By now you probably know that reps and warranties can be a powerful tool for facilitating a deal. Whether you’re considering using reps and warranties insurance for the first time, or you’re a seasoned RWI pro, there can still be uncertainty over who should broach the topic of reps and warranties first and at what stage of the deal.
Of course there is no single right answer. There are a variety of factors to take into consideration. In this post, I will outline the pros and cons of being the reps and warranties “first mover” from both the seller and buyer perspective.
Lets Say You’re the Seller
If you’re the seller, whether it’s an auction or an early stage negotiation, your goal is to maximize the amount of money you make and minimize the amount you have to leave behind in an escrow. You’ll also want to limit the cap on your overall indemnity.
Reps and warranties will help you achieve these goals, but should you bring the topic up first?
Upside for the Seller
It establishes your expectations
You can make it known early on that you want to use reps and warranties insurance, and set expectations around structure and the amount you are willing to pay. You could for example request a zero seller indemnity structure (an option where no escrow is put up at all) and are willing to pay for up to $10m of cover. You can also outline who you expect the insured to be. “We are willing to pay for” implies the buyer is the insured and again sets the expectation.
It shows you’ve done your homework
Being able to say “we expect this to cost in the region of $XX” shows the buyer that you know how this process works and what it should cost. This makes it harder for the buyer to come back later and try to force you back to the escrow position due to a high priced policy or difficulty getting coverage.
Downside for the Seller:
Does it scare off potential suitors?
Perhaps reps and warranties insurance is your preference, but for the right price you’d take an escrow. Discussing reps and warranties early might scare off potential suitors who only want to deal with an escrow. Asking your suitors to price both options can minimize this risk and keep the conversation open.
Can it tip your hand?
On average in the US, reps and warranties insurance is used to insure between 10-12% of a transaction. If you state a potential limit, it wouldn’t be hard for an experienced practitioner to work out what kind of bid price you are expecting. The best way to mitigate this risk is to stick purely to percentages. For example, we expect a 0% escrow and for you to take a retention equal to or greater than 1.5% of the overall transaction size. We would be looking to insure 12% of the transaction size at a price of around 2.3 – 3.5% of the limit of indemnity.
Let’s Say You’re the Buyer
Now let’s turn to the buyer. Obviously, your goals are the exact opposite of the seller’s goals at this point. You want to pay as little as possible and get as large of a physical escrow and as large of an indemnity cap as you can. Reps and warranties insurance could potentially hinder your goal, so why bring it up?
Upside for Buyer:
There was a time when the bidder who proposed reps insurance won the day. Today, it is rapidly becoming table stakes, even for the strategic buyer. Offering reps and warranties from the very beginning makes sure you don’t knock yourself out of the race before it’s even started.
Being the first to propose reps and warranties shows flexibility to the seller. It sends the message you are willing to find mutually beneficial solutions.
Sets expectation that you want them to pay
Just as either the buyer or seller can be the insured, so can either the buyer or seller pay, regardless of who the insured is. If you are looking to be flexible but don’t expect to pay for the privilege, now might be a good time to bring it up.
Downside for the Seller
Reduce chances of getting an escrow
You may favor a cash escrow in a particular deal for a variety of reasons. If you bring up the insurance you may decrease the seller’s willingness to give you a cash escrow. However, you can always mention the insurance as one of several options to at least keep the potential for a cash escrow on the table.
Does suggesting a limit hint at a price?
This is similar to the seller’s dilemma. Again, the answer is to stick to percentages and not actual numbers.
So what does this all mean?
Reps and warranties insurance is usually one of many moving parts in any deal negotiation. Who, when and how it’s discussed can add value to your position. Having said that, the only real mistake you can make is in not knowing what it is, how it works and whether or not you need it in the first place.