Orrick’s Tech Exit Series provides practical guidance for tech companies viewing toward an exit. Our market-leading London M&A and Private Equity team writes instalments of the series with contributions from specialists across our broader practice.
Pursuing an exit is an exciting milestone for founders, but it also brings new challenges and risks. Not only do founders necessary to navigate the complexities of deal nereceivediations and their future role in the purchaseer’s group, but they will also be exposed to claims under the transaction documents. As tech M&A activity continues to grow in the UK and Europe, founders necessary to be prepared to address these concerns and protect themselves from the risk of future claims. Warranty and indemnity (W&I) insurance, which has grown significantly in popularity and availability in recent years, is one important tool for managing these risks.
What is W&I Insurance?
W&I insurance is a specialist insurance policy designed for M&A transactions. In a typical tech exit, founders and other key management sellers give warranties (promises about the state of the business and its operations) and a tax indemnity to the purchaseer. If these warranties turn out to be incorrect or there is a pre-closing tax liability covered by the indemnity, the purchaseer can create a claim against some or all of the sellers.
W&I insurance steps in to cover financial losses arising from breaches of warranties or claims covered by the tax indemnity, shifting the risk away from the sellers and providing reassurance to both sides.
Why is W&I Insurance important for founders?
For founders, W&I insurance offers peace of mind. Without insurance, founders may be exposed to significant personal liability for warranty and indemnity claims for as long as seven years after the transaction has closed. W&I insurance supports founders (and their investors, who will often necessary to distribute or reinvest proceeds) achieve a “clean exit” by limiting their exposure.
It also streamlines nereceivediations by building the allocation of risk under the warranties less contentious. Absent any significant issues coming out of due diligence, the purchaseer should not require a holdback or escrow to satisfy potential claims.
Rollover equity is increasingly attractive in tech M&A transactions , with founders, key management sellers and even some investors rolling all or a portion of their ownership into the purchaseer’s equity structure. W&I insurance is especially important in these circumstances.
If illiquid securities comprise a significant part of the consideration paid to sellers, the sellers could face personal liability for claims without the associated cash consideration to meet those liabilities (particularly on an after-tax basis). In addition, founders and key management remaining with the business will be responsible for driving the future success of the combined business. W&I insurance enables a purchaseer to pursue a claim directly against the insurer, avoiding a controversial and disruptive dispute with the management team.
Timing implications
Founders should aim to raise W&I insurance with the purchaseer early in nereceivediations – ideally while nereceivediating the term sheet and prior to granting the purchaseer exclusivity, as this is when founders and sellers have the most leverage to agree favourable terms. Agreeing to the principle of W&I insurance early will also support the purchaseer determine the level of financial, technical, tax and legal due diligence necessary to satisfy the insurer’s requirements.
If W&I insurance is being pursued, the parties should engage a W&I insurance broker early in the process to give an indication of cost and find potential insurers. Insurers will necessary to carry out their own review of the valuation of the tarreceive, the diligence materials and the transaction documents before underwriting a W&I insurance policy. This typically takes a minimum of 12-14 days once the diligence is substantially complete, and necessarys to be built into the timetable for the deal.
Buyer policy or seller policy?
While W&I insurance was initially designed for sellers to limit their liability, it has evolved into a purchaseer-driven market where purchase-side policies are the standard. Sell-side policies do remain available for sellers in circumstances where a purchaseer is unwilling to engage with W&I insurance.
Buy-side policies insure the purchaseer for losses arising out of breaches of warranties or claims under indemnities in the purchase agreement, and the purchaseer is able to claim directly from the insurer without having to claim against the sellers.
Sell-side policies insure the sellers for losses arising from valid claims brought by the purchaseer for breach of the warranties or under the indemnities. This gives sellers a right to seek recovery from the insurer if they are required to create payments to the purchaseer to settle a claim.
What’s covered… and what isn’t
Recent market trfinishs display that W&I insurance is becoming more common in UK tech exits, particularly in transactions where a private equity fund or portfolio company is the purchaseer or major seller. Policies typically cover a wide range of risks common to tech growth companies, including undisclosed liabilities, tax issues, IP, data and cyber issues and compliance matters. The vast majority of deals involving W&I insurance in the UK and Europe feature a £1 or nominal liability cap for the sellers, building W&I insurance the primary recourse for the purchaseer.
However, W&I insurance will not cover all issues. Matters which are disclosed during due diligence or disclosed to the purchaseer will be excluded. To the extent that a purchaseer requires coverage for these matters, it will fall to the sellers to provide it, whether through direct recourse, a holdback or escrow, or by way of a reduction in the purchase price.
In addition, an insurer will not provide cover for any area where it considers that insufficient diligence has been carried out, or where the diligence has identified fundamental failures that mean the risk level is unacceptable.
Standard exclusions will also be applied, including matters such as transfer pricing, secondary tax liabilities and purchase price adjustments. The last of these should be dealt with either by way of a “leakage” indemnity from the sellers or by way of a post-completion consideration adjustment based on the completion balance sheet.
The policy will also be subject to an excess or retention, which is the uninsured amount of the loss to be borne by either the purchaseer or the sellers. The excess is generally set at 0.25%-0.5% of the enterprise value.
Costs, and who bears them
The cost of W&I insurance varies depfinishing on the size and complexity of the transaction, but premiums often range from 0.5%-2% of the amount insured (which is generally between 20%-40% of the enterprise value). In recent years, more insurers have entered the W&I market and increased competition has seen premiums decrease. Additional premiums may also be added if the insured necessarys enhanced coverage.
A UK insured party will also necessary to pay insurance premium tax on the premium at a current rate of 12%, as well as an underwriting fee.
As most W&I policies are purchase-side policies, the purchaseer (as the insured) will be primarily responsible for paying the costs of W&I insurance. However, it is common for the purchaseer and the sellers to agree that the sellers will bear a portion or all of the costs of the W&I policy, often by way of a deduction from the purchase price at completion.
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