M&A Escrows: Minimizing Your Exposure

No seller of a private company in an M&A transaction ever said, “Please create a hold-back escrow in case I breach my reps and warranties. And if you could, make that escrow as big as possible.”

And yet, when private companies are acquired, we see ever more serious representations being asked of the sellers, and ever-bigger escrows (hold-backs of sale proceeds placed in trust) to support these representations.

However, there’s good news for private companies that may be selling themselves one day: an insurance tool that can benefit both buyers and sellers and minimize a lengthy or costly escrow. This tool is called “representations and warranties” insurance. It’s a type of “transaction facilitation” insurance product.

As you may know, when a company sells itself, it makes representations and warranties about itself.  For example, a company will commonly represent that its financial statements are accurate.

Of course buyers want to be sure that the seller’s representations are accurate. And,  in addition to buyers conducting a diligent review of the seller, buyers commonly require that some percentage of the sale proceeds be held in escrow for a specified period of time, which could be a year or more.

The idea is that if a representation turns out to be inaccurate in a way that harms the buyer, the buyer has segregated funds at the ready to remedy this loss.

With M&A in the private sector, the buyer almost always wants a substantial escrow, while the seller doesn’t want any escrow at all. After all, money held in escrow is money that the seller may never get.

The beauty of reps and warranties insurance is that it provides the same type of protection that a large and lengthy escrow offers. This type of insurance greatly minimizes the amount of funds a buyer needs to hold in escrow in order to be comfortable with the transaction. There can also be benefits for the buyer, too (more on that in a bit).

Reps and Warranties Insurance Gaining Ground

Reps and warranties insurance has been gaining ground in recent years for several reasons, three of which are:

1. Buyers are less constrained from requesting large escrows after FASB eliminated pooling of interests in 2001. Companies that wanted to pool for accounting purposes were limited to relatively small escrows. The elimination of pooling eliminated this "collar" on the size of escrow that buyers would normally request.
2. It’s been successfully leveraged as a negotiation tool in the close of sale, both by motivated buyers and eager sellers, thus creating more excitement over this type of insurance as a viable option.
3. The price for this type of insurance has come down over the years; in the current marketplace, the cost is about 1 to 3 percent of the  Insurance limit to be put in place.

Reps and Warranties Insurance as a Negotiation Tool

If early on in the deal you know that escrow is going to be an issue, reps and warranties insurance is a great option, regardless of whether you are the buyer or seller. Consider the following scenarios:

• You, the seller, are being asked to agree to place 20 percent of the total sale in escrow for a period of two years.  This seems like a lot to leave a risk.  However, rather than walk away from the deal, you work with your broker to place a reps and warranties policy that results in bringing your own possible loss down to 10 percent of the sale proceeds.
• You, the buyer, are facing a competitive sale, and are extremely motivated to close swiftly. Your competition is asking for a long and costly escrow, but you’ve told the seller you’re willing to take half the escrow the competitor is demanding, and leverage reps and warranties insurance for the other half.

How to Place Reps and Warranties Insurance

A common misconception is that directors and officers insurance covers reps and warranties. This is due to the belief that since the Ds and Os are involved in creating the warranties, the insurance would step in.

However, this is not the case. Emily Chapple, head of the mergers and acquisitions practice group here at Woodruff Sawyer explains:

“The logic goes that the directors and officers are making the warranties, and so D&O insurance should step in. However, a representations and warranties claim is based on contractual breaches of warranty, and the concomitant diminution of value that results. It is not a claim against the directors for their actions as directors, but a claim against warrantors for warranties made. The causes and remedies are different, and so a separate policy is required.”

That said, timing is of the essence with reps and warranties insurance. Once it becomes obvious escrow may be an issue during M&A, that’s the time to talk with an insurance broker to find out if insurance is a viable option.

Consider the following when looking to pursue reps and warranties insurance:

• Work with a broker with expertise in this type of insurance. This is a very specialized market. You need the right combination of expertise to craft the language, and market access and relationships to place it.
• Make sure the broker works side-by-side with you. Whether seller or buyer, once you have a reasonable draft of the purchase agreement, give it to your broker who will use it to work with insurance carriers and negotiate the coverage. This type of insurance is always customized.
• Don’t forget about the extras. If you’re the buyer, you can also insure against fraudulent claims made by the seller.

Here’s what the insurance company is looking for when placing reps and warranties coverage:

• Sellers: As a seller looking for coverage, the underwriter will examine how reasonable the warranties are that are being made, and what efforts you went to in order to assess the accuracy of those statements.
• Buyers: If you’re the buyer looking for this type of insurance, the underwriter is looking at how thorough your due diligence has been to verify claims made by the seller.

Here at Woodruff Sawyer, we’re seeing more and more of this type of insurance used in M&A transactions. If you’re on the board of a company that may sell or buy another one day, keep this idea in your back pocket as a way to break a negotiation logjam or potentially sweeten a deal.

The views expressed in this blog are solely those of the author. This blog should not be taken as insurance or legal advice for your particular situation. Questions? Comments? Concerns? Email: phuskins@woodruffsawyer.com.