The landscape of M&A has been dramatically transforming in times of the COVID-19 pandemic.
Apart from the temporary market unpredictability, companies had to get used to the changing due diligence process and increase in litigation. But despite that, the reps and warranty insurance saw an increase in demand.
Let’s take a closer look at the representation and warranties insurance and the role it plays in M&A.
Before talking about R&W insurance, it seems logical to review its background and explain its origin.
Let’s say that you decided to acquire an inbound marketing agency. But a couple of months after closing the sale, you find out that the founders have unresolved litigation, which started before the deal was on the table. And here’s the thing: the founders are the masterminds behind the whole operation.
So now, let’s assume that the dispute causes one of the creators to exit the company. His exit causes a stir among clients, and they reach a decision to take their business elsewhere, which leads to cutting your revenue in half.
It is not uncommon for people to believe that such risks and repercussions must be the seller’s liability. Ultimately, such circumstances occur while the seller is taking care of the company. So what is the role of reps and warrants in this case?
As contractual statements, R&W allows sellers to assert the current state of the company. In other words, R&W works to assure the buyer about the specific business’s quality, characteristics, and risks.
But what if the seller’s statements are false? In this case, the seller will be held liable. It means that he will have to pay damages to the buyer suffering losses due to false or inaccurate statements.
R&W can also come in handy for buyers if they strive to back up their due diligence and protect themselves against unknown risks.
Infographics source: www.osler.com
Reps and Warranty Insurance Explained
What is R&W insurance? Reps and warranty insurance, otherwise known as RWI, is essentially an agreement between buyers (or sellers) and an insurance provider. It guarantees that the provider will compensate the promisee if the breach of warranty insurance takes place.
RWI is an effective tool that can shift the financial risk to the carrier and provide strategic benefits to both sellers and buyers. The policies can also safeguard buyers and sellers from bearing the costs associated with defending against claims. For instance, it can come in handy when an unintentional breach of the seller’s representations and warranties takes place during the M&A.
The acquisition process does not always imply competitive relationships between the parties. In certain circumstances, sellers can agree to bear the costs of the buy-side coverage. If that is the case, the buyer becomes the insured and the party interacting with the provider, but the seller is responsible for the insurance-related costs. So what’s in it for buyers? Typically, the parties look for a win-win approach. For instance, they can agree to reduce the purchase price in return for the covered insurance costs.
The latest trend is the use of R&W in mergers and acquisitions of privately held companies. Recently, the number of M&A deals that use RWI dramatically increased. Back in 2017, only around 29% of private company transaction agreements referred to RWI. In contrast, it went up to 50% by the end of 2019. Since RWI significantly simplifies the process, it is only natural for equity buyers and strategic acquirers to increase its use.
What triggers RWI?
The insurance can be triggered by the breach of R&W.
Here are some examples of breaches:
- Issues with client contracts
- Problems with labor contracts
- Incorrect or misleading information about the secret product formula
- Undisclosed ongoing litigation
- Massive unpaid bills
As previously mentioned, asserting the current state of the company is crucial for both parties. That is the essential step before drafting the acquisition agreement and closing the deal. Naturally, no one is safe from risks. And that is precisely why you need to utilize RWI.
Let’s review the whole process better to understand the RWI’s role in mergers and acquisitions.
The process is typically composed of the following six steps.
#1. Transaction Details
One of the parties (or both parties) expresses the preference to get RWI. If that is the case, the party contacts an insurance broker to address the transaction and policy details.
#2. Conditional Indication of Interest (IOI)
This step implies that your insurance broker will collect and provide comprehensive information on the transaction, including the sale and purchase agreement and financial information on the seller.
After collecting all the information, the broker can contact providers. And they, in turn, submit the conditional IOI.
#3. The Underwriting Process
At this point, the buyer can choose a provider and pay an underwriting fee ranging from $15,000 to $30,000. Afterward, the provider will start the underwriting process. This process implies providing access to accounting or tax reports and legal documents. When the information is processed, the provider arranges a meeting or a follow-up call with the buyer.
At this stage, the carrier provides the draft of the policy that lists all the exclusions. Then, the negotiation process starts. That is a chance for the insured to revise the R&W and remove some exclusions if the provider agrees.
The insured typically need to have the insurance in place before signing or closing the deal. That is why the carriers provide a binder that legislates the duties and obligations of the insurance company.
#6. Policy Issuance
After closing the sale, the provider receives detailed information and all the related payments like premiums. Afterward, the provider can issue the policy. But bear in mind that it might take up to 15 days to issue a policy after the deal is closed.
How Do You Know If R&W Is Right For You?
It is no secret that M&A deals can go sour, particularly when the buyer’s investment value gets reduced due to unexpected events. With R&W insurance, both parties can safeguard themselves from catastrophic losses and consequences.
Let’s be fair: unexpected events occur all the time. The first thing you need to do is evaluate the level of coverage your company requires. The nature of your company, industry-specific risks, transaction details, and risk appetite are the key factors that can help you make a final decision regarding R&W insurance.
Victoria is a Senior Content Writer at American REIA. She helps customers find the right educational material through easily-digestible blog posts and buying guides backing their insurance coverage choice. Victoria covers the latest industry news and various insurance topics, including auto, home, health, and life insurance.