The past several years have seen a rapid rise in deal volume in the technology sector, with cash-rich strategic acquirors from all sectors (including many old-line industrial companies) seeking to expand capabilities through regular acquisitions of privately-held startups.
This “boom” in strategic M&A levels, together with robust activity by financial sponsors aiming to deploy record levels of dry powder, has resulted in increased competition for tech targets.
With so-called “proprietary” deals declining in frequency, many buy-side tech companies have found themselves under pressure to distinguish their offers from competing bidders.
Last year’s release by Atlassian, a NASDAQ-listed enterprise software company and serial acquiror, of a model term sheet for its acquisitions is emblematic of this pressure. In Atlassian’s own words, the term sheet is intentionally “more favorable to selling companies than any [it has] seen among strategic acquirers in technology” and designed to make the “M&A process more efficient.”[1]
Clearly, Atlassian published the term sheet t o trumpet itself as a culturally-friendly buyer for founders and key employees. Notable among the deal terms proposed by Atlassian is the substitution of a rep and warranty insurance (“RWI”) policy in place of a traditional seller indemnity secured by an escrow funded with a portion of the sellers’ deal proceeds, a structure commonly used in the Valley.
Although RWI policies have become a relatively and increasingly common feature of private M&A transactions, [2] their use has traditionally been concentrated among financial sponsors, seeking alternative means to sweeten bids in the face of price constraints (due to a lack of synergies).
Even as strategic acquirors have increasingly turned to RWI policies to stand out in a competitive M&A landscape that increasingly sees strategic acquirors competing with financial buyers on price, the tech industry has lagged certain of these other sectors in its rate of adoption (see Figure 1).
Does the release of the Atlassian term sheet point to RWI policies becoming a mainstay of tech M&A negotiations in the foreseeable future?
Glass half full: the upside of RWI
RWI policies were developed as a tool to assist buyers and sellers in “bridging the gap” around risk allocation in M&A negotiations. By offering an alternative to post-closing seller indemnities while still providing buyers with coverage for breaches of the sellers’ reps, RWI policies provide counterparties with a path to avoiding costly and time-consuming negotiations over the exact scope of reps and related indemnification obligations.
In addition to such process benefits and the potential competitive advantages of agreeing to accept RWI as a buyer’s sole post-closing remedy in a bid, RWI may also offer strategic tech acquirors the following advantages:
Improved indemnity coverage
In cases where seller indemnities are limited, RWI policies offer an opportunity to expand the scope of coverage for breaches of reps. Notably, acquirors may be able to negotiate longer survival periods for reps (both generally and for particular reps) or higher caps for recovery.
For example, for an additional premium, RWI carriers sometimes offer incremental coverage limits relating to IP reps for deals in the $100m-$500m range. Such improved terms may be particularly useful in acquisitions of IP-heavy businesses, where acquirors may require more time to detect a breach of reps and the resulting losses (which may be substantial).
The cost of this additional premium will depend on the specific facts and circumstances of diligence but in some cases may not be meaningful to the overall transaction.
Protection of relationships
Given the prevalence in the tech industry of so-called “acqui-hires”, where targets are identified primarily for their management and engineering teams who also often happen to be selling stockholders, it is essential that acquirors be able to preserve relationships with those selling stockholders who will continue as employees and may comprise the primary thesis behind the transaction.
By relying on RWI policies, acquirors can
- avoid creating bad blood with employees who might otherwise be subjected to indemnification claims; and
- bring claims for recovery—in this case against a third-party insurer—that they otherwise might have avoided for fear of alienating key employees.
Ease of claim collection
RWI policies provide acquirors an alternative to having to pursue indemnity claims against counterparties who:
- may not be creditworthy (in the case of a selling stockholder that is a fund that liquidates all its holdings regularly or by a specified time horizon); or
- may be numerous (e.g. as is increasingly the case with private tech companies that often have in excess of 1,000 equity holders as they remain private longer and issue more equity to employees and third parties in reliance on flexible SEC rules and with the support of a strong market for private company stock), with the buyer instead holding a claim against a large credit-worthy insurer, often with an interest in “making right” by insureds if it wants to keep selling policies.
Glass half empty: the downside of RWI
Despite the growing maturity of the RWI market, the product is not without its drawbacks for strategic tech acquirors, including the following.
Standard exclusions
Certain subject-matter exclusions under RWI policies are standard, including losses relating to wage-and-hour claims, asbestos and PCB contamination, underfunded pension costs, failures to meet projections, government fines and breaches of covenants.
To the extent a target company’s risk exposures may be particularly high in any of these areas, an acquiror should think carefully about the appropriateness of using an RWI policy in that instance.
Deal-specific exclusions
Depending on the contours of a transaction, RWI providers may choose to expand the standard set of subject-matter exclusions to include other deal-specific items and limitations.
Due diligence red flags
Acquirors are unlikely to receive the benefit of coverage for areas of heightened risk that are identified during due diligence.
While some have argued that this creates an incentive for acquirors to limit the scope of their due diligence, RWI carriers are generally quite adept at detecting diligence gaps and will add policy exclusions accordingly.
Furthermore, RWI policies adopt an “anti-sandbagging” approach, whereby breaches of reps known by the insured’s deal team at the time the policy is bound are excluded from coverage. (Although strategic tech acquirors may not be used to accepting an anti-sandbagging construct for purposes of indemnity provisions, it bears noting that “knowledge” in the RWI context is generally defined in a pro-policyholder manner (i.e. the actual knowledge of the policyholder is required both of the underlying facts and that they constitute a breach of the reps.)
Strategic acquirors should be particularly cognizant of the incentives for in-house diligence teams, who will often have responsibility for the same areas after closing, from “over-identifying” issues that some decision-maker may ask them about post-closing.
These incentives are particularly strong in the technology context, where diligence leads may be particularly focused on the technical nuances of a target company’s business.
In our experience, outside specialists at law firms can be helpful in assisting in-house diligence teams distinguish between customary risks borne by acquirors and issues deserving of special escalation or treatment in the purchase agreement.
Specific intellectual property reps
We have found that most RWI carriers require “knowledge” qualifiers in reps relating to third-party infringement of a target company’s IP. This can be jarring for some cash-rich strategic acquirors who regularly obtain a clean infringement rep.
Further, in asset and carve-out deals, some RWI carriers may shy away from reps relating to IP sufficiency particularly if it covers aspects of the business “proposed to be conducted” (as opposed to “as currently conducted”).
In our experience, however, this hesitation by the carriers can often be overcome with a conceptual discussion of where the buyer sees the business headed or the scheduling of particular “future areas” that will be covered by the rep.
Cyber breaches and data privacy
We have found that RWI carriers often take the view that particular tech businesses should have stand-alone insurance policies for cyber breaches and are unwilling to provide primary coverage.
This position has been exacerbated by a trend toward increasingly stringent cyber breach and data privacy reps, which take a “there has been no breach” approach as opposed to the more general “compliance with laws” approach.
Reduced seller disclosure
In transactions where acquirors rely entirely on RWI policies for post-closing recovery (i.e. there are no post-closing seller indemnities), we often hear from our tech clients that they perceive the sellers as having less incentive to draft disclosure schedules with rigor.
This perceived lack of “skin in the game” can often be addressed by a discussion at the business level to give the buyer adequate assurance of the sellers’ diligence in crafting accurate and complete disclosures.
Other considerations
Separate and apart from the “pros and cons” inherent to RWI, strategic tech acquirors should also bear in mind the following considerations, which may vary in relevance depending on the transaction:
Cost
A leading factor in the increased use of RWI policies has been the reduction in policy costs over time, driven in part by the entry of more and more insurers into the market.
In 2019, premia for RWI policies averaged between 2.5 percent and 2.75 percent of coverage limits, with lower pricing available for particularly large transactions or low-risk target businesses.[3]
While competitive pricing offers a compelling window of opportunity for piloting RWI, acquirors should bear in mind that a RWI policy may still be cost-prohibitive for lower-value transactions. While RWI carriers are increasingly offering policies targeted toward lower and middle-market transactions in the $20m to $50m range[4], policies below that level are unusual and may require minimum premia that are disproportionate to transaction value in order to cover the carrier’s underwriting costs.
Furthermore, there is some evidence to suggest that pricing for RWI policies may begin facing upward pressure, with RWI carriers experiencing an increase in claims severity. For example, one recent study by AIG’s M&A Insurance team found that, among material claims made against its policies, the proportion of claims over $10m had increased from 8 percent to 15 percent in recent years.[5]
This trend is likely to continue if the US economy goes into a severe recession in the wake of the novel coronavirus pandemic and remorseful buyers look for other sources to recover value.
Timing
From start to finish, the binding of an RWI policy can take upwards of ten days to two weeks. In addition to building in time to engage a broker and obtain and evaluate quotes from carriers, acquirors need to afford carriers an opportunity to carry out their own diligence process—i.e. reviewing the data room, due diligence reports, draft transaction agreements and disclosure schedules, and having live discussions with the diligence leads for the buyer.
Furthermore, as a threshold matter, RWI carriers generally will not agree to begin underwriting until the insured has been identified as a winner in a competitive process.
As such, for an acquiror seeking to pre-empt an auction or otherwise gain a timing advantage over other bidders, it may be necessary to agree to bear an RWI carrier’s underwriting costs, which can later be offset against the premium of any policy that is issued, or to delay binding the policy until after the definitive acquisition agreement has been signed, which in turn leaves the buyer naked on any breaches of the reps that become known after execution of the definitive agreement but before the binding of the RWI policy.
Process management
Whereas financial sponsors generally rely on outside and in-house counsel to manage the RWI process, many strategic acquirors have other constituencies—e.g. risk officers and treasury departments—who will expect to be involved in any decision-making. Such constituencies, though well-intentioned, may lack visibility on the mechanics of M&A transactions and may seek to source RWI policies from brokers who lack specialization.
It is critical that acquirors facilitate close communication among internal teams (and outside counsel) to ensure that:
- an RWI policy aligns with the underlying transaction agreement and diligence process; and
- an experienced broker, who can be helpful in accelerating timing and negotiating favorable terms with carriers, is engaged.
Favorability of terms
Not all RWI policies are designed equally. Historically, repeat acquirors—generally, financial sponsors—have received more favorable terms from RWI carriers and have had the luxury of re-using negotiated policies from transaction to transaction.
As a result, strategic acquirors should be aware that, at least as an initial matter, their policies may require additional negotiation, and certain terms may only prove attainable over the course of multiple deals.
Fortunately, given the serial nature of M&A activity within the tech industry, many strategic acquirors should be well-positioned to develop favorable terms with RWI carriers over time.
Furthermore, such acquirors may be able to leverage other relationships (insurance or otherwise) with RWI carriers in their policy negotiations and to ensure the best possible treatment during any subsequent claims process.
Conclusion
Though not appropriate for every transaction, the use of RWI policies is poised to continue growing in prevalence should a seller-favorable M&A market persist.
In addition, RWI policies may be an appropriate tool to offer more competitive terms to sellers other than on price, particularly if cautious acquirors in a post-COVID-19 world become more reluctant to pay large multiples for unproven or fledgling businesses.
In either case, strategic deal leads and in-house lawyers alike would be well-served by gaining an in-depth understanding of the RWI market to ensure it is included in their M&A toolkit going forward.
References
[1] Chris Hecht and Tom Kennedy, “The M&A process is broken,” Atlassian Work Life (June 17, 2019): https://www.atlassian.com/blog/technology/atlassian-term-sheet.
[2] The American Bar Association’s 2019 study of deal points in M&A transactions featuring private targets identified references to RWI in 52% of sampled definitive agreements. See: American Bar Association, “2019 ABA Private Target Mergers & Acquisitions Deal Points Study – Indemnification/RWI Cheat Sheet” (January 2020): https://www.americanbar.org/digital-asset-abstract.html/content/dam/aba/administrative/business_law/ deal_points/2019_rwi_cheat_sheet.pdf.
[3] Arthur J. Gallagher & Co., “202 Market Conditions Report: Representations and Warranties” (February 2020): https://www.ajg.com/us/news-and-insights/2020/feb/2020-market-conditions-report-representations-and-warranties/.
[4] Id.
[5] American International Group, Inc., “Taxing times for M&A Insurance”, Claims Intelligence Series: https://www.aig.com/content/dam/aig/america-canada/us/documents/insights/aig-manda-claimsintelligence-2019-r-and-w.pdf.
