Going into an M&A deal there is always a “courtship” period where the Buyer is wining and dining the target company. If things go well, this leads to a Letter of Intent, which essentially states that the Buyer wants to buy the company, and the Seller agrees.
This is where things get more complicated. The courtship – and romance – is over.
Considering that a typical M&A deal is about as hard to complete as a Hollywood blockbuster, it’s a miracle these deals ever go through. There are so many elements that could derail them at any stage until the purchase and sale agreement is signed and the closing takes place.
So what happens?
If you’re a target company, you need to be aware of the mindset the Buyer takes on when approaching a deal.
It helps you manage expectations when you sit across the table. As the target, you must realize that as desirable as you may be, you might not have as much leverage after the Letter of Intent.
The Buyer’s attitude is that if they’re paying full price, then the target company has to perform to expectations or better once they assume control, even if there are unknown factors that come into play through no fault of the Seller. The Buyer believes the shareholders of the target company should take on all risks of the unknown, despite the due diligence they have done.
That’s why in these types of deals, a significant portion of the sales price (8% to 10%, generally) is held in escrow for a period of a year or more, with the Buyer basically free to take funds if there have been any breaches with the representations and warranties in the sales contract to pay for the financial losses. They can even clawback more money beyond that amount.
Understandably, Sellers aren’t eager to take that risk… or take home significantly less funds at closing… money which owners and shareholders are eager to use to retire or invest in new projects.
But, as we’ll see in a moment, there is a remedy that allows Sellers to protect themselves and not be required to leave any funds in escrow. In fact, they no longer have an indemnity obligation at all.
On the other side, the Seller maintains they can only give assurances for issues they know about and outline in the representations and warranties in the contract. The target thinks the Buyer should take on all the risk after those issues are outlined.
Clearly, the two sides are at odds. And this can make for difficult negotiations.
But there is an insurance product that can make both sides happy, remove the need for money to be held back in escrow and fulfil any indemnity obligations in the event of a breach of the Seller reps. Deals as low as $15 million will be considered by insurance company Underwriters.
Representations and Warranty insurance does this by transferring the indemnity obligation from the target to a third party – an insurance company.
For example, say a chain of restaurants is purchased. But post-closing, the Buyer discovers that there are $1M of gift cards out there yet to be redeemed. Without R&W insurance, the Buyer would have to go after the Seller to cover their financial losses. But with this coverage, they simply file a claim with the insurer.
Another big bonus: with this coverage in place, a deal is EIGHT TIMES more likely to close. Because the indemnity obligation has been removed from the Seller’s shoulders, that’s one less thing to negotiate. The process becomes that much smoother.
The vast majority of policies are “Buyer side,” where the Buyer is the Insured Party, although often the Seller is the one to pay for it, and happy to do so, considering all the benefits.
Securing this coverage is easy, and its cost is low. To secure a policy takes a couple of weeks at most, as the Underwriters review the due diligence performed by the Buyer. The rate is 2%-3% of the Policy Limit, including Underwriting fees and taxes. The price of R&W insurance has dropped considerably in the last several years, while the number of insurers offering this coverage has increased.
Timing is critical. If you want R&W insurance to cover your next M&A deal, there should be a provision made at the Letter of Intent stage. If it’s put in place at that time, it can always be removed.
If you’re interested in making Representations and Warranty insurance part of your next deal, contact me, Patrick Stroth, at firstname.lastname@example.org.