In case of a business merger if everything goes right both the buyer and seller are happy about it. But it is not uncommon to have a problem in business acquisition. Sometimes the buyer discovers that the seller has not disclosed important information about the business. In this type of situation, the buyer can file a case to seek compensation. On the other hand, the seller can think that the buyer is asking for too much compensation. This blaming game can go on for a long period. It can cost both parties time and money. Representation and Warranty Insurance comes to your rescue in this sort of situation. It covers legal costs and also helps to sort legal disputes.
What do we Mean by Representations and Warranties?
Representation is a statement that the seller has before an agreement. The buyer relies on the statement before making the decision. Suppose you have a company. You have made a $2 million profit last year. You make this statement before selling your company. The company which is going to buy your company believes in this statement. It is a representation. A warranty is a word of honor that the statement is true. Like our company has made a profit of $2 million, and we will reimburse you if the statement is not true. At the time of merger and acquisition, both buyer and seller have to disclose the necessary details. If anyone of them fails to give correct information or doesn’t share important information it is a breach of warranty.
What is The role of Representation and Warranty Insurance?
Usually, we see the use of Representation and Warranty Insurance in mergers and acquisitions of companies. Both the buyer and seller can buy this insurance policy commonly or separately. This policy protects the buyer from any damages caused by the non-disclosure of key information by the seller. So it helps the buyer with monetary compensation. In the case of the seller, Representation and Warranty Insurance provide liability coverage to the seller. It also helps to reduce or eliminate the need for an escrow. If the buyer is asking for too much compensation then this policy helps the seller to cope with the situation.
Representation and Warranty Insurance helps to stop the legal procedure at an early stage. It provides a path for both parties to have a cleaner exit.
How Does This Insurance Help the Buyer
In the case of a merger and acquisition, the party that benefits the most by representation and warranty is the buyer. Let us discuss the benefits of the buyer in Representation and Warranty Insurance. They are
#1: Protection and coverage – When there is a breach of warranty or the seller gives false information, the buyer receives the compensation from a well-known insurance company. He doesn’t have to rely on the seller anymore. The seller will also want to be a part of this policy because it will take the burden off him.
#2: Attractive to the seller – This policy is also very attractive to the seller. This policy offers reduced or no escrow. Due to this, the seller will be able to receive more money when the deal gets finalized.
#3: More time – Representation and Warranty provide more time for the buyer to find out any problem. Usually, it is more than a common escrow.
How Does This Insurance Help the Seller
Not only is the buyer benefited from this insurance policy. There is something for the seller also. The benefits that the seller gets are:
#1: Honorable exit – As there is reduced or no escrow in this process the seller receives more money. It also helps the seller as there are no post-closing liabilities.
#2: Protects from Liability– If something occurs after the closure of the deal, like a breach of warranty, Representation and Warranty Insurance provides the seller legal defense and helps him to settle the cost.
The Reason Representation and Warranty Insurance Comes Into Effect?
Representation and Warranty Insurance activates if there is any breach of warranty or representation. The reasons can be:
- If there is any trouble in the contract with the customer
- If an employment agreement is faulty
- The seller gives inaccurate information. Like it doesn’t disclose the “secret recipe” of a particular product.
- If the seller has pending litigation which he didn’t reveal
These types of situations are enough to breach the warranty.
What Limitation Does Representation and Warranty Insurance Have?
Although Representation and Warranty Insurance provides necessary protection to the business, it has some limitations. They are:
- The purchase price is adjusted.
- Pension or benefit plans are usually unfunded or very less.
This type of policy usually lasts for three to six years. However, it is higher than the normal escrow process.
What is The Cost of Representation and Warranty Insurance?
The cost of Representation and Warranty Insurance policies varies between 1% and 3% of the overall transaction. It is a one-time policy. You pay the amount when the deal is final.
The cost of the premium usually depends on the risk of the project, how much the policy has to cover, and the retention amount. Usually, most of the insurance companies charge from1.5% to 3.5% of the total transaction. You have to only pay this amount one-time. This is enough for the entire duration.
Let us take an example. Suppose the limit of the coverage is $10 million. So depending on the insurance company, the rate of the premium will be from $150000 to $350000.
Representation and Warranty Insurance is a better alternative than traditional escrow. When there are mergers and acquisitions, it is better to have representation and warranty policy. This policy helps the buyer to receive compensation from an esteemed insurance company like AIG and AXA. He didn’t have to wait for the seller to agree with him if there is a breach of warranty. As there is no escrow the seller gets full payment when the deal closes. The Representation and Warranty Insurance is getting popular, eventually, the price of the premium will also drop soon. So this insurance policy is a must buy during merger and acquisition.