M&A Monday: Product Warranties in an Acquisition
Do not overlook product warranty issues in a transaction.
Product warranties are applicable in the vast majority of acquisitions. Sometimes these warranties are by contract and sometimes, unwritten, but necessary for customer retention.
Last year I closed a deal for a Searcher-client for the acquisition of a B2B manufacturing business. After closing, the buyer found out that there was a defective part that had to be fixed in 20% of products delivered in the past year. He called me and asked: What we should do?
This is one of the most overlooked issues and potentially, one of the most costly ones.
Warranty Issues in Equity vs. Asset Acquisition Structure. Depending on how a deal is structured, warranty issues will be handled differently (if you are not clear on transaction structures, go back and read this post: Transaction Structures: Asset vs. Equity Acquisition https://x.com/Eli_Albrecht/status/1751969230856028400). In an equity acquisition, the buyer legally assumes all warranty claims whether pre- or post-closing. Thus, if a customer bought a product a year ago and the warranty is still in effect, the new buyer will have to honor and pay for that warranty. Without certain inclusions in the purchase agreement, this will fall on the buyer. Thus, good lawyering will be crucial for an equity acquisition.
In an asset acquisition, the buyer is acquiring just the assets of the business and leaving behind most pre-closing liabilities. Thus, technically, warranty claims are left behind with two major caveats: first, a savvy sellers’ lawyer will insist that liabilities related to assumed contracts (an asset assigned and assumed by buyer at closing), will also be transferred. An equally savvy buyer’s lawyer will insist that such liabilities related to assumed contracts are only as they relate to post-closing periods (if you did not get that, don’t worry, just make sure your lawyer is savvy).
Second, even if not legally required to honor a warranty claim, often that customer is important to the business. That customer won’t care that the business has been acquired, they want their warranty honored by someone. To maintain the relationship, a buyer may have to honor the warranty even if not legally required to.
Sellers often are adamant about buyer assuming the warranty claims. They say, I’m not going to lie awake for years worried that I have to pay for a warranty issue. You take the business, you take the customers, you take the risk.
One client has come up with a creative solution that they assume all amounts in line with historical levels, but not warranty claims (individually or in aggregate) beyond such amounts. This is communicated like, we will assume all the regular warranty issues of the business, but cannot account for extraordinary warranty liabilities.
There are three ways to handle warranty issues:
1. Diligence. Legal and Business diligence will understand whether there are historical warranty claims and what process is in place for dealing with them. This should be factored into the financial statements, already. The best time to deal with this issue (and others) is prior to closing.
2. Reps, Warranties, and indemnifications. In an M&A deal this is basically how we deal with getting a seller to pay for a loss that seller is responsible for (What and Who Must Stand Behind the Representations and Warranties: https://x.com/Eli_Albrecht/status/1816111570189234401). If buyer is not responsible for the product warranty loss, then buyer can bring an indemnification claim to recoup the losses. Often this can be decreased from a promissory note or escrow. If we know there could be an issue, we can add a Specific Indemnity (The Power of the Specific Indemnity: https://x.com/Eli_Albrecht/status/1790017185085042831) to make it very clear seller is responsible and bypass any survival, caps, and baskets. Rep and Warranty Insurance will often stand behind this to the extent it is not known prior to closing.
3. Budget for it. If you are selling products that have historical warranty issues, you have to budget for this issue after closing. You cannot rely on seller being honest and indemnification is an imperfect solution. It happens a lot.
If you are buying a business with product warranties, you want to be aware of these potential issues.