Various Legal Terms and What They Mean

Warranties:

In a nutshell, warranties are a list (usually a long list) of statements made by the seller, which confirm the state of the business the seller is selling.

Examples of warranties:

(i) “No legal claims of any nature have been brought against the business in the last five years.”

(ii) “All equipment used in the operation of the business is in good working order.”

(iii) “There are no sums owed to the business by any director or any person connected to a director.”

And so on… (usually for anywhere between 5 to 10 pages). It’s crucial for lawyers to carefully go through all the warranties with their client, to make sure that they are all appropriate and whether they are correct or specific disclosures need to be made against any of them (see Disclosure below).

Disclosures and the Disclosure Letter:

If any warranties are not correct, a ‘disclosure’ needs to be made.

Let’s take the first example above. If there has in fact been even one legal claim brought in the last five years, the seller will be in ‘breach of warranty’. Therefore, he needs to make a disclosure, setting out the relevant information to describe the ‘breach’ which has occurred. This provides the buyer with useful information which he is entitled to rely upon so that he knows what he’s really buying.

If a seller has made a disclosure, he cannot be sued on that matter. However, if he doesn’t disclose a breach of warranty, and the buyer finds out, then the buyer can bring a claim against the seller for the loss or damage suffered as a result of that breach.

As there are usually many warranties, there are often quite a number of disclosures too. Therefore, the seller’s disclosures are usually listed out in what’s called a ‘Disclosure Letter’.

Indemnities:

In essence, ‘warranties’ and ‘indemnities’ are two different ways of calculating a claim made under the terms of the agreement.

If the clause in the agreement which has been breached is a ‘warranty’, then the amount the Buyer can claim is limited to a foreseeable, reasonable loss. The amount a buyer can claim here will take into account a requirement for the buyer to make a reasonable effort to prevent any loss arising or increasing (called ‘mitigating a loss’).

But that’s not the case with an indemnity. If the clause which has been breached is an ‘indemnity’ then, in that case, there is no requirement on the Buyer to ‘mitigate his loss’. In such a case, the buyer can usually recover in full any amount of loss arising, whether or not foreseeable or reasonable.

So, if you’re a seller, you want to make sure warranties stay warranties (and don’t get metamorphosed into indemnities by the other side’s legal shenanigans). If you’re a buyer you may want to make sure a few, specific warranties are drafted as indemnities to give you the appropriate protection you need in those crucial areas.

Earn-Outs

Earn-Outs can also be called “Deferred Considerations” or “Staged Payments” and refer to a way of paying the purchase price on a business acquisition.

In most sales that involve an ‘Earn-Out’, the buyer still pays the bulk of the purchase price to the seller on signing the deal, but there’s a portion that’s left-over, which only gets paid at a later date.

The remaining Earn-Out payments are often linked to the success, growth or profitability of the business in a year or two following the sale. Here, the obvious tension is between buyers who will be looking to keep the profits low during the Earn-Out period (to avoid increased Earn-Out payments), while sellers will be keen to make sure that any deals on the order book come in, and get paid, during these crucial post-completion months.

Awareness covenants

When dealing with warranties, good lawyers know that you can water down a warranty, sometimes to a point of complete ineffectiveness (meaning it’s not actually worth the paper it’s written on), simply by adding the words “as far as I am aware” to the warranty.

Whilst the use of this phrase may be justified in some warranties, most of the time it isn’t, and it shouldn’t be there.

The buyer’s lawyer needs to be able to spot where this phrase isn’t being used appropriately and to get rid of any mentions of it that are surplus to requirements. A buyer’s lawyer should also ensure that he has a clause stating that any ‘awareness covenant’ will be given only after having made the appropriate checks.

Phantom shares:

Phantom shares are, in essence, ‘pretend’ shares that a company can issue to a person to give him the same rights ‘as if’ he was a real shareholder. Except, that he isn’t. He doesn’t own any real shares, just ‘copy cat’ ones.

There are several good reasons for using phantom shares. Firstly, the company may not be able to issue more shares. Obligations under shareholder agreements, or ‘pre-emption rights’ may mean that practically it’s not an available option to issue more shares.

Also, a company may not want to give ‘real shares’ (which have voting rights) to eg employees but may still want to incentivize them to do their best for the benefit of the company. Phantom shares allow the recipient to share in the success of the company, without a concern that these shares may be used to vote on critical corporate issues.

Do note however perhaps the main downside in creating phantom shares is that any bonuses paid under a phantom share scheme will be considered an income payment (just like a standard employee bonus) and will, therefore, be taxed more highly than a corresponding payment which a shareholder would have received in the same circumstances.