Reps and Warranties Basics in Middle-Market M&A
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Circular 230 / general information notice. This article is general information only. It is not tax, legal, or accounting advice. Reading it does not create an attorney-client relationship. Tax results depend on your facts and on law that can change. Consult your own attorney and CPA before taking any action. This article was not written to be used, and cannot be used, to avoid tax penalties.
Representations and warranties are the statements of fact about the target that the seller makes in the purchase agreement. In a middle-market deal they do three jobs at once. They force disclosure, because the seller has to schedule exceptions. They set the closing condition, because the buyer can refuse to close if they are not true enough at closing. And they define the indemnity, because most post-closing claims are claims that a rep was wrong.
This article covers the drafting decisions that move risk: knowledge and materiality qualifiers, the materiality scrape, disclosure schedule mechanics, survival periods under Texas and Delaware law, baskets and caps (with the math), sandbagging, and the tax reps and tax benefit provisions that are often left as boilerplate.
Knowledge qualifiers: whose knowledge, after what inquiry
A seller-favorable definition:
"Knowledge of the Company" means the actual knowledge, as of the date of this Agreement, of the individuals listed on Schedule 1.1(a).
A buyer-favorable definition:
"Knowledge of the Company" means the actual knowledge of any of the individuals listed on Schedule 1.1(a), and the knowledge that each such individual would reasonably be expected to have obtained after due inquiry of the employees of the Company with primary responsibility for the matter in question.
The difference is constructive knowledge. Under the first version, a plant manager's unreported safety violation does not breach a rep qualified "to the Company's Knowledge" unless a listed person actually knew. Under the second, it may, if a listed officer would have learned of it by asking the plant manager. The middle ground is usually actual knowledge after "reasonable inquiry of direct reports," with no duty to search files or interview outsiders. The list itself is a negotiation. Buyers want the CFO, the operations head, and anyone who signed the QoE management representation letter. Sellers want the fewest names they can defend.
Knowledge qualifiers belong on reps about things the seller cannot control or fully see: threatened litigation, third-party infringement of the company's IP, a counterparty's intent to terminate. They do not belong on reps about the company's own records, such as the capitalization table or the financial statements.
Materiality and the scrape
Reps are often qualified by "material" or "Material Adverse Effect." That makes sense for the closing condition. It creates a problem for indemnity, because a buyer would have to prove the inaccuracy was material before the basket even starts counting. The materiality scrape removes the qualifier for indemnity purposes:
"For purposes of this Article IX, any inaccuracy in or breach of any representation or warranty, and the amount of any Losses resulting therefrom, shall be determined without regard to any qualification as to materiality or Material Adverse Effect contained in such representation or warranty."
Notes on each piece:
"Inaccuracy in or breach of" is the double scrape: it applies to whether a breach occurred. Sellers sometimes accept a single scrape, applied only to "the amount of any Losses," which keeps the materiality threshold for finding the breach but measures all the damage once it is found.
The scrape should not reach defined terms such as "Material Contracts," or the rep listing them becomes unworkable. A sentence carving out defined terms that use the word "material" is standard.
A scrape plus a deductible basket is often presented to the seller as the trade: the basket absorbs the small claims that the materiality qualifier would otherwise have screened out.
Disclosure schedules
Two provisions do most of the work. The first is cross-application:
"Any disclosure set forth in any section of the Disclosure Schedules shall be deemed disclosed for purposes of each other section of the Disclosure Schedules to which the relevance of such disclosure is reasonably apparent on the face of such disclosure."
"Reasonably apparent on the face" is the usual compromise. Buyers resist anything looser, and sellers should resist a requirement of an express cross-reference in every section, which turns a missed cross-reference into an uncapped claim.
The second is data room disclosure. Most buyer drafts say nothing in the data room qualifies a rep unless it is scheduled. Sellers sometimes ask for general data room qualification. A buyer should refuse that, and a seller with a large data room should spend the effort on the schedules instead. A data room index attached as an exhibit can still help prove what was delivered, which matters for anti-reliance and sandbagging arguments.
Schedule updates between signing and closing are the third issue. A seller wants the right to update schedules and have the update cure the breach. A buyer will allow updates for information only, so the update does not cure for indemnity, sometimes with an exception: if the update discloses something that would let the buyer walk and the buyer closes anyway, the buyer waives the claim.
Fundamental reps and survival
Fundamental reps (organization, authority, capitalization, title to equity, brokers, and often taxes) usually survive longer and are capped at the purchase price. General reps survive for a negotiated period, such as 12, 18, or 24 months, and are capped at a fraction of the price. A sample survival clause:
"The representations and warranties in this Agreement shall survive the Closing until the date that is 18 months after the Closing Date; provided that (a) the Fundamental Representations shall survive until 60 days after the expiration of the applicable statute of limitations, and (b) any claim asserted in good faith with reasonable specificity in a written notice delivered before the expiration of the applicable survival period shall survive until finally resolved."
Texas has a statute that matters here. Section 16.070(a) of the Civil Practice and Remedies Code voids any contract term that limits the time to bring suit to less than two years. Section 16.070(b) says the rule does not apply to an agreement relating to the sale or purchase of a business entity if a party pays or receives consideration with an aggregate value of at least $500,000. Most middle-market deals clear that threshold, so an 18-month survival period is generally available. A small deal below $500,000 that uses a 12-month survival period may have a void provision. The clause should also say whether survival means a claim must be noticed, or a suit filed, before expiration. The sample above uses notice.
Delaware allows the opposite move. Under 10 Del. C. § 8106(c), a written contract involving at least $100,000 may specify a period for bringing claims of up to 20 years from accrual. A buyer that wants a fundamental rep to survive longer than the ordinary three-year Delaware limitations period should choose Delaware law and say so expressly.
Baskets and caps, with numbers
Take a $50,000,000 purchase price with a 0.5% basket ($250,000), a $25,000 per-claim threshold, and a 10% cap ($5,000,000) on general reps. The buyer asserts three claims: $15,000, $180,000, and $260,000.
The $15,000 claim falls below the per-claim threshold and is ignored. It does not count toward the basket either, under most drafting.
The remaining claims total $440,000.
With a deductible basket, the buyer recovers $440,000 minus $250,000, or $190,000.
With a tipping basket (sometimes called first-dollar), once the claims exceed $250,000, the buyer recovers the full $440,000.
The difference here is $250,000, on a single set of claims. Sellers should also watch the per-claim threshold language: "related claims arising out of the same facts shall be aggregated" keeps a buyer from splitting one problem to clear the threshold, and keeps a seller from splitting one problem to stay under it.
Special indemnities for identified diligence issues (a pending lawsuit, a known sales tax exposure, an environmental condition) usually sit outside the basket and the general cap. Treat each as its own negotiation: cap, survival, who controls the defense, and whether it is the exclusive remedy for that matter.
Sandbagging
A pro-sandbagging clause:
"The rights of Buyer to indemnification shall not be affected by any investigation conducted by or on behalf of Buyer or any knowledge acquired (or capable of being acquired) at any time, whether before or after the execution of this Agreement or the Closing."
An anti-sandbagging clause says the buyer may not recover for a breach of which it had actual knowledge before closing. Delaware's default leans toward the buyer. In Arwood v. AW Site Services, LLC, C.A. No. 2019-0904-JRS, 2022 WL 705841 (Del. Ch. Mar. 9, 2022), the Court of Chancery described Delaware as a pro-sandbagging jurisdiction, noting that the Delaware Supreme Court had raised but not decided the question in Eagle Force Holdings, LLC v. Campbell, 187 A.3d 1209 (Del. 2018). I do not rely on a settled Texas default. I would rather the agreement make the choice expressly than litigate what silence means.
The common middle ground is an anti-sandbagging clause limited to the actual knowledge of named deal team members, based on specific written disclosure, which avoids a fight about everything in a 9,000-document data room.
Tax reps, the tax indemnity, and straddle periods
The tax reps cover filing, payment, audits, statute waivers, tax sharing agreements, withholding, nexus, and listed transactions. The schedule to those reps is where known issues belong. Separately, in an equity deal the buyer usually wants a pre-closing tax indemnity that sits outside the basket and the general cap and survives until 60 days after the statute of limitations. Representation and warranty insurance commonly excludes known tax issues, so the policy does not replace this indemnity.
A straddle period is a tax period that starts before and ends after closing. The usual allocation:
"In the case of any Straddle Period, (a) Taxes based on or measured by income, receipts, sales, or payroll shall be allocated to the Pre-Closing Tax Period as if the taxable period ended at the end of the Closing Date, and (b) all other Taxes shall be allocated to the Pre-Closing Tax Period in the proportion that the number of days in the Straddle Period through and including the Closing Date bears to the total number of days in the Straddle Period."
Example: a calendar-year company closes June 30 in a non-leap year. Annual property tax is $36,500. The pre-closing share under clause (b) is 181/365 of $36,500, or $18,100. If the company earned $800,000 of its $1,000,000 annual taxable income before closing, clause (a) assigns $800,000 to the seller's period. A day-count allocation of income would have assigned about $496,000 (181/365 of $1,000,000) and understated the seller's share by about $304,000. Make the "end of the Closing Date" cutoff match the working capital and indebtedness cutoff, or a one-day gap opens.
Transaction tax deductions and Rev. Proc. 2011-29
Who keeps the tax benefit of deal costs is a price term. Treas. Reg. § 1.263(a)-5 requires capitalization of amounts paid to facilitate an acquisition. Success-based fees, such as a banker's fee contingent on closing, are presumed facilitative under § 1.263(a)-5(f) unless the taxpayer documents the portion that is not. For covered transactions described in § 1.263(a)-5(e)(3), Rev. Proc. 2011-29 provides a safe harbor: a taxpayer that elects it on its original return may treat 70% of a success-based fee as not facilitative and capitalize 30%.
On a $1,000,000 success-based fee, that is $700,000 potentially deductible and $300,000 capitalized. In a stock deal where the target pays the fee at closing, the deduction lands on the target's pre-closing return. If that return shows a loss or reduced income, the benefit may come back as a refund after closing. A seller-favorable clause makes the buyer pay over refunds attributable to "Transaction Tax Deductions," net of costs. A buyer-favorable clause keeps them, or caps the payment, or nets them against any pre-closing tax liabilities. Treat it as a deliberate economic term, and have the CPA model it before the purchase price is final.
Bring-down at closing
The closing certificate brings the reps down to closing. If facts change between signing and closing, the options are a permitted schedule update, a negotiated waiver, a price change, or a walk under the conditions. Silence is the worst choice, because a seller who signs a closing certificate knowing it is wrong has created the fraud claim the cap was supposed to prevent. Build a pre-closing fact check into the timeline. I cover the closing conditions and interim covenants in more detail in MAE clauses, closing conditions, and interim covenants.
Where each side lands
Sellers want actual knowledge of a short list, single scrape, face-of-the-schedules cross-application, schedule updates that cure, a 12-month survival period, a deductible basket, and an anti-sandbagging clause. Buyers want constructive knowledge, double scrape, no data room qualification, information-only updates, 18 to 24 months of survival, a tipping basket, and express pro-sandbagging.
A frequent middle ground in deals without R&W insurance: actual knowledge after inquiry of direct reports, a double scrape with a deductible basket, face-of-the-schedules cross-application, 15 to 18 months for general reps, and a negotiated position on sandbagging written into the agreement rather than left to governing law.
How I can help
I negotiate purchase agreements, disclosure schedules, and indemnity packages in middle-market deals, and I coordinate with the client's CPA on the tax provisions. Office: 1921 Greenville Avenue, Suite 200, Dallas, TX 75206. For more on our transactional work, see private equity and M&A.
Next step
If it would help to talk, email info@robertsandwillie.com or call (469) 910-4017. Sending a message does not create an attorney-client relationship.
Disclaimer. This article is for general information only and is not tax, legal, or accounting advice. It does not create an attorney-client relationship. Tax law changes and depends on your specific facts. Do not act on this article without consulting your own attorney and CPA. This article is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or other applicable law. Attorney Advertising. Roberts & Willie, PLLC, Dallas, Texas; Trenton Roberts, responsible attorney.
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