January 21, 2020
Warranty and Indemnity Insurance – Minimising Risk
By Joseph Davis of Simons Muirhead & Burton LLP
Beyond the purchase price, perhaps the most important negotiation regarding the sale of a business relates to the warranties and indemnities given by the seller. Warranties and indemnities represent the greatest ongoing liability of a seller to a buyer, and therefore ways to minimise this risk are very attractive to sellers. Warranty and indemnity (“W&I”) insurance is an increasingly popular means by which sellers may seek to reduce this risk, as well as providing additional comfort to the buyer.
What are warranties and indemnities?
When buying a business, a purchaser will require the seller to give warranties in relation to the target business within the sale and purchase agreement (“SPA”). Warranties are a set of contractual promises made by a seller about the state of the business being sold, which will be relied upon by the buyer. These warranties can be qualified by disclosures where the seller can explain that a warranty is untrue and, subject to the disclosure complying with the terms of the SPA, the seller will then not have any liability in respect of that matter.
A buyer requires the seller to provide warranties for two principal reasons: (1) to elicit information through the disclosure process; and (2) to provide a remedy for the buyer if it suffers loss in relation to an undisclosed warranty breach.
An indemnity is a promise from the seller to reimburse the buyer on a pound for pound basis in relation to a specific head of loss. When claiming under an indemnity the buyer is not under a duty to mitigate its loss, as it is regarding warranty claims, and indemnity claims can be framed as debt claims whereas warranty claims are for breach of contract.
What are the benefits of warranty and indemnity insurance?
One of the key benefits of W&I insurance for a seller is that it allows them to walk away with the proceeds of the sale without having to consider the risk that they may become liable for a claim in the future. The seller is therefore able to immediately spend or invest the purchase price with the certainty that they will not have to use their sale proceeds to cover a warranty or indemnity claim. One of the key benefits of W&I insurance for the buyer is that it covers the sellers’ fraud and increases the amount of contractual protection made available to them under the SPA through a broader suite of warranties , higher liability caps and lower de minimis claim thresholds.
Buyers will also want certainty, in this case the certainty that the seller will have sufficient funds to pay for any claims the buyer may have. A common solution to this problem is the use of an escrow account, meaning that the seller will not receive the sale proceeds until a later date (often several years depending on the limitation periods negotiated under the SPA). The use of W&I insurance eliminates the need for an escrow account, and therefore allows the seller to receive the proceeds of the sale immediately, whilst giving the buyer comfort that it will be able to recover any loss it suffers. W&I insurance can also reduce the risk of purchasing from a private equity seller who would not otherwise give warranties, or from a seller who would be difficult to make a claim against (e.g. a corporate seller which will cease to exist after the transaction).
Warranty claims can also harm the ongoing relationship between the buyer and seller of a business. This is of particular importance in circumstances where a selling shareholder continues to work for the business. Ordinarily a buyer may be reticent to bring a warranty claim against such a person and harm their ongoing relationship with the seller, but the use of a W&I insurance policy eliminates this issue as the insurer rather than the seller will be liable for the claim.
What are the disadvantages of warranty and indemnity insurance?
As a counterbalance against the benefits of W&I insurance there are a number of drawbacks to consider when deciding on the appropriateness of taking out a policy. The most significant of these is the cost – the price of the premium itself is discussed below, however the use of a W&I policy will also cause increased legal costs and may add time to a deal. There is an extra level of administration required to satisfy the requirements of the insurer, which means that deal timelines may be extended, and lawyers will have to expend additional time and costs for the buyer and seller. Whilst the risk of warranty and indemnity claims is an important factor for a seller to consider and seek to mitigate, provided a proper disclosure exercise is undertaken, such claims are rare. This remoteness of this risk should be considered when weighing up the cost of W&I insurance against the risk of warranty or indemnity claims arising.
Additionally, the use of a W&I policy means the seller will not have ‘skin in the game’. As the seller will not be financially harmed by warranty or indemnity claims that are covered by a W&I policy, the seller may be less motivated to make proper disclosure of potential warranty breaches. Especially in circumstances where a seller is remaining in the business after the sale, their lack of motivation to prevent a claim arising may be a significant drawback to a buyer.
‘Buy Side’ or ‘Sell Side’ policy?
Either the buyer or seller may be the insured party under a W&I policy, although it is more common for the buyer to take out the policy and be the insured party, known as a ‘buy side’ policy. Even where the buyer is the insured party the seller will often pay the premium. Lockton Companies LLP (“Lockton”) are a broker of W&I and other M&A related insurance products, and of the 224 transactions they closed last year, 97% were buy side policies.
If the seller is the insured party, a ‘sell side’ policy, then the buyer must make a claim against the seller who can in turn then make a claim under the W&I policy – this negates the benefits of the seller not having to maintain sufficient funds to cover a claim and the protection of the relationship between buyer and seller. The type of policy taken out will have to be agreed between the parties, and the form of policy as well as who pays the premium will depend on the relative bargaining positions of the buyer and the seller.
Is it expensive?
The cost of a W&I insurance policy, as with all insurances, depends on the risk profile of the potential heads of loss – in this case the warranties and indemnities – being insured. The premium is a one-off payment made up front when the policy is taken out, and it is dictated by a variety of factors. Key factors that determine the price include the excess payable on claims, the proportion of the purchase price the policy will cover and the perceived likeliness of any claims arising. Whilst no two deals will be the same, a rough marker is that the premium for W&I policies in UK transactions are usually around 1% of the amount covered (however, it can be as low as 0.65% of the insured cap depending on the nature of the target company), although prices may continue to come down as the market becomes more competitive.
What is, and isn’t, covered?
. Claims within the buyer’s knowledge at the time of the acquisition and certain tax and pensions related claims are likely to be excluded. Ultimately the level of cover will depend on what the party paying for the policy is willing to pay, as cover for warranties or indemnities that are considered to carry a greater risk of being subject to claims will mean a higher premium.
What does the process entail?
The insurer will need to review the key transaction documents and the due diligence process throughout the course of the transaction in order to ascertain the risk level of the insured party. It is a condition of W&I policies that a proper due diligence exercise has been carried out by the buyer, and a full disclosure process carried out by the seller, as otherwise the buyer would not be motivated to spend time and money doing so, safe in the knowledge that any loss it suffers as a result would be covered by the insurance policy. The insurer will therefore closely monitor the due diligence and disclosure processes and will require ongoing discussions with the buyer to provide sufficient comfort.
W&I insurers and brokers employ experienced corporate lawyers to oversee this process – they tend to be highly responsive and understand the market and the deal process. It is key to get them involved as early in the deal as possible, in order that they do not have to spend time getting up to speed with a deal, therefore the appropriateness of using W&I insurance should be considered at the outset of a transaction.
W&I insurance policies are an increasingly popular way for buyers and sellers to minimise the risks associated with corporate acquisitions. The particular circumstances of each deal will determine the appropriateness of a W&I policy, but the use of one can be a clean way to overcome issues that may otherwise derail a deal – such as the need for an escrow account, the breadth of warranty cover and the limitations on claims. However, W&I policies are not a silver bullet and are not a substitute for full due diligence and disclosure processes. W&I policies are bespoke products which are only appropriate in specific circumstances, and buyers or sellers considering the use of such a policy should take professional advice and consider all the circumstances of the deal. Ultimately the appropriateness of using a W&I policy will come down to balancing the risk of a warranty or indemnity claim arising against the cost of the insurance, both in terms of time, the insurance premium and additional legal fees.
Lockton explain that “W&I insurance has gone from a rarity on deals to commonplace or even the standard market position. Our team looks at nearly 1000 transactions a year globally. It’s now estimated that around 5000 policies are placed annually. Recent statistics suggest that over 50% of corporate real estate transactions in Europe now use W&I Insurance, and 25-30% of private equity transactions; a large driver for this has been the adoption of a £1 cap on sellers’ liability under the SPA, leaving buyers with little choice but to take out W&I insurance in the absence of any contractual protection under the SPA”.
Joseph Davis (Solicitor) Simons Muirhead & Burton LLP 87-91 Newman Street, London W1T 3EY Email: email@example.com Tel: +44 (0)20 3206 2731 Mob: +44 (0)7811 971400
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Richard Millward, Former Client
“We were delighted with the services that Bluebox offered us. Bluebox were challenged with finding us the right strategic investor and, thereafter, negotiating a deal that met our complex requirements. In identifying and securing the deal with LGC they have done exactly that. The process itself was efficient and smooth, largely due to the excellent communication from the Bluebox team, who also demonstrated excellent experience at managing a very engaging auction process. I would be delighted to recommend Bluebox to any corporate shareholder or private business owner looking to divest a business.”
Helen Dickinson, Former Client
It has been a real privilege working with the team at Bluebox over this last year or so. Bluebox’s attention to detail ensured that we were well prepared for when the business was taken to market and the sale process itself was managed expertly. Starting the process, I had no idea exactly what this would entail and the volume of work that has been produced by everyone and the result reached today is nothing short of brilliant.
Hugh Morris, Former Client
We are delighted with the services that Bluebox was able to offer. They showed an intimate knowledge of a deal cycle, managed a tight auction process and were highly communicative from the start. I would happily recommend Paul and his team to business owners contemplating a sale of their business in the next 24 months. Experience is key and this has paid off for us.
Laurence Seward, Former Client
Aligning ourselves early with Bluebox, and entrusting the team to guide us through their process proved to be a highly rewarding investment from all viewpoints. Bluebox’s support significantly enhanced both the value of our business and its ‘saleability’. I would highly recommend Bluebox to business owners contemplating an exit in the next two years. The earlier the engagement the better so far as I am concerned.
Mike Minett, Former Client
We began working with Bluebox in early 2015 through their Blue Diamond Programme, as we were contemplating an exit. We found that the process focussed our minds on the key areas of growth in the business, and prepared us well for the inevitable rigours of due diligence. During the sale process itself, the advice offered by the Bluebox team was invaluable. We found them to be helpful, straightforward and honest.
David Stokes, Former Client
When selecting our adviser, it was extremely important that they had access to international buyers and were experienced in cross-border M&A. The team at Bluebox proved to be invaluable by identifying a strategic acquirer from America who was not known to us and by negotiating an excellent deal for all parties. I was also impressed with the process management from Bluebox, which ensured that the deal was closed in a timely fashion.
Jeff Weinstein, Former Client
When I first engaged with Bluebox, I was hesitant as to the benefits of using an advisor to firstly, find a buyer for my business and secondly, to get a deal over the line. However, now that the deal has completed with KPM, I can honestly say that the finer negotiation points handled by Bluebox and their overall management of this process has been nothing short of first class. I would be delighted to recommend Bluebox’s services to any entrepreneur contemplating the sale of their business.
Bill Ballard, Former Client
Bluebox worked closely with us over the following six months and helped us to implement some key initiatives which made InferMed a more attractive acquisition target. Once we decided to sell the business, the Bluebox team were very diligent in ensuring that no stone was left unturned. They negotiated expertly on our behalf to ensure we got the best deal possible.
Alan Montgomery, Former Client
The pre-sale planning programme that we signed up for with Bluebox made us develop our strategies and focus on the bigger picture. It proved to be a very rewarding investment from all viewpoints and significantly enhanced both the value of our business and its ‘saleability’. I would highly recommend Bluebox to business owners contemplating an exit in the next two years.
Nigel Parsons, Former Client
I have experienced first hand the value that can be created through highly structured pre-sale planning. It amazes me that it is not something that everyone does. It is so disappointing to see around 90% of transactions collapse before they complete and pre-sale planning will not only enhance your price, but also significantly enhance your chance of a closed deal.
James Caan, Investor
We worked incredibly closely with our advisers who provided expert knowledge of the sale process with which we were not familiar. We were truly delighted with the results.
Marten Nielson, Former Client
We appointed advisers to manage the sales process after we had received a number of unsolicited approaches for the business. I was incredibly impressed by the immense value that could be created by expertly negotiating with a group of already interested parties.
Paul Duckworth, Former Client
I was delighted with the service that the team offered and their real attention to detail. The deal was not without its complexities and it was reassuring to have such experienced advisers assisting me throughout the negotiations.
Peter Bennett, Former Client
Truly delighted with the way my sale process was managed. The fact that the team I worked with achieved such a great multiple is testament to their experience and their ability to create some true competitive tension.
James Averdieck, Gü, Former Client
The team at Bluebox provided invaluable support in negotiating this complex transaction. Their access to international purchasers, and exceptional knowledge of cross border M&A ensured that the deal was concluded efficiently, achieving a highly successful outcome for us all.
Jon Parslow, Former Client
“We selected Bluebox after a fairly long round of evaluating potential advisors because of their scientific, yet challenging approach to maximising value. During our initial meetings they showed us how far short of “ready” we were and consequently we completed more preparation in the early stages which meant we were equipped for what was to come. We were delighted with our choice of Corporate Finance partner. I do not hesitate in recommending Bluebox for any SME to consider.”
Simon English, Former Client
Bluebox provided invaluable advice in managing the negotiations with incoming investors. Their skills in handling these discussions were evident from the outset and the vital interface that they provided between the incumbent team and the incoming investors was truly beneficial.
Henry Braham, Former Client
Bluebox have a professional, dynamic and experienced team that is greatly assisting me with my focus on my exit within the next 24 months. Their structured approach is very refreshing and their ‘Blue Diamond’ programme is adding immense value.
Matt Evans, Former Client
The team at Bluebox provided me with a seamless service from the start of the engagement until our deal was completed. Attention to detail was commendable and their understanding of corporate M&A very impressive. I could not recommend them highly enough.
Victor Lewis, Former client
Having tried to sell my business previously – and failed – I was only too aware of the importance of pre-sale planning. This is a talented team offering a service that most people find out about, but too late.
Simon Hulme, Former Client
Bluebox are a quality outfit. Their access to International acquirers and relationships with the highest quality domestic investors was impressive. My shareholders and I received excellent service from start to finish and it was refreshing to be dealing with a senior team throughout the sale exercise.
Michael Clapper, Former Client
I cannot recommend the team at Bluebox highly enough. Their expert guidance throughout the entire sale exercise resulted in my shareholders securing an excellent deal with which the entire team was delighted.
Mark Rodol, Former Client
I’m really pleased with the service Bluebox provided. The team demonstrated excellent knowledge of the process to follow and led negotiations for the hospital in a way that allowed us to ensure we received appropriate value whilst focusing on reputational risk. Communication and service were of a very high standard.
Steven Davies, Former Client
With Bluebox’s expert advice we were able to find the right buyer that will benefit our business strategically. We’re delighted with the outcome and look forward to starting our new chapter
Clive Hillier, Former Client
The advice offered by the Bluebox team throughout the process was invaluable to the shareholders. We strongly believe that participating in Bluebox’s pre-sale planning programme was a significant driver behind the success of the deal. Their project management and negotiation skills throughout the sale process itself resulted in an exceptional deal being delivered to all parties involved.
Harpal Singh, Former Client