De-Risking Small – Medium M&A Transactions

M&A transactions by their nature involve unknown risks. Despite the best efforts of the parties, liabilities may slip between the cracks, issues may simply not be fully understood at closing, and it may not be possible to uncover some of these risks through diligence given the operating state of the target company. Under a traditional asset or share purchase agreement, the Vendor makes certain representations and warranties to the Purchaser about the target company and its operations and gives the Purchaser recourse against a Vendor (such as an indemnity, backstopped by an escrow or holdback mechanism). This traditional method of recourse can end up in litigation, which may harm an ongoing relationship, be expensive and lead to unpredictable results.

An increasingly popular method of addressing the risk allocation issue has been representations and warranties insurance (“RWI”), which gives Purchasers the ability to claim against an insurance policy if there has been a demonstrable breach by a Vendor of the representations and warranties in a purchase agreement. RWI facilitates easier negotiation of representations and warranties and considerably reduces the parties’ risk in M&A transactions.

Traditionally, RWI has almost exclusively been used on large transactions because insurance companies charge a minimum premium that makes the cost unaffordable on smaller transactions. However, new simplified RWI policies (“SRWI”) specifically designed for lower mid-market transactions (from $250,000 in purchase price and up) are increasing the uptake in the market for RWI.

SRWI products may not be right for all transactions, but it does allow for a Vendor to, in many senses, “walk-away” after closing and give a Purchaser certainty and comfort on the state of the target company going forward. SRWI is so much cheaper than the traditional RWI product because it does not require an underwriting call and has a simplified diligence process for the insurers – resulting in a policy cost in the thousands or tens of thousands, rather than hundreds of thousands of dollars.

In practical terms, SWRI may help a Purchaser stand out during a competitive M&A bid process and may help a Vendor achieve the certainty of exit (onto the next phase of their lives) they intended when agreeing to sell their business. This tends to result in a simplified negotiation and closing process for both parties, predictable closing proceeds for Vendors and an insurer to turn to in the event of a claim post-closing. Given these benefits, together with the popularity of RWI south of the border, interest in SRWI continues to grow even as early as the marketing document, term sheet or letter of intent stage.

SRWI may be a valuable tool in the parties’ toolkits to get deals done, reduce transaction risk and build momentum between the parties for a productive ongoing relationship.