Unlocking the Power of Reps and Warranties Insurance in M&A

In this guide, I'm going to explore an increasingly popular and crucial component of Mergers & Acquisitions (M&A) transactions: Representation and Warranty Insurance (R&W Insurance).

We'll take a deep dive into the ins and outs of R&W insurance. We start by discussing what exactly representations and warranties are and why they're important.

We then go over how R&W insurance works, its pricing structure, and the various benefits it offers to both buyers and sellers in Mergers and Acquisitions (M&A) transactions.

If you're reading this, you're probably considering selling your business, or at least curious about the process involved. You're not alone in this journey, and I commend your proactive approach to understanding the complexities involved.

At MidStreet, we've been helping business owners successfully navigate the M&A process for over 20 years, with more than 400 completed transactions under our belt.

What Exactly are Representations and Warranties?

Before we delve into Representation and Warranty Insurance, it’s important to have an understanding of exactly what is meant by the term "Representations and Warranties" as it relates to selling your business.

Understanding the Concept of Reps and Warranties

Representations and warranties, more commonly referred to as "Reps and Warranties", are the factual assertions sellers make to buyers about their company during a sale.

These are key components of the purchase agreement, serving to provide the buyer with a snapshot of the business at a particular point in time—like the business's financial health, compliance with laws, ownership of assets, and much more.

Differences between Representations and Warranties

While used together, reps and warranties are different. Representations are statements of fact about the past and present. They give buyers a clear and truthful picture of the state of the business, often backed up with supporting documentation.

On the other hand, warranties are promises that certain conditions regarding the business are or will be true. In essence, they're a form of assurance to the buyer that specific facts or conditions relating to the business are as they are stated. If a warranty is found to be untrue, it may give the buyer the right to claim damages.

Importance of Accurate Reps and Warranties

The importance of accurate representations and warranties cannot be overstated.

They serve as a key basis upon which buyers decide whether to proceed with the transaction and at what price. Any inaccuracies could lead to post-closing disputes, or even worse, a loss of trust between the buyer and seller.

Moreover, they provide a basis for indemnification claims post-closing if it turns out that the seller's representations and warranties were not accurate. For this reason, sellers are often cautious about the representations and warranties they make and may negotiate them heavily in the purchase agreement.

As such, they act as a safety net for buyers, providing them with potential recourse in the event that the acquired business isn't quite what it was represented to be.

In the next section, we'll look at the key components of Reps and Warranty Insurance—a crucial tool that has emerged to manage the risk associated with these very representations and warranties.

Stick with me, the puzzle pieces are starting to come together!

What is Reps and Warranties Insurance?

Okay, now that we have an understanding of Reps and Warranties, what exactly is Representation and Warranty Insurance?

It's an excellent question and one we've begun to encounter more frequently, especially as it's a concept that has only recently gained widespread popularity.

When I started selling businesses over 20 years ago, Representation and Warranty Insurance was a relatively unknown concept. However, it has rapidly emerged over the past several years as a useful tool in mergers and acquisitions. 

Representation and Warranty Insurance, also known as "RWI", is a type of insurance specifically designed for the M&A world. Think of it as a safety net, a kind of protective layer that shields you, as a seller, from financial loss that could arise due to breaches of reps and warranties made during a business sale.

Let's break it down a bit further...

When you're selling your business, you make several representations and warranties about the company to the buyer. These are assertions about the condition of your business, covering a wide array of topics, from financial health to legal compliance. They are integral to the sale as they provide the buyer with a certain level of comfort regarding the state of your business.

But what if something goes wrong? What if one of these assertions isn't as accurate as you thought?

That's where RWI comes in.

With this insurance in place, if a breach of these representations and warranties occurs, it's the insurance company that steps up to handle the financial fallout, not you.

This not only helps ensure you keep your sales proceeds, but also provides the buyer with additional confidence in the transaction knowing there's a safety mechanism in place.

In other words, RWI can be seen as a win-win solution for both buyers and sellers in the sale of a business. 

As a seller, it gives you the peace of mind knowing you can walk away from the closing table without the worry of a financial boomerang coming back at you due to an unexpected breach of a representation or warranty.

And as a buyer, it provides an additional layer of security during what is often one of the most significant investments of their career.

But, it's worth noting that while RWI can be an incredibly valuable tool in the M&A process, it's not a substitute for thorough due diligence or carefully crafted representations and warranties.

Instead, it complements these crucial elements of a transaction to create a more secure, more confident, and ultimately more successful sale.

In the coming sections, we'll dive deeper into how this insurance works, its key elements, and what you need to know to navigate the process successfully. 

Key Components of Reps and Warranty Insurance

Reps and Warranty Insurance can provide you with some substantial benefits. But to truly leverage its benefits, it's crucial to understand its key components. So let's delve a bit deeper and unpack the major elements of this form of insurance:

 Covered Breaches: Not every potential problem is covered by RWI. This insurance specifically covers breaches of representations and warranties stated in the purchase and sale agreement. These could range from inaccuracies in financial statements to non-compliance with laws and regulations. It's important to thoroughly understand what is and isn't covered to avoid any surprises down the road.

Policy Limits and Retentions: Policy limits typically align with a portion of the purchase price, often between 10% and 20%. The retention (similar to a deductible in other types of insurance) is usually about 1% to 3% of the purchase price. These figures can vary, though, based on the specifics of the deal and the perceived risk.

Policy Period: The length of coverage varies but generally matches the survival period of the representations and warranties in the sale agreement. This period usually extends for one to two years post-closing, although it could be longer for certain fundamental representations. 

Exclusions: Every RWI policy will have certain exclusions. These could include known breaches (issues identified during due diligence), forward-looking statements, and underfunded pension liabilities, among others. It's crucial to be aware of these exclusions to ensure you understand what risks may remain uncovered.

Claims Process: If a breach occurs, the claims process follows a procedure similar to other insurance claims. The buyer will typically provide notice to the insurer detailing the breach, the damage suffered, and the requested payout. It's the insurer's responsibility to investigate the claim and determine if it's covered under the policy.

Understanding these components can help you as a seller better navigate the M&A process. The devil, as they say, is often in the details, and getting familiar with these crucial aspects of RWI is key to making the most of its benefits.

Next, we'll discuss a typical timeline for procuring RWI and how to streamline the process.

The Pricing Structure of R&W Insurance

Understanding how R&W insurance is priced can help shed light on why it is such an attractive option in an M&A deal. While prices can vary based on various factors, here's a general breakdown of how it typically works:

Premiums: Premiums for R&W insurance policies generally range between 2% to 4% of the policy limit. For example, for a policy limit of $10 million, the premium would typically be between $200,000 to $400,000.

Retention or Deductible: The retention (also known as a deductible) is typically structured as a percentage of the transaction value and generally ranges from 1% to 3%. This is the amount that must be paid out of pocket before the insurance coverage kicks in.

Policy Limit: The policy limit is often determined based on the size of the transaction and the risk profile of the target company. The limit can range from 10% to 40% of the transaction value. The higher the perceived risk, the higher the limit will likely be.

Underwriting Fees: Underwriting fees are charged by the insurer to cover the cost of assessing the risk, diligencing the representations and warranties, and issuing the policy. These fees can range from $25,000 to $50,000, depending on the complexity of the transaction.

Additional Costs: It’s also worth noting that there may be additional costs for amendments to the policy or specific endorsements.

Keep in mind that each transaction is unique, so these ranges are not set in stone. Market conditions, the risk profile of the target business, and the nature of the deal can all influence the cost of R&W insurance. Always consult with a knowledgeable broker or advisor to help you navigate the specifics.

In the next section, we'll take you through some of the benefits of obtaining an R&W insurance policy. This will give you an idea of what to expect if you decide to go down this route.

Benefits of R&W Insurance in M&A Transactions

Taking the plunge into M&A transactions can be a big decision. One thing that can make it easier and more secure is R&W insurance. Here are some reasons why:

Deal Closure Acceleration: R&W insurance can provide both the buyer and the seller with the confidence needed to expedite negotiations, and consequently, accelerate the closing process. Knowing that potential post-closing losses are covered makes it easier for both parties to move forward quickly.

Protection Against Unforseen Liabilities: Even with thorough due diligence, it's possible to miss potential liabilities during an M&A transaction. R&W insurance covers the buyer against any losses resulting from breaches of the seller's representations and warranties, providing a safeguard against unforeseen risks.

Clean Exit for Sellers: Sellers often want to walk away from a deal with the certainty that they won't be drawn back into issues post-closure. By transferring potential post-closing liabilities to an insurance company, sellers can enjoy a 'clean exit' from the business.

Enhancement of Bid: For buyers, having an R&W insurance policy can make their bid more attractive to sellers, particularly in an auction scenario. The seller might favor a bid backed by R&W insurance over one that relies solely on indemnities.

Strengthening Relationships: By taking off some of the pressure associated with potential post-closing liabilities, R&W insurance can help maintain a positive relationship between the buyer and the seller post-deal. This can be particularly important in transactions where the seller continues to be involved in the business post-acquisition.

In the next section, we will walk you through a sample timeline, so you'll know what to expect when obtaining an R&W insurance policy for your M&A transaction.

Sample Timeline for Obtaining R&W Insurance

If you're considering R&W insurance for the sale of your business, it's helpful to have an idea of the timeline involved. While the exact timeline can vary based on the specifics of your deal, here's a general outline of what you can expect:

Week 1 - Initial Contact & Information Gathering

The process starts with initial contact between you (or your broker) and the insurance underwriter. This typically involves an initial call to discuss the basic details of the deal. The underwriter will also request certain key documents, such as the draft purchase agreement, a financial overview of the target company, and any available due diligence reports.

Week 2 - Underwriting Call & Further Information Gathering

The insurance underwriter will arrange an underwriting call with you and your advisors. This call is an opportunity for the underwriter to ask detailed questions about the deal and the due diligence conducted. After the call, the underwriter may request additional information or clarification on certain points.

Week 3 - Insurance Quote & Negotiation

The underwriter will provide a non-binding indication (NBI), which is a quote for the R&W insurance policy. The NBI will outline the proposed policy limits, retention, premium, and any specific exclusions. You can then negotiate the terms of the NBI with the underwriter.

Week 4 - Policy Drafting & Finalization

Once the terms of the NBI have been agreed upon, the underwriter will draft the insurance policy. There may be further negotiations and revisions to the policy language before it's finalized.

Week 5 - Policy Issuance

Once the policy is finalized and the premium is paid, the insurance policy is issued. The R&W insurance policy generally comes into effect at the time the M&A transaction is completed.

Bear in mind that this timeline is indicative and can be faster or slower depending on various factors, including the complexity of the deal, the availability of information, and the response times of the involved parties.

Conclusion:

Congratulations on taking the time to educate yourself on Representation and Warranty Insurance. You're one step closer to understanding the intricacies of the M&A process, and that's a big deal.

At MidStreet, we understand that knowledge is power, especially when it comes to a significant life event like selling your business. With over 20 years of experience and more than 400 successful transactions, MidStreet is here to guide you every step of the way.

For further information, we invite you to explore MidStreet's resource center, where you'll find an array of articles, videos, eBooks, and whitepapers designed to help you deepen your understanding of the M&A process.

If you have any further questions or wish to begin your journey of selling your business, don't hesitate to reach out for a no-obligation, confidential consultation.