Several industries have recently experienced an uptick in mergers and acquisitions (M&As), including biotech, manufacturing, and many more. Historically, two vital components of an M&A agreement are representations and warranties — the seller agrees to secure the buyer for infractions of the seller’s representations and warranties. Not only is this structure traditional, but it’s also heavily negotiated by both parties. However, when representations and warranties (R&W) insurance emerged onto the scene, this typical standard became unnecessary in most M&As. In this post, we’ll review the reasons why having this coverage is beneficial. Let’s dive in!
What Is Representations & Warranties Insurance?
Informally known as “transactional risk insurance,” R&W insurance 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.
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 representations and warranties (R&W) can help to relieve pain points.
If massive M&A lawsuits occur, months and even years could pass until the parties reach some agreement. Representation and warranties insurance help sellers and buyers avoid this costly legal situation 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 R&W insurance would be the cure for a good compromise.
What Are the Benefits for Sellers?
Of the eight top benefits of representations and warranties insurance, four are seller-focused, and the remaining four have mostly to do with buyer benefits.
1. Breach of R&W
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.
However, R&W 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.
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. R&W insurance allows the M&A transaction to reduce or eliminate this type of holdback — 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. Representations and warranties insurance helps sellers land a cleaner exit. In other words, what R&W 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.
With an R&W insurance policy, however, sellers feel confident offering the buyer more desired extensive representations and warranties. This substantial knowledge isn’t always relevant to the deal, 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. Representations and warranties insurance can help bolster sellers’ confidence in a buyer for many reasons.
5. More Attractive Bid
As mentioned, R&W 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, a buyer’s bid automatically looks far more pleasing. Having this particular policy on your side gives you the one-up on other buyers.
6. Additional Time
Often, there’s a limit on how long a buyer has to discover issues and concerns with representations and warranties. This limitation is typically written into the M&A transaction deal. But representations 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 feel loads more comfortable and less pressured with the deal, in general, which encourages the M&A to progress at a steady pace.
7. 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 R&W insurance, too, but they’re usually higher than what a seller might agree to in a deal. In other words, R&W insurance enhances or increases buyers’ protection amounts — often in more significant numbers than what a seller might otherwise settle for in an acquisition agreement.
8. 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. R&W insurance does precisely this; it provides the buyer with more extensive representations and warranties in the deal since sellers are typically more willing to give it when R&W coverage plays a role. As a result, buyers have the upper hand.
Who Should Purchase R&W Insurance?
Strangely enough, buyers are more likely to purchase R&W 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 representations and warranties in the acquisition agreement? Hassles like this are how executive ulcers begin!
On the other hand, however, it’s the seller’s representations and warranties that a policy is trying to back up. So, it’s a smart move for sellers to purchase R&W insurance, as well. Thankfully, sellers are slowly awakening to the benefits of R&W insurance, making M&A momentum faster.
Lastly, since both parties usually heavily negotiate representations and warranties, using R&W insurance encourages a more simplified and speedy process. Mainly because neither party wants to duke out the scope of representations and warranties in the acquisition agreement because the insurance policy will cover them.
Understanding the details of what coverage your company needs can be a confusing process. Founder Shield specializes in knowing the risks your industry faces to make sure you have adequate protection. Feel free to reach out to us, and we’ll walk you through the process of finding the right policy for you.
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