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When it comes to merging two businesses, both the seller and the buyer are happiest when everything goes according to plan. However, hiccups during mergers and acquisitions (M&A) are not uncommon. In some transactions, the buyer may discover that the seller neglected to disclose important information relevant to the business. In this case, the buyer may decide to seek compensation. Conversely, the seller may feel that the buyer is asking for too much money in response to the seller’s failure to disclose key information, and that the process is much longer and more drawn out than anticipated.
Addressing a breach of representation or warranty can be contentious, expensive, and time consuming. Representation and Warranty Insurance can cover costs and prevent legal disputes in a way that benefits both the buyer and the seller.
What are Representations and Warranties?
Representation refers to any statements that the seller makes before entering into an agreement of sale that the other party is expected to rely upon. Example: “Our company made a profit of $25 million last year.” A warranty is a promise that the statements are true. Example: “Our company made a profit of $25 million last year, and I will reimburse you if I am wrong.” In mergers and acquisitions, both the buyer and the seller are required to disclose relevant information and make representations. If either of the parties misrepresents or fails to share key information, they may be held liable for inaccurate representation or a breach of warranty.
- You own a large beverage manufacturer and plan to purchase a smaller soft drink company. The smaller company makes 90% of its revenue from a special crystal-clear soda that tastes like lemonade. They promise to disclose the highly guarded secret recipe to you as the new owner, so that you can continue to manufacture it and continue with business as usual. After the sale goes through, everything appears to be fine. After your first batch ships, however, you start to receive feedback from customers that the special crystal-clear lemonade soda tastes different, and you suspect you were not given the correct recipe. Sales drop, and consumers say they don’t intend to buy the soda anymore. You sue the seller of the soft drink company for breach of representation and warranty.
What is Representation and Warranty Insurance?
Representation and Warranty Insurance is used in mergers and acquisitions to protect against damages and losses stemming from breaches of warranty or inaccurate representation on the part of the seller. Policies can be purchased by the buyer, seller, or both parties, and commonly, a policy purchased by the buyer will also contain coverage for the seller. Representation and Warranty Insurance offers protection for the buyer in the form of monetary compensation for losses relating to a seller’s breach of representation or warranty. For the seller, Representation and Warranty Insurance provides liability coverage and may reduce or eliminate the need for an escrow.
In the past, the buyer in an M&A deal relied on money that was previously set aside in escrow. In severe cases, the buyer directly negotiated with or sued the seller long after the deal was finalized. Representation and Warranty Insurance greatly reduces the need for the buyer or seller to pursue legal action against one another after the merger or acquisition has finished. This means that both parties have a cleaner exit.
Representation and Warranty Insurance vs Traditional Escrow Process
Representation and Warranty Insurance is increasingly being used as an alternative to the traditional escrow process that companies have historically used in a merger or acquisition. With a traditional escrow approach, a portion of the M&A purchase price is held back for a period of time in order to ensure the seller fulfills all obligations and commitments according to the sale agreement. Representation and Warranty Insurance, however, allows buyers and sellers to potentially forgo this process, giving the seller 100% of the purchase price when the deal closes and transferring liability onto the insurance company.
A typical escrow approach to M&A would generally proceed as follows:
- The seller agrees to reimburse the buyer if the buyer discovers a breach of warranty or inaccurate representation after the merger or acquisition is finished.
- The buyer sets aside 10-15% of the final price and gives it to a third party (referred to as “escrow”). The seller only receives 85-90% of the agreed final price when the deal closes.
- The money in escrow is used to cover the buyer for damage or losses if they discover a breach of warranty or inaccurate representation. If there is no breach of warranty or inaccurate representation, the seller receives the remaining 10-15% of the agreed upon purchase price after an established period of time, usually 12 to 24 months.
There are usually exceptions and limitations in the form of caps, time limits, and exclusions (e.g. your business must declare the breach of warranty within 2 years of the deal and can collect no more than $3 million).
- Your startup company is bought by a much larger software company. They decide to complete the transaction through a traditional escrow process. The larger company pays your smaller company $10 million. As part of the sales process, the larger company puts aside $1 million as an escrow holdback from the sale. Your company only receives $9 million of the $10 million they were promised when the sale closes. Under the terms of the deal, your startup will receive the final $1 million it is owed after two years have passed and the larger company is sure there hasn’t been a breach of warranty or inaccurate representation. You and your co-founder want to invest this money in new ventures but aren’t able to do so because $1 million is tied up in the escrow holdback account.
In some cases, the buyer has the right to seek reimbursement beyond what was set aside in escrow. This means that the seller is still liable and might be forced to engage with the buyer years after the merger or acquisition has been finalized. This is a major negative point for many sellers and one of the reasons Representation and Warranty Insurance has become more popular in recent years. When the companies have Representation and Warranty Insurance, all payment and liability is assumed by the insurer, and sellers can receive 100% of the agreed upon purchase price immediately at deal close.
Benefits of Representation and Warranty Insurance for Buyers
Usually, the party in an M&A deal with the most to gain from R&W Insurance is the buyer. Benefits for the buyer side of Representation and Warranty Insurance include:
- Better protection and coverage – In the case of breaches of warranty or inaccuracies in representation, buyers can be compensated through a reputable insurer, rather than relying on the seller. Sellers may also be more willing to offer broader warranties and representations, given the liability is being taken on by an insurer.
- Looks appealing to the seller – A seller may be more likely to pursue a deal with a buyer that offers reduced or no escrow or holdback because the seller will be able to receive more of the purchase value at deal close.
- More time to discover problems – R&W Insurance increases the length of time that buyers have to uncover problems, usually beyond the two year limit that is common with escrow.
Benefits of Representation and Warranty Insurance for Sellers
Benefits for the seller side of Representation and Warranty Insurance include:
- Clean exit – With a removal of escrow or holdback, sellers are able to receive the proceeds from a sale immediately after the deal is closed and avoid dealing with any contingent post-closing liabilities.
- Liability protection – If there are unforeseen complications like a breach of warranty, R&W Insurance can provide for defense and settlement costs.
- Passive seller protection – Any minority or passive investor that was not in direct control of the business but may be liable under joint and several liability can be protected under R&W Insurance.
What triggers Representation and Warranty Insurance?
Representation and Warranty Insurance is triggered by a breach of warranty or representation. These breaches may include:
- Problems with customer contracts
- Issue with employment agreements
- Inaccurate or missing information about a “secret recipe” for a product
- Undisclosed pending litigation
- Large unpaid bills
Limitations of Representation and Warranty Insurance
Though Representation and Warranty Insurance can offer your business more protection, it comes with limitations. The following are considered standard exclusions for Representation and Warranty Insurance:
- Availability of R&D or Net Operating Loss tax credits
- Sales projections and other forward-looking warranties
- Adjustment of the purchase price or working capital
- Underfunded or unfunded pensions or benefit plans
- Any breaches of which the buyer had actual knowledge at the time of closing
Policy terms are usually limited to between three and six years. This is, however, longer than the standard indemnity period under the traditional escrow process.
How much does Representation and Warranty Insurance cost?
Representation and Warranty Insurance policies generally include a deductible or self-insured retention. While the amount may vary depending on the risk of the deal, it is usually between 1% and 3% of the overall transaction price.
In terms of the premium, pricing varies based on the insurer’s risk assessment, coverage limit, length of coverage, and deductible or retention amount. Most insurance companies charge between 1.5% and 3.5% of the coverage limit, and the premium is usually a one-time payment made for the entire policy duration.
For example, if the policy’s coverage limit is $20 million, the premium will be between $300,000 and $700,000. The floor for premiums is generally a minimum of $150,000. The policy coverage of most policies is usually 10% of the total value of purchase price.
In M&A deals, Representation and Warranty Insurance offers a compelling alternative to the traditional escrow approach. As a buyer, you are essentially purchasing a protection plan against breaches of warranty or representation, backed by a reputable insurer. And as a seller, you are able to forego escrow and receive full payment at the time of close. R&W Insurance has become increasingly popular in recent years, and as it becomes more widespread, premiums will continue to drop. If you are buying, selling, or merging a private company, you might want to consider Representation and Warranty Insurance.