Reps & Warranty Insurance, What is it? Who needs it? How R&W Insurance De-risk M&A Deals
Risk, it’s an issue that both buyers and sellers of companies face through a merger and acquisition deal and for years thereafter, well after the ink is dry on the contract of sale.
Both parties attempt to hedge their risk through due diligence, contract negotiations and collateralizing a portion of the deal, but the threat and costs of litigation still exist.
So, How do you transfer those potential risks off to a third party?
Through the use of reps and warranty insurance.
In this article, I’m going to talk about reps and warranty insurance focused on small business deals where deal values are under $30 Million in Enterprise Value.
So, let’s start off briefly and talk about what reps and warranties are from a contract standpoint in an M&A deal.
The seller of a company will make certain representations about the condition of the company they are selling – there could be 10, 20 or 30 or more statements of fact made in this portion of the sales agreement that the buyer will rely upon as true and factual. These statements or representations help validate the value of the company that the buyer is willing to pay for it.
The seller, also in the contract of sale, agrees to indemnify the buyer if the representations are not true. It is this indemnification where the risk for the seller arises.
An indemnification is a promise to make good on your statements and pay the buyer for the damages they suffer as a result of a seller’s inaccuracies. The potential litigation from an irate buyer can be extremely expensive to defend against and pay for. What’s worse is that the indemnification period sellers are responsible for is typically six years.
Now, imagine a seller, exiting a business, and 4 years later they’re sued due to an innocent misrepresentation – that can be unnerving and be cause for a lot of worry for the seller.
The buyer tries hedges the risk of loss from misrepresentations by holding back ten to twenty percent of the deal proceeds as collateral for up to two years.
But this escrow has limitations
It only hedges the top 10 or 20 percent of the deal, there’s potentially much more at risk that’s not covered by this collateral
The escrow is only in force for two years, while the indemnity agreement is in place for six years, and
The value of the funds held in escrow deflate – they ’re less valuable down the road than they are today.
On top of that the seller doesn’t like any portion of proceeds to be held back or put proceeds at risk, and this can slow down negotiations.
So, how can Reps & Warranty insurance help reduce friction and risk, and get the deal done, while protecting the parties? Here’s how.
Let’s start with the seller – they face having a portion of their proceeds tied up for two years as collateral, as well as the potential liability for the entire deal’s value should litigation ensue. The unknowns can make negotiations difficult for the seller. R&W Insurance can help eliminate most or all of the collateral requirements.
More importantly, it stands behind the seller to respond to claims and pay for litigation and settlements for covered acts.
For the buyer, especially in the lower middle market, diligence only goes so far. Buyers are concerned that their investment in an acquired company may not perform or pan out they way they planned due to a misrepresentation and and they really don’t want to litigate over potential misunderstandings.
So how does Reps &Warranty insurance work?
R&W Insurance covers innocent misrepresentation and the resulting fallout from a misrep – loss of income, decrease in value, etc. The policy will not pay of course for fraud or outright lies.
Ultimately, the policy provides peace of mind for both parties should a claim occur, insurance steps in to smooth out the problem.
R&W insurance goes way beyond holding back escrow.
Sellers want to walk away from the closing table with all their proceeds in hand to retire, start another business, or invest. They don’t want the buyer holding onto their funds with no ROI.
Here’s an actual claim example to demonstrate the policy in action –
A successful Mexican restaurant chain in Texas sold their business to a regional restaurant group, and soon after the closing, the buyer was notified that various equipment leases were not disclosed in the sale agreement, resulting in $50,000 in damages for the buyer.
On top of that, the seller was not aware that the state labor department was conducting an investigation prior to the sale. After the sale a $409,000 fine was levied upon the business and new owner for certain employment law violations.
As you can imagine the buyer wasn’t happy getting stuck with these two additional costs and filed a claim with our insurer.
Both issues were resolved under the policy resulting in over $500,000 being paid out in costs.
Without this insurance the seller would have had a substantial loss to pay out of pocket and to defend against on their own.
If you’re an M&A advisor, why recommend reps & warranty insurance?
First, most business owners don’t even know this coverage exists, so by recommending it, you’re giving them access to greater peace of mind, less friction, and better results.
On top of that insurance often makes good economic sense over collateral holdbacks.
There’s a reason the majority of private equity deals deploy R&W insurance, now it’s available for the small business market.
To obtain a fast non-binding premium indication you can go to this page on my website. (Reps and Warranties Insurance)
This is a short 10 question form that takes only 2 minutes to complete – once I get it, we’ll send it to our underwriters to obtain pricing indications for you – this usually takes 3 days or less.
If you want to pursue coverage we’ll then need additional info to complete the underwriting and firm up the pricing which can also be done in another 3 days or so.
Have other questions on R&W insurance in the small business market? Let me know. I’d love to hear from you.