Representations and warranties insurance, which covers all assertions made by the seller and/or the buyer in a purchase agreement, is critical to any M&A transaction. Often referred to as “reps and warranties” (or “R&W”), this type of insurance guides the due diligence process and allows the seller to disclose material information about the company that could potentially derail the transaction. It protects the seller from liability for infractions in any claims regarding the company and allows potential buyers to move forward assuming that such claims are accurate and truthful. So, whether you are the buyer or the seller in a particular transaction, you can expect to benefit from using R&W insurance.
R&W insurance is a liability policy that covers indemnification for certain breaches of the parties’ representations and warranties in a transaction agreement. This insurance is used in most transactions with a value over $30 million to provide additional flexibility in addressing these obligations by removing liability from the parties for errors such as materially omitted information or the accuracy and completeness of financial statements. Either party can purchase R&W insurance from an insurance broker as a “sell side” or a “buy side” policy with a term typically lasting from three to six years.
The insurance contains a retention (or “deductible”)—the amount you, as the insured, would need to pay before the policy starts paying out on the claim—and a coverage limit for the insured amount. The retention typically represents between 1% and 3% of the transaction’s enterprise value. R&W insurance will cover claims beyond the retention as long as the figure does not exceed the policy limit. When you sign the insurance agreement, you pay a one-time premium, which typically ranges between 1.5% and 3.5% of the coverage limit.
One main benefit of using R&W insurance is that it limits or eliminates the seller’s liability for breaches of representations and warranties without materially diminishing the buyer’s coverage. This risk transfer benefits both the seller and the buyer and can remove the need for an escrow or holdback amount, making the bid more financially attractive. In addition, using R&W insurance can help accelerate and simplify the negation process for the purchase agreement, as both you and the counterparty will be less concerned with the scope of the company’s representations and warranties.
What Is the Value of R&W Insurance to Sellers?
If you are selling your business, R&W insurance can be valuable in mitigating risk and providing a cleaner exit. With the insurance assuming the risk regarding the accuracy, truthfulness, and completeness of your company’s representations and warranties, you are free of any contingent liabilities following the acquisition. Furthermore, by limiting or eliminating the escrow or holdback typically required by a buyer, R&W insurance allows you, as the seller, to collect the entire proceeds from the acquisition at the close of the transaction—thus reducing the risk of nonpayment should a representations breach occur after that point.
What Is the Value of R&W Insurance to Buyers?
If you are looking to purchase a company, R&W insurance can significantly enhance your offer’s attractiveness to the seller, extend the duration of the target company’s representations and warranties, and offer you more favorable protections against risk. Limiting or eliminating the need for an escrow or holdback can effectively improve your competitive position in a bid by offering a greater share of the proceeds to the seller after closing the transaction. Furthermore, extending the duration for representations and warranties can give you more time to discover any problems or potential indemnifications surrounding the target company. Finally, the insurance may be structured to offer protection in amounts higher than the seller might otherwise agree to.
Are There Any Drawbacks to R&W Insurance?
Whether you are the seller or the buyer, you should know that an R&W insurance policy typically contains several exclusions. Most important, the insurance will cover only indemnification associated with the representations and warranties of the company and does not include covenant breaches, purchase price adjustments, or other liabilities that might arise under the purchase agreement. It also excludes any known breaches or breaches the buyer should have uncovered through existing information. The insurance may also exclude other items related to misclassifications; certain tax-related issues; and forward-looking representations and warranties, such as revenue projections. Most commonly, insurance claims are related to the accuracy and completeness of financial statements, disclosure of material contracts, compliance, and taxation.
Choosing a good advisor is integral to ensuring that you select an R&W insurance policy that covers your specific needs. If you have comments or questions or want more information on R&W insurance, please contact us directly.