One of the most stressful parts for any stockholder selling a business is addressing the representations and warranties that are always required by a purchaser. This stress results from a number of factors, including that the representations and warranties are written using terms and language which are not familiar to a selling stockholder, and that misunderstanding a representation and warranty can expose the seller to losing part of selling price through an indemnification claim.
One of the considerations to reduce the risk of an indemnification claim based upon a breach of a representation or warranty in a Purchase Agreement is the use of representation and warranty insurance. Such insurance has been common for stock and assets deals in Europe, but is only recently being considered for such transactions in the United States of America.
Representation and warranty insurance insures over non fraudulent breaches of such representations and warranties, after a deductible is taken into account. However, certain topics may not be covered, such as environmental claims (although a separate policy may be available), and other topics may only be covered based upon the underwriting review of the insurer, such as product liability claims. In addition to the premium cost, there is also an upfront fee to underwrite the policy.
Unfortunately, these two categories of representations and warranties claims, environmental and product liability claims, are often times the ones that concern sellers of manufacturing businesses the most.
Ultimately, the decision of whether a seller should purchase representation and warranty insurance comes down to whether the cost and coverage of such insurance is acceptable to the seller.
If the seller determines that representation and warranty insurance is worth the cost, the insurance should be an item mentioned in the letter of intent between the seller and the buyer, and the seller should require that the purchase of the insurance reduce the amount to be held in a post-closing escrow to address any indemnification claims.
Daniel P. McGlinn is a stockholder in Kreis Enderle Hudgins & Borsos, P.C., who specializes in business transactions. He has represented four businesses that have sold for over $20 Million Dollars each in the last two years.