabilities, that material contracts are valid and listed, that the company complies with law, that taxes have been paid, that it owns its intellectual property, and many more. US practice usually treats the two words together; UK practice gives warranties more weight and representations a narrower role. The reps are typically made at signing and brought down, repeated, at closing.
Reps are qualified in two ways. Knowledge qualifiers limit a rep to what named individuals actually knew, and materiality qualifiers limit it to breaches that are material. Both narrow the seller's exposure, and buyers often seek a materiality scrape, a clause that ignores materiality qualifiers when calculating losses or determining whether a breach occurred for indemnity purposes.
The disclosure schedules are where the seller lists exceptions to the reps: the litigation that exists, the contracts that have change of control clauses, the tax audits in progress. A matter properly disclosed is no longer a breach, so the risk of it passes to the buyer, who must deal with it in price or through a specific indemnity. For this reason the schedules are negotiated line by line, and buyers resist general disclosure of everything in the data room.
| Feature | Fundamental reps | General (business) reps |
|---|---|---|
| Examples | Organization, authority, title to shares, capitalization, brokers; often tax | Financial statements, contracts, compliance, IP, employees, environmental |
| Survival (no R&W insurance) | Often 3 to 6 years, or statute of limitations plus a short period | Commonly 12 to 24 months |
| Cap | Often the purchase price | Commonly around 10 percent of price, sometimes lower |
| Basket applies? | Usually not | Yes |
| Why | Goes to whether the buyer got what it paid for at all | Ordinary business risk, shared with the buyer |
The indemnity package: baskets, caps, survival and escrow
Indemnification is the seller's promise to pay the buyer's losses from a breach of reps or covenants, and from specific matters listed as special indemnities, such as pre-closing taxes or a known lawsuit. The package that limits this promise has four parts. A de minimis threshold excludes individual claims below a small amount, and such claims usually do not count toward the basket. The basket is the aggregate threshold of losses before the seller pays anything, commonly around 0.5 to 1 percent of the price. The cap is the maximum the seller will pay for general rep breaches. Survival is how long after closing the buyer can bring a claim.
Baskets come in two forms. Under a deductible basket the buyer bears the losses up to the threshold and recovers only the excess, like an insurance deductible. Under a tipping, or first dollar, basket, once the losses exceed the threshold the buyer recovers all of them from the first dollar. The difference can be the full amount of the basket, so it is fought over.
An escrow secures the indemnity by holding back part of the price with a third party agent for the survival period, commonly around 10 percent of the price in deals without insurance and much less with it. Escrow funds are released to the seller at the end of the period, less any pending claims. The agreement also says whether the escrow is the buyer's sole recourse for general rep claims or whether it can pursue the seller directly up to the cap.
- De minimis
- Minimum size of an individual claim; smaller claims are ignored entirely.
- Basket
- Aggregate loss threshold before the seller pays.
- Cap
- Maximum seller liability for general rep breaches.
Ashby Foods: an indemnity claim under each basket
- A sponsor bought Ashby Foods, a hypothetical regional food manufacturer, for $400m with no R&W insurance. Figures in $m.
- General reps: de minimis $0.05m per claim, basket 0.5 percent of price ($2.0m), cap 10 percent ($40.0m), survival 18 months. Escrow 1 percent ($4.0m), the first source of recovery, with recourse to the seller beyond it up to the cap. Pre-closing taxes covered by a special indemnity outside the basket and cap.
- Claims made within 14 months of closing: inventory rep breach $1.2m; customer contract rep breach $0.9m; environmental rep breach $2.4m; three small claims of $0.04m each; and $1.8m of pre-closing sales tax assessed by a state.
- 1. Small claims below de minimis3 x 0.04$0.12m excluded
- 2. Eligible general rep losses1.2 + 0.9 + 2.4$4.5m
- 3. Deductible basket recovery4.5 - 2.0$2.5mPaid from escrow; $1.5m of escrow released to the seller.
- 4. Tipping basket recovery4.5, since 4.5 > 2.0$4.5m$4.0m from escrow, $0.5m directly from the seller.
- 5. Special tax indemnity, either caseOutside basket and cap$1.8m
- 6. Total recovery, deductible2.5 + 1.8$4.3m
- 7. Total recovery, tipping4.5 + 1.8$6.3m
- 8. Loss borne by buyer, deductible4.5 + 1.8 + 0.12 - 4.3$2.12m
- 9. Loss borne by buyer, tipping4.5 + 1.8 + 0.12 - 6.3$0.12m
- 10. If general losses were $50m insteadDeductible: min(50 - 2, 40); tipping: min(50, 40)$40.0m either way
The basket type moved $2.0m between buyer and seller on the same facts. Once losses are large enough, the cap binds and the basket type no longer matters, which is why the cap and the survival period deserve as much attention as the basket.
Representations and warranties insurance
Representations and warranties insurance (RWI) has become standard in US sponsor deals. In a buy side policy the buyer is insured against losses from breaches of the seller's reps, so it claims against the insurer rather than the seller. The seller can then accept a very limited indemnity, often just fundamental reps, taxes and fraud, and take almost all of its proceeds at closing. That makes a bid with RWI more attractive in an auction, which is why many sellers require it.
A typical policy has a limit of around 10 percent of enterprise value and a retention, the insurance equivalent of a deductible, historically around 1 percent and lower in recent years, sometimes dropping after the first twelve months. The premium is a single payment, commonly a few percent of the limit, plus underwriting fees and taxes. Coverage for general reps usually runs three years and for fundamental and tax reps six years.
RWI does not cover everything. It excludes matters the buyer knew about before signing, items flagged in diligence, forward looking statements, purchase price adjustments, and specific risks the insurer names, such as certain environmental, wage and hour or product liability exposures. Known issues therefore still need a special indemnity or a price adjustment. Insurers also underwrite the buyer's diligence, so a thin diligence process produces a policy with more exclusions.
Ashby Foods: the same losses with R&W insurance
- Same $400m deal, now with a buy side RWI policy: limit $40.0m, retention $2.0m, premium 3 percent of the limit. The seller funds half the retention through a $1.0m escrow. The $1.8m sales tax exposure was unknown at signing and is covered as a pre-closing tax.
- Eligible losses as before: general reps $4.5m plus tax $1.8m, total $6.3m.
- 1. Premium3% x 40.0$1.2m
- 2. Losses within the retentionFirst 2.0 of 6.3$2.0m
- 3. Retention paid from seller escrow50% x 2.0$1.0m
- 4. Retention borne by buyer2.0 - 1.0$1.0m
- 5. Insurer pays6.3 - 2.0$4.3m
With RWI the seller kept $399.0m of the price at closing with only $1.0m at risk, and the buyer recovered $5.3m of $6.3m of losses through the escrow and the policy, against a $1.2m premium. Small claims below the de minimis, here $0.12m, remain with the buyer under either structure.
| Feature | Seller indemnity | R&W insurance |
|---|---|---|
| Who pays for breaches | Seller, from escrow or directly | Insurer, above the retention |
| Escrow | Often around 10 percent of price | Small, often a share of the retention |
| Cost | None up front; price may reflect risk | Premium plus fees, paid by buyer or shared |
| Known issues | Covered if negotiated | Excluded; need a special indemnity |
| Relationship with management sellers | Claims can sour relations with rollover holders | Claims go to a third party |
MAC clauses and closing conditions
When signing and closing are separated, the agreement must say what happens if things change in between. Closing conditions typically include that the reps are true at closing (usually to a materiality standard, except fundamental reps, which must be true in all respects), that covenants have been performed, that regulatory approvals such as HSR clearance have been obtained, that no law or injunction blocks the deal, and that no material adverse effect (MAE, also called a MAC) has occurred.
The MAC definition describes a change that is materially adverse to the business, then carves out risks the buyer is taken to have accepted, such as general economic conditions, industry wide changes, changes in law, acts of war and pandemics, unless they hit the target disproportionately compared with its peers. Delaware courts have set a high bar: the adverse change must be significant and durationally significant, measured in years, not quarters. Akorn v. Fresenius in 2018 was the first time the Delaware Court of Chancery found a MAE that let a buyer terminate a merger, and the facts there were severe.
Between signing and closing the seller must also run the business in the ordinary course, under interim operating covenants that forbid actions such as large capital commitments, new debt, dividends or changes to key contracts without the buyer's consent. These covenants protect the buyer from the business it priced being changed before it owns it.