Insights

  • The Impact of an Economic Downturn on M&A
    POSTED 3.31.20 M&A

    Will there be an economic downturn in 2020? Aside from the current turbulence created by the coronavirus, which represents only a temporary setback, I don’t see any indication that we’re headed for a recession in the near future. As I’ve outlined previously:

    “The ongoing “trade wars” are no issue. The GDP is solid. Consumer spending is stable, if not going up. Consumer savings is up. Debt ratios are lower than they have been in years.”

    Of course, there are some out there who do forecast problems. And companies are making strategic plans in case of an economic downturn or recession. It’s always smart to be prepared, of course.

    But even if the market shifts from bull to bear after an impressive 10-year expansion, I don’t see too much impact on M&A activity. And many of those making deals on a regular basis agree with me.

    As noted in the recent report from Deloitte, The State of the Deal: M&A Trends 2020, 42% of respondents to their survey (which include PE funds and Corporate Strategic Buyers) said “an economic downturn may actually boost deal activity.” 19% said it would have no impact, and only 23% see a potential decrease in M&A activity.

    Seems counterintuitive. But, as Jason Langan, partner, M&A Services, with Deloitte & Touche LLP, put it:

    “If the economy slows, let alone dips into a recession, companies aren’t going to ignore M&A—they are just going to be even more deliberate in the deals they look to do.”

    Here’s how it will play out and why even in the wake of an economic downtown M&A activity will remain solid:

    1. Increased Divestitures

    If the economy goes south, expect companies to divest nonperforming, non-core assets. This allows them to generate more cash, be more nimble, and put resources elsewhere. In fact, 75% of corporate strategics expect to have divestitures in 2020. That’s the second-highest level in the last four years and compares to 77% last year, so only slightly lower.

    Why divest? According to the Deloitte report, those surveyed cited a change in strategy, financing needs, and a desire to shed technology that no longer fits with the business model.

    2. The Need to Maintain Competitive Positioning

    Even in a struggling economy, perhaps especially in a struggling economy, companies can’t sit back and decide to save cash by not making deals. They’ll be left behind by their competitors who continue engaging in M&A activity.

    What will change, most likely, are the size of the deals and how many are done. Strategics will also take time to make sure the deals they do make are beneficial; they’re less likely to take risks.

    3. Spur Inorganic Growth

    Why wait for a company to slowly grow on its own when you can make a key acquisition to get the technology, customer base, or whatever else you need to take the company to next level quickly? That’s why Corporate Strategics will continue to make smart acquisitions.

    4. The Search for Undervalued Assets

    If a downtown occurs… what happens to the prices of target companies? They go down. For PE funds, which have a lot of ready cash, that is a signal to start bargain hunting. So we will start to see a trend of smaller deals in case of recession.

    There are also other factors impacting M&A activity in 2020, including…

    • The ongoing stability of interest rates, which were just reduced in response to coronavirus, which means the cost of borrowing has not gone up. That encourages deal-making.
    • PE funds collectively hold trillions of dry powder. That’s plenty of cash ready to go.
    • More startup PE funds have entered the game, which means more players ready to make deals. Many of these PE’s are targeting the very business units being “spun-off” by the larger corporations.
    • Last but not least is the affordability of R&W insurance that will further hedge risks faced by M&A parties. At a newly established minimum price-point of under $200K for a $5M Limit R&W policy (including UW fees and taxes), executing a deal has never been more affordable.

    Nobody wants a recession. And based on my analysis of current market conditions, I don’t think there will be one.

    But should one happen, I don’t think M&A activity will slow significantly. Any slowdown will be the natural result of seven straight years of $1T+ in annual deal value. It’s hard to maintain that level of activity over such a long period.

    However, we will see smaller deals… and less risky ones. But overall look for both Strategic Buyers and PE firms to take advantage of the opportunity to make smart deals, both divestitures and acquisitions to maximize profit margin and spur growth.

    Whatever size deal, whether it involves Strategic Buyers or PE funds, the use of Representations and Warranty (R&W) insurance should be a given. It offers protection to both Buyer and Seller and helps get deals to closing much faster.

    But an experienced broker who knows M&A is needed to integrate this coverage. If you have any questions about R&W insurance – or have your own take on a looming recession and its impact on M&A activity – please contact me, Patrick Stroth, at pstroth@rubiconins.com.

  • Moore’s Law Comes to R&W Insurance
    POSTED 3.17.20 M&A

    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:

    • The number of insurers offering R&W insurance has more than doubled.
    • Rates have fallen from the 2.5% to 4% range to the 2% to 2.9% range.
    • Eligibility thresholds have decreased from deals at $75M in transaction value to $10M in transaction value.
    • Falling costs have given rise to more policies being placed.

    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.

    How Low-Priced R&W Insurance Changes the Game

    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.

    What’s Ahead

    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 pstroth@rubiconins.com.

  • The Rise of Smaller M&A Deals in 2020
    POSTED 3.3.20 M&A

    We’re not yet to the end of the first quarter, and we already have a solid idea of where M&A activity is headed in 2020.

    Deloitte put out a report, The State of the Deal: M&A Trends 2020, based on a survey of 1,000 corporate executives and PE firms that looks back at what happened in 2019 and their views and plans for 2020. And the outlook is good for M&A, although there will be some key changes to keep in mind.

    As noted in the report, M&A activity will continue to be very solid this year. Only 4% of those surveyed anticipate a decline in the number of deals. Sixty-three percent forecast an increase in transaction activity. That’s down from 79% last year.

    There will probably not be as big an increase compared to the last seven years, a boom time that has seen more than $10 trillion in domestic deals alone since 2013. But that’s to be expected as this level of growth in transactions is hard to sustain.

    As Russell Thomson, national managing partner of M&A services for Deloitte & Touche LLP put it in the report:

    “We’re fairly long into this M&A boom cycle, so it’s not surprising to see a drop in expectations for larger deals. What we’re seeing in the marketplace is more interest in deals in the sweet spot between $100 million and $500 million. Deals aren’t going away; companies are just being a little more careful about those larger deals.”

    So the boom is tapering off a bit, but it’s still a rising trend due to several factors, including…

    • Ample cash reserves in both corporations and PE firms.
    • The strong stock market that closed 2019 at record highs (which helps equity-funded transactions).
    • A belief that tariffs/trade wars aren’t too much of an issue.
    • A conviction that current interest rates will not have an impact on deals (and, in fact, 45% feel the interest rate environment will actually accelerate deals).

    But this is the biggest change we can expect in 2020:

    Fewer “Megadeals,” More Deals Under $500M

    The number of deals over $500M in transaction value will likely come down and be replaced by deals in the $100M – $500M range… and as low as $20M. This is for a variety of reasons.

    1. More corporate divestitures. Companies are looking to offload assets in this lower range. According to Deloitte, 75% of corporate execs expect to have divestitures this year, due to financing needs, change in strategy, and the need to offload technology that doesn’t fit a new business model.
    2. Returns for larger M&A deals have not been as valuable as expected. Firms just aren’t getting enough bang for their buck. According to the survey, 46% of respondents said that less than half of their transactions in the last two years gave them the ROI they were looking for. So look for them to reduce their risk and pursue smaller acquisitions that offer more impressive returns. Smaller targets, acquired at lower prices, are just a lot more efficient, cash-wise. To hedge and improve ROI, companies are looking for smaller targets. This isn’t at the expense of profitability. In fact, you can have a higher return on a $100M acquisition – 40% to 50% – than on a $1B deal.
    3. Strategic Buyers are also increasingly pursuing smaller deals because they have a greater need to acquire new technology as today’s tech is already obsolete. They need technology that is a better fit going forward to stay competitive. 
    4. Buyers can take advantage of more favorable terms when they go after smaller targets, especially those under $100M. 
    5. PE firms like smaller targets because they are increasingly looking for new acquisitions that they can “bolt on” to existing portfolio companies instead of hoping those portfolio companies grow organically.

    When they add on new acquisitions, the firms can expect to sell those portfolio companies at a much higher multiple than before. This is why they are getting better returns with smaller targets.

    What This Means Moving Forward

    Based on this Deloitte survey, it’s clear that M&A activity has slowed a bit but is still going strong, continuing a trend of an unprecedented level of deal-making that started back in 2013.

    Also, on the rise: the use of Representations and Warranty (R&W) insurance to transfer indemnity risk away from the Seller to a third party – the insurer. With this coverage now available to sub-$20M deals, look for this insurance to be a part of an increasing number of deals in 2020.

    Whether Buyer or Seller, R&W insurance coverage can offer many benefits including smoother negotiations, more cash at closing, and less risk. But it is important to have a broker with extensive experience with R&W insurance and how it can impact a M&A deal. If you’d like to discuss coverage for your next deal, please contact me, Patrick Stroth, at pstroth@rubiconins.com.

  • How R&W Insurance Has Changed the M&A Landscape Part 2 
    POSTED 2.18.20 M&A

    In the last few years, there’s been a game-changer slowly but surely transforming the M&A world.

    The use of Representations and Warranty insurance is increasing across the board as Buyers and Sellers, PE firms, VC funds, and strategic buyers all recognize that this coverage makes negotiations less contentious and more cost-effective. Because the indemnity risk is transferred to a third-party, this insurance also gives a sense of security.

    R&W insurance is changing how deals are structured.

    We covered why – and some of the foundational details in the first part of this article, which you should read here first.

    Now, we’re to going to get into the weeds, so to speak. Taking a look at some of the specific ways deal terms are being rethought when R&W coverage is part of the deal.

    Materiality Scrape

    If there is a breach of a Representation or Warranty in a Purchase and Sale Agreement, Sellers seeking to limit their exposure, prefer wording in the agreement that requires breaches to be “material” in order for the Buyer to be able to claim the breach for indemnification purposes. Depending on the deal size, “material” generally being more than $100,000 to $250,000.

    Naturally, a Buyer will want to remove this qualifier by applying a Materiality Scrape (i.e. to literally scrape “material” as a determinant for breaches), giving them the ability to determine a breach and thus reduce their risk.

    If R&W insurance is in place, most Sellers will agree to Materiality Scrapes because the policy coverage will mirror the Materiality Scrapes in the agreement, eliminating risk on both sides of the table. According to SRS Acquiom, 2/3 of deals with R&W include even Double Materiality Scrapes (where Buyers determine both the breach and the calculation of resulting damages).

    Pro-Sandbagging Provisions

    Buyers like having pro-sandbagging language in Purchase and Sale Agreements.

    Say a Buyer is performing their diligence and they find a problem. They see that a Seller’s representation has been breached… but the Seller hasn’t recognized the issue.

    Without R&W coverage, what happens next is…

    The Buyer is under no obligation to tell the Seller what they found. They can go through the deal and then bring up the breach post-closing. That blindsides the Seller, who is left wondering why the Buyer didn’t inform them sooner to avoid having to pay damages. Making a claim against the Seller like this is referred to as “sandbagging.”

    An R&W policy will have a warranty statement – a pro-sandbagging provision – that says the Buyer certifies they have no knowledge of any breaches. If it turns out they do have knowledge and don’t inform the Seller before the deal closes, that breach will be excluded.

    As you can imagine, this is great motivation for the Buyer to be forthcoming if any issues show up in their due diligence efforts. They will tell the Seller as soon as possible because otherwise they won’t get the benefit of the insurance later.

    This also enables the parties to address “known” issues before closing rather than the having a future “surprise” sprung on an unsuspecting Seller.

    Disappearing Escrows

    Before R&W Insurance emerged, the prevailing belief of Buyers was that large escrow accounts provided both security and a more “honest” Seller. As R&W began replacing escrows, Buyers and their advisors argued that having cash on hand was safer than hoping an insurance company would pay claims.

    After a successful period where R&W policies have incurred and promptly paid claims, confidence in R&W has only increased, while escrow amounts have decreased. So much so, that according to SRS Acquiom, the average escrow amount has fallen from 10% of transaction value on uninsured deals to 1% of transaction value on insured deals.

    Catch-All Reps

    There are certain Buyer-friendly “catch-all” reps out there, officially known as 10b-5 representations, or full-disclosure representations. Among all the other specific representations in a Purchase and Sale Agreement, this catch-all states that the Seller doesn’t know of any potential breaches or other issues. Therefore, any future unexpected event could potentially trigger these reps, greatly exposing Sellers.

    These open-ended reps can’t be underwritten, so they are routinely excluded by R&W policies.

    In response to the insurers’ position, Buyers and Sellers have agreed to remove these 10b-5 reps entirely so the corresponding exclusion is eliminated. SRS Acquiom reports that some 90% of deals with R&W no longer contain 10b-5 reps as compared with 62% in uninsured deals.

    Non-Reliance Provisions

    In a recent report on M&A trends from SRS Acquiom, the company noted that they are seeing more non-reliance provisions, which are very Seller-favorable, in Purchase and Sale Agreements.

    With this provision, the Seller is telling the Buyer that the Buyer cannot rely on information provided by the Seller, like a tax report or financial statements. The Buyer must perform their own diligence and use those findings to make any determinations.

    This protects the Seller if the Buyer claims that they were provided inaccurate financial statements or similar diligence reports. This shifts risk in the direction of the Buyer. But if R&W insurance is in place, the Buyer is not worried because the coverage would cover and pay the claim for any breach.

    Deductibles

    In the event of loss, there are deductibles due before a claim is paid. In the past, there was a tipping basket. For example, if there was a deductible of $500,000, the Buyer had to eat the first $250,000. However, the minute it goes over $500,000, the Seller is responsible for the entire deductible.

    With R&W coverage in place, the two sides are now agreeing to split the deductible 50/50, simplifying the deductible issue.

    On a side note, it’s amazing how many claims of breaches are reported at least one year post-closing. Most policies have a deductible dropdown. If after one year there have been no claims, the deductible goes from 1% of transaction value to ½%.

    Next Steps

    It’s clear that Representations and Warranty insurance is taking the M&A world by storm. I see it becoming standard in the next few years. You can get ahead of the curve by learning about this specialized type of insurance and how it could change the terms of your next M&A deal – whether Buyer or Seller. Just contact me, Patrick Stroth, at pstroth@rubiconins.com for all the details.

  • How R&W Insurance Has Changed the M&A Landscape Part 1 
    POSTED 2.4.20 M&A

    Representations and Warranty (R&W) insurance is not just here to stay, but growing – not to mention changing the way deals are structured.

    More than a dozen insurance companies now offer this specialized product that transfers the indemnity risk away from the deal parties over to a third party – the insurer. And while only the big deals were eligible before, Underwriters will now take on deal sizes as low as $15M, which opens up a new world for Buyers and Sellers in those mid- to small-market companies. Plus, policies are cheaper than ever before.

    Strategic buyers, VCs, and PE funds are all talking R&W coverage. Sellers are insisting on it because it reduces their escrow obligations and indemnity risk, and Buyers find having this insurance in place makes it easy to move forward.

    All Signs Point to More R&W in Deals

    This widespread adoption of R&W insurance has had a tremendous influence in the M&A world, not just smoothing out negotiations and getting deals done faster but also altering very specific and often contentious deal terms when it comes to the Purchase and Sale Agreement.

    All this provides a critical mass that will bring R&W insurance to the forefront, with wider awareness and adoption in the coming year almost a given, even as it changes deeply ingrained accepted practices.

    First, a little context and background.

    You know there is a sea change going on when even the most resistant “old guard” companies change the way they do business.

    For years, SRS Acquiom was the go-to provider in M&A deals for holding escrows and other financial guarantees. It’s no wonder that for a long time they actively discouraged Buyers and Sellers from using R&W insurance. They maintained that having cash in escrow was safe and more advantageous than spending money on insurance.

    But they weren’t able to hold back the R&W tide, and now they’ve set up a brokerage within the company to sell… R&W coverage. So, they’re finally catching on. It’s a can’t beat ‘em, so let’s join ‘em type of thing.

    The major change resulting from the wider spread introduction of R&W insurance is how it’s disrupted the balance of “power” in the M&A world.

    The Buyer Power Ratio

    SRS Acquiom has a metric – the Buyer Power Ratio (BPR) – that they use to gauge the negotiating strength of Buyer and Seller. It’s a simple calculation: Buyer Market Cap / Target Purchase Price = Buyer Power Ratio. For example, if a Buyer’s Market Cap is 25 times the value of the target company, then the Buyer would have a BPR of 25. The higher the BPR, the greater the leverage for the Buyer in terms of size.

    Basically, the larger the Buyer is compared to the Seller, the more power and leverage they have to get favorable deal terms. For example, companies such as Apple, being a thousand times larger than any potential acquisition target (thus a BRP in excess of 1,000), will always have the complete upper hand. In deals where Buyer and Seller are similarly sized… the less leverage and the more negotiation will take place.

    R&W insurance has introduced a wrinkle here. When the Buyer Power Ratio is low, Buyers are now increasingly using R&W as a way to make themselves more attractive to Sellers while decreasing their risk.

    For example, it’s harder for the Buyer to exercise their walk rights once the Letter of Intent is signed and the target company is off the market. At this point, the two sides are joined at the hip.

    If the Buyer tries to walk away, the target feels like they’re damaged goods and will have a hard time attracting another potential acquirer. If the Buyer wants to abandon the deal at this stage, they face a severe financial penalty. It’s like canceling a wedding at the last minute and not getting your deposit from the caterer or hotel ballroom back.

    However, this puts Buyers in a tough spot if they spot something during due diligence in the run up to closing the deal. They want to walk away but is the issue worth the penalty? That’s where R&W insurance comes in.

    The Buyer can shift this risk to the insurer. By hedging the risk, they can feel comfortable moving forward with the deal.

    Overall, the mindset of Buyer and Seller going into deals when they have an R&W policy in place is:

    What steps can we take to shift risk to the insurance company? And, how can we make sure the insurance company will accept risk?

    Now, we see two parties angling to have terms that they consider a risk to be covered by insurance.

    In part 2 of this article, we’ll drill down into some of the specific deal terms that are changing with the introduction of R&W insurance and how it will impact a M&A deal going forward, including elements like the double materiality scrape, non-reliance clauses, and more.

    For now, if you have any questions about Representations and Warranty insurance and how it could change the dynamics of your next M&A deal – whether Buyer or Seller – you can contact me, Patrick Stroth at pstroth@rubiconins.com or (415) 806-2356.

  • This Could Change Everything in M&A
    POSTED 1.21.20 M&A

    There is a potential game changer in the M&A world, especially for Strategic Acquirers, and Representations and Warranty (R&W) insurance is an integral part. And with this coverage available for transaction sizes of $20M (or even lower) the impact will be widespread.

    Tech powerhouse Atlassian, which offers software solutions for workplace collaboration, coding, and more, does a lot of acquisitions. It’s a multi-billion-dollar company, and it buys dozens of smaller companies to expand its services into new areas.

    So far, pretty standard.

    Most large companies use that leverage to “bully” the smaller business into accepting whatever terms of the deal they put on the table.

    But Atlassian has shaken things up… to put it mildly. 

    As Tom Kennedy, the company’s chief legal officer, and Chris Hecht, head of corporate development, put it in a statement announcing this bold move:

    “The M&A process is broken. It’s outdated, inefficient, and combative. Which is why we’re publishing the Atlassian Term Sheet to fix it.”

    Why the New Atlassian Term Sheet Is a Game-Changer

    The traditional way to go about M&A deals is to conduct negotiations in which one side wins and the other loses. The larger company will always win.

    Commandant #1 in the traditional M&A world is, “Those with leverage tend to use it.”

    But…

    You win the deal at the sake of losing trust from the those on the Seller’s side. It makes everybody uncomfortable. And it’s counterproductive.

    When bringing in a target company, you want them to be your next rock stars that will help you capitalize fully on your new investment. If you’ve beaten them into submission and they have to show up at the office on Monday, it can be quite difficult to really put your heart into your work.

    One of the biggest points of contention (and cause for resentment): Why is it standard to have escrows that are 20% to 30% of transaction value? Breaches are typically tiny. Big escrows are unnecessary. Atlassian is saying they will give their targets a choice: either provide a 5% escrow for 15 months or pay for a Buy-Side representations and warranties policy and provide a 1% escrow (this insurance would cover the other 4%). That represents a seismic shift from what well-leveraged Buyers usually do.

    After going through plenty of deals where that happened, Atlassian decided to make a radical change and be transparent during the whole M&A process, from the beginning.

    With the Atlassian Term Sheet, they’ve shown potential Sellers exactly where they stand on:

    • Closing Date
    • Due Diligence
    • Deal Documents
    • Holdback
    • Proposed Purchase Price
    • Outstanding Equity Awards and Other Equity Rights
    • Employment Offer Letters and Non-Competes
    • Employee Retention Pool
    • Indemnification
    • Escrow
    • Insurance
    • Transaction Expenses

    These terms are non-negotiable. A Seller can take it or leave it. And, in many cases, they should take it because if you read through the term sheet, you’ll see that Atlassian – the Buyer – actually assumes a lot more risk according to this term sheet than in a similar, standard M&A deal.

    This Seller-friendly stance horrifies M&A attorneys. But Atlassian is fine with it because they know there is not much risk in these deals. There are actually very few breaches in deals post-closing, especially with IP. And if there is a breach, it’s small in the vast majority of cases.

    Atlassian is not rolling over. Everything is still contingent on extensive, rigorous diligence.

    How R&W Coverage Fits In

    R&W Insurance is an instrumental part of this document. The glue that holds it together, in a way. And, the term sheet outlines that the Seller will pay for R&W insurance and D&O Tail insurance.

    For R&W coverage, the term sheet states that the Seller will pay for it, including any fees, premiums, taxes, or commissions, for a policy limit of 4% of the Purchase Price. It’s quite affordable, costing less than ½ of 1% of the transaction value.

    One of the reasons Atlassian can feel comfortable offering these terms is that if there is a breach, the R&W insurance kicks in. It transfers all the indemnity risk to the insurer. If there are any breaches post-closing, they file a claim and get damages – no need to go after the Seller.

    Ever since I first saw R&W insurance back in 2014, I’ve had the opinion that as M&A progresses, this specialized type of coverage will become as standard as title insurance for buying a home. Because of the speed and frequency of M&A deals – which is only increasing – things have to become standardized.

    And things are heading that way. PE firms and VCs, as well as Strategic Buyers, are being drawn to this insurance more than ever. There are about 20 insurers offering this coverage today, up significantly from a handful just a few years ago. And there are policies even available for deals under $20M, which is a development in just the last year or so.

    There is no good reason not to get this coverage, in most cases.

    How Will This Term Sheet Impact M&A in 2020 and Beyond?

    I think this is going to soon expand beyond Atlassian.

    This could be a potential signal for other Strategic Buyers out there. They know they had better streamline the process. Why are they reinventing the wheel for every deal and grinding the Seller into submission? That attitude is as productive as old school football coaches who wouldn’t let you drink water to toughen you up.

    Think of it this way. Forty-niners coach Bill Walsh established a policy of no-contact practice mid-season on. There wasn’t any need. And unlike other teams, his players weren’t beat up for pivotal games late in the year.

    The NFL is a copycat league, and other teams soon followed Walsh’s tactic. Corporate America is full of copycats, too. So I think you’ll see them follow suit when they see that the term sheet has made Atlassian very attractive in potential Sellers’ eyes.

    With everything, there is a hard way… and a smart way. The Atlassian Term Sheet is the smart way. This is a more efficient and cheaper way to get deals done.

    They have an eye on the end result: integrating the acquired company. This company wants peace, love, and happiness in their M&A deals going forward, and they’re not having to take on very much risk to get it.

    Be sure to check out the Atlassian Term Sheet in-depth. Then I’d invite you to speak with me, Patrick Stroth, about how Representations and Warranty insurance is a key part of this new way of thinking… and how it can protect you in your next deal. You can reach me at pstroth@rubiconins.com or (415) 806-2356.

  • Middle Market Privately Held Firms Fearful of M&A
    POSTED 1.1.20 M&A

    Every business must have some plan for growth. That’s obvious. But how they achieve that growth is another story.

    There are basically two methods:

    1. Organic growth
    2. A merger or acquisition

    Companies usually use a blend of both. But those that try to rely solely on organic growth, which takes a significant amount of time, even with the best businesses, will be left behind in the marketplace.

    M&A is a much more effective choice to add to their product offering, boost their capabilities, reach new groups of consumers, or expand their geographic presence.

    But there is an issue, at least among middle market, privately held firms. They might understand that organic growth is too time-consuming, yet they won’t move forward with promising M&A deals that seem like a good fit.

    In fact, a study from Synrgix, a business application development and consulting company, found that one out of 5 of the 25,000 middle market companies surveyed that are looking to execute an acquisition, actually do so.

    Why is this the case?

    There are several factors at play.


    Mainly it’s fear, due to lack of expertise… lack of time… lack of resources.

    These are relatively small, privately held companies. They don’t have an internal corporate development department. Besides, they don’t have the experience or knowledge base in how to conduct M&A deals, so they decide not to do it.

    It takes time to search for targets – and it always helps if you know what makes for a good acquisition. It’s usually a CEO or CFO that is placed in charge of an acquisition, but they have a full-time job already and often don’t even know where to begin. So, deals fall by the wayside… and growth stalls.

    The Consequences of Delaying an Acquisition

    Only when pushed to the brink in desperation do these middle market companies go through the whole acquisition process – or at least attempt to. They might eye a potential target only to find out a competitor grabbed them first, while they struggled to get their ducks in a row.

    If that potential target had a capability they were looking to add, it gets even worse. They might lose the target and lose an existing client that expected the company to serve them with that capability.

    Another consequence: the company was contemplating entering a new market and a competitor makes the acquisition and enters that market instead. Bad for business.

    There is a solution. Synrgix offers a software platform that streamlines acquisitions by helping organize the process and schedule milestone events until the deal is done.

    With a platform like this, companies eager to engage in M&A don’t have to hire an outside corporate development firm. They can do the work internally and spur deals that will allow them to add new capabilities, clients, geographic market, and more – all elements critical to growth. You can see the Synrgix platform yourself at: https://www.synrgix.com.

    Another element that can help spur successful acquisitions is Representations and Warranty (R&W) insurance. With this coverage:

    • Negotiations are generally much quicker and less contentious.
    • Any risk from breaches of reps in the Purchase and Sale Agreement are transferred to a third party (the insurer).
    • Insurance companies do pay claims.
    • Less money is held in escrow and there is no chance of clawback.
    • Both Buyer and Seller feel peace of mind as a result.

    There is potential risk in every deal, but R&W insurance mitigates it. And in the last couple of years, costs for this coverage have been coming down because more insurers are getting into the game.

    Not to mention, deal sizes as low as $15 million are being covered by multiple insurers – that’s perfect for middle market companies looking to grow through M&A.

    If you have a middle market company but haven’t been able to pull the trigger on a much-needed acquisition, I’d be happy to speak with you further about how you can avoid obstacles that are in your way.

    You can contact me, Patrick Stroth, at pstroth@rubiconins.com.

  • How R&W Insurance Makes M&A Deals Smoother, Easier, and Faster
    POSTED 12.17.19 M&A

    You know what it’s like when you drive to a new place – say you’ve just changed jobs and you’re heading to the office. Have you ever noticed how the very first time, the trip seems longer somehow? Of course, you’re using GPS for directions, so you don’t get lost and make yourself late.

    But… every subsequent trip seems shorter and shorter. And soon enough, you can ditch the GPS because you know exactly where you’re going. You don’t even have to think about the drive. Your morning commute becomes easy and intuitive.

    That’s kind of what it’s like when using Representations and Warranty (R&W) insurance for the first time to cover an M&A deal.

    The first time it’s a bit intimidating because you’re not familiar with the process. You don’t know how it works.

    But just like your commute, the more you do it, the easier it gets. And it’s well worth getting through the initial tough times and making R&W coverage a regular part of your standard operating procedure for M&A deals moving forward, whether you are a Buyer or Seller, strategic, VC fund, or PE firm.

    Why?

    Simply put, R&W insurance enables the parties on both sides of the table to save time and money and simplify the deal terms. Not to mention it smooths out, and speeds up, negotiations.

    It also gives both sides priceless peace of mind if there are any breaches to the Reps in the Purchase and Sale Agreement.

    All that – and much more, as you’ll see in a moment – and you don’t really have to do any more work than you’re already doing as part of the deal to secure this coverage because, for the most part, the Underwriters will base your policy on due diligence work already being done.

    What Happens When R&W Is Covering the Deal

    One of the biggest time drains on any M&A deal is negotiating the Letter of Intent and then later, the Purchase and Sale Agreement.

    What Reps are included…

    How broad or narrow are those Reps worded….

    Size of the Indemnity cap….

    How much of the Seller’s money will be held in escrow to cover potential breaches…AND how long will the fund be held…

    Those deal terms can result in a lot of back and forth, which doesn’t just take time, but also costs you big time in legal fees as each new iteration of the contract is reviewed by the attorneys.

    However, when R&W insurance is covering the deal, you don’t have to negotiate these points anymore. With this specialized coverage, if there are any breaches, the insurance company will pay the damages. And those claims do get paid in a timely manner. With that backup in place there’s no need to grind away to get marginally better terms. No need to go after the Seller for compensation.

    With R&W coverage in place, many Sellers will still accept Buyer-friendly Purchase and Sale Agreements because they want to limit their risk. They are doing so by transferring the risk to the insurance company.

    Why Sellers Love It

    For Sellers, one of the biggest benefits of R&W insurance – and a reason many will pay for the coverage, even a Buyer’s side policy – is that the money held in escrow for years past closing day is a fraction of what it would be without this coverage.

    In fact, because of the increasing use of R&W insurance, the average amount of money held in escrow for M&A deals has decreased across the board. Common escrow amounts used to be in the range of 10% of transaction value. Now the average is 1%.

    If you’re a Seller, you know you – and your partners and investors – will appreciate that cash in hand on closing day. And Buyers appreciate not having to go after Sellers, who could be new partners or a key part of the management team.

    This was a key reason why a partner in HR software company RedCAT Systems insisted on R&W coverage when they were acquired a few months back by PE firm Broadtree Partners. You can check out how this insurance changed the dynamics of the deal and why both sides are now big fans of R&W, in a pair of case studies examining the acquisition from both the Buyer’s and Seller’s sides.

    At one point, financial management companies that held money in escrow were pretty down on R&W insurance. They had a financial interest in large amounts being held in escrow, after all. They said that cash held in escrow by a third party was much safer than any insurance policy. Many of these management companies are now offering R&W coverage themselves. They’ve seen the light.

    Another benefit to Sellers is that when R&W insurance is in place, they can demand that 10b-5/full disclosure Reps will be taken out of the agreement. In fact, 90% of deals with Buyer’s side coverage don’t have these Reps, which are catchalls that could potentially result in the Seller being financially liable for issues they didn’t know about it. When that type of Rep is taken out, there is much less exposure for the Seller.

    Take the Leap

    The truth is that after you’ve done it once, you’ll become the biggest cheerleader and advocate for R&W insurance due to all the advantages it offers. It’s no wonder that more and more PE firms are embracing this coverage. And as the costs of R&W policies go down and deal sizes under $20 million are able to be covered, its use will just continue to grow in just about every sort of industry.

    If you’re a R&W insurance “first timer” – whether you are a Buyer or Seller – you no doubt have questions about how this coverage will work in your situation. I’m happy to answer your specific questions. I’ve specialized in helping companies secure this coverage for many years before its current moment in the sun. It’s great to see it gaining such widespread acceptance.

    Please contact me, Patrick Stroth, at pstroth@rubiconins.com.

  • We’re Not Going Into a Recession – Here’s Why
    POSTED 12.3.19 M&A

    As the song goes… it’s the most wonderful time of the year. The holidays are upon us. Aside from time with family and friends, my favorite part of the season is the Wall Street Journal’s Economic Forecasting Survey, specifically – the Recession Expectations forecast question: “When do you expect the next recession to start?”, which comes out every September or October.

    It’s a survey of several dozen economists, who chime in on the current health of the economy and when they think the next recession will hit.

    It’s one of many coming-year prediction articles, presentations, commentaries, etc. that come out every year around this time from various financial publications, investment banks, and others. As 2019 draws to a close, it’s worth taking a closer look.

    I wish you could place bets on this sort of thing because I knew exactly what the Wall Street Journal piece was going to say even before I read it.

    How is that possible? Because it’s pretty much the same every single year – and the predictions for 2020 were no exception.

    What to Expect in 2020… or Not

    As is usual in the Journal’s survey, economists are very pessimistic about the economy in the coming year. In fact, they are certain a recession will happen in the next 12 to 18 months. Before you sound the alarm, let’s go back to this time in 2018… 2017… 2016…

    These economists said the same thing: recession in the next year or so. But I don’t remember being in a recession the last few years. Do you?

    I don’t think we’ll be facing a recession in 2020. And, as far as M&A activity goes, there will certainly be no or negligible impact from economic conditions next year. That’s not just for lower middle market, but for M&A at all levels.

    For a different point of view than the usual dour economic forecast, I like to turn to Christopher Thornburg, PhD, a founding partner of Beacon Economics.

    He maintains mainstream economists think that a recession is inevitable every seven to eight years and that because things have been so good – too good – for so long, we’re well due. Not so, says Thornburg.

    Looking at the leading economic indicators, he says we’re in good shape.

    The ongoing “trade wars” are no issue. The GDP is solid. Consumer spending is stable, if not going up. Consumer savings is up. Debt ratios are lower than they have been in years.

    There is one constraint and caution: There are more job openings in the country than people eligible to work. That will slow down businesses because they have so many jobs to fill.

    But overall, we’re in a good economy, so businesses are expanding. And that means more M&A activity.

    What M&A Activity Will Look Like in 2020

    There are other factors that will encourage M&A activity in the coming year:

    • Interest rates remain stable – so the cost of borrowing is not going up, which is one less hurdle to getting deals done.
    • There remains a lot of dry powder held by PE funds – it’s still in the trillions. So there is a lot of cash on the sidelines waiting to be used.
    • There are more emerging, startup PE funds being created now than a year ago, which means more prospective financial Buyers on the playing field.

    And because M&A deals are easier to get done and costs are coming down, we’re seeing other side impacts as well:

    • Smaller PE firms can be successful as deals flow down to them. It’s not just the big institutions that are taking all the action.
    • Because there are more M&A deals being done, the top 100 law firms that used to handle the bulk of the transactions – and charge more money – just can’t keep up. That means smaller firms, especially regional firms, are getting more billable M&A legal work.

    In general, this “spreading of the wealth” is a good thing. As more revenue associated with M&A is going to more players, services will improve. That’s especially true with Representations and Warranty (R&W) insurance.

    The Outlook for M&A Insurance

    We’ve seen that there are already more R&W insurance placements because there are more insurers offering this coverage. Even deal sizes under $20 million can be covered. With this increased supply, costs are coming down. And the process for setting up R&W insurance to cover a deal is easier than even a year ago.

    So not only will 2020 be a banner year for M&A activity, but I expect a corresponding increase in R&W insurance policies written as Buyers and Sellers recognize not only the above factors, but also the many other advantages of this type of coverage:

    • It removes the need for cash to be held in escrow.
    • It removes the need for extensive negotiations on the indemnification clause in the Purchase and Sale Agreement, as the indemnity obligation is transferred from Seller to insurance company.
    • If there are any breaches in the reps, the Buyer can file a claim with a third party (the insurer) and get paid promptly to cover damages.
    • In short, all the risk goes to the insurer, which makes Buyers and Sellers happy.

    R&W coverage also makes negotiations between Buyers and Sellers much smoother. In some cases, it’s the make or break for a deal.

    As you look ahead to 2020 and consider your acquisition strategy (or plan to sell your company), it’s worth taking a close look at how Representations and Warranty insurance coverage could give you the edge.

    If you’d like to get all the details on how, please contact me, Patrick Stroth, at pstroth@rubiconins.com. Let’s chat before we all get so busy during the holidays.

  • Case Study: Rep and Warranty Insurance Helps Smooth M&A Deal in the Tech Sector
    POSTED 11.5.19 M&A

    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%.

    How R&W Insurance Changed the Deal for the Better

    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.

    Overcoming Other Complications That Delayed the Deal

    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.

    What’s Next for Broadtree

    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 pstroth@rubiconins.com.