Insights

Why Buyers Should Embrace R&W Insurance to Remove Seller Fear
POSTED 2.2.21 M&A

For lower middle market companies looking to be acquired, these owner/founders, often of businesses they have built from the ground up, are looking for a once-in-a-lifetime liquidity event.

They are ready to sail off into the sunset, perhaps into retirement or perhaps another business venture that will require as much capital as possible. They want to truly cash in from the sale and walk away without further obligation or liability.

At the same time, while they are experts in whatever their business does and passionate about their company, they are not well-versed in the world of M&A. You might consider them “unsophisticated” Sellers.

This creates an atmosphere of fear in these Sellers that can make them reluctant to move forward, especially when they realize they are personally liable to the Buyer if any losses are incurred post-closing from a breach of the Seller reps. But, as you’ll see in a moment, Buyers who take the right approach can remove that fear in one fell swoop.

What are these Sellers afraid of?

There could be issues with ESG (environmental, social, and governance) that could come back to bite them years down the line if a lawsuit is looming. Unfortunately, often these companies have not taken out Directors and Officers Liability insurance, which would protect them and pay legal costs and any claims due.

Any number of issues not uncovered in due diligence, such as IP infringement, tax problems, or others, that are no fault of their own, could crop up. In these cases, the money from the sale held-back in escrow could be at risk. This chips away at the major cash payout they were expecting. Money beyond escrow could even be clawed-back in some cases.

Not to mention, there is a lot of uncertainty in the new U.S. government administration.

They feel their future wealth is in danger – in more danger than ever before.

What a Buyer Can Do

Buyers can take away that fear by hedging the Seller’s risk with Representations and Warranty (R&W) insurance. This specialized type of coverage transfers virtually all the risk away from the Seller over to an insurer.

This insurance removes the need for indemnification provisions in the Purchase and Sale Agreement and for a major part (typically 8% to 10%, sometimes more in cases where the Buyer believes there is more risk) of the sale price to be held back in escrow, which makes the Seller happy. If there is a breach in any of the Seller Representations and Warranties, the Buyer simply makes a claim with the insurer. And there is no chance of claw-back.

And claims do get paid consistently, Buyers should understand.

This process also eliminates the need for such extensive negotiation in the lead up to the sale because there isn’t so much back and forth between lawyers for the Buyer and Seller. (Which can have the added benefit of saving both parties on legal fees.) In many cases, a Seller will be okay with a more Buyer-friendly agreement because R&W coverage has so effectively limited their risk.

As you know, Buyers want broad indemnification provisions to cover any potential loss, while a Seller’s goal is to narrow what breaches are covered and the survival period. With R&W in place, and a third party (the insurance company) paying for losses, no need to argue. In fact, some industry watchers maintain that deals with R&W in place are eight times more likely to close.

Previously, R&W coverage was the province of major deals – hundreds of millions or billions in deal size. But in recent years, Underwriters at many major insurance companies are taking on transactions as low as $15M.

And it’s very affordable. Right now, you’re looking at a rate that is 2% – 2.5% of limit, including underwriting fees and taxes, which is a significant drop in what it cost just a couple of years ago. The rising popularity of R&W insurance among savvy PE firms, as well as some Strategic Buyers, means more policies being written. And there are more insurance companies than ever offering this coverage. That has brought the cost down.

Better yet for Buyers, because of the removal of risk and peace of mind, Sellers are more than happy to pay for R&W coverage. Given the choice between accepting risk and the escrow that goes with it, Sellers will eagerly cover the costs, making R&W essentially “free” for Buyers!

It’s clear that for Buyers in the lower middle market space, the advantages of R&W insurance far outweigh any minimal additional cost and additional due diligence required by the Underwriters (which probably should have been done anyway and doesn’t necessarily add significant time to the process).

One important thing to note is that large Strategic Buyers – we’re talking the Apples and Googles of the world – have more than enough leverage that even if a Seller wants it, they are not likely to agree to R&W coverage. For them, any losses from something going wrong when acquiring a lower middle market company are just a drop in the bucket.

Lower middle market deals are right in the sweet spot for R&W. For smaller Buyers who understand that the fastest way to grow inorganically is with key acquisitions, it’s the perfect vehicle to bring Sellers to the table. As more Buyers focus on this space, it’s essential for them to have R&W to be competitive.

Buyers should bring up the concept of using R&W insurance early on, with a provision made at the Letter of Intent stage. It’s a gesture of goodwill of sorts that soothes concerns the Seller may have. Of course, knowing that any losses post-sale will be covered gives the Buyer peace of mind as well.

As mentioned, with this coverage in place at the beginning, negotiations are much smoother and go more quickly.

In the current climate, lower middle market Sellers are running scared. Buyers bringing R&W insurance into the equation will go a long way to gaining trust, making them feel secure and ready to go forward with the transaction.

It’s important to deal with an insurance broker well-versed with Representations and Warranty insurance and its role in M&A. While some of the bigger providers do offer this coverage, they focus the majority of their time and energy on bigger deals.

I specialize in securing this coverage for lower middle market deals, and I welcome your questions. If you’re a Buyer or Seller interested in finding out more, please contact me, Patrick Stroth, at pstroth@rubiconins.com.