One of the most tricky steps in any M&A operation is when the issue of “warranties”, in particular with reference to the economic situation, the balance sheet and the financial position of the company or business (or of a branch), namely the so-called “business warranties“.
On one side, the buyer would like to “ironclad” his investment by reducing the risk of an unpleasant surprise to a minimum. The seller, by contrast, wishes to provide the least possible warranties, which often translate in a provisory restriction on the full enjoyment of the proceeds; the same may be essential for further investment.
It should be noted, first of all, that the term “warranties” is usually referred to, in a non-technical acceptation, to a complex set of contractual provisions containing:
- any seller’s statements about the health of the company or business (or branch of business) being transferred;
- any compensation obligations undertaken by the seller in case of “violation” (i.e. mistruth) of the assertions;
- any remedies provided to ensure the effectiveness of the indemnity obligations entered into.
While there are several reasons why this set is necessary, the most significant one is that in M&A contracts, statutory sale warranties only apply to the good sold; therefore, if the good sold is an equity investment, the warranties do not cover any of the company’s underlying assets; and even as they exceptionally do apply, short terms and strict limitations still justify an ancillary obligation designed to ensure the economic success of the transaction.
As confirmed by current practice, there is not a single M&A agreement that does not include a set of warranties.
In particular, representations typically incorporate the buyer’s due diligence, which for its part usually follows a non-disclosure agreement (NDA) to protect any information disclosed.
Any criticalities identified should be properly mentioned. Clearly, wherever a criticality arises, it may not necessarily trigger an indemnity obligation. It will be up to the parties to lay down the rules, as they may also provide that any related risk is to be borne by the buyer; this may be offset by a reduction in the price.
Some aspects of the compensation obligation will have to be carefully negotiated. The main ones are certainly:
- duration (e.g. longer for tax-related warranties);
- who is entitled to compensation (the buyer or the company; one or the other as the case may be);
- any deductions and/or limitations (e.g. tax losses);
- compensation cap;
- any possible deductible;
- the compensation procedure (e.g. application deadlines, settlement procedure, particular circumstances).
These are highly relevant aspects and should by no means be underestimated. As an example, it is obvious that if the compensation procedure is poorly regulated, all the previous efforts are jeopardised.
Finally, suitable measures to ensure an effective protection of the buyer must be provided. Among these, the most conventional tools are:
- the surety;
- the “independent contract of guarantee”;
- the escrow;
- the deferment of payment;
- the “earn-out”-scheme;
- the “price adjustment”;
- the letter of patronage;
- the pledge and/or mortgage.
These are more or less widely used instruments, each one with its pros and cons.
At this point, however, we would like to address a new tool with an insurance character, which has been being used recently: the so-called “Warranty & Indemnity Policies“.
With a W&I insurance policy, basically, the insurer assumes the risk resulting from breaches of warranties and indemnities included in an M&A contract upon payment of a premium.
It is obviously a key condition that the violation arose from facts preceding the closing and which were not known at that time (and, therefore, not highlighted by the due diligence carried out).
The insurance policy may be subscribed by the buyer (buyer side) or the seller (seller side). Usually the first option is preferred. These W&I insurance policies come with a number of advantages:
- a warranty is given even when the seller has been unwilling to commit himself contractually;
- the insurance policy usually does not provide for any recourse against the seller, other than in the case of malice, so that the seller is fully released;
- it is also possible to achieve a higher ceiling than that provided for in a purchase agreement;
- likewise, coverage may be provided for a longer period;
- it is easier to deal with the seller, especially if there are several and some are still part of the company, perhaps as members of the Board of Directors;
- compensation procedures become significantly easier, especially in cases where there are multiple sellers, including individuals;
- the buyer gains a higher certainty of solvency.
The cost of the insurance policy may be shared between the parties, eventually by discounting the purchase price, which the seller may be more willing to grant, considering that he will not be required to issue other warranties and can immediately use the proceeds of the sale.
Premiums are usually set somewhere between 1% and 2% of the compensation limit (with a minimum premium).
Besides the price, which makes the tool mostly suitable for operations of not modest entity, currently, the main limitation seems to be the commonly required deductible, equal to 1% of the Enterprise Value of the Target, which may be reduced to 0.5% in case of higher premiums. Keep in mind that the W&I insurance policy implies a review of the due diligence by the insurance company, which can translate into an actual intervention in the negotiation of the warranties.
Beyond this, this tool needs to be carefully evaluated: facing highly complex scenarios, it could be the ideal solution to solve an impasse in negotiations and make relations between professional investors and SMEs easier.