As part of any M&A transaction, the buyer will expect sellers to provide warranties and indemnities through a share purchase agreement. This leaves sellers in the position of facing potential liability for an extended period of time post-exit.
Warranty & indemnity insurance (known to US investors as representation & warranty insurance) is a specialist type of insurance product which enables the parties to share purchase agreements to insure against liability under the warranties and indemnities in the share purchase agreement. In the vast majority of cases W&I policies are taken out by the buyer – though this is often at the seller’s request.
In recent years we have seen a sharp increase in the use of warranty & indemnity insurance to facilitate exits – particularly in relation to exits involving technology companies and particularly where the selling shareholders include venture capital or private equity funds. When preparing for an exit it is therefore helpful for management teams to have an understanding of the benefits and drawbacks of W&I policies and the impact it has on the exit process.
W&I policies come with significant advantages:
- Clean exit for investors – Financial investors such as VC and private equity funds will typically not agree to give substantive warranties or indemnities in share purchase agreements, hence W&I policies can be a necessary way of giving the buyer sufficient comfort.
- Clean exit for founders – W&I policies will allow sellers to cap their liability under the share purchase agreement to a far greater extent than would be acceptable to the buyer if a W&I policy was not in place. In the past management sellers were expected to retain some personal liability, but it is increasingly possible to purchase policies under which seller liability is capped at £1.
- Reduced need for escrow and holdbacks – W&I policies give the buyer comfort of knowing that it has recourse against a creditworthy insurer. This reduces the need for buyers to ask for part of the sale proceeds to be subject to escrow or holdback arrangements, allowing sellers to access the full consideration proceeds upon completion in circumstances.
But they also come with drawbacks:
- Cost – We often see buyers request a price reduction to account for the cost of purchasing W&I insurance – particularly where the request for insurance is driven by the sellers. That price deduction could be for the entire cost of the policy, or there could be an agreed split between buyer and seller. It is helpful to agree the level of policy coverage (which could be 100% of the consideration, or could just be a portion of the consideration), and which party will bear the cost, at term sheet stage.
- Exclusions – W&I insurance policies will come with exclusions. In particular, known issues discovered during due diligence will typically not be covered. As such W&I does not represent a “complete solution” and there can still be a need for escrow arrangements or for the sellers to take on liability for known problems.
- Not a substitute for due diligence – Insurers expect a thorough due diligence exercise to have been conducted by the buyer and will expect the sellers to have undertaken a thorough disclosure process, as is standard practice for M&A transactions.
- Retention – W&I policies typically come with a deductible that is excluded from coverage. Responsibility for covering the deductible needs to be negotiated between buyer and seller. Policies which allow for zero recourse against the sellers are becoming more common, but may come with additional cost and are not always available.