Understanding Representations and Warranties Insurance

When it comes to conducting a business sale, many things could hold up completion of the transaction, such as disagreements about the sale price, (re)negotiating specific terms of the deal, a prospective buyer’s funding challenges, and more. But an insurance policy?

Truth be told, business owners may find if hard to believe that an insurance policy could prove pivotal to sale of their business, but it’s critical for owners to understand such coverage. Let’s explore the reasons why holding an insurance policy to address representations and warranties is an important consideration for buyers and sellers alike.

When a business owner approaches the sale of their business, it’s common to view the sale as a removal of all responsibility and financial liability. Many owners believe that once they sign the deal, they’ll receive their payout and all liabilities and responsibilities will transfer to the purchaser.

However, this is not necessarily the case. In the purchase agreement, the seller will typically attest to a number of representations about the business, such as the completeness and accuracy of financial statements, the condition of property and equipment, etc. If proven to be false, the seller could face financial liability.

So, whereas a seller of a business generally wants to sell all business interests to remove any present and future liabilities, the buyer typically wants to purchase assets of the business without incurring any known or unknown liabilities. Considering the immense financial, legal and reputational risks that liabilities may present, this often leads to conflict as both parties seek a high degree of certainty when executing the transaction.

How can private equity groups or other potential buyers purchase the entity without assuming additional unwanted liability? One way to address potential risks is representations and warranties insurance, which helps protect both the buyer and seller, and may facilitate the amenable closing of a sale.

What is representations and warranties insurance?

Simply put, representations and warranties are formal statements made by the seller in the purchase agreement pertaining to their business.

• Representations are assertions about the past and current state of the business
• Warranties are similar to representations, but not limited to the past and present. While forward-looking statements or post-close covenants can be made regarding future events, they are not covered by insurance

Either party may initiate representations and warranties insurance, but frequently the buyer takes out coverage and pays the premium, which generally costs approximately 2.8% to 4% of the purchase price. The scope of the coverage may vary but usually involves financial statements and assets, taxes, employee considerations and litigation. Typically, representations and warranties are not made until the purchase agreement is drawn up. When signing the preliminary Letter of Intent (LOI), the seller may have no insight into what the buyer will propose.

Key features of representations and warranty insurance involve the following:

• The period of time the seller can be held liable, referred to as the “survival period”
• The minimum threshold before a seller can be held liable, called a “basket” (and typically about 0.75% of the purchase price)
• A holdback that is usually 10%-20% of the purchase price and held in escrow to settle any disputes between buyer and seller. Holdbacks usually last for 12 to 24 months
• A cap that may be implemented in the agreement, which limits the maximum amount a seller can be held liable. The average cap is approximately 10% to 20% of the sale price (and, much like representations, the cap may vary based on the agreed-upon survival period)

The potential benefits of representations and warranties coverage are numerous for both parties. For the seller, this type of insurance policy helps reduce liabilities, may allow for quicker negotiations and may reduce escrow. For buyers, the coverage may be conducive to expediting the transaction, allows for higher caps and offers another level of due diligence from the insurance underwriting process.

Common exclusions:

• Issues that are known prior to closing
• Fraud of seller that the buyer becomes aware of, pre-close
• Underfunding of pensions
• Forward-looking warranties
• Current event exclusion
• Deal-specific exclusions
• Collectability of accounts receivable
• Pre-close business reorganization

Learn more

Business owners have found that representations and warranties insurance—while often complex and multi-faceted—to be a useful and valuable tool in the sale of their business. Such policies can help business owners protect their financial interests by reducing or eliminating selling-related liabilities, both now and into the future. For more information about companies that offer this important type of insurance coverage, speak to a Corient Wealth Advisor today.

¹ https://www.srsacquiom.com/our-insights/reps-warranties-insurance-rwi-fast-facts/

² Types of baskets

• Tipping basket: Seller must reimburse the buyer for all of the losses if the basket is exceeded
• Non-tipping basket: Seller must reimburse the buyer only for the amount of losses that the basket is exceeded
• Shared basket: The seller and buyer split any losses, up to the deductible amount

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