The use of Representations and Warranty insurance in M&A has been growing over the last several years. It jumped 240% from 2001 to 2015. And while in the not-too-distant past only deals of $50 million to $1.5 billion were eligible for coverage, insurers are now covering deals as low as $20 million.
One reason: the clear and powerful benefits of this specialized type of insurance to both Buyers and Sellers. We covered why Buyers should be insisting on this insurance in this article.
Here, we’re going to cover how R&W insurance offers Sellers a smoother transaction, reduces the amount they could lose if there is a breach of a representation or warranty included in the purchase and sale agreement, and, most importantly, allows them to walk away with more cash at closing.
An R&W insurance policy is designed to protect the Buyer and Seller if there is financial loss due to a breach of one of the Seller’s representations in the sale and purchase agreement.
Instead of the Buyer going after the Seller for damages and keeping money held in escrow as part of indemnification, the Buyer simply files a claim with the insurer.
That alone makes it worth using R&W insurance in any M&A deal. But as you’ll find out in a moment, that’s just one reason you, as a Seller, should insist on using this specialized type of insurance.
1. Escrow is Reduced to 1%—or Less—of Purchase Amount
The sale of a company should be a time for celebration. It’s the payoff for the Seller’s years of hard work building a business.
But without R&W coverage, a Seller will have a nagging feeling for years after the sale that they could still lose a significant portion of the purchase price.
If there is a breach of a representation or warranty, even if it’s no fault of the Seller, that money goes to the Buyer to cover reported damages. Often there can be an expensive and lengthy legal fight to sort out just how much will be paid out from that escrow.
R&W insurance eliminates the risk of the Seller losing any money from a breach.
The risk has been transferred to a third party, the insurance company. And because the policy will cover 98% to 99% of the damages from the breach beyond the premium, the Seller also gets significantly more cash at closing.
While the average escrow amount for a $50M deal without R&W coverage is about $5 million (10% of transaction value), if that insurance is in place, the escrow amount drops to $500,000 (1% of transaction value).
In essence, the Seller has walked away with $4.5 million more in cash at closing. And it’s not as if they’re “sacrificing” that remaining escrow money. After the escrow period is over, they get to keep those unused funds.
Indemnification is a big sticking point for many Sellers. Granted, only one in six M&A deals that are insured report a loss. But, however unlikely indemnity is, if there is a chance to eliminate that possibility, that gives the Seller peace of mind.
2. Quick Distribution of Proceeds of the Sale
With significantly less money in escrow thanks to R&W insurance, the Seller will walk away from closing with more cash in hand. Any Seller will be happy with that outcome.
For financial sellers, having that risk of indemnity claw-back eliminated is an extra level of benefit.
Those funds are available that much sooner for early and final distribution of sale proceeds to their limited partners and investors, which creates a ton of goodwill and makes for happy investors. More importantly, though, it accelerates and increases the rate of return their private equity fund can report, which explains why PE is the biggest user of R&W.
Officially, of course, past good performance is not an indicator of future results. But future investors will no doubt be attracted by this successful track record.
3. Locks in the Return and Provides a Clean Exit
In a typical M&A deal, a sword of Damocles hangs over the Seller’s head for years after the transaction. R&W insurance locks in their return and provides a clean exit because contingent liabilities are covered. The risk goes from minor to zero.
In one case we observed, a doctor was selling his company to a healthcare conglomerate. His plan was to move to Israel after the sale.
The Buyer was worried he wouldn’t be reachable in case of a breach, so they insisted on 50% escrow instead of the standard 10%. In straight numbers that’s $25 million of the $50 million sale price held back for three years.
Fortunately, the Seller was able to bring in R&W coverage and negotiate the escrow amount to $1 million (matching the R&W policy retention). He walked away with $49 million at closing. The price of the insurance that made it possible? Just over $500,000.
4. Quicker and Easier Negotiation
In a standard M&A deal, negotiations for the purchase and sale agreement can be lengthy—and possibly even contentious. As each term and definition is debated between attorneys for Buyer and Seller, the contract can go back and forth twenty times or more. That’s a lot of billable hours.
It’s a totally different ballgame when R&W insurance is in play. Each representation insured by Underwriters is one less to be negotiated. The two sides won’t argue over every little definition; if something goes wrong, both Buyer and Seller are protected.
That means a quicker and smoother negotiation process. It can save weeks when you don’t get bogged down in minor points.
That’s key, because the biggest deal killer in M&A is time. Whatever time can be saved will make it more likely you’ll get to closing—and sooner rather than later.
5. Increases Likelihood Deal Will Close
The last thing a Seller wants after putting their business up for sale and negotiating with a potential Buyer is for the deal to fall through, requiring them to go back to the market.
Former interested parties will smell blood in the water and will likely submit discounted offers.
Having R&W insurance in place early in the negotiation process drastically decreases the chance of that happening. Industry watchers maintain that an insured deal is eight times more likely to close successfully.
A Win-Win Situation
In business, traditional thinking has it that there are winners and losers in every deal. While that’s true of most interactions, with R&W insurance, both sides can win. And as you’ve seen, the benefits to a Seller are wide-ranging.
That’s why, as the Seller, it makes sense for you to pay for the R&W policy, even if it’s a Buyer’s-side policy.
The protection and peace of mind, as well as the cash you walk away with, is well worth the investment. Depending on the negotiation, the return is eight to ten times what you would get in an uninsured deal. If you, as the Seller, pay $300,000 in costs, you can expect an extra $4.5 million or more in cash at closing (a 15x return).
To get more information about the benefits of Rep and Warranty insurance, contact Patrick Stroth at 650-931-2321 or pstroth@rubiconins.com.