The goal of so many high growth startups today is “the exit.” Big companies are happy to meet this demand. They’re looking to expand market share or improve their product and an efficient solution has been snapping up these startups. Experts believe this trend will only accelerate over the next year. While there’s an understandable tendency to focus on ‘the deal’ and the next steps, businesses can do themselves harm by thinking about risk management as an afterthought. What happens to your insurance when you sell your company?
Two insurance products play a particularly large role in risk management post-acquisition: representations and warranties insurance and tail coverage.
Two reasons why this matters
First, when you buy an insurance policy for your company, you’re acting on its behalf to form a contract between your company and the insurer. When your company doesn’t exist, the contract can’t exist. So whatever protections were given to the individuals working for your company can’t exist anymore either. Acquired companies don’t survive most acquisitions and claims can take a long tome to develop. The result? Those former executives will need to find a way stay protected somehow.
Second, when an underwriter offers a company an insurance policy, they do it because they feel they understand the company to a reasonable extent. The underwriter also carefully designs the pricing and coverage of the policy around the unique nature of this company.
Think of the underwriter as the host of a big annual party. She knows her house and she knows who will get along. Your company, “Coco,” is one of the host’s guests. She knows Coco, she likes Coco, Coco fits right in…that’s why she invited him in the first place. And the first year was great! But now it’s the second year and here’s Coco bursting through the door with an improv troupe and marching band in tow. Suddenly it’s a very different party. Ducking out of the way of a flying baton, the host realizes she no longer has control. She hates not having control.
Underwriters need to be able to control the party. Sometimes they won’t be able to cover the new liability introduced by a company you acquire during a policy year. And they certainly don’t want to be responsible for anything this uninvited +1 did before they got through the door.
If your want your insurance policy to stay in force, you need to be aware of how the underwriter wants it to respond to M&A.
Key policy provisions
Carriers have built triggers into their policies that allow them to exert this control. To really understand what happens with your insurance when you sell your company, you need to know both how your policies would respond as the seller as well as how buyer’s policies would respond.
- ‘Change in risk’ provisions: these provisions appear under different names but, at their core, their purpose is to dictate what will trigger a change in the coverage available to you. If another company purchases a certain percentage your assets or voting shares, the carrier may have the right to change the terms of the policy and/or charge additional premium. Same goes with an acquisition where the company you’re buying exceeds certain prearranged thresholds. These are important rules to be familiar with.
- Prior acts exclusion: regardless of whether any automatic coverage or notification agreements are triggered, the policy will never offer look-back coverage for the new subsidiary. Any wrongful acts committed prior to the acquisition will have to be covered by the acquired company’s old insurance carrier.
- Automatic extended reporting period (ERP): if you get acquired, your coverage is cancelled as of the date of the transaction. The automatic ERP is added to some policies to provide additional cushion for reporting claims. This provision will set a specific window after the cancellation date, usually 30 or 60 days, during which you would be able to use your policy to make a claim. But the wrongful act that led to the claim must have occurred prior to the acquisition date. Once that ERP ends, the policy is effectively dead.
- Tail coverage: (aka “optional ERP” or “run-off” coverage)…
What is tail coverage?
Not all claims are made right when the wrongful act happens. With claims-made policies like D&O or professional liability, it can take months or even years before an act triggers an actual letter from a lawyer or investigation from a regulator.
An optional ERP is a coverage extension that responds to that problem. For additional premium, this will replace the automatic ERP to provide an even longer window where you can report claims to your old policy. The torts covered by these policies usually have a statute of limitations of six years which is why it’s so important to negotiate five- or six-year ERP terms with the underwriter prior to binding your policy. Not all underwriters will agree to do this but the ones that do provide their policyholders who are looking at acquisition offers with some financial certainty.
Companies on either the buy-side or sell-side of an acquisition can demand this coverage. For good reason, too. The seller’s motivation to purchase an optional ERP is the same reason they had the original policy to begin with: it will protect them into the future from exposure to their old company’s risks.
On the other side, buyers want to be just as certain as the seller that, should a dispute arise out of the former operations of their shiny new subsidiary, they won’t have to pick up the bill. Instead an insurance policy will pay for the defense costs and judgements or settlements.
So while that addresses some legacy disputes your company may be involved in, we’re still left with a major gap: what about new disputes? What’s the available insurance when you sell your company and you’re faced with a disagreement with your own buyer?
Enter representations and warranties insurance (RWI)
Also known as “transactional risk insurance,” RWI policies are underwritten specifically for each deal. If there is some actual or alleged breach in specified representations or warranties in the purchase agreement, the policy will respond. They have become a proven solution for reducing M&A risk as far out as six years from the date of transaction.
Buyers and sellers benefit from this policy as well. And just like with tail coverage, it’s helpful to view potential concerns from both sides even if you’re only in a position of selling a company.
If you’re buying a company, you want to be sure that you can rely on the various financial, tax, legal, compliance, workforce, corporate structure and other representations made by the current owners. A RWI policy will give the buyer peace of mind in the form of insurance company-backed indemnification.
This peace of mind may then actually lead to more wiggle room in the buyer’s own risk management demands. They can lean on this policy and demand less from sellers in the form of escrow, indemnification, and due diligence. Buyers who are participating in an auction and need to differentiate themselves from the rest may find this particularly useful.
Those on the sell side have the most obvious benefits from the policy. If they’re sued by the people who bought their company on the basis of a misrepresentation or breach of warranty, the policy will provide money to defend them. Sellers can also walk away from a deal much quicker: shorter escrows and elimination periods on representations means that the acquisition doesn’t have to hang over their heads.
A deal will usually have to be over $20 million in total enterprise value before the economics of this policy make sense, but there are exceptions. Those companies that do purchase the policy realize the clear benefit of addressing one of the largest risk exposures in business.
Wrapping it up
There’s a lot to consider in terms of insurance when you sell your company. The most important thing from a risk management perspective is analyzing and addressing your actual exposures in an effective way. One good way to make that happen is to work with the right insurance broker. Whether you’re buying or selling a company, a qualified professional will work with you to identify the right policy without sacrificing convenience or service. The answer may be a tail policy, a RWI policy or a combination of the two, but each deal is often so unique and complex that the best first step is often a quick conversation.
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