M&A experts worldwide are using an insurance policy known as a Representation and Warranty (R&W) to transfer risk from the parties in a transaction to an insurance company. R&W policies are designed to, “step in the shoes” of a seller to pay indemnification claims made by the buyer for inaccuracies of the representations and warranties outlined in the purchase/sale agreement. Due to the low cost of R&W insurance, sellers are driving the demand for these policies rather than accept large, lengthy escrow or withhold terms. Buyers are discovering how R&W insurance can enhance their bid without having to raise their offer.
Limit Capacity – Up to $100M on a single policy. Excess capacity up to an additional $400M available as needed.
Retentions – commonly 1% to 3% of the purchase price. Reduces over time
Premium – 3% to 4.5% of the limits purchased (including taxes and fees). Minimum premium is $300,000
Underwriting Fee – From $25,000 to $35,000 in addition to the premium. Covers the cost of Insurer’s attorney’s fees and due diligence costs to review and manuscript a policy. Non-refundable.
Terms – designed to match the survival period. Post survival extensions available upon request.
When lower middle market PE fund Broadtree Partners expressed an interest in acquiring the small HR software solutions provider RedCAT Systems (which works with Uber, LinkedIn, and NYSE, among many other major firms), it looked like everything was going smoothly.
RedCAT’s management team and founders felt that Broadtree’s post-closing plans for the company meshed well with their core values of not growing too quickly in order to best serve existing customers, which have complex needs, especially with benefits for well-compensated workforces.
Broadtree was enthusiastic about RedCAT’s impressive customer base and how they had filled a hole in the marketplace with a unique and vital service. They felt, with their management resources and capital and the RedCAT team’s contacts and experience, that they could take the company to the next level – with smart growth.
The sticking point: one of RedCAT’s partners felt that Representations and Warranty (R&W) insurance should be part of the deal.
This specialized type of coverage, created especially for M&A deals, transfers all the risk, including the indemnity obligation, to a third party – the insurer.
It eliminates the need for money to held back in escrow and for an indemnification clause – which makes the Seller happy. This is why the partner wanted the coverage: to make sure his proceeds from the sale were safe and not held back. They had previous experience with lawsuits from a corporate perspective and saw this as a potential area of risk.
But there are benefits for the Buyer, too. If there are any breaches to the Seller’s reps, the Buyer can file a claim and is quickly compensated with no hassle by the insurer.
Deals with a transaction value as low as $15M will be considered by insurance company Underwriters for R&W policies. With a transaction value under $25M, the deal with RedCAT certainly qualified. But this is a development within the last year or so, which is one of the reasons why the Buyer was somewhat reluctant, at least at first, to make this accommodation to the Seller.
Another new development is that deals under $20M can be insured by R&W coverage for up to 75% to 100% of the transaction value. In the case of RedCAT, the parties were seeking a policy covering up to 75% of the transaction value. For larger deals, unlike this new lower middle market segment, Underwriters are only comfortable going up to 30%.
For Broadtree Director and Portfolio Company CEO Rob Joyce, this was the first time he had taken R&W insurance all the way to the finish line. So they were familiar with, but weren’t aware of, all the potential advantages for both parties.
“[Rep and Warranty] on my end was really used primarily as a tool to help one of the Sellers become comfortable with the transaction, and that was based on their prior experience,” says Rob. “This person was very, very concerned about this, and Rep and Warranty insurance pretty much mitigated the issue. This was something that could have been really, really time intensive had we not used the solution, and it could have derailed the deal.”
This is the perfect example of one of R&W insurance’s biggest benefits: it smooths negotiations, removing the contentious elements of escrow and holdback, which also speeds up the journey to a final Purchase and Sales Agreement and eventual closing.
For the Buyer, it gives reassurance that they will be paid promptly if there is a breach in one of the Seller’s reps, without the need to go after money held in escrow that would normally go to the acquired company’s management team… that could now be, as is the case with RedCAT, part of the Buyer’s organization.
As negotiations progressed and the due diligence process began, other issues began to emerge. And what happened should provide helpful tips for other lower middle market companies contemplating a sale by showing them what they can be doing now to prepare.
The issue was the financials. As a smaller company, RedCAT didn’t have the amount of financial data required, and it wasn’t in a format Broadtree was familiar with.
This often happens due to lack of resources. For example, in RedCAT’s case they didn’t have an investment banker or adviser actively pushing the deal. The founders were working on the deal, which takes significant time, as they continued to run the business.
The financials themselves were good, but the quality of the data reflecting that was different than you see in larger companies. The other issue was the technical diligence, which is vital with a software company. But soon enough, Broadtree understood the software development process, code base, and related items. Having R&W backing them up was an unexpected, but welcome benefit.
Broadtree Partners, after this positive experience with R&W insurance, now consider this coverage to be part of their strategy for acquisitions going forward.
Instead of being reactionary to a Seller’s requirements (for example, a banker who needs it on the deal) as they have in the past, this PE fund plans to introduce it early in the deal process because of the benefits it offers both Buyer and Seller.
“This is an immediate part of my toolkit, one that can allow some risk mitigation on my side if I feel the need, and, two, I think it’s also a great tool to help overcome some Buyer discomfort if they’re worried about the sort of risks to the deal that Rep and Warranty insurance can cover,” says Rob. “I would not hesitate to use it again.”
At this point, RedCAT Systems is well on its way to growing to the next level. They’ve acquired new customers and are gearing up for a big hire to push further growth. And it might not have happened, had Representations and Warranty insurance not entered the picture.
Note: This is Part 1 of a two-part series examining the Broadtree Partners acquisition of RedCAT Systems, focusing on the use of R&W insurance. Here we covered the deal from the Buyer’s perspective. Coming up next time, we’ll check out how the Seller saw things develop.
If this case study has interested you in Representations and Warranty insurance, contact me, Patrick Stroth, at pstroth@rubiconins.com.
The Letter of Intent (LOI) – sometimes called a term sheet – is a vital first step in many M&A transactions. With an LOI, Buyers show that they’re serious about acquiring a business. And it allows the Buyer and Seller to have conversations to discover whether the vision each has for the deal lines up with the other… before they spend time and money on negotiations and due diligence.
It’s like the marriage proposal before the wedding, which is when the deal closes and the purchase sale agreement – which often contains very similar terms to the LOI – is signed.
An LOI is non-binding. But it shows commitment, outlines the basic structure of the deal, lays out a path forward, and contains an agreement to not talk to any other potential Buyers.
LOIs typically vary in length from about two to 10 pages, depending on a number of factors. Some argue a shorter LOI can help speed up the negotiating process as it centers the conversation around the most important elements of the deal. If there’s not agreement there, the logic goes, there’s no need to discuss other factors.
But in general, it pays – literally – to be very detailed in your LOI, especially for Sellers. What’s dangerous about a simple, two-page LOI is if there are any questions or disputes about terms, the Buyer has all the advantage and leverage. So you want to have as much spelled out as early as possible. This makes terms much easier to agree to later – and you can always pull out a term. But it’s a lot harder to add language to the LOI after it’s signed.
During the LOI stage, Buyer and Seller should talk indemnity. This, of course, is when the Seller is liable to the Buyer financially if the Seller’s reps and warranties weren’t accurate and not uncovered in the due diligence process. There’s a remedy that makes this discussion virtually non-confrontational.
It’s at this point that the Seller should build in an option for Representations and Warranty (R&W) insurance. Any escrows or withholds (which will be substantially reduced) will be based on the amount of R&W insurance in place. And if there is a breach, a third party – the insurer – will pay the damage, so the Buyer is protected, and the Seller is off the hook.
At the LOI stage, you don’t need to determine how much coverage is needed, or the cost. As a Seller, you just want that option there. But you should reach out to a broker. With the proposed purchase price, details on how much indemnity the Buyer is expecting- say 10% or 20% of purchase price, and what, if any escrow or withhold the Buyer is seeking, the broker can come back with a quote and a proposed policy. Having knowledge of the R&W cost in advance provides leverage when negotiating who pays (equal shares is very common).
With that info, the Seller can say, “We agree to the escrow and indemnity cap if we can have R&W insurance to cover it”. That puts some power back in their hands. This usually also accelerates the Seller’s acceptance of the LOI, shows good faith, and removes fear on the Seller’s part.
The other components of an effective LOI include:
Is the transaction a stock or asset purchase? What are the forms of payment? This can include cash, stock, seller notes, earn-outs, rollover equity and contingent pricing.
When the parties agree not to shop around. The Seller can’t talk to any other potential Buyers. This is typically a binding clause requested by the Buyer, who wants to ensure that Sellers are negotiating in good faith. It’s typical for Buyers to request an exclusivity period from 30 to 120 days, while Sellers will typically want as short a period as possible.
Because the Seller has taken themselves off market, if the Buyer drags their feet, the target can go back out to market. It happens often enough. On this note, Sellers have to be very careful when Buyers offer big topline numbers subject to lots of terms that are left nebulous.
Sensitive information shared during talks will not be shared. The Buyer can’t share the secret sauce recipe. Both parties have likely already signed an NDA earlier in the process, but this clause further ensures that all discussions regarding the proposed transaction remain confidential.
An agreement for the signing and closing to be at a specific target date. It’s always subject to change. But if the Seller sets this deadline, it incentivizes the Buyer to take action.
What are the tasks, approvals, and consents that need to be obtained before or on the closing date? For example, the amount of cash that should be in the business at closing, what happens to employees – what percentage remain, and debts or obligations that must be resolved/paid. The company must also be operating at the same level as it did as negotiations began.
NOTE: Closing conditions are viewed by courts as literal. If the condition was for $400K in operating costs to be left in the business, and at closing you only have $375K, it’s a serious violation of the terms. The Buyer will deduct the shortfall from the purchase price, or the Buyer can literally walk away from the deal with no liability.
In short, Buyers don’t want to acquire a company to find they defaulted on lease payments or loans or has other issues.
Compensation if either party stalls or delays. This clause is also typically binding, though breakup fees are less common in the lower middle market. In larger deals (>$500MM), breakup fees of approximately 3% are typical.
Which members of the senior management will stay on? Who will be provided equity plans? This aspect of the deal may be vague at the LOI stage before due diligence has been conducted.
Does the Buyer or Seller need any approvals (e.g., from a board of directors, regulatory agencies, customers) to complete the transaction?
How will due diligence will be conducted? This includes the nature of information (financial, technical, etc.) that will be disclosed and the manner in which it will be disclosed. A sample term would be the need to speak with three of the Seller’s largest clients. Or a requirement to interview certain people in management.
Includes size of escrow or holdback. This is the IDEAL place to include wording referring to Indemnity to be paid by R&W insurance. This will not appear fully until the purchase agreement, but sometimes the Buyer will include summary terms of their expected escrow terms for holding back some percentage of the purchase price to cover future payments for past liabilities, and this is where the Seller can counter (reduce) the Buyer’s amounts using R&W.
This also may not be finalized until the purchase agreement, but if there are contentious or non-standard terms, the Buyer may include them in the LOI.
The Letter of Intent (LOI) is an important step in most M&A transactions. It serves in some ways as a preview or summary of the deal terms that would be expected to appear in the purchase agreement down the line.
It’s not unheard of for Buyer and Seller to skip over the LOI and go straight to the purchase agreement. However, an LOI can be useful for a number of reasons.
It helps ensure that Buyer and Seller have similar (or at least similar enough) expectations around deal structure, scheduling, and other big concerns. It also means that any potential deal-breakers come up earlier in the process, so that the parties can either a) stop the transaction process before significant resources are spent on due diligence and drafting deal documents or b) figure out a resolution sooner.
The LOI is also a nice way to ensure that Seller and Buyer are on the same page about how due diligence will be conducted. In addition, the LOI’s terms serve as important protection for all parties in a deal (e.g., exclusivity periods protect Buyers, while breakup fees protect Sellers).
Representations and Warranty insurance can be a key part of your next M&A deal, and timing is critical. It’s vital that this coverage and its impact on the indemnity cap and amount of withhold be included in the LOI.
As a broker, I’d be happy to discuss this specialized coverage with you at your convenience. Please contact me, Patrick Stroth, to set up a call at pstroth@rubiconins.com.
After an M&A deal closes – and there are breaches of any of the Representations and Warranties from the Seller – the Indemnification provision protects the Buyer from the resulting damages. In most cases, a portion (10% of the transaction value) is held back from the Seller to pay for these financial losses.
Indemnification provisions, which are enshrined in the Purchase and Sale Agreement, are an ideal way for a Buyer to mitigate risk. But at the same time, Sellers aren’t too pleased with having a significant amount of cash they expected from the sale of their business held in escrow in case of a breach.
In short, Buyers want very “broad” Indemnification provisions, covering any potential loss, while Sellers strive to narrow the scope of what breaches are covered, the amount to be potentially paid out in case of a breach, and how long Indemnification provisions can be enforced – the survival period.
As you might expect, Indemnification – and all the elements that go into it – is one of the most hotly contested deal points when an M&A deal is being negotiated.
As an advisor in an M&A deal or an owner/founder who is selling their company, it’s important to understand just how important Indemnification is – it’s definitely not an afterthought but rather a critical part of negotiations with the Buyer. It could have a tremendous impact on the amount of money you take home after a deal closes and have ramifications for years down the road if any liabilities pop up that the Buyer blames you for.
Here’s a quick analogy to break this down into simple terms:
You want to buy a Tesla. You ordered it, gave the dealer your specs, and put down a down payment. You don’t want to show up at the dealership and be given a Nissan Leaf. If that happens, you want your money back. That’s the mindset of the Buyer.
But, from the Seller’s point of view… they sold you a car. Once you drive off the lot (the deal closes), it’s not their problem anymore. They want no liability for what happens after. They expect the Buyer, after having done their due diligence, to assume all the risk.
Reps can be divided into fundamental and non-fundamental, with fundamental being core reps covering the basic operations of the business, like stock ownership, authority to sell the company, or tax issues. Of course, this isn’t set in stone. Buyers want to move as many reps into the fundamental category as possible (such as intellectual property), with Sellers resisting that effort. For good reason…
In general, survival periods can run from six months to two years on non-fundamental reps. However, when considering so-called fundamental reps, the survival period is longer.
Of course, that’s where negotiation comes into play again. Buyers and Sellers will often disagree on what constitutes a fundamental rep. For example, environmental liabilities can be very expensive and time consuming to clean up… and often these issues don’t come up until long after closing. Buyers would prefer these to be fundamental reps.
Some items are subject to survival periods negotiated separately. For example, say the target company is the subject of a government investigation – that may or may not go to the courts. Buyers will advocate for a survival period for “special” Indemnification provisions for any related reps and warranties that is indefinite – because the legal process could be very slow.
Not only do Sellers want to limit the time Indemnification provisions are in force and which types of claims can be brought, they also want to “cap” how much they might have to pay out in case of a post-closing breach.
The indemnity cap is typically a percentage of purchase price. A portion of that cap is held in escrow for at least a year or until the survival period ends. That’s money that the Seller doesn’t get to take home or distribute to shareholders at closing. The feeling is that the money might never come home because Buyers will find any reason to retain it.
Indemnification is such a contentious topic that it can slow down or even shut down deals entirely. There is a way to sidestep all of this.
Representations and Warranty (R&W) insurance is a specialized coverage that transfers all the indemnity risk to a third-party – the insurer. If there are any breaches of reps and warranties post-closing, the Buyer simply files a claim and the insurer covers the Buyer’s damages. And unlike other types of insurance, this coverage is affordable (costing less than ½ of 1% of the transaction value) and more widespread than ever, with about 20 insurers now offering this coverage, even for deals under $20 million.
Savvy PE and VC firms, as well as corporate strategic buyers, are recognizing its benefits to smooth out deals and mitigate risk and increasingly making it a must-have in their M&A deals.
With IP becoming a standard fundamental rep, R&W insurance is ideal for small technology companies, at $20M or less, being sought after by larger firms. And if the Buyer is not interested in R&W coverage, which can often be the case for big companies, it is possible to insure only the IP reps in the deal. The premiums are just $125,000, with $30,000 in underwriting fees. A small price to pay for the Seller’s peace of mind.
If Indemnification has your M&A deal hung up, or if you’re a Seller concerned about this issue because you’re about to put your business on the market, I’d invite you to speak with me about Representations and Warranty and other types of M&A focused insurance that could protect you.
You can reach me, Patrick Stroth, at pstroth@rubiconins.com or (415) 806-2356.
It’s a landmark moment in the world of M&A. Marsh JLT, the world’s largest insurance brokerage, has announced they successfully placed the first Transactional Liability policy at a $1 Billion Dollar Limit, the largest such policy ever written. As impressive as this may seem, it’s only a matter of time before a larger policy Limit is placed on an even bigger transaction. This is just one of the many data points outlined in the Marsh JLT 2019 M&A Trends report.
The biggest takeaway is that if you have a billion-dollar deal – you need look no further than Marsh JLT. They have the resources and experience to handle these very opportunities. I’ve always believed the world needs the Mega Brokers like Marsh JLT because “someone” has to insure Disneyland!
This is just one indication of how the benefits of transactional insurance, especially R&W insurance, is being recognized by Buyers and Sellers and made an essential part of a growing number of transactions, even for transactions going as low as under $20M.
According to Marsh JLT’s June 2019 Transactional Risk Insurance Report, which looked back at trends in this space in 2018, there are 25 firms offering this specialized type of insurance. That’s a sizeable increase from the handful offering this coverage just a few years ago.
More policies are being written as well, with Marsh JLT alone experiencing a 40% increase in policy count, from 359 in 2017 to 504 in 2018. The median transaction value for those insured deals was $135M. The size of the average R&W policy placed is about 10% of the transaction value.
Industry-wide, the number of M&A insurance policies rose for the fifth straight year, according to the Marsh JLT report, driven by strategic acquirers who are gaining confidence with this product. The number of R&W transactions conducted in this sector increased by 21% from 2017 to 2018. PE and other financial acquirers are already comfortable with this insurance, with PE being the majority users.
Of the policies written, 99%, were Buy-Side R&W, leaving only 1% as Sell-Side R&W. Buy-Side policies continue to represent the vast majority because they provide broader protection (i.e. covering Seller fraud) and because they best facilitate a “clean exit” for Sellers, with no indemnity obligation and less, if any, money held in escrow.
This allows the Seller to have most of the sales price in hand when the deal closes so they can move on to new investments or distribute funds to shareholders and investors. That’s the reason why Sellers, in many cases, are more than happy to pay for this coverage.
Looking at trends and what the future holds, it’s clear that the increase in usage of R&W is the direct result of three factors that aren’t changing anytime soon:
It’s also important to note that Underwriters have more experience than ever in writing R&W and other transactional risk policies. This allows this component, including due diligence, to become a seamless part of an M&A deal.
All this is taking place with a very healthy M&A environment as the background. The Marsh report notes that global M&A activity jumped 11.5% from 2017 to 2018 to $3.5T, even as the total number of deals actually fell. That’s the fifth year in a row that deal values have topped $3T. PE firm buyout activity, meanwhile, was valued at $557B, which is the highest level in 10 years.
Expect to see increased use of R&W and other transactional risk insurance in the rest of 2019 and beyond.
The great news for specialty firms, such as Rubicon M&A, is that Marsh’s growth into the billion-dollar deal level opens a wider gap of underserved deals as there are far more sub-$135M deals out there with the exact same needs for protection and service. We’re thrilled to have Marsh JLT out there to serve the mega-deals. We’ll handle the rest!
To discuss how Representations and Warranty insurance can impact your next M&A deal, contact me, Patrick Stroth, at pstroth@rubiconins.com or 415-806-2356.
