What is representation and warranty insurance?

Takeaway: Representation and warranty insurance is a valuable tool in startup acquisitions as it covers losses arising from breaches of seller representations and warranties, thereby transferring risk from transaction parties to a third-party insurer.

When a company is acquired, there is often a risk that the seller's representations and warranties about their business are inaccurate, potentially leading to financial loss for the buyer. In that case, the buyer may bring a claim for indemnification against the seller. To mitigate this risk for the seller, representation and warranty (R&W) insurance has become increasingly popular in the M&A landscape. Here's a quick rundown of what R&W insurance is and how it can be beneficial in startup acquisitions.

What is R&W Insurance?

R&W insurance is a specialized type of insurance policy that covers losses arising from breaches of representations and warranties made by the seller in the purchase agreement of a M&A transaction. In other words, if the seller's statements about their company turn out to be inaccurate or incomplete, and this causes financial loss to the buyer, the R&W insurance policy will cover this loss, subject to certain terms and conditions.

Benefits of R&W Insurance

The primary benefit of R&W insurance is that it transfers risk from the parties involved in the transaction to a third-party insurer. For sellers, R&W insurance can help expedite the sale process and facilitate a clean exit, as it can eliminate or reduce the need for an escrow or holdback of the purchase price to cover potential indemnity claims. For buyers, R&W insurance can increase deal certainty, as it provides a source of recovery for potential breaches, thereby reducing reliance on the financial solvency of the seller post-closing.

Considerations

While R&W insurance offers many benefits, it's important to understand that it does not cover all risks. The policy will typically exclude known issues that are identified during due diligence, as well as forward-looking statements and covenants. Further, these policies often carry a deductible and require the payment of premiums, so the cost of the insurance must be weighed against its benefits.

It's crucial to work with experienced legal and insurance advisors when considering R&W insurance, as the negotiation of the policy terms can be complex and needs to align with the underlying transaction documents.

Conclusion

R&W insurance can be a valuable tool in startup acquisitions, as it can help mitigate risk, expedite the sale process, and increase deal certainty. However, it's important to seek expert advice to ensure that it is used effectively and provides the anticipated benefits.