Historically, the sale of a private company carried with it a significant risk of claims by the purchaser. Months or even years after the sale closed, purchasers would frequently contend that the seller’s representations and warranties in the purchase agreement had been breached. This claim would support demands by the purchaser for the seller to forfeit some or all of the purchase price held back in escrow, and give rise to other claims, as well. The often contentious relationship that existed between company buyers and sellers began to change, however, when representation and warranty insurance (“R&W Insurance”) emerged and began to gain acceptance.
Although it was almost unheard of ten years ago, R&W Insurance is now widely used in today’s seller-friendly merger and acquisition (“M&A”) market. This post therefore provides an overview of R&W Insurance, explains how R&W Insurance works, and reviews how this type of policy allows buyers and sellers to an M&A transaction to allocate risk for their mutual benefit.
Role of R&W Insurance
At its most basic level in this context, R&W Insurance is an insurance policy issued to the buyer of a private company, and it protects the buyer from unanticipated losses that result from a breach of the seller’s representations and/or warranties in the purchase agreement. Some R&W policies are issued to company sellers, but more often the buyer is the insured party.
The concept of R&W Insurance is not new, but it has gained a much broader market acceptance over the past decade due to a number of factors, including, seller-friendly market conditions and an increase in the number of new insurers entering the market. The existence of multiple insurers providing R&W Insurance has led to lower costs (premiums), better policy terms, and a quicker underwriting process allowing the policies to be issued more promptly.
R&W Insurance Basics
Traditionally, in the documentation of M&A transactions, buyers require sellers to issue representations, warranties and indemnifications in the purchase agreement, which helps reduce the risks borne by the buyer in purchasing the business. If a breach results of the representations and warranties, the indemnification provisions define when and how much the seller is required to pay to cover the buyer’s losses. Often, the buyer and seller will establish specific amounts for a deductible and liability cap, and further agree that some amount of the purchase price will be held back and placed in escrow to cover any future indemnification obligations. These provisions are heavily negotiated as the buyer desires to obtain broad indemnification protection while the seller seeks to limit its future indemnification obligations as much as possible.
The use of R&W Insurance can substantially alleviate this tension between the buyer and the seller, and reduce the time and resources spent negotiating representations and warranties and indemnification provisions. The R&W Insurance shifts some or all of the risk of a breach by the seller to an insurance provider. As noted, R&W Insurance policies in which the buyer is the insured party are most common.
When the buyer is the insured under the R&W policy, the buyer will typically engage an insurance broker, who will connect the buyer with one or more insurance providers who provide quotes for the policy and begin the underwriting process. Depending on the negotiations and the leverage of the parties in the transaction, R&W Insurance policy premiums are split between buyer and seller or allocated to one of the parties. The insurer will require substantial due diligence of the seller’s representations and warranties before issuing the policy, and may even conduct its own due diligence to supplement the buyer’s due diligence efforts.
Typical R&W Insurance policy terms include:
- Coverage of all representations and warranties of seller, though more limited policies are available (i.e., fundamental and tax reps only) and policies exclusions are typically seen
- Coverage for losses in excess of the deductible amount up to the policy’s limits
- Pricing generally in the range of 2% to 3.5% of policy limits (i.e., $200,000 to $350,000 per $10 million in protection)
- Self-insured retention (or deductible) from 1% to 3% percent of the purchase price
- Policy’s coverage limit usually ranges from 10% to 30% of the purchase price
- Policy coverage period typically 3 years for general representations and warranties (up to 6 years for fundamentals)
- Most commonly in transactions with enterprise value of $20 million to $1 billion
- Underwriting fee ranging from $25,000 to $50,000 charged by the insurance carrier
- No coverage for (i) known issues, including issues discovered during due diligence or described in disclosure schedules, (ii) purchase price, working capital, or similar adjustment provisions, or (iii) adjudicated fraud of the seller.
Benefits of R&W Insurance
Private company business owners and their purchasers both find R&W Insurance to be financially attractive for several key reasons:
- When R&W Insurance is used, the seller may be able to avoid the requirement of an escrow – no funds are held back and the full purchase price is delivered at closing
- The buyer may agree to pay the full premium for the R&W policy, which may reduce the amount of the purchase price, but the tradeoff of receiving the full purchase price with no holdback may be an acceptable trade-off
- The seller’s liability will be limited to the amount of the R&W Insurance and the seller therefore has no risk of liability beyond the total amount of the insurance policy
- The purchaser has a readily available source of funds to cover all breaches by the seller of the representations and warranties without having to litigate these issues
R&W has become much more common because it provides the parties with a greater degree of certainty as a risk allocation tool. Sellers know what amount they will actually be paid for the sale of their business without risk that some portion of the sale price will be clawed back by the purchaser. Further, sellers want to receive the full amount of the purchase price up front without any holdbacks. From the purchasers’ perspective, buyers receive the protection of a clearly stated insurance policy and a ready source of funds to cover any losses resulting from the breach of the seller’s representations and warranties.
As the price or R&W insurance has come down and policies have become more readily available from multiple insurance carriers, it has created a win-win scenario for both sellers and purchasers. The result is that an increasing number of M&A transactions for companies with an enterprise value of more than $20 million now involve some type of R&W Insurance.