For many, an IPO is the most exciting event in the life of a business. But I liken it to a team’s top pick in the NFL draft because the IPO itself is just the beginning. There are a lot of expectations for the player (or company) … and it could end up being a bust.
But in M&A, Sellers are done, they’re exiting. To me, that makes these deals life-changing, even generational events. And who wouldn’t want to be a contributor to that process?
If I do my job, I make this life-changing event faster, cheaper, simpler and happier for all sides. If that doesn’t get you fired up, I don’t know what can!
Since I started doing this in 2014, my tool of choice to do just that has been Representations and Warranty (R&W) insurance.
This specialized product removes the need for an indemnification clause in the Purchase and Sale Agreement and for money to be held back in escrow. It ensures that if there are any breaches, the Buyer can file a claim easily and be made whole in a timely manner.
In short, this type of coverage transfers all the risk to a third party – the insurer. And, as you’ll see in a moment, this is just a small sampling of its many benefits.
The first time I was introduced to R&W insurance was with a deal with a long-time owner and founder ready to sell his business for $50M. His goal was to take the money and “ride off into the sunset” to build settlements in Israel. The culmination of a lifelong dream.
He almost didn’t get there.
Because the Buyer was worried there might be a breach two or three years after closing and they would have a hard time tracking down this Seller out of the country, they were asking for half the purchase price to be held in escrow.
I realized we could change the Seller’s life by facilitating the deal the right way. In this case, R&W coverage would allow him to avoid this huge escrow requirement that would see him stuck waiting for the other half of his money for years.
We arranged for a $20M policy with a $1M deductible. So instead of $25M in escrow, the Seller was given the opportunity to exit the country with $49M out of $50M. What I call a clean exit!
Since that day, it’s been my mission to provide this coverage for as many deals as possible.
The use of R&W insurance is more widespread than ever, with PE Firms especially embracing this coverage. There are many reasons why there’s never been a better time to sign up with your next deal.
Lower costs, quicker closings, less money held in escrow… for these reasons and many more, there is no debate. R&W insurance has never been stronger and more available.
That said, there are hundreds of brokers out there offering this product. But instead of going to the big houses where you’ll just be a number and your deal is not a priority, or your local insurance rep who doesn’t specialize in M&A, you should work with a broker who is “geeked out” about the benefits of Representations and Warranty insurance and really believes in this product.
I’m one such broker.
If you’re interested in making Representations and Warranty insurance part of your next deal, contact me, Patrick Stroth, at email@example.com.
As the major player in the industry, AIG has been the long-standing, nearly sole source of claims information for the Representations and Warranty (R&W) insurance market. In 2020, Liberty Mutual, which has been actively writing M&A-oriented policies for about 10 years, issued its first such report based on their own experiences in this space.
An important factor to note is that overall, the number of claim notifications is going up, with 19% of policies bound in 2017 with notifications, up from the 14% from 2012 to 2015, and 15% in 2016. Liberty Mutual expects to hit or exceed 19% for policies written in 2018 and 2019; as notifications are still coming in steadily for those years.
Why the jump? Simple. As R&W insurance, which transfers indemnity risk to a third party (the insurer), has been…
… more policies than ever are being written. It’s only natural that the more policies there are out there, the more claims there will be. It does not point to a problem with this specialized type of insurance in the M&A world at all.
I’m not worried that this rising trend in notifications and claims will impact the viability of R&W insurance. Neither will this cause coverage to shrink or prices to rise. This trend is not foreshadowing a rate increase or lack of capacity.
Quite the contrary, because there are good reasons for this increase in notifications and claims: not only are more R&W policies being placed than at any point in history, including many deals in the sub-$250M transaction value, but policyholders are more aware that they can use their R&W policy for reporting.
The increased reporting of breaches in recent years will not trigger higher prices because properly underwritten deals have not suddenly become riskier to insure despite the increase in notification frequency. As the report points out, no more than a quarter of notifications actually result in a request for payment from the policyholder. And only a fraction of reported breaches actually exceeds the retention and lead to payment by the Insurer.
It’s also worth noting that tax-related notifications (in the form of audits) are among the most common breaches reported, usually within three years. Tax authorities aim or are required to commence an audit within one to two years of receiving returns due to the statute of limitations.
There may be nothing wrong, but because the IRS is launching an audit, policyholders will report it to the insurance company to put them on notice so they can bring their resources to bear to defend them if necessary. However, these audits usually do not result in a claim. Most agreements require a six-year survival period for tax Reps, which may not be necessary.
Overall, R&W insurance has established itself as credible, reliable, and sustainable. This is a respected, solid product. It’s on everybody’s checklist right now.
The simple fact that Liberty Mutual has issued this report is reassuring. AIG was the only insurance company to put out any information about claims before now. This new report shows this is a maturing market.
More competition brings better products and services and lower prices. It’s innovation in action.
It’s also important to note that insurers like Liberty Mutual and AIG do pay these claims. As Gareth Rees, Liberty GTS Chief Underwriting Officer, put it:
“In the past, R&W insurance was essentially something that helped solve a deal problem and get a deal over the line, but then often forgotten about post- closing. Now it is also seen as an asset from which an insured can recover value in the future, and much greater thought is given from the outset as to whether a policy claim exists.”
The Liberty Mutual report, 2020 Claims Study: Exclusive Insight Driven by 10 Years of Data, is worth a close look, especially the section on emerging trends in the claims R&W insurance policyholders make. Here are the issues they expect to be leading claims generators in the next 12 months.
There are a few elements at play in these types of claims, which, as you might expect, are most common in retail and manufacturing businesses and mostly involve slow moving, obsolete, or damaged stock. The COVID-19 pandemic has only intensified this trend.
There is more risk if the business is seasonal, or if the products in question are frequently updated or subject to price volatility or physical damage. There is even more risk, says the report, in so-called locked-box deals with no stock-take at, or following, closing.
Why are these claims relatively common?
Gareth Rees says: “The reality is that stock can be a difficult area to diligence, particularly on a deal that is moving very quickly. A lockdown situation obviously makes it difficult to carry out any physical checks.”
“Also, there will be many companies that have built up large quantities of stock as a result of the lockdowns, but which may not have updated their policies around obsolete and slow-moving stock to reflect this. This is an issue of heightened underwriting focus for our team at the moment.”
As with the previous trend, we are likely to see a pandemic-related impact here as well, which is why underwriters are taking a closer look at “the size of the accounts receivable figure in the accounts relative to the size of the balance sheet and asking more questions around this issue.”
Common allegations with regards to accounts receivable claims include the setting of inadequate bad debt reserves and errors in quantifying the acquisition’s total accounts receivables. In some cases, it’s unclear in these times whether a customer on the books is “real” or will disappear or even shut down due to COVID.
Essentially, this is when you have onsite audits from software providers to check how many people at a company are using software that has been licensed. According to Liberty Mutual’s report, these types of audits are on the rise.
An acquired company could state that they have 100 licenses, but it turns out that 300 employees are actually using the software. That’s a big no-no. Punishments range from penalties, to a requirement by the vendor that the company buy new software at list price and pay support costs.
This issue could be very impactful for SaaS companies and other tech businesses.
Insurers are taking a closer look at software licensing in the underwriting phase too, says the report, which states: “[We] expect it will also become an area of focus for buyers and their advisors during the due diligence process as target businesses become more digitally enabled and more reliant on licensed software.”
When you sell a company, you can’t have zero cash in the bank on closing day. The incoming Buyer needs money for payroll, leases, etc. for, say, 90 days post-closing. The Buyer will make an amount, say it’s $9M, part of the deal. But they will ask the Seller what amount is needed for operating expenses for that 90 days.
This can be trickier than you might think when you consider the different ways revenue is recognized and then booked for accounting purposes. When there is a disconnect, a claim results.
According to the report, this is an issue particularly with project-based work. In these cases, revenue is recognized over time and compared to incurred costs, instead of in line with actual income received. The fact that the projects involved are long-term and have multiple elements makes this even more complicated. This means tougher due diligence in this area.
States the report: “We are increasingly looking for signs that management have been challenged appropriately in key areas of judgement associated with the entity’s revenue recognition practices and sufficient evidence has been obtained to support those judgements.”
This has become such as issue that SRS Acquiom is adding side-escrows for revenue recognized and net operating revenue in the deals they oversee.
Minimum wage provisions are excluded by most R&W policies. So, although this can be a serious issue to those companies impacted by employees’ claims for backpay, increased tax liabilities, and fines from governmental authorities, it’s not something that insurers have to worry about in most cases.
State governments, facing reduced tax receipts and pressure from advocacy groups, are increasingly seeking to classify independent contractors as employees. California is the perfect example.
This could, says the report, “result in a large number of notifications with the potential for significant consequences for a business, both in terms of increased tax liabilities and payroll costs.”
With increased regulation, especially in the real estate sector, and more stringent compliance measures, we are seeing more claims related to breaches of health and safety laws. The result, as the report states, are significant business disruption and remedial costs to get into compliance.
As the report states: “We anticipate that this will lead to buyers and their advisors focusing more on this area as part of their due diligence, with technical reports addressing this specific issue becoming more common.”
The Liberty Mutual report does see climate change as an area of concern and increasing risk, but it’s mostly an issue for companies operating in the European Union.
As I stated earlier, more R&W insurance policies are being written, so more notifications are being made. More notifications that don’t result in claims being paid out means that R&W isn’t any riskier than before.
This trend of rising notifications actually points to sustainability and maturity in the R&W insurance market. As a result, we should have stable pricing for the foreseeable future.
One thing to keep an eye on are new trends related to COVID-19, with Underwriters scrutinizing new potential areas of exposure, such as:
For guidance on the use of Representations and Warranty insurance in the time of COVID-19 and beyond, contact me, Patrick Stroth, at firstname.lastname@example.org for all the details.
While attending a recent M&A conference, I was surprised to hear so many of the participants – including PE firms, M&A attorneys, and bankers – still hold the mistaken belief that Representations and Warranty (R&W) insurance is too expensive.
In fact, the floor for R&W coverage has actually come down drastically in the past year to the point that a $5M policy can easily be found and it will cost less than $200K, including underwriting fees and taxes. (This figure doesn’t include broker fees, which the big firms are adding to maintain income levels. More on that below.)
Why the disconnect? These folks haven’t checked in on R&W insurance for a while, and people assume what was true a couple of years ago is still valid. They tend to get their information and updates from conferences. I was happy to spread the good news while I was there, and I got positive response. These folks did not see value in a policy if the cost was $225K, $350K. But if they could get a policy for under $200K, they were interested.
This significant drop in costs reminds me of Moore’s law. Quite appropriate considering how many M&A deals are done in the tech space. This maxim holds that every 18 months we can expect the speed and capability of our computers to double, while we pay less.
There are several reasons why the cost of R&W coverage has dropped:
I expect this trend to hold steady as the increase in R&W policies written has not yet translated into a corresponding increase in paid losses by Underwriters. Due to the simple fact that more policies are out there, reported losses are up. However, most of these cases fall within the policy retentions, so insurers are not having to write many R&W checks to cover damages. Plus, just because they’re writing smaller deals doesn’t mean Underwriters are getting sloppy and accepting just anything. They expect the same due diligence, making the smaller deals just as safe for them as bigger deals.
It should be noted that unlike other discounted insurance products, these low-priced R&W policies provide coverage just as comprehensive as the higher priced alternatives (depending on the complexity of the deal and diligence completed, of course). You’re not getting lower quality coverage or added restrictions just because it’s cheaper.
A sub-$200K priced R&W policy is good for M&A for the following reasons:
1. Lower costs make the value proposition on smaller deals more “palatable” – especially for Sellers where $1M or $2M less in escrow makes a material difference. These folks can’t take a $1M to $2M hit if there is a breach. R&W coverage is a lifesaver for them.
2. Lower priced policies more easily enable Buyers and Sellers to share the costs.
Many Buyers are saying that Sellers want R&W coverage on the deal but don’t want to pay for it. And Buyers are chagrined by that. But if costs are split and it’s under $100K for each side, it’s more favorable, and both sides benefit from having the policy in place.
As you know, this specialized insurance makes negotiations smoother, lets the Seller keep more cash at closing, and ensures that the Buyer doesn’t have to take legal action against the Seller if there is a breach, which is awkward if the Seller’s management team is on board with the new entity.
3. The lower price point makes R&W an affordable tool for add-ons, which are expected to increase as PE firms and Strategics look to enhance the value of their portfolio companies.
With PE firms in particular, thanks to lower cost policy and premium, they won’t just reserve R&W coverage for deals above $100M in transaction value. This lower price justifies using R&W on deals at $30M, which they are doing more of because it’s a lot easier to spend $30M to $50M than $100M. PE firms will transact two to three times more add-ons per year than one big acquisition.
I saw this first-hand recently with a policy I provided here in Silicon Valley. The company brought in a $90M add-on to an existing portfolio company. The $5M limit R&W policy cost just $175K (including underwriting fees and taxes).
Overall, with the lower price for an R&W policy, cost is no longer an objection for either party to consider a policy.
If R&W continues its stellar performance, expect to see even fewer exclusions and possibly lower retention levels.
But how much lower can the price go? Not much further if R&W insurance is to be sustainable. If the product gets too cheap insurers will not be able to collect enough in premiums to pay claims.
We’d caution prospective users to be wary of policies coming in under $100K.
One observation from this drop in premium rates is that the major insurance brokers offering R&W coverage have reacted to this price drop (which they’ve had to go along with to stay competitive) by adding broker fees of as much as $25K. These big firms have big overheads and want to protect their profit margin.
That’s where a boutique firm like Rubicon Insurance Services shines. In this segment of small market M&A deals, we take a back seat to nobody. We can broker policies more cost effectively and more efficiently because we don’t have the overhead. We won’t charge those broker fees.
I’m happy to provide you with more information on R&W insurance and provide you with a quote. Please contact me, Patrick Stroth, at email@example.com.
If you’re involved in lower middle market M&A deals, you should know that Representations and Warranty (R&W) insurance is now available to cover transactions as low as $10M, offering tremendous benefits to both Buyers and Sellers.
This isn’t common knowledge in M&A circles, even though it’s been more than two years since insurers started entertaining sub-$100M transactions.
The pandemic has disrupted the normal route that this sort of news gets out: M&A conferences, where insurance companies share details on product development and product changes.
If I wasn’t sharing this with you now, chances are, you wouldn’t know about it.
That’s why I’m compelled to share that R&W policies created for lower middle market deals are available, and, although costs are rising because of the immense number of deals seeking this coverage, they are cheap – costing $225,000 to $240,000 for a $5M Limit R&W policy.
This makes R&W coverage perfect for add-ons, which have been an increasing focus of PE firms in order to add value to existing portfolio companies.
According to a recent report from Axial, the online platform that connects Buyers and Sellers, “Add-on acquisition activity in the United States has experienced a steady, near linear growth since the early 2000s.”
Axial reports that 90% of acquirers are looking for add-ons right now—it’s a very robust market.
Also noted in the report: add-ons represented 43.2% of buyout activity in 2002 and that had risen to 71.7% by 2020.
Add-ons are often a smaller investment with potential for greater returns.
The benefits to Sellers in an add-on deal are:
Overall, this type of deal allows Sellers to strengthen a “weakness” keeping them from the next level. And the outlook for add-ons keeps getting better and better because Buyers in these deals are focusing on blending company cultures more than ever before. Add-ons are being done more “thoughtfully,” with conscious attention brought to successful integration—it’s not just “buy and forget.”
The greatest benefit of an add-on is that it’s a “second bite at the apple.” Sellers retain a portion of the new entity, giving them potential for additional money when the new entity is eventually sold.
For example, the owner of a $20M company agrees to sell for $15M cash and roll-over $5M (25%) in shares of the new firm. Later, when the new firm is sold for $100M, that 25% is now worth $25M, 5-times the original $5M roll-over figure and $5M more than the value of the original company.
There’s a catch. Add-ons are smaller and less experienced in M&A than their counter parties. Once a LOI is signed, Buyers with huge leverage can exert great pressure in negotiations, which creates tremendous stress on the Seller.
The acquired company might feel cornered and bullied into agreeing to take a lot of risk and liability away from the Buyer – like take on a sizable escrow. Traditionally, the Seller could be at risk of losing 10% to 30% of proceeds if there is a serious breach. And they have to swallow the fact that they’ll only get a portion of their money at closing.
Sellers have to wait a year or more – and the money sitting in escrow can be exhausted in the event of a breach that the Seller had no control over.
That’s where Rep and Warranty comes in.
Removing Risk With R&W Insurance
One way to remove some of the contentious issues in a deal is through R&W, which enables Sellers and Buyers to transfer their M&A risk to an insurance company. This specialized type of insurance is helping add-ons be successful.
Until recently, this powerful tool was not available to smaller (sub-$50M deals) due to cost and target companies not having thorough financial documents or Buyers developing key diligence reports.
As detailed in my previous piece “Moore’s Law Comes to R&W Insurance” greater competition among M&A insurance companies has driven down premium levels and simplified prior eligibility criteria. To read the Moore’s Law piece, go to: https://www.rubiconins.com/moores-law-comes-to-rw-insurance/
Insurers no longer require audited financials (a deal-breaker for lower middle market companies). Thanks to low costs, R&W is the ideal fit for sub-$100M acquisitions – especially add-ons. However, as I mentioned, due to increased competition in the last several months costs for these policies are going up.
Currently, a $5M policy will cost $225,000 to $240,000.
Another caveat: While deals as low as $10M are eligible for R&W insurance… not all insurers are offering coverage at this level. Due to a surge in M&A activity, the big national insurance brokers don’t have the staff available to handle all the applications coming their way. So, they’re focusing on deals with a transaction value of $200M+.
If your deal falls under that threshold, you should be looking at a smaller firm that focuses on that level of deal—R&W coverage is still out there if you want it, you just have to look a little harder.
(Also, keep in mind that Transaction Liability Private Enterprise (TLPE) insurance is available for deals with a Transaction Value of $250,000 to $10M.)
Having this coverage in place makes for a much healthier environment post-closing, where you didn’t have to grind down the target company in negotiations. These are the folks joining your team, and if they come limping in, you can bet they won’t be as enthused to make the merger work.
In the tech community, Buyers are especially reluctant to penalize their newest partners by using up escrow funds. So they have a dilemma. Do they eat the loss… or risk demoralizing their new partners? With a R&W insurance policy in place, that dilemma is gone.
You want people to hit the ground running. How?
Make sure they get as much money as they can with as little risk as possible. If you are the Buyer, the R&W policy is zero cost to you. And it can be applied directly to the purchase price which Sellers will eagerly accept.
You want these transactions happening fast. You want to integrate the new group into your team in a positive way to ensure a successful transaction. What better way than this tool – Representations & Warranty insurance.
It has withstood the test of time. It’s worked for the big deals, and now it also works for the lower middle market deals.
What To Watch Out For
As the R&W insurance market has matured, different insurance companies now favor different M&A profiles. Some prefer larger risks over $200M. Some prefer lower middle market – $50M or less. So when selecting a broker, make sure you work with one who is focused on your market segment.
You could go to a “brand name” institutional broker for your lower middle market deal. They are not bad people, but they are focused on their bigger deals. They don’t have the bandwidth to handle the smaller transactions. If they have two or three billion-dollar deals going, they can’t handle a dozen $20M deals at the same time.
Another wrinkle is that, due to lower priced R&W coverage, some brokers will add in extra fees to supplement revenue and maintain profitability per deal.
I’m a broker with hands-on experience with the Representations and Warranty insurance product, specializing in insuring lower middle market deals.
To learn more about the protection R&W coverage offers, I invite you to contact me, Patrick Stroth, at firstname.lastname@example.org.
Article Updated: September 01, 2021
The special purpose acquisition company (SPAC), sometimes called a “blank check company,” is the newest darling of the stock market for going public because it’s so much easier, quicker, and cheaper than a regulation-heavy traditional IPO.
As you know, SPACs are created for the sole purpose of acquiring or merging with an existing company. And there is no deal more perfectly suited for Representations and Warranty (R&W) insurance than one involving a SPAC.
Private Equity took years to embrace R&W coverage, which transfers the indemnity risk away from the Seller to a third party – the insurer. It’s just a matter of time before SPACs do the same.
SPACs have been in the news lately.
Oakland A’s executive vice president (and former general manager) Billy Beane of Moneyball fame partnered at the end of January with RedBird Capital Partners to form RedBall Acquisition, a SPAC set up to the acquire a pro sports team. Hedge fund leader Bill Ackman raised $4 billion for his SPAC, the largest listing to date. All told, SPAC listings have raised just about $40 billion so far in 2020, eclipsing the $13.2 billion raised in 2019, according to SPAC Research.
PE firms and big-name investment banks like Goldman Sachs are getting in on the action.
Partly driving this trend is the pandemic. The valuations of private companies are falling, and they’re looking for liquidity fast – which is something traditional IPOs definitely don’t offer, especially in this time of market volatility. SPAC IPOs aren’t as dependent on market performance to be successful. Finally, they also allow sponsors to acquire quality companies at lower valuations.
All this means opportunity for savvy investors, who enjoy the many benefits a blank check company provides:
Sellers love SPACs because they regularly outbid other offers to get these acquisitions and they are under time pressure. SPACs consistently pay more than everybody else. PE firms can’t match these premiums because they want to get the best return on investment.
SPAC founders are under tremendous time pressure to get deals done within the two-year deadline, which, except under very specific circumstances, is set in stone.
They need deals to go smoothly and on schedule. Plus, the longer it takes SPACs to complete a business combination – the more leverage the target has to insist on narrow Reps and Warranties and other Seller-favorable terms.
That’s where R&W insurance comes in. It hedges risk for both Buyer and Seller and is built to facilitate fast acquisitions. Here’s why:
This speeds up the process – not to mention saves on legal fees, about 20% savings on the negotiations part of the deal. The management team of the acquisition target will likely work with the SPAC going forward, so if negotiations are amicable, it means a good working relationship going forward.
SPAC sponsors are incentivized to make deals work, because if they have to give money back to investors, they don’t get paid and could lose standing in the eyes of potential future investors in other SPACs.
With SPACs there is no history of performance. Investors look at the sponsors’ reputation and expertise when they decide to buy shares, as do target companies when they decide to accept offers. A tarnished reputation makes it hard to move forward.
If deals are eight times more likely to close with R&W coverage in the PE market, I would believe it’s at least that much in the SPAC market.
Given all this, why aren’t SPACs running to R&W insurance right now?
Until recently, most sponsors have been big-time banks and successful investors and executives. They have experience in M&A, of course, but as Strategics they held so much leverage over their targets, R&W wasn’t necessary. So they never really considered it – or even knew what it was.
Today, large PE firms, who have embraced R&W insurance, are coming to the forefront as SPAC sponsors. R&W is definitely in their “toolbox”.
It’s clear that Representations and Warranty insurance is ideal for SPACs. To find out how this specialized type of insurance can change the game for you, whether you’re a SPAC sponsor or a target company, contact me, Patrick Stroth, at email@example.com for all the details.
The COVID-19 pandemic has changed trade, commerce, and business in so many ways already… with more changes to come. The world of M&A has reacted as well. But as I noted in my previous piece, No Significant Drop in M&A Activity During This Recession, we won’t see the slowdown happening.
Instead, we’ll see a shift to a Buyer-friendly market. Also, watch for PE firms with plenty of cash to look for opportunities – and bargains… struggling companies they can turnaround.
The pandemic will impact a key part of M&A activity: the due diligence process and the use of Representations and Warranty (R&W) insurance to cover breaches of reps in the Purchase and Sale Agreement.
Just as with any insurance product, COVID-19 must be addressed with R&W policies. And expect pandemic-related questions from Underwriters in the due diligence process.
Not every company, of course, has been affected by COVID-19 in the same way. For example, a software company that already had a largely remote workforce is in much better shape than a retailer forced to close brick-and-mortar locations.
But overall, insurers are closely monitoring the impact of COVID-19 on operations of any acquisition target. This is how I expect it to impact R&W coverage moving forward:
As a worldwide pandemic affecting billions, nobody can claim that COVID-19 is an “unknown” prior to a deal being signed. And R&W policies only cover breaches that were unknown, “historical,” or related to issues that were not disclosed by the Seller.
The impact of the virus on the workforce, including layoffs and supply chain disruptions will be the focus on enhanced due diligence in particular, and not considered breaches. Claims related to a drop in revenue are right out the window. These will be excluded, but perhaps covered in another M&A related policy, such as business interruption insurance.
That being said, you can limit exclusions for specific things related to the pandemic, not just anything COVID-19 – that exclusion would be too broad. Despite its seriousness, the pandemic can’t touch every rep. So expect very careful language.
Since R&W policies are largely written for each individual transaction, a broker has the ability to identify the right Underwriters and products and make the exclusionary language in a policy as favorable/narrow as possible for the policyholder.
Take the Fraud Exclusion for example. Fraud is absolutely excluded in virtually every insurance policy because it’s a moral hazard. However, savvy Brokers and Underwriters can create wording in a policy to provide legal defense of a policyholder accused of fraud until the alleged fraudulent behavior is proven. If there is no proof of fraud, the exclusion cannot be triggered, therefore, a policyholder benefits from the protection provided by the policy. Depending on the rep in question and the amount of diligence shown to Underwriters, a Broker can negotiate wording that can lessen the scope of a COVID-19 related exclusion.
With some M&A transactions, there can be a long period between signing the Purchase and Sale Agreement and actually closing the deal, especially with large and complex deals. For example, it took months for Amazon’s acquisition of Whole Foods to win regulatory approval and close.
Imagine if a deal like this had been done recently, and COVID-19 swooped in during that interim period. Remember, to be considered a breach, the issue must be unknown and/or result from failure to disclose a harmful issue by the Seller.
But a change in the overall economic environment or the industry such as this pandemic, can’t be considered an “unknown” and therefore would not be covered.
Thankfully, this is not much of an issue with lower middle market companies because interim periods between signing and closing are rare, and if there is an interim, it is likely measured in days, not months.
One last thing to watch out for. For now, R&W coverage pricing and deductibles haven’t changed. They should be increasing as more claims are coming in in this time of crisis.
The previous trend had been for consistently falling prices and its use in ever-smaller deal sizes – down to $15 million, which was one of the factors in its growing use by middle market companies. It’s something to watch out for.
To discuss the impact of COVID-19 on R&W and other M&A-related insurance, I invite you to contact me, Patrick Stroth, at firstname.lastname@example.org.
In insurance parlance, if you insure a particular exposure, you’re covered. If not, you’re bare. If you’re looking for a policy that covers something that’s never been covered before, you’re… naked.
That’s the situation many privately held, small and middle market companies find themselves in when they seek to sell their business.
The Buyer asks them to secure Directors and Officers Liability insurance (D&O), specifically a “tail” policy to make sure there’s a source of insurance coverage in case the Seller is held liable for any wrongful acts against an employee or others – things like human resources issues or fraud – committed before the closing date.
Essentially, the Buyer doesn’t want to find out six months after the closing date that there is some sexual harassment lawsuit or anti-trust complaint against the former owners.
As the new owner, the Buyer doesn’t want to be on the hook for incidents that happened before they purchased the target, so they require Tail coverage that extends the target’s D&O Liability, Employment Practices Liability, and Fiduciary Liability coverage for up to six years from closing.
Tail policies provide virtually the same protection as a traditional D&O policy that has a Tail Endorsement. On the acquisition date, the Tail kicks in and covers lawsuits brought against the directors and officers of the target company. This covers any allegations that they committed a wrongful act prior to the acquisition, all the way back to the incorporation date.
This sort of coverage is standard in the M&A world. I’ve been working in this space for years. As I mentioned in a previous article, when Representations and Warranty insurance is not a fit for a deal, Naked Tail coverage is one of three alternatives.
(To put it in to perspective, the cost of D&O Tail coverage is about $20K to $50K. That’s a fraction of the cost of a R&W policy. And the deductible on a Tail policy is $25K to $50K, which is also a fraction of what it is for R&W.)
There are literally thousands of privately held companies in the $30M to $50M range that have never held D&O insurance and now need it to satisfy the terms of their acquisition. Today, this can be done quickly, easily, and broadly.
For example, a small business, run by husband and wife for 20 years. They never felt the need for D&O coverage and had gone the whole 20 years without any sort of legal claim against them. But, when they were ready to sell and enjoy a well-deserved retirement, they were forced to scramble and find coverage because the Buyer required a D&O Tail. Since the couple had never carried D&O previously, their options for finding suitable coverage were limited. That is until now.
Insurance companies didn’t look at these Naked Tails favorably in the past. Generally, they wanted to see three to four years of successful coverage under a regular D&O policy (and wanted three to four years of premiums).
What happened to people who didn’t previously have a policy and are about to sell or merge? The insurers would provide scaled down policies with multiple exclusions at rates that were substantially surcharged.
Things have changed. Now, insurers understand that the risk of anything that the Seller didn’t know about blowing up post-closing is very small. And they are willing to offer these Naked Tail policies for even small transaction size deals.
Today, Underwriters need only a statement from the Seller warranting that, as of the closing date, they know of no fact, event or circumstance that would give rise to a claim. Such warrants are hardly problematic because the Seller is already making these warrants to the Buyer on a much broader scale. Therefore, the Naked Tail is a relatively low risk for Underwriters.
There are a couple of reasons you need a D&O Tail policy when you’re going through any M&A deal, besides the fact that it is contractually required. (For those who’ve never had D&O insurance and don’t see why you need it now, pay close attention.)
D&O Tail coverage doesn’t cover fraudulent behavior, but it will give you money to defend yourself against allegations of fraud. An allegation is not proof. But if you want to keep your escrow, you must defend yourself in court, no matter how frivolous the claims. Without D&O coverage, you’ll pay your own legal costs.
D&O Tail coverage doesn’t cover fraudulent behavior, but it will give you money to defend yourself against allegations of fraud. An allegation is not proof. But if you want to keep your escrow, you must defend yourself in court, no matter how frivolous the claims. Without D&O coverage, you’ll pay your own legal costs.
As I mentioned, if you’re looking to sell your business, you’ll most likely be contractually obligated to take out a D&O Tail policy. There’s no getting out of it, so to speak. And with the legal and financial protection it offers, why wouldn’t you want a policy anyway.
I would recommend not going to your regular commercial insurance broker, even one with experience in standard D&O insurance. A Naked Tail policy is a whole other animal.
You need a broker experienced in insuring M&A transactions and Naked Tails in particular. It’s a slightly different skillset. And because this issue usually comes up close to closing, you want a pro who can get the paperwork processed in a day or two.
I’ve worked in this world for years and would love to answer any of your questions about setting up a D&O Tail policy to your deal. It’s low cost and easy to do.
You can contact me, Patrick Stroth, at email@example.com
Steven Epstein, founder of RedCAT Systems, and his partners and management team had slowly but surely built their company in a highly specialized niche serving top clients, including those in the Fortune 500. They were ready to sell to take the company to the next level.
But this small, Colorado-based software company involved in HR and compensation solutions for clients like LinkedIn, Uber, NYSE, and many more wasn’t interested in being acquired by just anybody.
They were looking for a partner who wouldn’t accelerate growth too fast or take on too many new clients too quickly because they wanted to ensure a slow growth strategy that would keep current clients happy and give the new ones the same high level of customized service they’re known for. In their specialization of executive compensation, which has a lot of moving parts, this counts for a lot.
After a time, they found their match – a company that understood their business culture – and were recently funded by PE firm Broadtree Partners.
“We wanted to make sure that our clients were treated well. It’s a very high-level service. There’s really nothing that we would be asked that we weren’t able to fulfill on time, on budget, and pretty much the experience was exceptional. That’s why we were able to get the type of work that we do. And we wanted someone who would share that philosophy and maintain that while at the same time doing measured growth,” says Steven, of RedCAT.
As with any M&A transaction, there were some hiccups along the way… as well as one major obstacle that could’ve derailed the whole deal, and probably would have, if this transaction was being negotiated prior to 2019.
This is an in-depth examination of this real-world M&A transaction. We first got the story from the Buyer’s perspective – you can check out that article here. Now, we’re hearing from the Seller as we explore how the deal went down so that both sides were happy. Additionally, Steven was featured on my podcast, M&A Masters. You can listen to his episode here.
Once Broadtree and RedCAT had a signed a Letter of Intent, it took roughly nine months to close the deal.
One of the things that stalled the deal moving forward was due diligence. Broadtree was more used to dealing with larger companies that had more in-depth and detailed financial records that could be combed through. It took a while for RedCAT management to get all the required information together.
“As a company, if that was your plan [to be acquired], I would just keep much more meticulous track of every single document,” says Steven. “Every little bit of every single dollar that was ever spent took a lot of effort to come up with… and then thousands of pages of contracts we had already signed. Looking at and reviewing every single thing took quite a while.”
Tech due diligence – which involved making sure no code or other IP could be claimed by another party – also took some time to get through.
But what was the major sticking point?
One of RedCAT’s partners, who had been burned in business deals in the past, wanted some protection. Specifically, he wanted to use Representations and Warranty insurance so that less money (including his) would be held in escrow and there wouldn’t be any threat of clawback.
With R&W insurance, if there are any breaches in the Seller’s reps, it’s the insurance company – not the Seller – who reimburses the Buyer and pays the financial damages. Those claims do get paid, and this coverage is reasonably priced.
Often the Seller pays for the insurance because of these benefits. But there are plenty of reasons for a Buyer to get on board, too. For one, in case of a breach, they don’t have to go after their new team members (the Sellers) who’ve joined the company after the acquisition for damages – that’s very awkward. Also, there is no need for costly or time-consuming legal action. The claim gets paid, and everybody goes about their business.
“[R&W insurance] allayed our partner’s fears, basically of the deal and the liability,” says Steven. “If something did come up, I think it would be tremendously beneficial to have it. Let’s say we didn’t have R&W, and we put in $1.5, $2 million in escrow. And then some kind of obscure thing comes out, and we disagreed with it. That would cause a serious breach. Not only of, say it’s a million or two dollars, but then we probably wouldn’t want to stay on. And the effect is most likely the failure of the new business.”
Just a short time ago, this wouldn’t have been possible because insurers were only offering R&W coverage for larger deals. But recently, we’ve seen an increase in Underwriters crafting policies for transaction sizes under $20M, which opens up this insurance to a whole other section of the M&A world, including lower middle market companies like RedCAT.
For Steven, the R&W coverage offered more than financial protection.
“The peace of mind can be priceless. Just the feeling that I don’t have to worry about this. We’re covered. It’s not a thing that will A) damage the relationship and B) just consume life energy where you’re fighting about something that is likely frivolous.”
That’s a ringing endorsement for Representations and Warranty coverage. If this case study has interested you in this specialized type of insurance, tailor-made for M&A transactions, and now available for deal sizes under $20M, contact me, Patrick Stroth, at firstname.lastname@example.org.
In the world of M&A, many companies, on both the buy-side and sell-side, have realized the tremendous benefits provided by Representations and Warranty insurance.
The Buyer is able to recover any losses from a breach of the Seller reps without doing so at the expense of the Seller. The Buyer simply makes a claim with the insurer. Plus, the policy cost is either discounted significantly or is free because the Seller will gladly cover the premium.
Sellers love it because they take home more at closing and the indemnification risk is transferred to a third party – the insurance company. A clean exit, and they have zero fear of future potential clawback if there is a breach.
That being said, not everyone is willing to entertain using this insurance.
This is especially true in the case of a corporate, strategic Buyer, in which one company buys another because of synergy of products… to expand to a new customer base or geographic region… or to acquire products they want.
The thing is that strategic Buyers are often much larger than the acquisition target – often hundreds of times larger. In these cases, there is no incentive for the Buyer to get R&W insurance; the protection it provides them is negligible. This is the case even if the Seller is willing to cover the cost. The other issue: the Seller has no leverage here.
So what’s a Seller to do?
As a small Seller, you don’t have to enter into an M&A deal with no protection. There are alternatives if your Buyer isn’t interested in full R&W insurance.
For tech companies, the most sensitive reps are those dealing with technology, of course. If those reps are breached, it could be very expensive as they are critical to the value of the company.
The target tech company could be confident that their IP is not infringing on anybody, but the Buyer no doubt still has a bit of worry.
If the Buyer is not willing to consider full R&W insurance, a Seller could get a limited policy that just covers IP reps. These types of policies do rely on the Buyer’s due diligence. So the Underwriters still have to engage the Buyer to get their diligence on IP. But it’s not the full report, so it’s a relatively easy ask. And the cost is still on the low end, with a premium cost at 2% – 2.5% of policy limit (subject to $100K minimum premium), with 1% transaction value retention.
The same sort of arrangement could be made for tax reps, as well.
Although the vast, vast majority of R&W insurance is on the buy-side, it is possible for Sellers to get their own policy. This could be handy if the Buyer refuses to disclose any of their due diligence and the Seller is nervous about not having any protection from risk.
To be frank, sell-side policies can be more challenging than those of the Buyer’s side. It essentially protects the Seller in the case of a third-party (which includes the Buyer) bringing action against them for a breach of their reps.
For example, McDonald’s recently bought a small AI company – the technology will be used to speed up the drive-through ordering process. A huge company buying a small one.
Hypothetically, let’s say the AI company had unknowingly breached another company’s IP. That other company will sue McDonald’s and the AI company. McDonald’s is fine – they have their own protection and legal team. But the founders of the AI company need protection because they no longer have insurance after the acquisition. A sell-side R&W policy can be a perfect option.
Owners and founders can also rely on a Directors and Officers liability policy to protect them in case of allegations of misrepresentation, unfair dealing, or fraud. At the very least, the D&O policy can pay lawyer costs to protect the policyholder.
In the vast majority of purchase and sale agreements there is a requirement that the target company have a D&O policy in place. Privately owned companies with a small number of shareholders/owners might think they don’t need this coverage because they don’t have outside shareholders. But this protection is key.
Once the Buyer acquires a company, the board is their responsibility. They don’t want to take a risk on things done before they acquired the company. It’s best to have some other source of recovery like this on their end as well.
A D&O liability policy will run you a tiny fraction of what R&W costs.
For those companies that never carried D&O insurance in the past, there’s a solution. Companies can purchase a D&O Tail policy that will provide virtually the same protection as a traditional D&O policy that has a Tail Endorsement.
In the event there is a claim against any of the directors and officers, they will be protected from legal action for up to six years post-closing if there is a D&O “tail” policy.
Even if they didn’t have insurance previously, on the acquisition date the tail kicks in and covers any lawsuits brought against the directors and officers at the target company. This covers any allegations they committed a wrongful act prior to the acquisition, all the way back to the incorporation date.
Let me wrap things up with a quick case study of a company that wanted R&W coverage in place… and a Buyer who wasn’t willing to deal… and what they did next.
A small AI company was bought by one of its clients – one 1,000 times its size, roughly, and worth $20B. The total transaction value was $17M.
The Buyer had no interest in R&W insurance, even when we offered a policy that covered the full $17M.
The Seller was really concerned because the IP reps went from general reps to fundamental reps with a longer survival period. That’s a lot of risk out there for them for years down the road if another company claims IP infringement.
We offered to insure just those IP reps, with a premium from $100K to $300K, which the Seller was ready to pay.
All that was needed to write the policy was the Buyer’s due diligence report. But they didn’t want to disclose any confidential information.
The last alternative we were able to offer the Seller was a D&O Liability Insurance policy. We got the thumbs up and did a $5M limit D&O policy for $50K.
The company was acquired on July 1, 2019. Until July 1, 2025, any lawsuit filed against the company’s board of directors for allegations prior to the acquisition date will be covered.
Of course, R&W insurance would have been preferable for the Seller. But this was the best option and does offer substantial protection.
If you’re interested in exploring your options for protecting yourself post-closing with Representations and Warranty insurance or some other type of coverage, get in touch with me, Patrick Stroth, at email@example.com.
In recent years, as more insurers have entered the Representations and Warranty insurance market (according to a study from Harvard Law School, there are now more than 20 insurance companies writing these policies), there have been more opportunities for ever smaller M&A transactions to secure coverage, with deals as low as $15M deemed eligible.
The insurers that offer these policies understand that given the smaller transaction size, they will be asked to cover most, if not all, of the transaction value (TV) of the deal.
Insurance companies are providing flexibility for Buyers and Sellers by offering policies that provide coverage up to the purchase price, while also insuring the Non-Fundamental reps to a specified Limit – more on this below.
Sellers of small TV targets have less leverage than their counterparts, so having the ability to transfer ALL the indemnity risk can provide a productive tool for both sides.
Naturally, Underwriters in this space require the same levels of Buyer diligence as the larger deals, so eligibility for R&W should be checked before proceeding.
Here’s why this matters: most R&W policies don’t cover the entire cost of the transaction. They only have to provide Limits up to the Indemnity Cap (Cap) as outlined in the Purchase Agreement.
A Seller’s maximum exposure is equal to that Cap and no more. Therefore, there’s no need to provide more protection above that Cap. In many cases, the Cap runs 20% to 30% of the TV.
Typical R&W insurers that cover $100M+ M&A deals are reluctant to insure more than 30% of the TV. So, the maximum an insurer would be willing to cover on that $100M deal is $30M, even though that same insurer has the capacity to provide a $50M or $75M Limit. The reasoning is that Underwriters are not comfortable insuring a majority of the TV.
This position is not the case with deals in the lower middle market (sub-$30M TV space). Unlike the larger deals, it’s easier for Caps to exceed that 30% threshold. Consider a $5M Cap is 33% on a $15M deal. Buyers have significantly more leverage over targets in this sub-$30 TV space, and therefore routinely require higher Caps, particularly with regard to Fundamental reps.
Within the Purchase and Sale Agreement, there are specific categories of reps: Fundamental and Non-Fundamental.
Fundamental reps often include:
Any rep not identified as Fundamental is considered a Non-Fundamental rep.
Buyers scrutinize the Fundamental reps more closely than any of the other Seller reps, as breaches of Fundamental reps lead to larger, more serious financial damages.
Breaches of Fundamental reps are rare because they have been so closely watched, but according to the recent AIG claims report, they do happen.
R&W insurance is priced based on the amount of Policy Limits provided. Since smaller transactions traditionally don’t need higher Limits, Underwriters haven’t been able to set a price for small deals that justifies the risk.
For that reason, Underwriters developed the approach of offering to insure the entire transaction by covering the Fundamental reps at a maximum Limit, while including coverage for the smaller, Non-Fundamental reps Cap.
The per Limit rate for these purchase price policies is discounted due to the lower risk of the Fundamental reps, while enabling Underwriters to collect sufficient premium to insure the smaller deals.
Take the case of a PE firm seeking to purchase a chain of car washes for $22M.
Within the Agreement, the Buyer seeks a $4.4M (20%) Cap on Non-Fundamental reps, but no Cap on Fundamental reps.
Prior to the entry of the new R&W policies, the maximum limit of coverage for Fundamental and Non-Fundamental reps would be $6M to $7M and the parties would have to bear any risk above that Limit.
Today, policies are readily available to offer a package that provides $22M in Limits for Fundamental reps, with a Sub-Limit of $5M for Non-Fundamental reps.
Consider the pricing benefit as well.
A $22M Limit R&W policy runs $400K to $600K. However, a policy with a $22M Limit on Fundamentals and a $5M Sub-Limit for Non-Fundamentals can be as low as $220K.
It’s clear that the use of R&W insurance will continue to grow as more Buyers and Sellers come to understand its benefits and insurers are willing to cover a wider range M&A deals.
If you are considering a M&A deal on the small side but didn’t realize you could secure R&W insurance to protect yourself, let’s talk about this recent trend of insurers covering full transaction value.
You can reach me, Patrick Stroth, at firstname.lastname@example.org or 415-806-2356.