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.
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.
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).
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.
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.
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.
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.
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%.
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.
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.
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.
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.
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.”
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:
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.
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.
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.
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:
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.
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:
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.
