In the world of M&A, many companies, on both the buy-side and sell-side, have realized the tremendous benefits provided by Representations and Warranty insurance.
The Buyer is able to recover any losses from a breach of the Seller reps without doing so at the expense of the Seller. The Buyer simply makes a claim with the insurer. Plus, the policy cost is either discounted significantly or is free because the Seller will gladly cover the premium.
Sellers love it because they take home more at closing and the indemnification risk is transferred to a third party – the insurance company. A clean exit, and they have zero fear of future potential clawback if there is a breach.
That being said, not everyone is willing to entertain using this insurance.
This is especially true in the case of a corporate, strategic Buyer, in which one company buys another because of synergy of products… to expand to a new customer base or geographic region… or to acquire products they want.
The thing is that strategic Buyers are often much larger than the acquisition target – often hundreds of times larger. In these cases, there is no incentive for the Buyer to get R&W insurance; the protection it provides them is negligible. This is the case even if the Seller is willing to cover the cost. The other issue: the Seller has no leverage here.
So what’s a Seller to do?
As a small Seller, you don’t have to enter into an M&A deal with no protection. There are alternatives if your Buyer isn’t interested in full R&W insurance.
Rep and Warranty Lite
For tech companies, the most sensitive reps are those dealing with technology, of course. If those reps are breached, it could be very expensive as they are critical to the value of the company.
The target tech company could be confident that their IP is not infringing on anybody, but the Buyer no doubt still has a bit of worry.
If the Buyer is not willing to consider full R&W insurance, a Seller could get a limited policy that just covers IP reps. These types of policies do rely on the Buyer’s due diligence. So the Underwriters still have to engage the Buyer to get their diligence on IP. But it’s not the full report, so it’s a relatively easy ask. And the cost is still on the low end, with a premium cost at 2% – 2.5% of policy limit (subject to $100K minimum premium), with 1% transaction value retention.
The same sort of arrangement could be made for tax reps, as well.
Seller’s R&W Insurance
Although the vast, vast majority of R&W insurance is on the buy-side, it is possible for Sellers to get their own policy. This could be handy if the Buyer refuses to disclose any of their due diligence and the Seller is nervous about not having any protection from risk.
To be frank, sell-side policies can be more challenging than those of the Buyer’s side. It essentially protects the Seller in the case of a third-party (which includes the Buyer) bringing action against them for a breach of their reps.
For example, McDonald’s recently bought a small AI company – the technology will be used to speed up the drive-through ordering process. A huge company buying a small one.
Hypothetically, let’s say the AI company had unknowingly breached another company’s IP. That other company will sue McDonald’s and the AI company. McDonald’s is fine – they have their own protection and legal team. But the founders of the AI company need protection because they no longer have insurance after the acquisition. A sell-side R&W policy can be a perfect option.
Directors and Officers Liability Insurance
Owners and founders can also rely on a Directors and Officers liability policy to protect them in case of allegations of misrepresentation, unfair dealing, or fraud. At the very least, the D&O policy can pay lawyer costs to protect the policyholder.
In the vast majority of purchase and sale agreements there is a requirement that the target company have a D&O policy in place. Privately owned companies with a small number of shareholders/owners might think they don’t need this coverage because they don’t have outside shareholders. But this protection is key.
Once the Buyer acquires a company, the board is their responsibility. They don’t want to take a risk on things done before they acquired the company. It’s best to have some other source of recovery like this on their end as well.
A D&O liability policy will run you a tiny fraction of what R&W costs.
D&O Tail Insurance
For those companies that never carried D&O insurance in the past, there’s a solution. Companies can purchase a D&O Tail policy that will provide virtually the same protection as a traditional D&O policy that has a Tail Endorsement.
In the event there is a claim against any of the directors and officers, they will be protected from legal action for up to six years post-closing if there is a D&O “tail” policy.
Even if they didn’t have insurance previously, on the acquisition date the tail kicks in and covers any lawsuits brought against the directors and officers at the target company. This covers any allegations they committed a wrongful act prior to the acquisition, all the way back to the incorporation date.
Step by Step, Down the Line
Let me wrap things up with a quick case study of a company that wanted R&W coverage in place… and a Buyer who wasn’t willing to deal… and what they did next.
A small AI company was bought by one of its clients – one 1,000 times its size, roughly, and worth $20B. The total transaction value was $17M.
The Buyer had no interest in R&W insurance, even when we offered a policy that covered the full $17M.
The Seller was really concerned because the IP reps went from general reps to fundamental reps with a longer survival period. That’s a lot of risk out there for them for years down the road if another company claims IP infringement.
We offered to insure just those IP reps, with a premium from $100K to $300K, which the Seller was ready to pay.
All that was needed to write the policy was the Buyer’s due diligence report. But they didn’t want to disclose any confidential information.
The last alternative we were able to offer the Seller was a D&O Liability Insurance policy. We got the thumbs up and did a $5M limit D&O policy for $50K.
The company was acquired on July 1, 2019. Until July 1, 2025, any lawsuit filed against the company’s board of directors for allegations prior to the acquisition date will be covered.
Of course, R&W insurance would have been preferable for the Seller. But this was the best option and does offer substantial protection.
If you’re interested in exploring your options for protecting yourself post-closing with Representations and Warranty insurance or some other type of coverage, get in touch with me, Patrick Stroth, at pstroth@rubiconins.com.