What is representation and warranty insurance?
Takeaway: Representation & Warranty Insurance (RWI) is a specialized insurance policy that transfers the risk of a breach of your reps and warranties from you and your stockholders to an insurance company, allowing for a cleaner and more certain exit.
In a traditional M&A deal, the primary protection a buyer has against a breach of the seller's representations and warranties is the indemnity escrow. A portion of the purchase price (typically 10-15%) is held back in an escrow account for a period of time (typically 12-18 months) to cover any potential claims. This means that the selling stockholders do not receive all of their money at closing and remain financially on the hook for a long period.
In recent years, a powerful alternative to this traditional escrow model has become increasingly popular, particularly in larger transactions: Representation & Warranty Insurance (RWI).
How Does RWI Work?
RWI is a specialized insurance policy that is purchased as part of the M&A transaction. The policy insures the accuracy of the representations and warranties made by the selling company in the merger agreement.
The Process: Instead of a large portion of the sale proceeds being held in escrow, the buyer and seller jointly purchase an RWI policy from a specialty insurance underwriter. The insurer will conduct its own intensive due diligence on the company and the reps & warranties.
The Coverage: If, after the closing, the buyer discovers a breach of one of the reps & warranties, they do not make a claim against the sellers' escrow. Instead, they make a claim directly to the insurance company.
The Advantages of RWI
RWI has become popular because it provides significant benefits for both the buyer and the seller.
For the Sellers (A "Clean Exit"): This is the primary benefit. RWI allows the selling stockholders, including founders and employees, to receive a much larger portion (or even all) of their sale proceeds immediately at the closing. It dramatically reduces the amount of money that needs to be held back in a long-term escrow, providing a much cleaner and more certain exit.
For the Buyer (A Better Recovery): For the buyer, making a claim against a large, well-capitalized insurance company is often a much simpler and more certain process than trying to claw back money from hundreds of individual former stockholders. It also preserves the ongoing relationship with the key founders and employees who are joining the new company by removing the adversarial dynamic of a direct indemnity claim.
The Cost and Scope
RWI is not cheap. The premium for the policy is typically around 2-4% of the coverage limit, and there is also a retention (similar to a deductible) that must be met before the policy pays out. Because of this cost, RWI is most commonly used in larger M&A transactions (e.g., deals over $50 million).
While not a fit for every deal, Representation & Warranty Insurance is a powerful tool that has fundamentally changed the landscape of M&A, allowing both buyers and sellers to transfer risk and achieve a more efficient and certain outcome.
Disclaimer: This post is for general informational purposes only and does not constitute legal, tax, or financial advice. Reading or relying on this content does not create an attorney–client relationship. Every startup’s situation is unique, and you should consult qualified legal or tax professionals before making decisions that may affect your business.