A couple of years back, I witnessed a train wreck of an acquisition that could have gone much, much smoother if the parties involved had taken one extra, but very low cost, step as they put together the deal.
Let me set the scene. The owner of a telecommunications company was ready to sell… to the tune of $100+ million. He had a buyer all ready to go. That’s when the trouble started.
The seller decided to “bare his soul,” so to speak, and, against the advice of his attorney, disclosed information about his company well beyond what he was obligated to. He figured he had nothing to hide.
Next, the buyer required a 20% indemnity cap – ($20 million), half of which ($10 million) was to be held in escrow for 12 months, which was their standard practice. The seller had figured that after his gesture of goodwill the cap should be 10% with little or no escrow. The buyer wouldn’t budge because it was company policy. The seller was furious because he felt that the buyer didn’t trust him. And the deal struggled as the attorneys tried to negotiate a compromise.
What could have been the saving grace here?
A representations and warranty policy (R&W) covering the sale that would remove the risk from the transaction from either buyer or seller and shift it to a third party – the insurance company.
In cases like these, and any other M&A deal in fact, the buyer should be the side that insists on having that insurance in place. I’ll show you in detail why in just a moment.
R&W policies offer coverage in the event there is a breach of the seller’s representations or warranties in the purchase and sale agreement. It’s meant to replace or add to a contractual indemnity. This type of policy is generally only available for deals with transaction values from $20 million up to $1.5 billion, although most are $50 million and up.
For a very reasonable cost, the seller in this telecom sale would have only had to put $1 million to $2 million in escrow, instead of the proposed $10 million. Even better, the R&W policy would cap the seller’s indemnity exposure from $20 million down to the $1 million or $2 million escrow amount. That would have given both sides peace of mind. Plus, having the policy in place would have eliminated any need for the complicated negotiations that came after the seller’s “over-disclosure.”
For the buyer it would have meant having the deal go through without this hiccup.
I’ll admit, as a strategic buyer from a company with deep pockets you’re not facing very much risk during an M&A deal. You don’t strictly need R&W insurance to protect you financially if there is a problem down the road, say an unknown tax liability or if the seller breached their representations or warranties.
But there are several reasons you should take on this type of insurance, which although the buyer as policyholder is the one who collects from the insurer in the event of a loss, is usually paid by the seller. So this insurance doesn’t cost you anything but you enjoy a faster and smoother transaction… and the deal is 8 times more likely to go through.
With R&W, you get these specific benefits:
When you buy a company, it’s always a risk, no matter how much due diligence you’ve done. There could be unknown tax exposure, misstated financials, intellectual property issues, problems with the pension fund, or some other issue that reveals itself well after money changes hands.
But with R&W insurance, if something does go wrong, you simply notify the insurer of the breach, provide them with information showing the breach and subsequent financial loss that resulted, and they write you a check.
R&W policies offer specific coverage, for the representations and warranties outlined in a purchase and sale agreement. Unlike other insurance policies, there is very little ambiguity as to what is and isn’t insured (e.g. items discovered in due diligence are NOT covered), so no one’s in the dark as to whether or not a rep is covered.
As I mentioned, the seller often pays for rep and warranty insurance because they realize how it “sweetens the deal” for a buyer. The cost has dropped dramatically in recent years as underwriters have realized the low number of claims being made.
The premiums for R&W policies are determined by the amount of insurance needed, not the transaction size. Currently, the premium rates run about 3% of the Policy Limit (a $10M R&W policy would rate to $300K in premium). In addition to the premium are underwriting fees and state insurance taxes. Underwriting can cost from $25,000 to $50,000. The taxes depend on the buyer’s state of domicile, but run from 2.5% to 6% of the premium. Total costs for a typical R&W policy are 3.5% to 4.5% of the policy limit – a one-time expense.
For a strategic buyer, especially those from large corporations, buying a company is routine. The people handling the transaction inside the buying organization are usually employees of the company, and they’re not “playing” with their own money. Their mindset is we buy companies – it’s our job.
But for most sellers, this transaction is much more personal. It might be their first and only time ever doing a deal like this. The sale is the result of years of hard work. This is the bulk of their net worth at stake, and they probably answer to a small number of shareholders. So emotion is tightly wrapped up in this deal, including a tremendous amount of fear. Like in our opening story, this manifests itself in obsessing over contract terms, like the amount of money in the indemnity cap.
But R&W insurance takes this anxiety away.
The seller is able to leave much less money in escrow, which they fear the buyer will try to get. And if something does go wrong, the buyer won’t go after them – the insurance company reimburses them for their financial loss.
Sellers also have access to more cash from purchase right away, which satisfies investors and frees up funds for other investments or projects.
With the need to negotiate every little detail in contract gone, thanks to the protection offered by R&W insurance, buyers and sellers find that negotiations are smoother.
In a typical M&A deal, the purchase and sales agreement can go back and forth between the buyer’s and seller’s attorneys 20 times or more as they negotiate over small tweaks in the contract language, especially regarding the indemnification agreement and amount to be placed in escrow.
But with R&W in place, there’s no need. If something goes wrong, the policy takes care of it. A bonus here: because the attorneys involved don’t have to go through so much back and forth on contract terms, your legal fees will be lower.
Another benefit to a buyer suggesting R&W insurance is that, if there are multiple potential buyers, it makes their bid more attractive.
There is a survival period (the length of time a seller is liable to a buyer) for certain representations and disclosures. Depending on the types of reps, survival periods can run as little as 12 months, to as long as 6 years.
As you can imagine, a buyer would like to stretch that period out as long as possible and the seller wants it as short as possible. The survival period can be a point of contention during a negotiation.
Again, R&W insurance comes to the rescue. The policies are written to mirror the purchase and sale agreement survival periods all on a single policy. With that coverage in place, the survival period could be 12 months or 72 months – it doesn’t matter because it’s insured.
So as the buyer, you can assure your counterpart that the R&W policy will match all the survival periods, regardless of length, which will make them happy and more likely to move forward.
All purchase and sale agreements carry provisions where the seller is liable to the buyer for financial loss resulting from a breach of the seller warranties; however, NO ONE really wants to “pull that trigger” unless absolutely necessary.
You just acquired a coveted new “partner” with whom you are heavily invested in for the future success of your organization. The last thing you want to do is alienate them by taking away their escrow and commencing a clawback of funds for indemnity.
Having R&W insurance eliminates that situation entirely.
Instead of facing the dilemma of swallowing a loss or ostracizing your new partners, there is a third party that will pay your loss without any need to involve the sellers. All the emotional “wear and tear” of a claim is removed, and you can focus on moving forward with your new team.
I’m routinely told by veteran M&A attorneys of uninsured deals that suffered a breach that lead to so much bitterness between the parties that the only resolution was going to trial.
At that point the costs to both sides eclipsed what otherwise could have been a straightforward business expense – paid by the insurer, not the parties!.
It’s clear that, as a strategic buyer, an R&W insurance policy should be standard procedure when you buy a company.
You’ll minimize financial risk, promote a quick and easy negotiation, and ease the anxiety of a potentially nervous seller.
For more information about why this coverage can be so helpful in M&A deals, call Patrick Stroth at (650) 931-2321 or email email@example.com.