Insights

6 Ways Buyers Benefit from Representations and Warranty Insurance in an M&A Deal
POSTED 5.16.18 M&A

If you’re the Buyer in a merger or acquisition, you can take one action at the start of the deal—at the offer stage—that will

  • help you rise above other potential Buyers in the eyes of the Seller;
  • transfer liability to a third party in the event of a breach of a Representation or Warranty (making it much easier to seek damages);
  • smooth out negotiations with the Seller;
  • ensure you maintain a good relationship with the Seller, post-transaction;
  • enhance your reputation as a “Seller-friendly player” within the M&A community.

That one action: insist on using Representations and Warranty (R&W) insurance to cover the deal.

In most cases, you don’t even have to pay for the policy; the Seller will be happy to, as you’ll see in just a moment.

R&W insurance protects both Buyer and Seller if there is a financial loss resulting from a breach of the Seller’s representations that were outlined in a purchase and sale agreement. Generally, transactions can be covered from the $20M level and up.

In the event of a breach, the insurance company covers the losses because R&W insurance transfers the indemnity obligation away from the Seller.

Let’s get more in-depth and explore exactly why R&W insurance is so advantageous to Buyers.

1. Using R&W Insurance Makes You Stand Out

When there are multiple Buyers for a company, the most common way to “outduel” the competition is to raise your offer.

But you can distinguish yourself without overpaying. In fact, you won’t even have to pay anything above the asking price.

You do it by eliminating the Seller’s risk in the transaction—and increasing the cash they walk away with at closing—with R&W insurance. For most Sellers, these benefits are worth more than a higher sale price.

One of the biggest worries of a Seller is escrow. In a typical M&A deal, 8% to 10% of the sale price is held in escrow for a period of a year or longer.

Problem #1 is that they don’t have access to that cash. Problem #2 is that if there is a breach and the Buyer alleges damages, they lose some or all of that money.

They’re worried that the Buyer will always find something wrong in order to keep the escrow funds.

Remove that pain by making R&W a component of your offer and you’ll make a Seller very happy.

Even better, as the Buyer, you’ll also be covered by Rep and Warranty insurance, so you can make a non-contingent offer. That boosts your chances in the eyes of the Seller, too.

It’s sort of like making an offer on a house in a good neighborhood. The potential purchaser who approaches the Seller with fewer contingencies (for example, the offer being contingent on a home inspection) will be looked upon more favorably.

When you sign a letter of intent with contingencies, the price goes in just one direction: down. Sellers know that and don’t like it.

2. R&W Coverage Eases Concerns about Collecting on the Seller’s Indemnification

In some cases, Buyers are concerned that Sellers won’t honor their commitments set out in the terms of the purchase and sale agreement once a deal is closed.

As the Buyer, you have the burden of chasing down the Seller—or even multiple Sellers—for the 10% to 20% indemnity. But with R&W coverage, you avoid all that. You don’t have to chase down one Seller, or worse, multiple shareholders, widely dispersed, to collect.

You simply “break glass” in that emergency and file a claim with your insurer… and get paid damages. It’s a relatively easy process, and there is virtually no risk that you won’t get paid. (Need to put the link to Claims article here)

Many lawyers would tell you that putting language in the contract—joint and several liability—will protect you as a Buyer. What this does is set down in the contract that if one Seller is liable for damages, all Sellers are liable.

This type of agreement creates bad blood and fear in Sellers. Minor shareholders don’t want to be lumped in with major shareholders—they have small stakes in the deal—and major shareholders want the minor shareholders to stand with them.

If R&W insurance is in place, all that unpleasantness can be avoided.

3. Smooth as Silk Negotiations Thanks to R&W Coverage

A typical M&A deal involves attorneys going back and forth, probably twenty times or more, as they nitpick over definitions.

In general, the Seller wants the representations and warranties in the contract to be as narrow as possible; the Buyer wants them as broad as possible.

With R&W insurance, there is no need to argue or nitpick over definitions; it removes the bulk of the contentious terms within a purchase and sale agreement. The back-and-forth between M&A attorneys on both sides is cut to six iterations.

If there is a problem, the Buyer is protected, and can simply collect damages from their insurer.

4. R&W Insurance Preserves the Buyer’s Relationship with the Seller

In most cases, you’re keeping the management team of that acquired company for a period of time. 

You want your relationship with these people to be as positive as possible because you’re integrating personnel, training, and resources.

Here’s what can happen without R&W insurance: say there’s a breach that the Sellers didn’t know about. As a result, you, the Buyer, suffer a loss. And, however uncomfortable it may be, you have to collect damages from your new best buddies in management who are supposed to help change the direction of your firm.

If there is a significant loss, not only do the Sellers lose the money in escrow they are counting on, you’ll have to claw back even more funds, which will further contaminate the relationship.

That puts you in a serious dilemma: do you mention the breach or eat the loss to maintain goodwill?

With R&W coverage in place, you have an elegant and convenient solution.

You can tell your transition team that there was a breach, they can apologize, and then you can say, “It’s no problem, we have insurance.”

5. The Seller Will Pay for Your R&W Policy

There are such significant benefits to the Seller with R&W insurance that they will gladly cover most or all of the expenses for the buyer, including the underwriting fee, premium and policy tax.

Why?

Thanks to the smaller escrow commitment, they get millions of dollars more at closing, and those millions are no longer at risk in the event of a breach.

For that security and peace of mind, they’ll usually pay for a Buyer’s-side R&W policy. It’s a small investment (usually 3% of limit) for a big payoff at closing.

6. R&W Enhances Your Reputation as a “Good Citizen” in the M&A Community

The M&A community is a small one with a range of members, from seller-friendly players to bare-knuckled grinders. It’s well-known where everyone falls into this range. So it’s no surprise that the grinders end up having to pay much more than the non-grinders.

R&W is clearly a seller-friendly tool that, used regularly, will enhance a Buyer’s reputation as an attractive partner for other companies. Professionals in M&A routinely cite examples where the “good citizens” in the community win more deals at lower prices than the grinders.

It’s Clear R&W Insurance is the Way to Go

As you’ve learned, there are many advantages to using R&W insurance to cover an M&A deal.

As a Buyer, you should bring it up early with the Seller—at the offer stage. It will make you shine in the eyes of the Seller and get you to closing much quicker than a non-insured deal. Plus, there’s less financial risk to you.

It’s a no-brainer.

To keep these benefits top of mind, be sure to download our free Buyer benefits cheat sheet, 6 Reasons Buyers Should Insist on Representations and Warranties Insurance, here.