Consider the following real scenarios:
Company A purchased Company B, only to realize that the latter failed to accurately report historical revenue. Company B’s revenue was lower than was originally presented, which resulted in a decrease in profitability. As a result, Company A feels it overpaid for Company B, and is able to make a claim under their Representations & Warranties policy and received full economic relief.
Similarly, Company X purchased Company Y. After the transaction, it was discovered that Company Y failed to reveal that their largest customer was planning to terminate their contract. As a result, Company Y is now generating significantly less revenue than anticipated, and the valuation of Company Y was artificially inflated.
Traditionally, seller escrow accounts were used to protect buyers from inaccurate statements made by sellers. These accounts can now be reduced or eliminated as a result of a Representations & Warranties (R&W) Insurance policy, which is currently utilized in a record number of mergers and acquisitions.
While the seller can also purchase a policy, Representations and Warranties Insurance is typically purchased by the buyer, as buyer’s policies include fraud coverage as well - seller policies do not.
R&W Insurance benefits
Ideal for domestic and international private companies, where the seller’s enterprise value is greater than $25M, R&W Insurance provides a minimum of $5M of coverage and a number of benefits beyond simple escrow reserves, including:
- Maximize cash at closing. R&W coverage eliminates the need for a seller escrow account, which can be 10% of the purchase price or more. This allows sellers to distribute higher proceeds post-sale to their shareholders and move on to the next investment quickly.
- Improved negotiations. Having R&W coverage will expedite and smooth negotiations between buyer and seller and their respective legal counsel, providing confidence in the deal’s financial accuracy. This enables parties to resolve issues and close the transaction quickly. R&W insurance will provide additional financial security when the buyer is concerned with the seller’s ability to indemnify the buyer.
- Improve post-deal relationship. An insurance policy protects the future relationship between the buyer and seller’s management, who often stay on post-deal. Buyer will not need to pursue seller for breaches, and instead uses the policy as a backstop.
4 things to know before purchasing an R&W policy
Like other specialized coverage, there’s no form or standard R&W policy. R&W policies are a bespoke product. Each policy is written according to the buyer and seller’s contract. Negotiating the policy to meet the needs of the deal will be critical to having the right coverage.
- An R&W policy can be engaged in cross border transactions. R&W insurance is a global product regardless of the location of either company.
- Due diligence is required for R&W coverage. Underwriters will expect buyers to perform due diligence on all aspects of the business before they write a policy. Buyers will have to engage third parties to author reports on the company’s legal, tax, financial, environmental, operations and insurance/benefits standings.
- Your industry may affect your R&W coverage options. For years, financial services and consumer finance companies, for example, were harder to underwrite when it came to R&W coverage. Make sure your broker and/or underwriter have extensive knowledge of your industry, and can help you negotiate the optimal policy for your transaction.
- R&W policies cover more than you think. R&W policies include unknown breaches to general, fundamental and tax representations and warranties within a purchase agreement including: financial statements, company ownership, intellectual property, environmental, employee related matters, fraud (buyer policies only) and more.
Contact HUB’s Transactional Risk/Management Liability team for more information on how to build the right R&W policy for your next M&A.