The question of “Who pays for what?” is pretty important when it comes to any aspect of an M&A transaction. This is a question I get asked a lot with regards to the use of Reps and Warranties Insurance. Unsurprisingly, underwriters aren’t concerned where the money comes from as long as they get paid their premium. What this means is that regardless of who the insured is, the premium can be paid by the buyer or seller. The retention and deductible are also up for grabs depending on the structure of the sale or merger agreement.
In this post, we’ll go over the primary costs involved in a Reps and Warranties transaction, different sale structures, and who is responsible for payment.
Who Pays The Premium
This question is often followed up with, “Well, what’s normal?” There is no hard-and-fast rule and I have seen all permutations. I would say that generally, the seller pays more often than the buyer, but above and beyond that trend, the party with the strongest desire to get the deal done quickly is most often the one who pays.
Who Pays Deductibles/Retentions
Deductibles and retentions on a reps and warranties policy work in the same way as a deductible and retention on most insurance policies. In essence, it is the amount of pain that someone must feel before the insurance kicks in.
The big question, however, is who feels that pain? Unlike a traditional insurance policy, there are a number of ways to structure a deal, and a reps and warranties insurance policy can result in different parties being responsible for the initial loss. Here are three payer scenarios:
In this scenario, the physical escrow in the Sale and Purchase Agreement (SPA) is equal to the deductible on either a sell-side or buy-side policy and in the SPA the escrow is depleted first before any claim is made against the insurance. Therefore, the seller ends up paying the deductible regardless of whether they or the buyer are the insured.
In this scenario, the SPA allows for no physical escrow and the insurance is a “zero seller indemnity” structure. This is only available on a buy-side policy. In this case, the deductible is the amount of loss that the buyer must suffer before the insurance kicks in. So in essence, the buyer pays for the deductible.
When the seller is only willing to put up a limited escrow, we can see a situation where both parties take some of the pain. Let’s say we have a $100 million deal. We have a $1 million deductible but a seller who is only willing to put up a $500,000 cash escrow. In the agreement, the SPA states that the escrow is the first port of call, but after that, the buyer must suffer a further $500,000 of loss before the insurance kicks in. In this version, both parties are suffering some of the loss.
Whatever the structure of the deal, one of the things that makes reps and warranties such a useful solution is its inherent flexibility and the way it can wrap around an agreement to fill in the gaps.