While use of representations and warranties insurance (RWI) by private equity (PE) firms has become nearly ubiquitous in recent years, some technology companies have been slower to adopt RWI to facilitate completing their strategic mergers and acquisitions (M&A) transactions. Some technology companies may believe their due diligence is so thorough that RWI is unnecessary, others may think that the traditional indemnity escrow or holdback has always worked well in the past, or they may be acquiring a venture capital (VC) backed company and VCs have historically been less focused on gaining few additional tenths of a percent when calculating their internal rate of return on an exit than PE firms.
However, in additional to the general use case for RWI in M&A, RWI can provide several advantages for completing tech M&A deals:
- Improved Post-Closing Relationship with Founders and Key Employees: Frequently, one of the key strategic rationales for tech M&A is to acquire (and retain) the team of managers or key founders and employees at the target company. With a traditional indemnity or holdback structure, part of their deal consideration is at risk. If a post-closing indemnity claim arises, these employees may feel shortchanged if the indemnity escrow or holdback is not released due to circumstances that may have been entirely unknown to them or outside of their control. The target’s founders may need to divert their attention to deal with the claim, which can create tension and an adverse relationship between the founders and management of the acquiror. By using RWI, acquirors can avoid disappointing employees and any adverse relations that may arise with founders and instead negotiate with a professional, third-party claims team. Liberty GTS has a global claims team that has responded to over 500 claim notifications since 2019, so is highly familiar with the issues that can arise and has a history of responding promptly and professionally to a variety of claims, including multiple claims globally involving up to $5 million+ in costs to defend an IP-related lawsuit.
- Non-Dilutive Cash to Pay Third Party Claims or Other Cash Expenses: In an all stock or equity-for-equity M&A deal, the indemnity escrow or holdback consists of stock (or other equity securities) of the acquiror. If a claim occurs, the buyer’s recourse is to cancel or return those equity securities to treasury. While effective at reducing the consideration the sellers receive, this does not directly generate cash to pay third-party claims, cover defense costs, or satisfy other out-of-pocket cash costs. RWI, as an insurance product, provides a cash payment for valid claims and, depending on the specific factors of the claims, can even cover things like defending an allegation of IP infringement, which can run to six or even seven figures in legal fees or expert costs. Tech companies that stick with an indemnity or holdback comprised of equity could instead find themselves faced with the choice of being forced to settle on unfavorable terms to avoid those costs or trying to raise financing in a slow market for VC funding to fund litigation costs, rather than the growth of the business.
- More Competitive Offers: Using RWI helps place strategic buyers on even (or better) footing than PE buyers, by also allowing tech firms to provide sellers with the full consideration at closing, rather than waiting a year or more for the escrow or holdback to be released. Particularly in the current environment where VCs have fewer exit opportunities, VCs may push more strongly than they have historically for use of RWI in order to maximize the cash they can distribute to their limited partners on the sale of a portfolio company. RWI insurers frequently insure no seller indemnity (NSI) transactions, where the sellers receive 100% of the consideration at closing, other than a small holdback or indemnity for the purchase price mechanism and for cases of fraud.
- Easier Negotiations: Eliminating the traditional seller indemnity structure in a purchase agreement for a transaction can also expedite the process for negotiating these M&A deals. Particularly in an NSI structure, the target company can more readily limit negotiations over the representations and warranties to those that create a true scheduling burden, making it easier for the buyer to obtain its desired scope of representations and warranties in the transaction documents. In addition, there is no need to negotiate with VCs or other large shareholders to backstop an indemnity where the acquisition is structured as a merger. Liberty GTS has negotiated, precedent RWI policies with most major law firms, including the leading Silicon Valley based/tech focused law firms, allowing RWI policies to be quickly finalized with minimal back and forth.
- Coverage Enhancements: Using RWI can also provide buyers with several coverage enhancements that may be difficult or impossible to obtain in a traditional indemnity structure. RWI typically provides a three-year period in which to make claims for “general” representations and warranties, compared to typically one year in indemnity deals, and six years for “fundamental” representations and warranties. In addition, RWI insurers are generally, depending on the deal specifics, able to price and provide a variety of customizable, deal-specific coverage enhancements, such as a policy providing coverage for more than the typical 10% of the deal price, extended periods for specific representations and warranties beyond those typically viewed as “fundamental” or, in the current regulatory environment where longer periods between signing and closing have become more common, extended interim periods between signing and closing.
- Mitigate the Risk of “Unknown, Unknowns”: No matter how thorough the diligence process, until the buyer actually takes ownership of the target business and starts running it, there will always be the risk of issues being discovered that are simply unknowable until then. Like other insurance products, RWI provides tech M&A buyers with protection against the unknowable.
We expect that the use of RWI in tech M&A transactions will continue to grow and become nearly as common in strategic transactions as it has become in PE-involved M&A as more and more VCs existing their investments and tech companies recognize the benefits that using RWI can provide. As part of Liberty Mutual, Liberty GTS is part of an organization with over 100 years of history of protecting individuals and businesses against the unexpected. Liberty GTS has three West Coast based RWI underwriters with experience in tech M&A and at leading law firms, as well as a global team, to support tech M&A whether in Silicon Valley or around the globe.
