Tech exits are on the increase in New Zealand. One of the trends in M&A deals is the increasing use of warranty and indemnity insurance (W&I insurance). This guide covers briefly what W&I insurance is, typical policy exclusions, key drafting considerations, the process of obtaining cover, and premiums.
why W&I insurance is used on M&A deals
On any sale of a company or business, a buyer will require certain warranties and indemnities to be provided by the sellers. The question of who carries the liability, and how much, is a key negotiation point. Buyers will want to allocate risk under the transaction as much as possible, and ensure they have sufficient financial protection in the event of a breach.
Tech businesses often grow via investment from third parties. That means that the company at the point of exit may well have institutional shareholders such as private equity and venture capital funds. Such investors will not generally agree to be liable for a substantial part of their sale proceeds for breaches of the warranties and indemnities on M&A deals. This may result in parties agreeing to hold a small portion of the sale proceeds in escrow to reimburse the buyer if there are claims (often around 10% of the total sale proceeds).
This level of protection may ultimately not be sufficient for the buyer. Or it may instead result in additional liability falling on founders who may be critical to the business going forward, and may even be retaining a small interest post-sale. If buyers need to bring claims post completion against founders that are still involved with the business , this could cause tension and affect the ongoing relationship.
Getting this balance right can create a deadlock in negotiations. Buyers want broad warranties and indemnities and sufficient financial protection for claims. Sellers on the other hand want a clean exit to minimise the financial consequences of a claim and to avoid deferred or escrowed amounts of the sale proceeds, if at all possible.
This sometimes creates a potential liability gap on M&A deals for which the answer can be warranty and indemnity insurance.
what is W&I insurance
W&I insurance is a product which can partially protect against the financial impact of breaches of warranties and indemnities under a sale and purchase agreement (SPA). A W&I policy can be taken up by a seller or buyer, but buyer cover is the most common. As a result, this guide focusses on buy-side cover.
In simple terms, under a buy-side W&I policy, if there is a claim under the SPA following completion, the buyer must recover under the policy and is prevented from seeking reimbursement from the sellers, subject to any policy exclusions.
Like all insurance policies, W&I cover always contains exclusions. One such exclusion will be fraud but there will be several other general exclusions and potentially some that are specific to the transaction or the type of target company involved. These exclusions create a new liability gap which then needs to be negotiated between the buyer and sellers as to who retains the risk for breaches of these excluded matters.
Over time, policy exclusions have become more standardised, and will likely include some or all of the following:
- forward looking warranties, financial forecasts and projections
- purchase price adjustments arising out of locked box mechanisms and completion account adjustments
- criminal penalties and fines
- claims relating to cyber breaches, which may be particularly relevant for sales of tech companies
- anti-corruption matters
- environmental breaches
- property defects
- consequential losses
- claims relating to Holiday Act 2003
A key point to note is that matters already known to the buyer will always be excluded. Therefore, liability under specific indemnities for known matters under an SPA will not be included. Nor will any item formally disclosed by the sellers in a disclosure letter or otherwise known to the buyer pre-completion. As with any matter disclosed pre-completion, once on notice of the issue, a buyer needs to evaluate the risk and either adjust the purchase price, or seek a specific indemnity for any potential future loss.
The SPA and W&I insurance policy should be carefully reviewed and read side-by-side to ensure that there are no gaps in cover (other than those agreed), and that exclusions are carefully drafted.
In particular, the following key drafting points should be considered:
- Typically an SPA on a W&I insurance deal will look like any other SPA with the usual full suite of warranties, and limitations on liability providing protections to sellers. However, the SPA will additionally contain specific language making it clear that the buyer’s sole recourse for breaches of all warranties under the SPA will be against the insurer, with no separate recourse against the sellers. Buyers may try to put this obligation on a best endeavours basis, but sellers should resist this – the requirement to seek sole recovery against the insurer should be absolute.
- W&I insurance is not a substitute for buyer due diligence and negotiation of the SPA on the business or company being sold. In fact, insurers insist on seeing the due diligence reports and reviewing the warranties in the SPA to ensure that there has been a reasonable negotiation process undertaken. The result can be that buy-side W&I underwriters actually require certain warranties to be narrowed or qualified by materiality or awareness so they are less onerous on the sellers.
- Insurers often expect parties to assume some financial risk, i.e. the excess. The sellers will want to link their maximum liability cap under the SPA to the excess under the W&I insurance policy. For example, if a policy will cover all losses above an excess of $100,000, the sellers’ liability under the transaction documents should also be capped at $100,000.
- The duration of the coverage should mirror the duration of the warranties given under the SPA, including a customary longer period for tax claims. Any claim under the W&I policy would need to be notified within the stated policy period.
- The SPA is likely to set out a schedule of those excluded warranties which should mirror the W&I policy document. Care should be taken to check these line up exactly. The SPA should ensure that any warranties excluded from W&I coverage remain subject to all other limitations on liability under the SPA, including separate financial caps on liability.
- Check that the W&I insurance policy terms do not conflict with the conduct of claims provisions negotiated under the SPA. These need to work together.
- Even if W&I insurance is used, any limitations of liability under the SPA will not apply in the event of fraud by the sellers.
- On a buy-side W&I insurance policy, sellers should insist that the right to subrogation against them should be waived by an insurer. This prevents an insurer which has paid out money to a buyer being entitled to step into the shoes of that buyer as an insured person and recover all or some of compensation from the sellers. The common exception to this waiver is claims involving fraud however.
process for W&I insurance
When W&I insurance was first introduced for M&A deals, there was some skepticism particularly around the impact on the transaction process and timetable. Over time, underwriters have streamlined the process for getting W&I insurance in place. The steps might look something like the following:
- initial review of term sheet or draft SPA by the broker
- submission to insurers to seek pricing
- calls between buy-side lawyers and broker
- insurers provide terms, subject to due diligence
- due diligence by underwriters and their lawyers
- issuance of draft policy for review by advisers
- finalisation of policy wording and equivalent W&I insurance language / warranties in SPA.
- confirmation of binding cover and signed policy
- completion of M&A transaction under the SPA
Whilst some of the above steps can be undertaken at the same time as negotiating the SPA, they may impact slightly on the overall timetable and process. For example, there is added pressure to get the SPA in near final form as soon as possible so this can be shared with the underwriter. Similarly, due diligence reports and the disclosure letter need to be finalised and submitted, and ideally there cannot be material ongoing revisions to these documents following the point of submission. Otherwise, the underwriter will need another round of reviews and discussion with the buyer’s lawyers.
As W&I insurance becomes more commonly used in the NZ market, premiums have come down and could be around 1%-2% of the insured amount. There may be additional costs to cover the underwriters’ due diligence. The cost of the premium may well be borne entirely by the sellers, on the basis that the effect of the policy is that sellers’ liability is being reduced. More commonly however, it is split between the parties in some agreed proportions. The premium is usually paid up front on the date the policy becomes effective (i.e. on completion of the deal). In practical terms, the SPA often accounts for this payment in the provisions covering the distribution of the sale proceeds, particularly if the sellers are making a contribution to the premium.
We have an experienced team of corporate lawyers regularly advising on tech M&A deals. If you are considering the sale of your tech company or business, get in touch.