Reps & Warranties Insurance
This is the first in a series of videos on reps and warranties insurance, which is a form of transactional liability insurance. Transactional insurance is a valuable tool in mergers and acquisitions to help buyers and sellers facility transactions and offset certain liabilities on an insurance company.
What are reps and warranties?
Representations and warranties are a section of a purchase and sale agreement used to facilitate the sale of a company from a seller to a buyer. It is a set of statements made by the seller regarding the condition of the company they are selling. These statements can be things like the company is not engaged in any litigation, or there are no undisclosed liabilities, etc.
This portion of the sales agreement is what the buyer relies upon to be true and accurate, and if the seller breaches these statements the buyer can seek indemnification for the costs of that breach from the seller.
While the representations made in a sales agreement are statements of fact, it’s a negotiated allocation of risks. Which party, is willing to take on which risks in a transaction and live by them, and if wrong will pay for those misstatements?
That of course is an oversimplification of the reps and warranties section of the sales agreement, but it gives you the basics of what comes next.
When Rep and Warranties Insurance is used in a deal, the insurance company steps into the place of the seller to fund those indemnification requirements.
In the middle market, about half of the private deals done are backed by Reps and Warranties Insurance, also known as R&W Insurance. That percentage is likely higher when a Private Equity firm is involved on either side of the deal.
Why is Reps & Warranties Insurance used in a sale of a company?
Sellers assume the risk of potential liabilities which occurred while they owned the company but are only discovered after they sell the company. If those liabilities cause financial damages to the buyer, the buyer will seek recovery from the seller.
Sellers, especially in private companies, are often forced to escrow funds for some time to guarantee the security of the representations they’ve made in selling their company.
What sellers want though is the proceeds of the sale of their company once the transaction closes and be done with it. They don’t want long-drawn-out escrow arrangements or the potential for a portion of their proceeds consumed by litigation or disputes.
By purchasing R&W insurance much of this is resolved and the risks are transferred to an insurance company.
R&W insurance can also help smooth out the transaction by simplifying the buyer/seller negotiations around representations and warranties; and, the buyer has reduced credit risk since any future claims are asserted against an insurer rather than the prior owners of the firm they purchased.
In future posts, I’ll discuss Reps & Warranties Insurance focused on the small and medium-sized business market, targeting deals under $10M in enterprise value.
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