Assessing damages in breach-of-warranty claims
Warranties in the context of a transaction between companies aim to allocate risk between the buyer and the seller. When a warranty is breached, the buyer may have a contractual claim against the seller, requiring the assessment of damages.
Breach-of-warranty damages may relate to warranty claims or misrepresentation claims, each depending on different counterfactuals.
Depending on the type of breach-of-warranty damages, the strategic premium paid in a transaction may be excluded or included in the assessment of breach-of-warranty damages.
The assessment of damages can be broadly divided into four steps:
- Define the appropriate counterfactual
- Determine how the breach affects EBITDA and free cash flows
- Determine how the breach affects valuation multiples and risk profile of cash flows
- Determine how to treat the strategic premium
Define the appropriate counterfactual
In a warranty damages claim the usual comparison is between the value of the shares had the warranty been true and their actual value at the relevant date, usually the date of breach.
In a misrepresentation damages claim the comparison is typically between the position the buyer would have been in had accurate information been provided before signing (including whether it would have paid a lower price, negotiated different terms or declined the transaction altogether) and the actual position the buyer is in at the relevant date, usually the date of breach.
In cases where a court determines fraud as the cause of the breach, that may restrict the seller’s ability to rely on contractual caps, exclusions or other limitations, depending on the governing law and the wording of the SPA.
Determine how the breach affects EBITDA and free cash flows
In breach-of-warranty cases the buyer must demonstrate how the inaccurate information relied upon affected the economics of the deal.
The strongest evidence is usually contemporaneous: the original valuation model, investment-committee papers, forecasts, due-diligence reports, bid calculations and negotiation records.
This evidence is key in reconstructing the purchase price that would likely have been agreed had the correct information been available.
Where the valuation was based on the market approach (maintainable EBITDA and enterprise-value multiple), EBITDA and Enterprise Value / EBITDA multiple (EV/EBITDA) should be restated to reflect the impact of the breach. Where the valuation was based on the Discounted Cash Flow method, the cash flows should be restated accordingly.
Relevant EBITDA adjustments may include overstated or non-recurring revenue, understated operating costs, incorrectly capitalised expenses, omitted provisions, exceptional items presented as recurring, loss of customers, contracts, licences, or key personnel.
Determine how the breach affects valuation multiples and risk profile of cash flows
In addition to restating EBITDA and free cash flow, it may also be necessary to reconsider the valuation multiple and discount rate used to determine the warranted value of the target.
The original transaction multiple and discount rate should be adjusted where the breach affects the growth and risk profile of the earnings being valued.
This may be the case, for example, where revenue presented as recurring proves to be non-recurring, customer churn is structurally higher than represented, or a key licence, contract or other business asset is lost. In those circumstances, the original multiple and discount rate may have reflected a business with materially different growth prospects, earnings quality or profitability.
Determine how to treat the strategic premium
A strategic premium is the amount a particular buyer pays above standalone financial value because of buyer-specific benefits such as synergies, cross-selling, market access or competitive positioning.
The distinction matters because the purchase price is not always the same as the warranted value. A buyer may have paid a premium for synergies or strategic access. That premium may be relevant in a misrepresentation claim if the buyer had not paid it had the truth been known.
In a conventional warranty valuation, a buyer-specific strategic premium will typically not affect the assessment of damages. That is not the case for misrepresentation claims where the strategic premium is part of the price paid, a key variable in the assessment.
Separating the strategic premium from the underlying stand-alone valuation is inherently judgmental. There is no precise or scientific method for separating from the transaction multiple the component that reflects strategic premium. The best evidence one can rely on will probably comprise of contemporaneous transaction materials, including valuation analyses, board papers, bid models, internal approvals.
What valuations are required
In a warranty claim, the expert will generally be required to determine two values as at the relevant date: the value of the target on the assumption that the warranties were true (the warranted value) and the target’s value given the actual circumstances (the actual value). Breach-of-warranty damages are ordinarily assessed by reference to the difference between those two values.
In a misrepresentation claim, the expert will generally be required to determine only the target’s actual value at the relevant date. That value is then compared with the purchase price paid to estimate damages.
In performing the required valuation or valuations, the expert considers the contemporaneous evidence, including the original valuation model, financial forecasts, due-diligence reports, investment documentation, and negotiation records.
The valuation of shares shall not use the benefit of hindsight, rather it shall be based on an applicable measure of damages using the information that was available, or ought properly to have been reflected, at the valuation date.
Conclusion
Assessment of breach-of-warranty damages are not mechanical exercises. The outcome depends on choosing the right counterfactual, understanding how the deal was priced and isolating the true economic effect of the breach.
The expert’s task is simple to state but difficult to execute. The decisive question is how the wrong information changed the value of the bargain or the transaction the buyer would otherwise have entered into.
This article provides a general overview and does not constitute legal advice. The applicable measure of damages and valuation methodology depend on the governing law, the SPA, the facts and the court’s or tribunal’s instructions.
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