Rep and Warrants insurance.  What is it, how does it work and why should we care?

Rep and Warrants insurance. What is it, how does it work and why should we care?

By Terry Fick

September 09, 2014

Purchase AgreementWe all know that the most difficult part of the negotiations of a Purchase Agreement are the Reps and Warrants and Indemnification sections.  An R&W insurance policy basically takes a seller off the hook for the typical indemnifications they accept when they sell their company. It can be a great tool when you have that seller that thinks he has (and will accept) no responsibility for damage claims from the buyer for sins that occurred prior to the sale.

Occasionally, when a seller digs his heels in on these issues, the buyer will buy the insurance.  Dan Vermeire just completed a $15 Million sell side transaction and he and the attorney got the buyer to buy such a policy. The seller is not responsible for anything that may come up except for fraud, and obviously, there is no escrow. The attorney that Dan brought in convinced the buyer there would be no deal if there were even market indemnifications, so they bought and paid for the policy.

Keep in mind that it is expensive and is not as simple as calling your P&C broker and asking for a quote. Multiple sources tell us that the cost is usually 1% of the amount of the policy (Usually the cap the seller wants on the indemnifications), with a minimum premium of about $150,000.  Obviously, this means that on most of our deals, the minimum will apply. In addition to that, there is a due diligence fee of $20-$40,000, paid before the insurance company agrees to underwrite the policy.

The hassle factor comes into play because the insurance company will perform yet one more level of due diligence prior to issuing the policy. They want to assess the risks of claims so an independent law firm and others will be brought in to scrutinize the verbiage of the R&W, the risks inherent to this company and historical litigation factors.  That is what the $20-$40,000 pays for. This gets yet one more nose under the tent and can take several weeks.

While we all know that buyers rarely actually make R&W/indemnifications claims, the risk is still there for the seller. Many sellers are selling to diversify their risks, so it is logical that putting up a $2 Million escrow and assuming those risks is not very appealing. Paying almost $200,000 to cover that risk for a couple of years doesn’t seem logical…until it is your $2,000,000. It makes the most sense with the very risk adverse seller, the seller that includes shareholders that are not involved in the business, or the seller with institutional shareholders that will not accept the indemnifications.

When is it right to introduce your sell side client to the concept? Maybe never.  We always discuss the concept of R&W and indemnification with sellers on the say they engage us. That is a very good time to gauge his appetite for the risk.  If nothing else, you can remind him of this discussion later when he and his attorney push back on the documents outlining the indemnifications. If you sense a real aversion to this type of risk you briefly might tell him he can buy an insurance policy and avoid all of that risk and that he can make that decision later in the process. What you don’t want to do is wait too late so that this due diligence process is added on to an already long closing cycle.  If that seller really balks at the initial Purchase Agreement, that is the time to see if this makes sense.

The first step is to tell the buyer that you are very concerned that his R&W and Indemnification sections will at least cause long expensive negotiations and have put the deal at risk. Then suggest the buyer buy a policy. Only if he won’t consider it do you take the idea to your client.

Hopefully, you won’t need it on many deals, but make sure you have every tool available to get to the finish line.  I suggest you talk to a carrier or broker in your area to get a sense of how you can work together on those deals.

Posted by Terry Fick.

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