Risk in M&A deals
The M&A process centres around the allocation of risk. In a typical sale, the vendor provides representation and warranties to the buyer to be outlined in a Sale and Purchase Agreement (SPA). These are factual statements about the target business covering all key aspects of the business, such as employees and accounting records. The provision of this information is intended to protect the parties involved, highlight any inconsistencies and misrepresentations and give buyers the right to bring claims against sellers for losses arising out of a breach of the warranties.
Why use W&I insurance or escrow services?
Good advice, full disclosure and robust due diligence normally mean that claims are rare. However, rare does not mean impossible. With large sums of money involved, the possibility of undisclosed matters or misrepresentations is still risky, and many do opt to insure against the warranties to protect their finances.
While W&I insurance may appear to be the obvious solution, we must not forget the alternatives, not least escrow. In this article we will consider both the W&I insurance and escrow options, comparing value points such as speed and cost.
What are the costs involved?
Generally, the minimum premium of W&I insurance is £50,000. The cost will be calculated in the region of 1% - 1.5% of the amount of coverage required but will be dependent on factors such as jurisdiction, industry sector and financial stability of parties involved. However, there are other costs involved:
- Sharing risk: Most insurers will expect sellers to share some of the risk by ensuring they pay an excess (normally 1% of the policy limit) to be held in escrow.
- Legal charges: Insurers may look to engage lawyers to review the documentation and add these costs to the premium.
- Tax: W&I insurance comes with an insurance premium tax, currently set at 12%.
- Investigating and bringing a warranty claim: In the event of a breach, the insurance provider will usually add extra costs for the investigation process.
There is no set way to charge for escrow meaning each provider will charge slightly differently; you need to be sure you are comparing like for like when comparing options. Providers may charge in one or multiple of these ways:
- A percentage of the amount of money held
- An initial setup fee
- An annual fee - dependent on the length of the escrow
- A set cost per payment out of the escrow
While this may seem clear-cut, watch out for hidden charges! The provider may include more complex pricing mechanisms dependent on circumstance. For example, there could be a low annual fee but an obligation to pay a margin of monies escrowed if interest rates are below a certain level – this can become very expensive very quickly.
At Shieldpay we keep it simple. Once we have understood the key components of the transaction, we will quote a one-off, all-inclusive fee.
What are the advantages for buyer and seller?
- Clean exit: Individual sellers can have access to the sale proceeds immediately as there is no need to hold back sales proceeds in an escrow account. This is particularly attractive for sellers wishing to roll funds into future investments.
- Value enhancement: The transaction price could be enhanced by allowing full warranty provision to be made where they otherwise may not.
- Covenant strength: Where the buyer has concerns about the sellers' covenant strength, claiming under a W&I policy removes the risk that the seller will not be able to pay against any warranty claim that may arise.
- Relationship: Where sellers are still employed by the business after completion, there may be a reluctance to bring a claim against retained valuable staff.
- Cost: As noted above, escrow can be more cost efficient with the right provider and simple cost structures.
- Ease: With standard form contracts widely accepted in the legal industry, there are no lengthy contract reviews and negotiations to be wrapped up in.
- Simplicity: The standardisation of escrow terms means it can be straightforward to set up, close and manage any claims. W&I insurance policies, however, often add complexity to the process, both at the initial stages of arranging the policy as well as in recovering indemnification, especially as the policy will have exclusions to the coverage.
- Time: W&I can take several weeks to be put in place as they require an extensive document review period. If time is an issue, Shieldpay can have an escrow account set up in 48 hours.
- Tradition: Not all buyers find the same level of comfort in W&I insurance and prefer a traditional approach where the vendors stand behind the warranties to an agreed cap, held in escrow.
Every transaction is different and will require different solutions to ensure both the buyer and seller come to an appropriate agreement on how to manage risk in the acquisition. In some cases, this may actually involve the use of both escrow and W&I insurance; the two solutions are not mutually exclusive.
On larger deals, for example, the vendors might be asked to stand behind the deductible on the W&I insurance, in which case escrow will be used. There may also be cross-over if the buyer or seller wishes to extend the extent of the indemnities solution, opting for W&I insurance but combining it with the use of escrow to cover exclusions in the policy, such as known risks.
Shieldpay's technology-led escrow offering brings speed, efficiency and ease to the traditional escrow product for the professional, financial and legal services industries.
Ready to explore the escrow option? Enquire today to find out more - contact Robin Bates to discuss your upcoming escrow requirements.