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.