Ep 30: Keep More Cash at Closing: How Reps & Warranty Insurance Works

Talk for a smidge about how you got
involved in reps and warranty insurance.

Well, the way I was brought into it,
I've been doing directors and officers

liability for years, and one of my clients

was selling his company,
and he was going to take the money

and move to the old country,
which was to Israel.

And he when the buyer found out
that he was leaving the country,

they changed the terms of the payout.

And they're going to hold back half,
not 10%, but half of the proceeds on a 50

plus million dollar deal,
they say is nothing personal.

We don't mean to be adversarial.

It's just if you leave the country we have
and something goes wrong,

there's nothing we can do about this
and we can't pursue.

So I'm sorry we
we have to put this in as a hedge.

And the client said to me, well, Patrick,

there's got to be some insurance for this.

And I said, well, yes,
but it's prohibitively expensive.

And he said, Patrick Price is no option.

It's no object. Just go get it.

And you know, when people come to me
and they're about to close a dealer,

do some big transaction,
you know, prices no object

and they honestly mean it
until you've given them the price.

Then it becomes a really big object.

In this case, in 2016 is

when I did my first M&A deal,

we went out to the ripple warranty market
to get those coverage,

and it was one fifth
where I thought it was going to cause

I thought this was going to be
a seven figure premium to insure $50

million deal,
and it ended up being a fraction of that.

And when I learned about that, you know,
it was great because by

getting this insurance, my client,
the seller, was able to leave

rather than having $25
million held back in escrow.

He only had $1 million left in escrow.

That was the deductible for the policy.

And so he just said, Patrick,

I got an extra 25, $24 million
in my jeans pocket thanks to you.

And I was like, from there I decided,
this is my calling.

This is what I want to do with insurance,
where we can take

owners and founders
who started with nothing

and help them realize,
and they create a tremendous value.

We can help them exit with as much money
as possible.

As a thank you to them.

And so it's been nice
rather than waiting for something bad

to happen with,
which is the case usually with insurance.

This is something that has tangible,
real benefits.

You know, once you get the deal done.

Those of you that are just joining us,

on touched on talks, this is Patrick
Strath with Liberty Company

and we're talking today
about reps and warranty insurance.

Reps and warranty insurance protects

buyers and sellers in a transaction
similar to what Patrick just described.

In a way that,

has historically been
only the big deals, right?

Your billion dollar, you know, if you're
if your transaction had a B on it,

then you were getting roughs
and warranty insurance,

and now we're seeing it
at the lower middle market.

And so it's important to understand
what it is,

how we could use it
and why we might want it.

There are different types.
Tell me, tell me.

I kind of think of it
like ice cream flavors.

Tell me about the

the flavors of ice cream that we have
for reps and warranty insurance.

Well, thanks for having me here, Deborah.

And I'll tell you as we talk about
there are two buckets of ripple warranty

insurance.

Before I get into that,
let's talk about a more global choice.

You either have protection, have
insurance, or you go forward without it.

Traditionally, mergers and acquisitions.

What would happen
is before the insurance policy came along.

You know, the buyers as as it is common,
nobody wants to get stuck holding a lemon.

And so the buyers, even though they

perform due diligence,
you're not never going to know everything.

And they don't want to find out
after they've already closed the deal

and the money has been sent out
that they way overpaid

because there was something
the seller didn't

tell them or just something to come up.

So what would traditionally happen
is buyers would hold back.

Well, first of all, the buyers
would get a money back guarantee clause

in the purchase agreement.

It's called an indemnification
or indemnity provision.

That way the buyer can get their money
back if there's something out there.

And traditionally,
what would happen is buyers would go ahead

and have a percentage of the enterprise
value as the amount they can take back.

They can claw back,
you know, 20, 30, even 100%

of the purchase price
if certain conditions hit.

And so they put that in there.

And usually what would happen is under,

you know,

the buyer want to have a little cash
put aside so that in the event

something bad happened,

they had ready cash to throw
at the problem to mitigate the loss.

So they would hold back traditionally 10%

of the purchase price
into an escrow account.

It would sit there for a year, 18 months,
and if nothing happened, seller.

Here's the rest of your money.

We'll give you a thousand, five,
90% of cash a close.

You get the rest a little a little later
on, provided nothing happens to wish

the seller sitting there saying, wait,
I answered all your questions.

I gave you all the information out there.

You can't blame me or hold me responsible
for something that wasn't my fault

that I didn't even know about.

Months, even a year later.

So I'm sorry.
We're not going to have that.

And so that's the friction or the dilemma
between buyer and seller is reasonable.

And so the insurance industry came along
and said to tell you what

let's look at the reps.

Let's look at the diligence that's there
for a couple of bucks parties.

Rather than go pointing at each other.

If something blows up, you come to us
and then we will go ahead and take a look.

And, you know, buyer,
we will pay your loss.

So we're hedging your exposure.

We're limiting your risk seller.

You don't have to deal with this
big escrow.

You can get off and get a clean exit.

And so the traditional in about ten years
ago, 11 years ago in the middle market,

this tool came in and you know, to
to take a look at the impact.

You have $100 million deal. Okay.

Well there's going to be a $10 million
held back in escrow.

And the seller city, there's a
I want my $10 million today.

And well, what happened
is with an insurance policy came in.

All of a sudden
that $10 million rescue was reduced to

just a 10th of that, down to $1 million.

So $100 million deal.

You're exiting with 99 million
at closing buyer.

They're still protected because they would
have up to $10 million policy.

And so it worked out great.

And from 2016 to probably about 2024,

the usage of reps and warranties
went from less than 5% of deals

to well over 90% of middle market deals
have some form of this warranty insurance.

And it's been very, very effective.

And what has happened, as Deborah said, is
it was reserved for massive accounts,

massive transactions, usually, you know,
nine and ten figure transactions

because you had you had audited
financials, you had extensive diligence,

you had a lot of background stuff
the underwriters could look at.

Over the years,
as diligence has gotten more

sophisticated, the parties understand
what's going on.

The threshold for eligibility for Reps
and Warriors has come down, down, down

to where there are, in some cases, deals

that can be insured
under $10 million in enterprise.

Five.

There's actually another one for even
smaller deals we'll get into later.

But that's been the process.

You know, the concept with having
insurance is you want to go ahead

and take that risk away from the deal
parties.

They've got enough other friction
to deal with.

But if we take some of that financial risk
away from them, it can move forward.

And so that's how reps and warranties
insurance came about.

And that's what it does.

It essentially stands in the shoes
of the seller to pay the buyer

that indemnity exposure
to cover the buyer's law.

So again buyer is guess remedy

seller gets a clean exit.

Why this is gone very very successful.

Oh sure.

So many of our many of our listeners
are likely

not at this point of a transaction yet.

So let's let's take a step back even with,
you know,

we've done a couple of different podcasts
on reps and warranty

and why they're, you know, what,
what's going to be asked of them.

But let's just remind everybody
that, you know, indemnification is

is promising that what you have said
and what you've put in

your legal schedules in, in the contract
is accurate, valid and provable.

So you
as a seller have to say to your buyer

that, yes, I have told you everything
that could go wrong,

everything that I know to be true,
everything about my whole company.

That's a lot to sign off on.

Because you've been working
in your company

probably 20, 30 years,
maybe your third generation.

Right.

So you're saying that to your knowledge,
all of this is accurate,

and reps and warranty insurance can help

step in in situations
where maybe you haven't been operating it

for the last five years
and your CEO has been operating it, or

your granddaughter
has been operating it, or.

Right.

So there are times that as an owner,

this isn't all in your knowledge base.

And your buyer is looking at it as you're

the expert, and you should know it.

All right.

So this is by, by bridging that, you know,

practical knowledge basis.

It gives
it gives a platform to help de-risk it.

Absolutely.

And you have to understand that the,
the buyer's perspective on

this is when they go ahead
and they put this onus on the seller,

like, look,
I've told you everything I know,

and the buyer is going to come back
and say, yeah, well, I'm

betting tens of millions of dollars
sometimes that your memory is perfect.

And you told me everything.

And when you go through the day to day
grinding on operations,

even if you're not directly involved,

you're being held to a standard
that you are directly looking at.

Every invoice,
every expenditure out there,

every contract and and contracts either
with key customers or key suppliers.

They they can change.

Or employees. Or employees. Yes.

And and some standards can change.

And some things in regulatory
can change without your knowledge.

And there are things with permitting
and other laws

where a company may be grandfathered in
with whatever they're doing.

They don't have to upgrade
whatever policy, procedure or permit.

And then there's a change of control.

And suddenly nobody thought that
there was going to be any impact on this.

And all of a sudden it happens.

And, you know, for the seller,
unfortunately, you're going to be held

to the standard
that you should have known.

And under the contract,
the buyer is going to come after you.

Yeah.

And we've seen it happen. Right.

It can be something
as simple as an uncollected invoice

and something as complicated as you said.

You had completed all the work
for what you invoiced, and they find out.

Maybe you didn't.

And now they're on the hook
for something that you got payment for.

Or. And it's not intentional.

Nobody's thinking it is,

but it's better to have it covered
by an outside policy,

then to have to hit an escrow
where you left your money,

or in some cases,
take it out of your back pocket

from where you just invested it with your
your purchase price.

Right.

So that's kind of the intention of this.

Is the buyers protected
because they have this to lean on

and the seller is protected
because it's, it's an extra

an extra resource for the buyer

to tap into that doesn't
involve your pocketbook.

Absolutely.

And I let me use an analogy here
because they're

this is is new
and it's insurance is coming in.

It's another expense and so forth.

And so a lot of things to think about.

But let's think about an alarm system
for your home.

Okay.

Some people will say, well,
I live in a really nice neighborhood.

We're not,
you know, we never have any crime here.

Besides, my neighbors
have substantially more wealth.

They got bigger houses,
they got nicer stuff.

So nobody's going to target me.

And by the way, you know what?

We're just never leaving the house
because we don't go on trips or anything.

We stay here.

So we're, you know,
there's always somebody home, okay?

And you think about that, it's like, oh,
I don't need it.

And then you come along
and you get the reality.

And, and this is the mathematics of,
of, of insurance here is that,

you know, with an alarm system,
let's say the alarm system costs $700.

And I just personally went through this
when we bought our house.

But the alarm system was $700.

By getting the alarm system, though,
my insurance cost

for homeowners
insurance went down by $1,000.

So it paid for itself.

And on top of that, you know what?

Now we can go on a trip and not worry.

Okay. And and so it goes.

The same mathematics, the same economics
happens with reps and warranties.

And we can get into costs,
you know, in a moment.

But the mindset

is that what you're trying to do is you're
trying to remove as much financial risk,

both sides because both sides benefit
and and move forward with that.

And I will talk about
there are three major things that reps

and warranties does okay
for all transactions.

And this is why it has become
one of the fastest growing.

Yeah, lies of insurance coverage
out there in the industry

and why it's facilitated
so many M&A deals.

It does three things.

Number one
is that financial risk transfer.

You transfer in the rest.
So there's no more escrow.

And I can tell you in the middle market
nobody.

This is why it's 95% utilization
in the middle market.

Nobody's
going to have a 7 or 8 figure escrow okay.

You know when they can get it for,
you know, 1%.

It just doesn't happen
because it's built in.

So we transfer the financial risk
away from the parties.

That really helps.

The second thing it does is it

optimizes the negotiation process
and really shortens it.

Because there are with having an insurance
policy,

you bypass
the most contentious negotiation points.

How much indemnity,
how long, how big of an escrow.

All those are gone.

Also the scope of the reps,
you know, if you want your your

financial really broad and huge,

you can get them narrowed down now
because the reps were insured.

It makes things a lot easier. Tax,
things like that.

All of those are taken care of.

It will save the parties
tens, even hundreds of hours

billable on both sides of the attorneys
by having this process in place.

The third thing it does, it pays claims
what good is an insurance policy

but doesn't pay claims.

It is the most effective claims
paying mechanism

throughout all of the insurance lines,
I can tell you.

And if you think about it, particularly
if you're selling

and let's say you've got $1
million held in escrow

and the buyer goes in
and gives the announcement saying,

I'm sorry, we're taking the
escrow, there was a breach.

You're not going to take that sitting
down.

You're going to get an attorney
to go and respond to that, okay?

That attorney comes out of your pocket
to deal with this.

If there's an insurance policy,
all of a sudden there's a third party

mechanism and it all gets worked out
and it's in the expenses there.

So it's done some really, really effective
things and it, you know, into the why.

And if you think about it,
for a lot of owners and founders,

you may not have a $300 million
manufacturing company,

but you should see private equity
and a lot of these big,

strategic acquirers
who are cutting $300 million checks.

They don't even think about the ripple
warranty.

Okay? It's just built in.

And when you think about smaller
deals, well, we're too small.

Hey, your margin for error is a lot

smaller than a $300 billion deal.

And so and the cost again,
we will get in the cost later.

The cost is commensurate
with the smaller risk and so forth.

Well,
and one of the very first transactions

that I did, we ended up with
a, with an escrow post close issue.

And the, you know, the seller
had an attorney and an accountant

and all all the all the people back me

all back into the process again.

To kind of re renegotiate, re haggle.

It becomes contentious.

And then do you agree?

Do you agree? Do we need a third party?

You know, that's the accounting,

an additional accounting firm to come in,

you know, then do you go to mitigation?

Do you do you fight it?

Do you agree to it?

Like, it's just not, not a fun process.

Had there been reps
and warranty insurance?

And and a paid for attorney, I think
my seller would have been a lot happier.

Of course, this was.

This was before it was in our territory.

But,
it's one of the reasons that I look at it

and go, that would have been
a different ball game, because our buyer

has an attorney on a retainer,

has an in-house accounting firm.

The only person paying for these services
out of pocket is the seller.

Because
and now you don't even necessarily

have access to the employees
that you would have relied on

to help with this process
because the buyer owns them now.

Yeah. So

having having that backup built in is,

is a nicer feeling that should help
you sleep better at night.

Yeah,
I would, I would think for peace of mind.

It's a wonderful tool.

And there are two scenarios out there.

You've got the owners and founders
that want to get a clean exit.

They don't want to think about anything.

They just want to write off
into the sunset.

They've got some other new venture
they want to get get involved with,

and they will have
as much of their money out there.

That's one thing.

You do have another set of owners there

that they want to,
you know, upgrade and level up.

And so they are, you know, rolling equity

to the new to the buyer
and moving forward.

And I can tell you
and I'm in Silicon Valley, that gets very,

very awkward
when you are rolling a lot of equity over.

And, and the buyer goes in
and says six months into it, you know,

there's been a problem,

and if there's no insurance that's
going to come out of somebody's pocket.

There is a dilemma in Silicon Valley,
depending on the size of the deal,

where some buyers are so afraid
that they're going to demoralize

or lose these rock star programmers
and coders, they just quired

they're all going to disappear on them,
that they're just like,

you know,
we're going to have to eat the loss.

Okay.

Now, you know,

now that's taken away from the two sides
and it works out very, very nicely.

Great.

So let's talk about by side
versus sell side.

Sure. Okay. There are two flavors.

You know for your analogy
there of reps and warranties.

And it just depends on
who the policyholders who the insured is.

The traditional policy is a buy side
policy okay.

It is in the name of the buyer.

It requires the buyer to perform

extensive due diligence, share
that diligence with with underwriters.

Okay.

And if in the event there's a breach
and that the buyer suffers financially

because of a breach,
then suddenly the buyer just goes,

we don't even talk to the seller.

The buyer just goes right to the insurance
company says, here's my breach.

Here's the math.

How I calculate a $1.5 million
loss of value in the company

because of this breach,
and they'll sit down and work it out.

It is the traditional form of reps
and warranties policy.

The formats, you know, the vast
majority of policies are biased policies.

The challenge is the cost.

There is a $40,000 underwriting fee
at the start

that underwriter is going to charge.

When I say they have to look
at the diligence reports and so forth,

their underwriters are going to require
a legal diligence report.

They require, in most cases, audited
financial.

Some cases they will allow a Q of report
rather than that.

And then a lot of other third parties
have to come in here.

Consultants,
operational consultants, environmental.

They're not just going to take
the buyers. Word for that.

Well we looked at everything looks great.

They're going to require that.

So there's an additional expense.

But again that that's consistent
with $100 billion transaction.

You're going to spend $1 million
in diligence to get that right okay.

And it moves forward.

It is very broad even in the event,
because the underwriting process

doesn't even consider
or touch base with the seller.

So even in the event of seller fraud,
where the buyer just didn't catch it

and the seller lied or misrepresented
things, the policy is going to pay

the buyer provided
the buyer didn't know about it.

And again.

Starting costs on
these policies is going to be about

130,000 $140,000.

Add the $40,000 underwriting fee.

And so, underwriters
provided the diligence

as their underwriters are open
to ensuring transactions.

As I've written a bias policy
for a $9 million enterprise value deal.

And so it is available

if you're willing to deal with the cost
and you and you can qualify

for the underwriting,
that's fine if you don't have the reports.

Here's the problem.

If you don't review something because
you don't want to pay for it, that's fine.

It's in the report warranty.

So it is a challenge there.

Now, as broad and robust as that policy
is, it's not necessarily

a fit for deals that are priced
between 1 million and 30 million.

A lot of these are going to be add
ons to other platforms

or just independent sponsors, small,
you know, search funders,

other organizations
or small strategic organizations

that don't have a full corp
dev department.

But they want to go ahead and acquire,
you know, another, another commercial

business in, in, in a new research
or whatever, you know, those

sub $30 million

deals have been kind of stuck where
if the buyer doesn't

like to spend the cost on rep of warranty,
they go forward without insurance.

There is now product for.

Before we get to the next product,
let's let's just

poke on the the buy side policy
for just a minute.

As a company owner
looking to sell your business,

it is unlikely that you get much say

in having a buy side policy.

Generally the people in that,

you know, sub $30 million transaction,
it's the buyer coming in saying,

we've used this before, we want to do this
because we like it as a seller,

you'll find that,

you don't get a lot of say
and putting in a buy side policy.

So let's talk process for a second.

Where do we learn what the
what the buyer wants for reps and warranty

and where do we
where can we motivate somebody?

And we see it in the negotiation
of the letter of intent.

That's the first place where you want
to hear them talk about indemnification

reps and warranty and whether or not
they're considering an insurance policy.

So but by side you're the seller.

So you have very, very little control.

That does not mean
they will not ask you to pay for it.

That does not mean

that they won't take down
the purchase price to accommodate for it.

So these are kind of the T's
and sees that, you know,

when we work through an alloy,
we want to keep our, our ears up

to make sure that,
that we have an understanding of that.

So if your buyer is unwilling to do it

because of cost, expense, time,
and you still want to do something

because you're the kind of person

that wants to either
reinvest all your money or move,

you know, sleep better at night, whatever,
whatever your own proclivities are.

There's another way to do it.

And that's
that's the second option, right?

It's the cell cycle.

Well, you mentioned a couple things that's
really highlight on this is the time

to discuss the concept of whether or not
there's going to be insurance.

Okay.

The low time is ideal for that
and for sell side advisors out there.

And also for sellers,
this gives you a chance for some leverage.

And you're not getting pushed around
to, you know, extensively by the buyer.

But you know question one
is there going to be insurance yes or no.

And if there is insurance,
there should not be a big escrow,

because the purpose of the insurance
is to replace the X for escrow

as much as possible.

There are some buyers that just out
of principle, they want skin in the game.

They're going to require something.

And so you debate you can debate that.

But then it will be
the concept of repertoire T-shirts.

If the buyer insists
that it's going to be a buy side policy,

they have made a decision because
they have to do all the underwriting.

They have to do all the involvement
with the underwriters.

If they're open to doing that,
it really is their call.

Okay, because as much as a seller
may want a buy side policy out there,

if the buyer doesn't agree
that it's not going to happen.

But first, you get the idea that there's
going to be insurance in there.

Then if the buyer says by a side,
you move forward, that that's wonderful.

Now a lot of times the, you know,
you do have the case with the buyers,

like we're going to get a buy side policy
and you're going to

we're going to split the cost 5050,
which is now common.

Okay.

If you're the seller, you could the
we have posited this

on a couple of occasions
where the seller says, well, look,

if if I'm paying half the cost,
I should have some say into

which insurance policy,
you know, is going to get,

you know, particularly
if you get a couple of bias policies

and one is 250,000
and the other one is 230,000.

Yeah.

I'd like some input if I'm paying
half of that, which is reasonable

now for transactions that are under

$30 million where this makes sense.

There's an alternative to this by side
with a $40,000

underwriting fee
and $130,000 minimum premium.

Okay, there's now a what
we call a sell side policy.

The Brits branded seller protect.

It was designed for a lot of these smaller
deals, between 1 million and 30 million

that were getting no insurance
because the buyer just wasn't going to get

because cost
something is better than nothing.

And so what happened was Lloyd's of London
developed this product

where what we do is we ensure the seller
rather than the buyer.

The by doing this,
we underwrite the seller

rather
than getting the third party diligence.

So there's no underwriting fee.

We limit the scope of the types
of industries are eligible.

It's usually business services, light
manufacturing, technology, simple things.

We just stay out of things
like healthcare,

banking, heavily regulated industries.

But we do the smaller ones,
they're smaller,

they're less risky
and they're less complicated.

So why charge a higher rate?

And so with an application process,
no audited financial is required,

no queue of okay financial information
and a simple application.

We can provide terms where the pricing,

the rate goes between 15 and $20,000

per million in limits,
a fraction of the cost of a biased policy.

Is it as broad?

Well, it's not going to cover the fraud
entirely as it does on the other side.

That's one.

Number two, if you have a, a company
with very heavy asset values,

we're a multimillion dollar equipment,
multi-million dollar inventories.

It may not be a fit because it's not going
to cover a condition of assets reps.

Outside of that, though,
for most businesses it is a viable option

that can come in there
and you figure you figure the cost.

Again if a buyer and this is one argument

that we are having now
with a lot of construction companies, HVAC

organizations, those types of businesses
were $20 million enterprise value.

I just give you the math.

On a $20 million deal
outside of insurance, there's $2 million

that's put aside.

Sellers
got to wait a year for $2 million over.

Two months. For 18 months. Yes.

Outside of that,
if we were to go to a by side policy,

you're looking at
a, you know, a 2 or $3 million limit

policy is 175 to $200,000 in expense.

You split that, you go seller
protect a $5 million

limit policy is less than 100,000,
maybe $90,000.

Okay, 5 million

in protection,
a deductible now of 50,000, let's say.

And you have now if you split this 45,000.

And so what
the seller can say to the buyer

is, well, I know you want to buy a side
and it's going to cost,

you know, $200,000.

Well, I've got this thing as 90.

What do you want to do.

And so there is there are options.

I would say this
we can get into a longer explanation.

I would just invite people to,
to speak with me

about this, to get in the granular
on the differences between the two.

But what we look at
is that by side is the broadest, most

product out there.

Sell side where it fits.

It makes great sense, particularly
if you do,

you know, you do cost benefit analysis.

Either
one is better than no protection at all.

And I think that's where we want to do
I mean, you know, sellers shouldn't

have to struggle with seven figure escrow
and with rebel warranty.

They don't have to.

It's just their options available.

Great.

Well, Patrick,
thank you for joining us today.

We appreciate the time
you've put on this.

You hit the nail on the head.

If somebody wants more information
we would encourage them to contact you,

your socials and your bio
and all of your page links are going to be

on the the bottom of the touchstone page
and be on our LinkedIn socials as well.

So I have one parting

question
that I ask all of my all of my attendees.

If you are not working in the insurance
realm,

okay, this this job is off the table.

What other career path
would you have gone into?

Boy that's tough.

It's a little different now because,

I'm Gen X, and so we're brought up.

We were thinking, you know,
going into white collar jobs and so forth.

I'll tell you, with the things
that swing now, I wouldn't mind being,

in construction,
you know, a contractor building things.

I, I, I love the grit and the thing
of being able to have something tangible.

So I probably would be a builder that,
that or that or I would teach history

one of the two.

Because then I can go
and do a lot of talking.

So two, two offices, things
I, I would not have given you that,

that any answer 5 or 6 years ago.

But I'll tell you
again, I'm in Silicon Valley.

You do not have a,

in construction.

You don't have a poor plumber,
electrician or contractor.

Okay?

They actually have nicer vacation homes
than most of us in Silicon Valley.

So that's probably the place
I would have gone.

We see the same thing in New England,
so that's not special for California.

I think that that our
our hands on construction plumbers

and mill workers and,
and they're all doing really well here

and they're not going
to be taken out by AI. No.

Nobody can AI build a.

It is a proof or a building.

Yes, absolutely.

Well, thank you, Patrick, for joining us.

And if you are just seeing Touchstone
Talks for the first time, please

make sure you like, subscribe and follow
on all of your favorite podcast platforms.

Means we.