Reps & warranty insurance insures the buyer from a breach of reps & warranties in the purchase agreement. A purchase agreement’s representations can include data security, outstanding taxes, and accounting policies, which insurance would not otherwise cover. If there’s a breach, the buyer (or seller) would tap the insurance policy instead of an escrow or other mechanism. Without reps & warranty insurance, a portion of the seller’s closing proceeds would generally be held in an escrow to protect against potential breaches. The escrow is typically 10% of the purchase price and stays in place for 12 to 24 months. Reps & warranty insurance can replace or significantly reduce the escrow, increasing the seller’s closing proceeds. Buyers also prefer reps & warranty insurance versus escrows because it prevents potential conflict with management over a breach of representations.
Reps and warranty insurance typically costs 3% to 5% of the coverage amount, with larger deals on the lower end of the range. The insurer also typically charges an underwriting fee of $50,000. A broker, if used, charges on average of 15% of the premium. For example, on a $100 million deal and 10% coverage, $300,000 would be paid in premium, $45,000 in underwriting fees, and $45,000 in broker commission for a total cost of $390,000. The portion paid by the buyer is generally negotiated during the LOI phase.
Engaging a legal counsel familiar with reps & warranty insurance is critical to ensure the purchase agreement is drafted accurately. Once the LOI has been signed, the seller should retain a broker. A broker requires the term sheet, CIM, NDA, financial statements, access to the data room, and the purchase agreement draft with detailed schedules to begin shopping quotes. However, engaging a broker earlier gives them time to become familiar with the material while drafting the purchase agreement. The insurer’s underwriting process typically takes two weeks and will include an underwriting call with management. Insurers are efficient at the underwriting process and will not delay the deal.
For more on reps & warranty insurance, listen to Middle Market Mergers and Acquisitions podcast by Colonnade Advisors, episode 010: Escaping escrow – Reps & Warranty Insurance https://www.coladv.com/podcasts/010/