When lower middle market PE fund Broadtree Partners expressed an interest in acquiring the small HR software solutions provider RedCAT Systems (which works with Uber, LinkedIn, and NYSE, among many other major firms), it looked like everything was going smoothly.
RedCAT’s management team and founders felt that Broadtree’s post-closing plans for the company meshed well with their core values of not growing too quickly in order to best serve existing customers, which have complex needs, especially with benefits for well-compensated workforces.
Broadtree was enthusiastic about RedCAT’s impressive customer base and how they had filled a hole in the marketplace with a unique and vital service. They felt, with their management resources and capital and the RedCAT team’s contacts and experience, that they could take the company to the next level – with smart growth.
The sticking point: one of RedCAT’s partners felt that Representations and Warranty (R&W) insurance should be part of the deal.
This specialized type of coverage, created especially for M&A deals, transfers all the risk, including the indemnity obligation, to a third party – the insurer.
It eliminates the need for money to held back in escrow and for an indemnification clause – which makes the Seller happy. This is why the partner wanted the coverage: to make sure his proceeds from the sale were safe and not held back. They had previous experience with lawsuits from a corporate perspective and saw this as a potential area of risk.
But there are benefits for the Buyer, too. If there are any breaches to the Seller’s reps, the Buyer can file a claim and is quickly compensated with no hassle by the insurer.
Deals with a transaction value as low as $15M will be considered by insurance company Underwriters for R&W policies. With a transaction value under $25M, the deal with RedCAT certainly qualified. But this is a development within the last year or so, which is one of the reasons why the Buyer was somewhat reluctant, at least at first, to make this accommodation to the Seller.
Another new development is that deals under $20M can be insured by R&W coverage for up to 75% to 100% of the transaction value. In the case of RedCAT, the parties were seeking a policy covering up to 75% of the transaction value. For larger deals, unlike this new lower middle market segment, Underwriters are only comfortable going up to 30%.
For Broadtree Director and Portfolio Company CEO Rob Joyce, this was the first time he had taken R&W insurance all the way to the finish line. So they were familiar with, but weren’t aware of, all the potential advantages for both parties.
“[Rep and Warranty] on my end was really used primarily as a tool to help one of the Sellers become comfortable with the transaction, and that was based on their prior experience,” says Rob. “This person was very, very concerned about this, and Rep and Warranty insurance pretty much mitigated the issue. This was something that could have been really, really time intensive had we not used the solution, and it could have derailed the deal.”
This is the perfect example of one of R&W insurance’s biggest benefits: it smooths negotiations, removing the contentious elements of escrow and holdback, which also speeds up the journey to a final Purchase and Sales Agreement and eventual closing.
For the Buyer, it gives reassurance that they will be paid promptly if there is a breach in one of the Seller’s reps, without the need to go after money held in escrow that would normally go to the acquired company’s management team… that could now be, as is the case with RedCAT, part of the Buyer’s organization.
As negotiations progressed and the due diligence process began, other issues began to emerge. And what happened should provide helpful tips for other lower middle market companies contemplating a sale by showing them what they can be doing now to prepare.
The issue was the financials. As a smaller company, RedCAT didn’t have the amount of financial data required, and it wasn’t in a format Broadtree was familiar with.
This often happens due to lack of resources. For example, in RedCAT’s case they didn’t have an investment banker or adviser actively pushing the deal. The founders were working on the deal, which takes significant time, as they continued to run the business.
The financials themselves were good, but the quality of the data reflecting that was different than you see in larger companies. The other issue was the technical diligence, which is vital with a software company. But soon enough, Broadtree understood the software development process, code base, and related items. Having R&W backing them up was an unexpected, but welcome benefit.
Broadtree Partners, after this positive experience with R&W insurance, now consider this coverage to be part of their strategy for acquisitions going forward.
Instead of being reactionary to a Seller’s requirements (for example, a banker who needs it on the deal) as they have in the past, this PE fund plans to introduce it early in the deal process because of the benefits it offers both Buyer and Seller.
“This is an immediate part of my toolkit, one that can allow some risk mitigation on my side if I feel the need, and, two, I think it’s also a great tool to help overcome some Buyer discomfort if they’re worried about the sort of risks to the deal that Rep and Warranty insurance can cover,” says Rob. “I would not hesitate to use it again.”
At this point, RedCAT Systems is well on its way to growing to the next level. They’ve acquired new customers and are gearing up for a big hire to push further growth. And it might not have happened, had Representations and Warranty insurance not entered the picture.
Note: This is Part 1 of a two-part series examining the Broadtree Partners acquisition of RedCAT Systems, focusing on the use of R&W insurance. Here we covered the deal from the Buyer’s perspective. Coming up next time, we’ll check out how the Seller saw things develop.
If this case study has interested you in Representations and Warranty insurance, contact me, Patrick Stroth, at email@example.com.