Is there anything riskier than making an acquisition? No matter how much due diligence a buyer performs, there is simply no way to know for sure whether a company has skeletons in the closet–indeed, that fear is often enough to spook buyers and scuttle a deal at the last minute.
One way to assuage those fears is to buy insurance that shifts some liability onto a third party. So-called representations and warranties policies cover financial losses that occur if a seller is found to have made false claims in the representations and warranties section of a sale contract. These policies have grown increasingly popular, thanks to lower premiums and the hot M&A market. “It’s starting to become mainstream,” says Charles Leasure, a corporate insurance lawyer at Philadelphia-based law firm Pepper Hamilton.
Such insurance was a deal-saver for Michael Alexander, managing partner of EchoBridge Entertainment, a film distributor in Needham, Mass. Alexander was close to signing a deal to buy Platinum Disc, a DVD distributor in La Crosse, Wis. Platinum had been profitable for years and its books seemed clean. But Alexander was concerned, partly because the family-owned business had been following the Financial Accounting Standard Board’s Generally Accepted Accounting Principles for only two years. “You worry that there’s something the sellers aren’t telling you–or something they don’t even know about,” Alexander says. Indeed, EchoBridge was already in a dispute involving allegedly false claims made by a video library it acquired a few months earlier.
Alexander asked Platinum’s owner, Dave Thompson, to set aside a chunk of the sale proceeds in an escrow account until it was clear that the conditions of the deal had been met. When Thompson balked, Alexander bought a representations and warranties policy and let Thompson put a smaller amount in escrow. It cost EchoBridge $200,000 to cover the deal, which was worth tens of millions of dollars, and Alexander says it was worth it: “You get millions of dollars in protection and sleep more comfortably.” The deal closed in February. So far, there have been no surprises.
Representations and warranties insurance can rescue a troubled deal.
What it does: Covers financial losses if a seller makes false claims in a sale contract.
What it costs: Five percent of the policy’s coverage amount, plus a 1% to 5% deductible.
Who needs it: Buyers or sellers involved in deals worth at least $10 million.
Such insurance also can be used as a bargaining tool during the bidding process, notes John Gilluly, of Austin law firm Piper Rudnick Gray Cary. In most deals, buyers ask sellers to put at least 10% of a deal’s value in escrow. By offsetting some risk with insurance, bidders can slash their escrow requirements, effectively offering the seller more cash up front. One of Gilluly’s clients recently won an auction by asking the seller to place just 4% of the sale proceeds in escrow, compared with the 10% to 15% requested by other bidders. The client then hedged his bets by taking out insurance. Sellers, for their part, can offer the insurance at the outset to attract more bidders and, theoretically, drive up sale prices.
The insurance rarely makes sense for deals worth less than $10 million, since potential losses are likely to be too small to warrant the expense. And the price tag is nothing to sneeze at: about 5% of the coverage amount, plus a deductible of between 1% and 5%. Even if you can afford it, never use the insurance to rationalize a bad deal. Sometimes the best insurance is your own gut instinct.
This article originally appeared in the October 2005 issue of Inc. magazine.