Often times, in the late stages of an acquisition, or even after the acquisition of a company is complete, an issue presents itself that may pose a significant financial risk to the acquiring company. Reps and warranties insurance can act to protect both the buyer and seller in such a situation, but what exactly are reps and warranties, and what information should they include? How is reps and warranties insurance used, and where can you obtain it? To answer those and a host of other questions, Jeff Allen visits Mr. Kirk Sanderson, vice president at Equity Risk Partners in New York, who oversees the firm’s transactional risk practice.
I think the most common representations that have issues post-closing, or breached post-closing, if you would, are related to financial statements.
- Kirk Sanderson
The insurance companies obviously want to make sure that they are not taking the first dollars of losses, and that both buyers and sellers are appropriately negotiating the purchase agreement and the language there, as well as the disclosure schedules provided by sellers.
Jeff: Representations and warranties, what are these exactly?
Kirk: Representations and warranties are statements made by the seller and purchase agreements, for the most part, providing the buyers with a view into the operations as well as the ownership and title of the company they're selling.
Jeff: OK, very good. It seems to me that these would be the types of things that would be pretty much, I guess, you might say, items that are in plain view. But as I understand it, that sometimes there can be a breach of these representations and warranties, really not necessarily through any abject fault of the seller, but in fact these types of things can present themselves during the M&A process, is that correct?
Kirk: That's correct. Sellers are trying to divest of their assets. They're obviously making these factual statements to buyers with as much information as they have at the time. Those facts and circumstances may change post-closing to the extent that previous to closing would make the facts they made as of closing incorrect unbeknownst to them. And the buyers clearly would want to see recourse for any statements that end up being incorrect post-closing, and therefore any loss that they may occur under such incorrect statements being made.
In the event that you as a seller are unable to convince a buyer to take an insurance policy, there is a sell-side policy that exists that covers you as a seller and the indemnification that you are now having to provide to the buyer and as well as the escrow that the buyer will more than likely expect you to post.
Jeff: OK. Can you give us an example, maybe by chance, Kirk, of something that would be considered a representation or a warranty kind of statement, anything that might present itself, maybe something that you've seen in real life that the buy-side had to make sure that they were protected against, and maybe they weren't?
Kirk: Sure. I think the most common representations that have issues post-closing or breached post-closing, if you would, are related to financial statements. Obviously the individual selling the company has a good handle and a good grasp on inventory levels and things of that nature. But if it turns out to be the case that any of the numbers within the financial statements are incorrect, to some degree that would be breach of those reps, the financial statements reps. And as you can imagine, that could have a material impact on the buyers and their ability to receive returns and valuation based upon the assets that they're purchasing.
Jeff: OK. The breaches, I guess we're talking, really occur post-closing then. Is that right in every single case?
Kirk: For all intents and purposes, yes.
The ability for a seller to walk away cleanly without lingering liabilities and indemnification, as well as the escrow, which is idle funds sitting around with a potential clawback risk associated after closing, the seller should really be considering this.
Jeff: OK. Very, very good. Typically, who is on the hook in terms of dollars and cents for all of this stuff? Can the seller be sued for failing to disclose these things?
Kirk: Only if there was fraud, in the event of fraud, or willful misconduct. So again, the representations and warranties that are made are within the purchase agreement, which is the seller providing to the buyers as much information as they possibly can about the company. All that information may not always end up being true, in which case there's a breach of the representations and warranties. Under the purchase agreement, there's indemnification, which handles how any of those breaches would be settled should the seller knowingly or unknowingly breach any of those representations and warranties. That indemnification is what provides the buyers with the ability to seek recourse from the sellers should that be the case.
Jeff: OK. Let's say, for example, I think it was, I think kind of interest on both parts to kind of protect themselves against any legal recourse and certainly financial issues that might arise as a result of all of this. There is, it seems, there's insurance for everything, right? And there is insurance for representations and warranties, just quite simply representations and warranties insurance. So let's talk a little bit about that. How does it work exactly and how much money can it save potentially either side?
Kirk: It's not necessarily about saving money but ultimately it does increase the returns a seller would otherwise be looking at under a standard purchase agreement. So the answer to that question goes and dovetails into the last comment that was made as it relates to the indemnification provided to buyers within a standard purchase agreement, which is meant to back the reps and warranties made by that seller. In which case the indemnification is often also backed by escrow or a seller holdback, in which case for any given $50 million transaction roughly 10% of that may be put aside in escrow at closing for a period of 12-18 months where by the sellers would not have access to that $5 million, in this case, 10% of 50 million. And that escrow would sit aside for 12-18 months to support any claims post-closing where a loss was experienced by the buyer. So technically there is this "clawback risk" that the sellers are now facing for 12-18 months. And it's that clawback risk, that $5 million escrow and/or indemnity cap that the insurance effectively seeks to replace. So if you can replace this $5 million of escrow you can eliminate the need for the escrow, and therefore the sellers will effectively close with $50 million roughly in proceeds minus the cost of insurance, versus 45 at closing.
Jeff: OK. Really it protects both sides. And when you say 12-18 months escrow for holdback, that's really something ... you can kind of equate that essentially to a term, which I think would probably make sense to most people who have insurance and that it protects both sides for that 12-18 month period. Can that be extended in case of any unforeseen circumstances by either side?
Kirk: Yeah. It's not by either side first. The policy is meant to cover the seller’s representations and warranties, not the buyers.
Jeff: I got it. OK.
Kirk: But the buyer holds the policy. In most cases the buyer will hold the insurance policy. And so what the seller has effectively done is transferred this clawback risk for post-closing indemnification from the buyer instead of providing them that indemnification under the purchase agreement. The seller will give them a policy and the buyer will hold the policy. And of course they pay a premium for that policy, but at least the seller is now off the hook for much of that indemnification.
Jeff: How much is that premium typically? Is that a percentage?
Kirk: Yeah. It's anywhere from 3%-4% of the total limits sought. So if we are speaking in regards to a $50 million transaction with a 10% escrow or holdback that you are seeking to replace with a policy, you're talking about a $5 million policy at roughly 3%-4% or $150,000 to $200,000.
Jeff: At what point in the M&A process do we take out that policy?
Kirk: These days it’s being done very early on in the process, especially whereby a financial sponsor is selling the company, and within an auction scenario the sellers will actually line up the reps and warranties insurance policy with the potential insures, and provide an overview of what that policy will look like to the buyers with the expectation in writing or in the offering memo to the potential bidders that the expectation would be that the eventual successful buyer would purchase a reps and warranties insurance policy to replace the seller’s traditional indemnification. So as early as possible.
Jeff: You're listening to “Deal Talk,” my name is Jeff Allen. We're talking about reps and warranties insurance today with Mr. Kirk Sanderson. He's vice president at Equity Risk Partners in New York. He oversees the transactional risk practice at the organization, and we do appreciate him for being here. This is really something that if you don't have any prior experience selling a business or certainly you don't have any experience selling your business, yet this is some information that you could find really useful, and if you're a buyer as well. This is some information that you'll find useful as well particularly if this is a first time process for you getting involved in any kind of a deal or transaction that would require the purchase of a business. And the requirement also to having that reps and warranties insurance could in fact offer you some protection where indemnification is concerned and really what could be significant financial loss when really there were certain things that may have been disclosed to you and then all of a sudden it seems like the wheels come off at the wrong time in the process of transitioning that business from one owner to another. We've got more to talk about reps and warranties with Kirk Sanderson. We're going to take a quick break and then when we come back we're going to talk about the different kinds of reps and warranties insurance policies that exist, why you need to know the difference of those. And that's all when “Deal Talk” returns after this.
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We're also interested to know your thoughts about “Deal Talk,” what you like, and your suggestions for how we can make this show even better for you. So send us an email to email@example.com. That's firstname.lastname@example.org. Jeff Allen with you, and also with you our guest Mr. Kirk Sanderson, vice president at Equity Risk Partners in New York. We're talking about representations and warranties. And, Kirk, what I'd like to ask you, representations and warranties, is this something that is necessary to have in any M&A transactions? And if so, which party, which side usually requests to have this policy taken out?
Kirk: Yeah, so representations and warranties are made in practically all M&A transactions. But again, the indemnification is there under the purchase agreement as well to cover the seller's representations that are being made. In most cases, the buyer will take the insurance policy to cover the seller's representations that are being made, thereby allowing the seller to exit more cleanly with more proceeds at closing by transferring the risk associated with their representations they've made to the buyers, transferring that to a third party, the insurance companies.
Jeff: Very good. Really this is done, it's mutually agreed upon, and it's really agreed upon by both sides for very important reasons. And there are also additional ... apparently there is more than one type of policy. We're going to talk about that in a minute, by the way, here, Kirk. But I'd like to first of all talk about maybe some additional reasons or strategic considerations on the sell-side for representations and warranty insurance. And I was wondering if you might be able to kind of enlighten us to that. For example, why would there be a special consideration for a company that may have minority investors involved?
Kirk: Yeah, oftentimes a minority investor may not be part of the day-to-day operations and therefore part of what's called joint several liability under a purchase agreement, which ultimately means that the representations that are being made by the "company" under the purchase agreement regarding the operations. And those are the minority interest would be on the hook for making those representations. And if those representations end up being incorrect and there's a loss experienced by the buyer, ultimately this clawback risk we discussed earlier, the minority interests would have this clawback risk associated with representations that they themselves do not have direct line of sight into the accuracy of or not. In which case the minority investor themselves could actually purchase a policy to cover their portion of what would ultimately be that clawback risk, and ultimately be the payment of any future losses post-closing.
Jeff: What about those companies that have distressed assets that are part of a deal, does this also help them as well?
Kirk: Distressed assets are a little bit more difficult to cover, but certainly in instances where individuals are trying to divest distressed assets there are ways to "ring fence” or “box in" certain liabilities that are through the course of an M&A transaction or at least driving heightened concern with potential buyers to make sure that those deal items, specifically those liabilities, are taken off the table, and allowing a seller to gain more interest from a subset of buyers and/or ultimately increase potential valuation of those assets knowing the exact quantum of valuation applied to any such liabilities.
Jeff: OK. Like most insurance policies, different types of insurances, there are different types, I guess you could say, of representations and warranties insurance policies out there, and it's important to select the right one. There is no such thing I would assume, Kirk Sanderson, of an off-the-shelf type of policy that you could just simply go slap your names on it both sell-side, buy-side you agree to it, but these things have to be negotiated pretty tightly, isn't that correct?
Kirk: That's exactly correct. Most of the terms and conditions under the standard reps and warranties insurance policy will attempt to track and mirror the purchase agreement as much as possible. The policies are meant to cover all the reps from start to finish under a purchase agreement, or all of the sellers reps, anyways, pre-underwriting, I should mention. The result of full underwriting by the insurers, which is a process that takes about 7-10 days, may come out with additional exclusions, i.e. certain reps or a sentence or two within a particular rep that would otherwise be excluded from the insurance policy for reasons such as known issues or highlighted exposures provided in certain buyer’s diligence reports.
That's exactly correct. Most of the terms and conditions under the standard reps and warranties insurance policy will attempt to track and mirror the purchase agreement as much as possible.
Jeff: What about things like deductibles, as we're all used to paying on our, whether that be homeowner's insurance policy, automotive, whatever the case may be. Are there also deductibles that apply in this particular case?
Kirk: Yeah, absolutely. The insurance companies obviously want to make sure that they are not taking the first dollars of losses, and that both buyers and sellers are appropriately negotiating the purchase agreement and the language there as well as the disclosure schedules provided by sellers, which are basically exceptions to all of the representations that the sellers are making. And in order to do that, they want to make sure that both buyers and sellers have a little bit of what they call “skin in the game” in order to make sure that those negotiations are being appropriately handled. And so the retention that, generally speaking, most insurers are looking for is anywhere from 1%-2%. The retention is what you are referring to as a deductible. The insurers in this space call it a retention. The reason for the definition as a retention is, generally speaking, this retention, this 1%-2% of enterprise value, is going to be shared between both the buyer and the seller through what most individuals would recognize as a buyer basket, which is that the buyer is generally on the hook for the first dollar of losses under the purchase agreement itself before they can go against the seller for recourse for any breaches.
And then the seller next has what's called an indemnity cap in most cases, or an escrow indemnity whereby they then agree to pay out up to a certain amount, the cap of losses. And so ultimately what you do is you back in and now you are able to match the basket plus the indemnity cap to equal the retention under the insurance policy, therefore having back-to-back coverage of losses. First loss is to the buyer under the basket. The second loss is to the seller under the indemnity cap. And then once that escrow indemnity cap has been exhausted, then the insurance policy will kick in.
Jeff: Now, I just want to make sure that I let our listeners understand that there is information about this available online. So if you were taking notes, for some strange reason you may have derailed... the train came off the rails, there's a lot to remember. Obviously there's some details here that you can probably learn about, there's information on the website there at Kirk Sanderson's company, and we'll tell you how you can get that information at Equity Risk Partners. There is a very, very good publication there that you can take a look at. And we'll tell you more about that coming up in just a few minutes. I'm assuming that really depending on where you go, your market size, that reps and warranties insurance could cost different amounts at different places, really, depending on your business and the industry and what areas you're located in, is that correct?
Kirk: The pricing is fairly flat. It really comes down to the size of transaction and some of the other mechanics. But pricing very rarely is outside of the parameters of 3%-4%, very rarely higher than 4%. If you're looking at a billion dollar transaction, which most people wouldn't be through the normal course, you can certainly get rates down to closer to 2%, but otherwise pricing is quite flat and fairly predictable.
Jeff: OK. Talk to us a little bit if you can, Kirk, now because so many of our listening audience are business owners who themselves are considering selling their business at some point in the future. It could be 3, 5, 10, 15 years from now, whatever the case may be. Tell us a little bit about these seller policies that are available, and the coverage in terms. If you can kind of lay it out there, we just really need kind of a summary. But if you can tell us a little bit about how these are used and why the seller needs to look into these specifically when they're considering reps and warranties insurance for those occasions when the M&A deal is imminent.
Kirk: Sure, absolutely. As I mentioned before, the most prevalent policy is the buy-side policy, which the buyer is the insured and therefore any claims that they can make against the policy they go directly to the insurance company versus going toward the seller. If you're a seller, obviously you want to do your best in order to convince the buyer to take a policy, which it allows you to walk away cleanly with 99.5% of your proceeds, if not more, at closing, as well as eliminating that tail risk. In the event that you as a seller are unable to convince a buyer to take an insurance policy, there is a sell-side policy that exists that covers you as a seller and the indemnification that you are now having to provide to the buyer and as well as the escrow that the buyer will more than likely expect you to post. The insurance policy will cover you as the named insurer, you being the seller and the company, where a buyer will make a claim against the seller. The seller will either pay that claim directly or will turn around and hand that claim directly to the insurance company. And the insurance company will either reimburse or pay the buyer directly for covered losses under the insurance policy.
If you're a seller, obviously you want to do your best in order to convince the buyer to take a policy, which it allows you to walk away cleanly with 99.5% of your proceeds, if not more, at closing, as well as eliminating that tail risk.
Jeff: And where exactly can the business owner or the representative for the business owner find out more about these policies? Are these pretty much readily available through most business insurance companies, or are there certain intermediaries or representatives that one has to contact in order to get more information about reps and warranties policies?
Kirk: Yeah, and maybe that was a good place for us to start. I am an insurance broker, representations and warranties insurance broker, it's all I do 100%. There are roughly four other brokers out there that have the expertise to the extent that myself and my firm does. So it's a very small universe of individuals, but certainly that is our job, is to be a broker, to be an advisor, to consult both buyers and sellers. And that's half of the work we do, is spending the day on the phone with individuals to help get them up to speed, and explain to them and their outside counsel, as well as their bankers, "How does this work? What does it look like? What are the economic benefits and what is the process generally?" Obviously the process here is highly intensive. However, again, the value that is derived by replacing and eliminating certain escrow and liability is significant, so well worth the 3%-4% that individuals are paying in today's market.
Jeff: Kirk Sanderson, this has been a great conversation, and we have just very small portion of time here left in the program. If people walk away from this conversation about reps and warranties insurance with nothing else other than just one key piece of advice, what would that one takeaway or piece of advice be?
Kirk: In today’s market, a reps and warranties insurance policy is not a surprise to most buyers. So the ability for a seller to walk away cleanly without lingering liabilities and indemnification, as well as the escrow, which is idle funds sitting around with a potential clawback risk associated after closing, the seller should really be considering this. And it's worth the 15-20 minute phone conversation to call an experienced reps and warranties insurance broker to have the discussion.
Jeff: By the way, we talked just a little bit, Kirk, about that piece of information that people can find online on your company's website. And I'm referring to a PDF that I actually have used and referred to a little bit. It's Lexis Practice Adviser publication from Kirk Sanderson at Equity Risk Partners all about representations and warranties insurance. Where can they find that publication for more information about what we've been talking about today?
Kirk: Absolutely. Our website is equityrisk.com. Within there you will find a transaction risk tab. And under the transaction risk tab, you will also find our knowledge center tab. And then that holds all the information you could ever want on reps and warranties insurance and more.
Jeff: And if there's someone who might want to get in touch with you personally to talk about their own particular situation, and maybe they've got a question or two that they'd rather just speak to a human being about, how can reach you?
Kirk: Absolutely. I would absolutely welcome that. My cellphone number can be reached any time, day or night, 843-424-1057.
Jeff: Kirk Sanderson, this has been a great conversation to have, an important one about an important subject that we often don't talk very much about here on “Deal Talk,” but it's something I think that's critical and something we needed to know, and I want to thank you so much for joining us here today on the program.
Kirk: Great. Thank you very much. I appreciate the opportunity you've given me here.
Jeff: Kirk Sanderson, vice president overseeing the transactional risk practice at Equity Risk Partners in New York, has been our guest, and I hope that you enjoyed it. Tell a friend about “Deal Talk,” won't you? In addition to morganandwestfield.com, you can find us on iTunes, Stitcher and Libsyn. “Deal Talk” has been brought to you by Morgan & Westfield, the nationwide leader in business sales and appraisals. Learn more at morganandwestfield.com. My name is Jeff Allen, thanks so much for listening. We'll talk to you again soon.
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