Top 8 Benefits of Having Reps and Warranties Insurance

What Is Representations & Warranties Insurance?

Informally known as warranties insurance, representations and warranties insurance, protects and helps to reduce the risk associated with M&As. This coverage is often combined with directors and officers coverage, offering a one-two punch to pesky vulnerabilities when selling or buying a company.

If you’ve ever experienced the sale or purchase of a company, you also know the murky waters of post-acquisition litigation. Perhaps, the seller made inaccurate representations about the company, which frequently involve finances, corporate structure, taxes, etc. Companies being purchased must live up to the seller’s claims. If they don’t, sellers and buyers often find themselves in messy (and costly) lawsuits to straighten out the deal, which can lead to significant financial loss.

However, it’s not only sellers who are at risk in an M&A transaction. Buyers also face exposures. Most buyers compete with each other to appear the most attractive to the seller, but they don’t always have what it takes. When the two parties strive to find middle ground on a contract, risk management options like reps and warranties can help to relieve pain points associated with transactional risk .

If massive M&A lawsuits occur, months and even years could pass until the parties reach some agreement. Reps and warranties insurance help sellers and buyers avoid this costly legal situation and make necessary purchase price adjustments related to seller’s escrow by:

• Indemnifying the buyer according to the agreement terms and conditions with the seller up to the policy limit.
• Providing capital for defense costs and judgments or settlements against the seller.

We’ve said it before, but if a “good compromise” means both parties are left dissatisfied, then reps and warranties insurance would be the cure for a good compromise, especially from the perspective of corporate executives.

What Are the Benefits for Sellers?

Of the eight top benefits of reps and warranties insurance, four are seller-focused, and the remaining four have mostly to do with buyer benefits, which are often highlighted to private equity fund managers. In short, reps and warranties insurance benefit both the buyer and the seller in various corporate transactions, including those involving venture capital funds . Let’s first look at the latter.

1. Breach of Reps and Warranties

In a traditional M&A transaction, agreements typically include indemnification provisions. These arrangements are often called an “exclusivity of remedies” or “EOR provision,” and work as guidelines for what rights each party has regarding how they handle claims, often involving various contractual protections.

However, representations and warranties insurance can reduce or eliminate the need for these particular provisions. The overall transaction is far less complicated without including the traditional indemnification for breach of representations and warranties.

By incorporating reps and warranties insurance, the insurance provisions streamline the process, making the transaction smoother and providing clearer guidelines for handling potential claims, especially during negotiations that occur within the data room.

2. Escrow or Holdback

An M&A transaction frequently impacts shareholder value in ways that are less than optimal. For example, an escrow or holdback can decrease the seller’s shareholders’ proceeds at the closing of the acquisition because of how many sellers and buyers construct agreements.

Representations and warranties insurance allows the M&A transaction to reduce or eliminate this type of holdback related to net operating losses — which is a massive bonus to everyone involved.

3. Cleaner Exit

One unfortunate element of M&As is that they can get messy quickly. Rarely do two parties see eye-to-eye on every minuscule detail of a transaction. As a result, sellers can end up with an ugly, complicated, strings-attached sort of exit.

Reps and warranties insurance helps sellers land a cleaner exit, minimizing issues related to fundamental reps, as reps and warranties insurance shifts potential liabilities from them to the insurance company. In other words, what reps and warranties coverage could mean for a seller is fewer contingent liabilities having to do with the company’s sale.

4. Quicker Resolution

Just as buyers do, sellers want to appear as attractive as possible. Sometimes, however, a seller and a buyer disagree on what’s authentic information and what’s not — and massive lawsuits ensue, especially when business entails risk and misunderstandings arise.

With a representations and warranties insurance policy, however, sellers feel confident offering the buyer more desired extensive reps and warranties that adequately provide coverage for both parties. This substantial knowledge isn’t always relevant to the deal involving a new asset, per se, but the added and detailed information usually leads to a quicker acquisition agreement.

What Are the Benefits for Buyers?

On the buyer side of things, one of the main goals is to appear like the best option, the most attractive to the seller, which is crucial for risk managers involved in the process . Under the terms of the policy, an insurance company will typically indemnify the buyer for losses resulting from an unknown breach of a representation or warranty in the definitive transaction agreement. Therefore, reps and warranties insurance can help bolster sellers’ confidence in a buyer for many reasons.

1. More Attractive Bid

As mentioned, reps and warranties insurance can reduce or eliminate the need for escrow or holdback since a buyer will depend on the coverage for indemnification protection. When this is the case, following an initial non binding indication a buyer’s bid automatically looks far more pleasing. Having this particular policy on your side gives you the one-up on other buyers.

2. Additional Time

Often, there’s a limit on how long a buyer has to discover issues and concerns with But representations and warranties insurance extends the survival period, allowing a buyer to uncover specific problems with the acquired business.

Here’s the breakdown; this limitation is typically written into the M&A transaction deal. But reps and warranties insurance extends the time frame for which a buyer can uncover specific problems with the acquired business. Having this extra time lets a buyer, especially strategic buyers, feel loads more comfortable and less pressured with the deal, in general, which encourages the M&A to progress at a steady pace.

3. Enhanced Protection

Just as there are time limits on discovering issues, there are typically also protection limitations included in an M&A. Granted, there are policy limits with representations and warranties insurance, too, but they’re usually higher than what a seller might agree to in a deal.

In other words, reps and warranties insurance enhances or increases buyers’ protection amounts to match the enterprise value — often in more significant numbers than what a seller might otherwise settle for in an acquisition agreement, particularly in private equity deals.

4. Upper Hand

In addition to being the best option for a seller, buyers strive for some advantage. The odds of winning in an M&A lawsuit, should one arise, is a good example of having an advantage.

Reps and warranties insurance does precisely this; it provides the buyer with more extensive reps and warranties in the deal since sellers are typically more willing to give it when representations and warranties insurance plays a role. As a result, buyers have the upper hand in private transactions.

Who Should Purchase Reps and Warranties Insurance?

Strangely enough, buyers are more likely to purchase reps and warranties insurance over sellers. On the one hand, it makes sense that buyers would opt for this coverage more often than sellers. After all, what buyer wants to track down a seller after a couple of years to sue them for issues having to do with reps and warranties in the acquisition agreement? Hassles like this can affect other stakeholders and are how executive ulcers begin!

On the other hand, however, it’s the seller’s reps and warranties that a policy is trying to back up. So, it’s a smart move for sellers to purchase reps and warranties insurance, as well. Thankfully, sellers are slowly awakening to the benefits of this coverage, making M&A momentum faster.

Lastly, since both parties usually heavily negotiate reps and warranties, using representations and warranties insurance encourages a more simplified and speedy process. Mainly because neither party wants to duke out the scope of reps and warranties in the acquisition agreement because the insurance policy will cover them.

Understanding the Cost of Reps and Warranties Insurance

Understanding the cost of reps and warranties insurance, also known as transaction liability insurance, involves several key factors. While there isn’t a standard price, the underwriting process plays a significant role in determining the premium. Insurers meticulously review the financial statements of all parties involved in the transaction to assess the inherent risks. The scope and nature of the warranties themselves are a primary driver of cost.

The policy deductible will directly impact the premium, with higher deductibles generally leading to lower upfront costs. However, it’s crucial to balance this with the potential for significant out-of-pocket expenses. Minimum premiums are often in place, particularly for smaller deals. Keep in mind that tax credits are not typically a direct factor in the insurance premium calculation.

However, engaging an experienced insurance broker specializing in transactional risk is vital. They can navigate the complexities of the market and secure competitive quotes, taking into account potential defense costs in the event of a claim.

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