Reps & Warranties Insurance – A Seller’s Perspective
I’ve produced a few videos on the subject of Reps & Warranties insurance, a form of transactional liability insurance commonly used in the world of M&A. I thought an example of how this is deployed may be helpful, especially for business owners who are or may be approaching the sale of their company shortly.
In this example the client, let’s call him George, is a second-generation owner of a successful food products distribution business.
George is in his early 60s and is being approached by a mid-market Private Equity firm looking to expand their holdings in the food distribution vertical. The initial discussions between George and the PE firm are encouraging. The potential buy-out numbers exceed George’s expectations, but he knows that negotiations and discussions would still need to take place to get to that target buy-out figure.
George feels good that the years of hard work, long hours, and personal capital invested in the business were worth it. He is now going to reap significant benefits from all that work and investment.
The PE firm conducts abbreviated diligence on George’s company, which was a bit of a relief for George. Not that he had anything to hide, but it just concerned him that a sophisticated buyer could drag out negotiations over a long period of time and he’d end up with less than he initially expected.
But that abbreviated diligence did result in a long Reps & Warranties schedule.
A Reps & Warranties schedule is a set of factual statements about the company’s conditions that George will be making and guaranteeing to the buyer. If those statements or facts are breached after the sale, George could be sued for the buyer’s financial damages as a result of incorrect information made in this schedule. In addition, the Private Equity firm wants George to deposit 10% of the sales price into an escrow account for two years to help guarantee the accuracy of the schedule.
George has no problem committing to these facts contained within the reps and warranties section of the sales agreement, but it worries him.
He knows his company and its finances inside and out. He was confident that all those statements were true and honest. But, in the back of his mind, he worries that a big Private Equity firm has a lot of lawyers who may try and prove some of his statements as false or untrue down the road and end up in litigation.
The last thing George wants is to litigate with a powerful financial institution and possibly have to return a portion of the sale proceeds to the buyer when he didn’t do anything wrong.
This nagging feeling probably plagues every private seller, and the thought of leaving 10% of the proceeds on the table on the day of closing is of course worrisome. You sell your company and want to walk away with the proceeds and invest them to benefit you and your family. After all, you’ve just sold your biggest asset and are headed towards retirement, the more time all of the assets are earning interest the better.
The good news is that there is a ready-made solution for George and other business owners selling their companies, in the form of Reps & Warranties Insurance or R&W for short.
With an Reps & Warranties policy, George can lay off most of the potential risks contained in the deal to an insurance company instead of risking his own money left in escrow.
Yes, there’s a premium and other fees to pay for the insurance, but financially the math works out in George’s favor, and in this situation, he gladly exchanges his premium payment for certainty at the closing table.
So, the transaction moves forward at the end of the day after the Reps & Warranties Insurance was placed. George walks away with the full proceeds less the premium for the insurance, and post-closing liabilities are minimized. The Private Equity firm got the company they wanted at the price they wanted to pay for it, and everyone was happy.
Yeah, that’s a bit of an oversimplified example of how reps and warranty insurance works, but it does give a bit of insight that’s on the minds of the seller when they’re about to make the biggest financial and emotional transition in their life.