When boards are deliberating the purchase or sale of a business, they need to consider the long-term risks of the decision. Understanding the representations, warranties and indemnifications being made is essential to executing fiduciary duty, since the risks do not go away after the deal is done.
Managing risk is one of the primary responsibilities of the board. The board has three choices: risks can be ignored, managed or insured by a third party at a cost. As part of considering a transaction, boards need to determine if representation and warranties insurance (RWI) is needed and/or required as part of the deal.
First, it’s important for business owners to know the difference between representations, warranties and indemnities. Representations are factual statements about the state of the company, meant for drawing in the buyer; warranties are assurances that the representations are true. Indemnities are a promise to reimburse the other party if the reps and warranties are breached.
My experience over the years is that sellers get excited about a price but fail to fully understand the representations, warranties and indemnifications they provide in exchange for the cash. Over time, people tend to forget about how great the price was, but live with regret for obligations they endure that money can’t make go away. Getting sellers to truly understand reps, warranties and indemnities is essential to a good deal.
The opposite of risk is opportunity, and the ability to insure the representations and warranties may give one party a competitive advantage in negotiations.
After completing a thorough diligence process, buyers usually have one or two issues that are difficult for them to get comfortable with; sellers usually know when they have exposure that they can’t manage.
Owners often accept risks they know and understand, or risks that they know they cannot change. Buyers don’t want to take any risks they don’t have to, and don’t take any risks they can push back on the seller.
This is why insurance companies sell reps and warranties insurance. It allows buyers and sellers to sell certain risks to a third party with defined limits and exposures. While most people don’t like paying for insurance, it may be the only way to bridge a gap in negotiations. RWI has been available in the USA since the 1990s.
RWI and D&O (directors and officers liability insurance) policies serve different purposes. D&O protects officers, directors and the company. RWI serves the shareholders of the company. This is because certain reps, warranties and indemnifications are made by shareholders individually, not the company.
Policies have these major components:
RWI is usually interested in deals between $25M and $1B enterprise value.
Sellers buy RWI to sleep easier at night. With insurance, they can move forward with their lives, investing the proceeds without worrying about a claw back.
Buyers seek RWI so that in case of a breach, they do not need to chase individual owners who have likely dispersed, may be unsophisticated, or have spent their proceeds and be unable to pay what they owe to the buyer.
Smart buyers use RWI to gain an advantage in negotiations. With RWI, they can set smaller escrow amounts, lower caps and shorter survival periods, thereby appearing more attractive to the seller. Most RWI is purchased by buyers for these reasons.
Like all insurance, the client has to go through an underwriting process. For RWI, there are two steps: indication and quotation. Initial, non-binding indications can be provided in a week or two. To receive a binding quotation, clients must pay a non-refundable underwriting fee (usually $10,000 to $30,000) to the underwriter. Firm quotes are typically available in a week or two.
Premiums for RWI usually run at 2% to 4% of the coverage, with a minimum retention (deductible) of 1.5%. The policy period should match the reps and warranties. Beyond that, the terms of the policy are negotiable, since it is a contract between parties.
At smaller private companies, RWI is typically too expensive and, therefore, not a good option. Attorneys for these firms will usually advise clients to negotiate an out-of-court settlement and avoid litigation if there is a claim against them.
At larger private companies, where the costs are manageable, RWI becomes more appealing, since litigation is more common. It is easy to think about RWI as paying a fixed amount now in order to avoid possibly paying a large, unknown amount later.
At a private company with a fiduciary board, the directors have to decide if reps and warranties insurance is needed and if it provides the coverage required. At a private company without a board, RWI is really about letting the owners sleep better at night. For the buyers, this is about managing buyer’s risks and avoiding hassles post-close if things go south.
[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: Key Provisions in M&A Agreements and Post-Closing Issues: Integration & Potential Buyer/Seller Disputes 2019.]
Bruce Werner is the Managing Director of Kona Advisors LLC and served as an outside director on private company boards for the last three decades. Kona Advisors LLC provides advisory services to the owners, investors and CEOs of private and family-owned businesses. With deep experience in governance, succession planning, finance, strategy and management issues, Kona…
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