M&A | Loss calculation where warranty breaches affect enterprise value

M&A – Calculation of loss for warranty breaches with effects on enterprise value

Transaction agreements for the sale of an enterprise normally include warranties from the seller, including business warranties. Upon a warranty breach the transaction agreement would normally entitle the buyer to claim compensation, subject to the basic conditions for compensation being fulfilled. The compensation claim may be directed against the seller or against the insurance provider, if the warranties are insured.

The transaction agreement or insurance policy normally entitles the buyer to claim damages corresponding to the loss suffered as a consequence of the breach. This is in line with the basic principle of putting the buyer in the same financial position as they would have been in if there was no breach.

M&A transactions are often structured as a sale of shares. The purchase price for acquisition of shares in a private company is normally calculated by taking the enterprise value of the target company and adjusting it to reach the equity value or purchase price through the “equity bridge”, by adjusting for cash, debt and working capital items, as wells as transaction-specific items.

If the warranty breach only impacts items in the equity bridge, such as understated debt, it would be difficult to argue that the breach would have anything other than a one-off effect on the purchase price, and that the loss should be calculated accordingly.

Warranty breaches may however also be considered to impact enterprise value itself. A claim for compensation for such value reduction would typically entail that the warranty breach is given more than a one-off effect in the loss calculation.

Recent unpublished but cited arbitration awards confirm what has been the prevailing view in legal theory and among practitioners for some time: in the absence of clear contractual provision to the contrary, the buyer could be entitled to claim compensation equal to the reduction in enterprise value caused by the warranty breach, which opens up for giving warranty breaches more than a one-time effect.

Enterprise value reduction – the recurring effect challenge

A value reduction equals the difference between the enterprise value without the breach (“as warranted” value) and the enterprise value with the warranty breach (“as is” value).

The “as warranted” value presumably corresponds to the enterprise value ascribed by the buyer at the time of purchase.

The “as is” value must be determined based on a new valuation exercise. The question is how a reasonable buyer would have valued the enterprise had it known about the warranty breach. The assessment shall be made ex ante, meaning that it shall be made on the basis of information available at the time of the purchase, using the buyer’s methods for calculating the enterprise value as the starting point.

This approach means that a seemingly minor warranty breach can snowball into a substantial compensation claim. If the buyer has used a DCF analysis and/or EBITDA multiple or similar parameters to calculate the enterprise value, a warranty breach affecting operational cash flow may be given significant recurring effect.

Given this potential for significant exposure, sellers and insurance providers may seek to limit the buyer’s right to give misrepresentations anything other than a one-off effect in loss calculations. The calculation of loss is subject to contractual freedom, meaning that the parties are in principle free to agree how the loss shall be calculated. However, achieving this limitation may not be as straightforward as it seems.

Standard exclusions may prove insufficient

In one of the arbitration cases, the transaction agreement included a customary “no other warranties clause”, which stated that “no representation or warranty is made regarding budgets, estimates, projections, future prospects or other forward looking information.” It was argued that this clause made it clear that the buyer had to bear the risk of its own expectations as to future cash flows, and that this prevented the tribunal from taking a value-based approach to the loss calculation, where the warranty breach was given more than a one-time effect.

This argument was, however, rejected. The tribunal noted that while budgets, estimates, prospects and similar forward-looking statements cannot be considered warranted, this does not mean that one should disregard assessments as to development of the company which seem probable, adequate and reasonable. The buyer was as a result awarded compensation based a reduction in the enterprise value.

A related question, which is not addressed in the arbitration awards, is whether indirect loss exclusions can be construed to limit warranty breaches to one-off effects in loss calculations, excluding any assessment of their flow-through effects on enterprise value.

The Act on Purchases provides that loss of revenue from business interruption is considered an indirect loss. While the Act on Purchases also applies to the sale of enterprises, it is primarily designed for the sale of movable property. For such sales, it is natural to deem loss of revenue from business interruption as a derivative consequence — an indirect loss. For enterprises, on the other hand, what the buyer is in reality paying for are expected future cash flows. As such, it may be more appropriate to deem a loss of cash flows as a direct loss. This is also supported in legal theory. Accordingly, an exclusion for indirect loss may prove to be insufficient for ensuring warranty breaches are only given a one-off effect in loss calculations. This said, losses arising from the buyer’s inability to realise cash flows and value uplift from synergies with its existing operations, can be deemed indirect.

What to consider during contract drafting

The above demonstrates that standard exclusion clauses may be insufficient to prevent warranty breaches from being given more than a one-off effect in loss calculations. The distinction between treating a warranty breach as having a one-time effect in loss calculation versus a recurring effect in a valuation-based loss calculation can mean the difference between a modest and substantial compensation payment.

Where it is desirable to restrict warranty breaches to one-off effects in loss calculations without considering enterprise value reduction, explicit contractual provision should be considered. Such exclusions are rarely accepted in Norwegian law-governed SPAs, though we seem them appear more frequently in other Nordic jurisdictions.

Given the complexity of loss calculations, consideration should be given to including an expert determination procedure for loss calculation with pre-defined principles. We see such procedures regularly being included for disputes relating to closing balance sheets, but the same mechanisms may in principle also be applied to calculation of loss. This could avoid time-consuming and costly disputes.