Representations and warranties insurance should be part of any large-scale merger or acquisition deal. Such a policy puts the risk in a business transaction away from buyer and seller and onto a third party – an insurance company.
If you researched this coverage in the past and found it too expensive – things have changed. It’s now much less than you might think, thanks to big changes in this industry.
In 2011, the rate was 10% of limit. So, a policy covering $20 million cost $2 million. Now, the same policy can be secured for just $400,000.
It’s a small price to pay for the value.
With this coverage, the buyer can rest easy because if there’s an issue with the business post-purchase, say unforeseen tax exposure or the seller breached their representations or warranties, they go to their insurance policy to recoup their losses.
The seller is happy because a much lower amount of their money is kept in escrow as part of the indemnity agreement and they have also reduced their liability.
Rep and warranty insurance also makes the transaction much smoother and helps negotiations move along much faster.
All of this also gives both sides of the deal peace of mind – that’s priceless.
Generally, to qualify for rep and warranty coverage, the transaction has to be $20 million or above, with most policies being written for deals of $50 million and up – all the way to $1.5 billion.
Why did the price for this coverage drop so drastically in the last couple of years?
When this was a relatively new type of coverage, the underwriters didn’t have enough data. Once they discovered that there weren’t many claims, they realized the risk to insurance companies wasn’t as high as they thought – it was a profitable line of business with good performance. The due diligence process became faster and cheaper, also. Plus, as more insurance companies started offering these policies, competition drove prices down.
So if you’ve looked at rep and warranty coverage in the past but thought it was too pricey – it’s time to take a second look.
Two Main Factors in Cost
There are two main elements to look at when determining what your representations and warranties insurance coverage will cost – aside from your premium, of course.
1. Underwriting Fee
When both parties agree to get rep and warranty coverage, the first step is to contact an insurance broker specializing in M&A. A well connected broker will present a deal to a network of established insurance companies that are looking to insure M&A transactions. Their underwriters can look at the deal and offer an estimated quote based on the information you provide, such as the size of the deal, the amount of coverage you want, and the like. This estimate is provided at no cost.
But if the parties want to move forward, the underwriters will have to start on a comprehensive due diligence process, involving merger and acquisition attorneys. These folks do not do their own investigation. They rely on the documents provided by the seller. This formal underwriting takes a couple of weeks and costs from $25,000 to $50,000 (it’s usually $30,000 to $35,000) depending on the size and complexity of the deal.
That fee is nonrefundable. But you don’t have to worry about paying it and then not getting the policy. Underwriters will really only drop a deal all together if they find blatant fraud during their due diligence. If they do find problem areas, they’ll just exclude them from the policy.
Every state has its own insurance policy sales tax (also known as Surplus Lines tax), which runs from 2.5% to 6% of the premium.
Take a look at a quick example. Let’s say a $600,000 premium, which is pretty typical, is subjected to a 3% tax. That equals $18,000.
As you can see, your overall fees are quite affordable… under $50,000 total to get your policy done.
Whether the buyer or seller pays for the rep and warranty insurance is actually a point of negotiation, and generally falls to whomever stands to benefit the most.
Buyer side policies are the most common. They allow the buyer to recover any losses directly from the insurance company, without having to seek a claim from the seller. And there is generally a longer period of coverage during which the buyer can seek reimbursement from the insurance company – from three to six years.
But, in many cases, the seller is happy to pay for a buyer side policy because having the policy in place means there is much less money in escrow and they get more of the sale price in their pocket at closing. And, their liability is reduced.
Having that money out of escrow is well worth it as often a buyer will find any reason to keep at least some of the money. Without rep and warranty insurance, that can be very costly to the seller.
Say you have a $200 million transaction going through without rep and warranty coverage. Sixteen million dollars (8%) will be held in escrow. But with the indemnity cap (20% of the transaction value), the buyer can potentially come back for $40 million total. With rep and warranty insurance in place, just $2 million is in escrow (1% of the transaction value) which represents the entire amount of seller’s risk (down from $40M).
Let’s say a large corporation wants to acquire an innovative start up. The deep-pocketed company has quite a bit of leverage. They don’t necessarily need rep and warranty coverage because the deal is a small percentage of their bottom line. But the smaller company has worked hard to get where they are and being bought could be their dream. And the primary investors are ready to cash in and get a return on their investment. So they want to get as much of the money right away, rather than wait a year or more for it to come out of escrow.
What is the cost of not having representations and warranties insurance? Eight to 12% of the purchase price will be held in escrow for a year to 18 months. For the seller, the opportunity cost is huge – you don’t have access to that money to start other projects or invest elsewhere.
With rep and warranty insurance coverage, you can also experience smoother, faster deal negotiations, as I’ve mentioned. That means less attorney fees. You’ll save 10% on legal expenses purely because negotiations during the deal will be reduced. Instead of the contract going back and forth between attorneys with changes 20 times, you can expect the number of exchanges to drop to five or six. No more arguing over every letter of the contract because rep and warranty is on the table.
With rep and warranty insurance coverage, you can also experience smoother, faster deal negotiations.
And who can put a price on increasing the chance of a deal closing?
With this type of coverage, a deal is EIGHT times more likely to successfully close – that’s a statistic one investment bank in San Francisco has shared with me based on their experience. There’s nothing more expensive to a seller than a deal that gets almost all the way through then gets shut down.
Get on Board with Rep and Warranty Insurance
The use of representations and warranties insurance is increasing as many companies recognize its benefits to both buyer and seller. By 2015, there were 1,700 policies written worldwide – and 240% jump from 2001. And 40% of that coverage was in North America.
If you’re going into a deal with a value of $30 million or more, you should investigate this coverage immediately.
You can get a rough estimate of your cost to get a representations and warranties policy to insure your deal.
While many consider Rep & Warranty insurance a “no brainer,” it’s not appropriate for every deal. But it is worth examining for every deal over $50-million.
To get started, download our free Rep and Warranty Insurance Calculator: R&W Insurance Cost Calculator