When selling your business, you make a set of promises to the buyer. You “represent and warrant” certain facts about the business. Essentially, you’re certifying that you provided accurate information and that there are no known issues pending (e.g., financial, legal, tax, compliance, etc.).
If it turns out those promises are false, the buyer has the right to recoup a percentage of the purchase price. Non-fundamental reps and warranties (typically all items aside from key ownership, legal, and tax items) typically allow the buyer to recoup up to 10-50% (a “cap”) of the transaction if there is a material breach.
At current trends, businesses over $20-$25 million often require an escrow to help fund any breaches in reps & warranties. Smaller transactions, however, will often offset against a seller note or earnout.
On a $20-25 million deal, escrow amounts can commonly be 10-20% of the purchase price, held for a period of 18 – 24 months. On a $30 million deal, for example, the seller might have to delay receiving $3-$6 million of the purchase price until the reps and warranty period has expired.
Representation and warranty insurance offers an alternative to seller escrow. This insurance product is designed to isolate risk and the resulting claims between buyer and seller in the event of a non-fundamental breach in reps and warranties. (Note: Reps and warranty insurance will not cover fraud and intentional misrepresentation.)
Pros and cons of reps and warranty insurance
For the seller, the advantage of reps and warranty insurance is that they can realize the full value of their purchase price, without holding money in escrow. For many sellers, the holding cost of that money is enough to justify the cost. It also reduces seller risk, for inadvertent, unknown mistakes.
For the buyer, reps and warranty insurance offers a way to collect a claim without jeopardizing their relationship with the seller. Consider a buyer who wants to do multiple deals in the industry. They want the seller to provide a positive referral in the future, encouraging other sellers to work with them.
Similarly, consider a buyer who has retained the seller in a leadership position. They don’t really want to make an expensive claim against their new CEO or sales director. Having reps and warranty insurance protects any ongoing buyer/seller relationship.
Reps and warranty insurance can also expedite the sale process and drive down your legal fees. When sellers know they’re indemnified against certain risks, they don’t have to lobby as hard to protect themselves. To put it simply, negotiations are easier with insurance in place. Conversely, this insurance product requires third-party due diligence which can slow the overall process.
What does it cost and who pays?
Reps and warranty insurance can be purchased by the buyer or seller. Minimum fees are typically $250,000, which makes this product cost prohibitive on smaller transactions. In a competitive market, some buyers will offer to pay or split the cost of reps and warranty insurance with the seller as a way to sweeten their offer.
Sellers need to have adequate representation looking out for their interests. Watch out for exclusions that are overly broad (e.g., an ‘impact of covid’ exclusion) or non-standard for the market.
Be aware that the policy will have a retention figure (like a deductible) – often around 1% of enterprise value. Who covers that retention is another point that needs to be negotiated in your deal terms. Again, we might see a 50/50 split here. So on a $30 million deal, the seller may have to escrow 0.5% or $150,000 (far less than the $3-$6 million escrow estimated above.)
Considerations and alternatives
Reps and warranty insurance is a newer product on lower middle market deals in Canada and the US. Since it’s a relatively young offering, it’s harder for buyers to vet insurance brokers as the track record for payout is not well established. (In other words, the buyer may have a policy, but can they actually collect on it? And what legal fees will they incur in order to collect?)
In cases where buyers are looking for a mechanism to collect without the overhead cost, other options may be more appropriate. For example, if the deal terms include a sellers note, the buyer may prefer to offset a sellers note proportionally to any breach.
Again, sellers should consider that reps and warranty insurance reduces their risk. They would be prudent to factor this in when evaluating buyers and perhaps give preference to buyers who accept a lower cap (the max amount they can come back for in the event of a breach) or who are willing to cover all or a portion of reps and warranty costs.
Jim Friesen, MBA, CPA, CMAA | Founder