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Buying a business is a significant milestone for most people. Unfortunately, vendors can innocently or fraudulently misrepresent facts that were critical in attracting you to purchase their business. However, you can mitigate these risks of vendor misrepresentation. Therefore, you should not necessarily be scared off by what may appear to be a risky and daunting process.

When you purchase a business, it is crucial that you: 

  • verify the company’s key documents through due diligence; and 
  • ensure your business sale agreement contains adequate contractual protections (warranties).

This article explains vendor misrepresentation and how you can reduce your risk when buying a business.

What is a Misrepresentation?

Broadly speaking, a misrepresentation is a false assertion by one party that induces the other to enter into a contract. Consequently, misrepresentations fall on a scale depending on the intention behind them. For instance, they could be innocent (made without knowledge of its falsity) or fraudulent (made with knowledge of its falsity). However, the degree of misrepresentation is not always clear cut. Thus, it is essential to have the correct safety net to protect yourself from vendor misrepresentation.

Warranties and Indemnities 

Typically, vendors seek to provide minimal warranties, while purchasers seek extensive warranties to reduce their risk. Some commonly seen warranties in business sale agreements include:

Solvency

Solvency warranties are crucial for the purchaser to ensure the business can meet its financial obligations as they fall due (solvent). Therefore, a vendor who does not want to include solvency warranties would usually set off alarm bells.

Accounts

These warranties ensure the business has prepared its accounts according to the applicable accounting standards. The vendor must stand behind the financial information’s completeness and accuracy. This is because they are purchasing the business based on this information. These warranties ensure that any accounting documents contain accurate and fair information regarding the business’ financial position.


Accuracy of Information 

Where the vendor has provided due diligence material, the purchaser should ensure the business sale agreement contains warranties that confirm the information’s accuracy. This will make the vendor liable for any misleading information they provide. 

Litigation

A standard non-contentious warranty to the purchaser is that the business is not subject to any legal proceedings, dispute resolution processes, or regulatory investigation. Additionally, the vendor will also warrant that they are unaware of any circumstances that could lead to such proceedings or investigations. 

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Due Diligence

When purchasing a business, you should undertake a due diligence process. The business sales agreement will only take effect if certain preconditions are satisfied (known as conditions precedent). For instance, a standard condition precedent is that there has been no material breach of the vendor’s warranties. If you are purchasing a larger business, you should make sure there is a clause that makes completing the purchase conditional on completing your due diligence investigations. Generally, a failure to satisfy a condition precedent will give rise to a right to terminate the sales agreement. 

Due diligence is a process whereby you confirm the status of the business by reviewing all the essential documents and assets of the business. A secure data room is established to store any of the company’s shared documents. Legal and tax advisors will review the company’s key documents and evidence on behalf of the vendor.

They will search for critical risks in the company:

  • financial and company records; 
  • commercial contracts;
  • employment liabilities (e.g. superannuation and tax compliance);
  • IP assignments and registrations; and
  • client lists.

Although this process is largely conducted in electronic data rooms, you can also ask the vendor to inspect the premises and any essential equipment in person.

Misrepresentations Before Completion

Many business sale agreements have a timeframe between when you sign the business sale agreement and when the sale takes effect, during which you can terminate the agreement if you discover any material misrepresentations during your due diligence. Usually, when the vendor is notified of a breach, they will be given a set period to fix it.

If the vendor warrants that they have assigned all intellectual property to the business, the sale agreement may contain a clause that states a breach will not give rise to a right to terminate if the vendor implements the correct assignment within 10 days. 

If you uncover a misrepresentation that breaches a warranty that the vendor cannot fix, you will be able to terminate the contract. However, you must ensure that the contract contains a refund of any deposit if this scenario unfolds. 

Misrepresentations After Completion

Some warranties will still apply after the business sale is completed. However, vendors will commonly negotiate time limitations so that the risk of a warranty claim is not indefinite. Therefore, vendors will commonly seek to negotiate time limitations and cap their liability at set amounts. 

Thus, where you have incurred a quantifiable loss from a breach of warranty, the vendor will usually have to indemnify you for the loss you have incurred. However, indemnities and liabilities are often subject to constraints, such as time limitations and a cap on the maximum amount claimable.

Key Takeaways

Like any contractual relationship, you risk being induced to an agreement by innocent or fraudulent vendor misrepresentations when buying a business. Having a well-drafted agreement with adequate warranties can reduce this risk. Furthermore, you should also undertake thorough due diligence. While some of this you can do yourself, it is always recommended to have lawyers and accountants onboard to help you.

If you need help with vendor misrepresentations when buying a business, our experienced business purchase lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 1300 544 755 or visit our membership page.

Frequently Asked Questions

What is a vendor misrepresentation?

A vendor misrepresentation is when somebody who is selling their business makes a false assertion to you, inducing you to enter into the contract.

What is the due diligence process?

Due diligence of the process of thoroughly researching a business’ status by reviewing essential documents and information.

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