Armando (0:00 – 2:29)
Hi, I’m Armando Roman, host of the Founder’s Guidepost. You’ve built your business over decades and now it’s time to think about that once-in-a-lifetime exit. You’ve come to the right place.
Here you will hear business exit professionals talk about what you should know before exit. Besides hosting the Founder’s Guidepost, I’m CEO and founder of Axiom Founder’s Family Office, a Scottsdale wealth management firm helping founders and their families preserve their American success story. We oversee and coordinate a network of vetted professional advisors to help maximize their probability of achieving everything that is most important to you.
And we host the Scottsdale Founders Forum, a biannual live event for the founder considering exiting in the next 36 months. Here’s to your hard work and your American success story. Enjoy.
Hello, this is Armando Roman with the Founder’s Guidepost podcast here with Gaurav Sud. And Gaurav, I’m really a little bit anxious to have this conversation with you because as we’ve had conversations before about what you do and how you help people navigate that often once-in-a-lifetime sale of their business, if they don’t know what you do and why it’s relevant to them, they might not engage you or someone like you to help them because they just don’t know. And in the broad picture, when I think about what you do with lockdown, and I’ll talk more about your background one second here, but when I think about you and what you do, when that seller’s going through that business sale for the first time and they’ve had their company say 20, 30 years, never gone through a sale before, now all of a sudden it’s game on and they’re trying to get things done very quickly, very timely, get all those things done that have to get done. And by the way, should you think about reps and warranties insurance or tail insurance or some kind of insurance for after the sale, which is of course your expertise with lockdown.
And what I was interested to hear about you when we first met is that you, prior to joining Lockdown, were in the merger and acquisition space as an attorney in the Bay Area doing that kind of work. So from the lens that you bring to Lockdown, it seems that you can add a lot of value in terms of designing and getting things into those reps and warranties and other insurance policies that can really be relevant to that first time seller.
Gaurav (2:30 – 4:02)
Yeah, no, thank you for having me. First of all, I’m excited to chat today. And yeah, that’s exactly right.
I’ve been in the sort of M&A space for really my entire career now, 20 plus years in one form or another. And when you think about what transactional lawyers are doing much of the time in negotiating transactions, whether they’re representing a buyer or a seller, it’s risk allocation, right? It’s sort of looking at the asset that’s trading hands and understanding where the known risks are, where the potential unknown risks are, and how those risks are going to be allocated between a buyer and a seller, an investor and a company, and then legislating that sort of risk allocation in the purchase agreement.
And so much of what we are doing in the kind of transaction liability space and specifically around representations and warranties insurance has just been allocating that risk in a slightly different way, right? So instead of sort of having it sit with the buyer as kind of a cost of doing the transaction or parked with the seller, such that they have exposure kind of post-closing, we’re taking that risk in transferring it to the insurance market. And so that’s kind of how I think about this product, but really my career has just been taking that risk and allocating it in what we think is the most efficient way at any given point in time.
Armando (4:02 – 5:13)
Good. So let me see if I can just kind of paraphrase a bit of what you just said there. So when a seller is going through that sale, and let’s say it’s the first time they’re selling a company ever, and this is a once in a lifetime event, they might get very wrapped up with the emotion, with the dollar signs, with the attorneys and the CPAs and all these things that have to happen very, very quickly.
And if they’re really wanting to walk away from that sale, you know, sign, get their check, or maybe some equity or not, whatever it is, once they walk away from that sale, part of how they can be protected once they sign and walk away is by having some type of insurance that can cover things that maybe were not, maybe they were a possibility with the company later after they leave, but maybe they weren’t really seen as a big deal or as a potential problem. But the insurance that you help to structure and design and the space that you operate in, it’s all about insurance to cover the possibility that something, if something does happen to the company after the new owner takes over, that’s really what you’re helping to mitigate, correct?
That risk?
Gaurav (5:15 – 9:34)
Yeah, that’s right. So when you think about being a seller of a company and you’re approached by a potential buyer, maybe multiple potential buyers, and you’re thinking about your business that you’re looking to transact, to trade hands, very simply, right, there’s two types of risk. And in our world, we’re really thinking about pre-closing risk, right?
So these are not things that would transpire or things that would happen post-closing, that’s kind of a perspective, forward-looking type of risk. Everything that we’re doing is from that point in time of closing, looking backwards, right? And very simply, that kind of pre-closing risk for the entire time really that the seller has owned and operated the business, you can think about falling into two categories.
Very simply, there’s known risk and there’s unknown risk, right? So as a seller that’s looking to find an exit, the known risk, we have products around that, right? So we can look at a particular kind of piece of litigation or potential litigation or any number of types of issues, any types of issues that might be the subject of some scrutiny from a buyer that the seller knows about, right?
That is not rep and warranty insurance. Those are kind of bespoke products that form a big and growing part of our practice. It’s just looking at those kind of identified issues and saying, can we, the insurance market sort of solve that in a more efficient way than having a buyer and a seller kind of fight tooth and nail over whose problem it is when everybody knows it’s out there, right?
And it’s just a matter of how you’re assessing that risk. The other category is unknown risk. And this is where rep and warranty insurance comes in, right?
So these are, this is your seller kind of saying, look, I don’t know of anything, right? I can make all these representations, these warranties to the buyer. I think they’re accurate, right?
To the best of my knowledge, I’m making kind of accurate representations. I’m not sort of hiding the ball on anything, sweeping anything under the rug, right? Pick your analogy.
And the buyer comes in and this is any buyer, right? Will come in still and say, okay, I’m going to do my diligence. I’m going to ask you a whole bunch of questions.
I’m going to check a whole bunch of boxes. And at the end of the day, I’m going to ask you to make these representations to me, but then I’m always going to be worried as a buyer about that information asymmetry, right? The fact that you, the seller, at least in theory, you’re always going to know more about this business than I do, than I ever will.
I can do diligence until the end of time, but the reality is I’ve not owned and operated and had my hands on this business for years and years. And so I need some type, I as a buyer need some type of recourse should one of those representations you’re making to me turn out to be untrue post-closing. And again, we’re talking about something that you learn about post-closing, but that sort of brings into question the accuracy of the representation at the time of closing, right?
So something that predated closing, but you as the buyer learn about it six months, a year, two years after closing. And most buyers will kind of come at that and the product is being priced correctly. This creates an economically kind of more efficient outcome really for both parties, right?
Where the seller is kind of walking away with those proceeds, getting a cleaner, more creative exit from the business. The buyer still gets their downside protection. And in the sort of weeks and months of negotiation of any transaction, you can spend your time kind of talking about real dollar issues, right?
As opposed to contingent dollar issues, right? All the hypotheticals around unknown exposure can be left for the insurer to deal with and the it can make a lot of sense.
Armando (9:34 – 10:15)
If the business sells for say $10 million and the buyer wants to hold 10% of that money back, just to hold it back, that’s a million dollars being held back. So rather than the buyer holding back that million dollars, if buyer and seller can agree and get rep warranty insurance on there, then the seller can get his million dollars when he, along with the other 9 million on that 10 million sale, they both maybe share or somehow they bear the cost of that rep warranty insurance. And it’s more clean or a cleaner, more efficient, can be a cleaner, more efficient transactions all the way around is what you’re saying, right?
Gaurav (10:16 – 10:55)
That’s right. That’s exactly right. So it’s not, you know, a lot of sellers initially when we really started kind of building this market and this product out, felt like there might be a stigma almost associated with suggesting to the buyer to kind of go to insurance, right?
In other words, that they were hinting at that there’s some issue. It’s really not that, right? It’s as simple as kind of this is just a more efficient, kind of cleaner, economically, kind of more attractive way to do a transaction once, you know, if the insurance is being priced as it should be.
Armando (10:56 – 11:18)
Okay. So I am curious how, you know, businesses are there for all kinds of stuff, services and products and all kinds of stuff. I am curious how as an insurance company, how you would look at that risk, quantify that risk, assign a premium to it.
That to me seems like a big mystery.
Gaurav (11:19 – 14:39)
Yeah. It’s a very interesting, you know, kind of market and sort of pricing regime that exists for us. So you’re totally right, right?
A business, I, you know, use the analogy, it’s sort of a used car, right? Any business is a used car, right? It’s entered into contracts, it’s terminated contracts, it’s hired people, fired people, it’s had some litigation, it’s open facilities, closed facilities, right?
Things have happened surely over the time of, you know, growth and all of those things need to be kind of reconciled at the time of the transaction, right? The buyer needs to understand sort of the current state of the business and then other sort of historical things that may create exposure for them or create liability, you know, going forward. In the same way, the insurance underwriter kind of needs to understand the same things, right?
And so the way this product gets priced in the first instance is very much market-driven still in our market, meaning that, you know, there’s times of intense competition, there’s times of, you know, kind of a softer insurance market and the market tends to drive that pricing. As the product has evolved, there’s been more, you know, there’s certainly more kind of actuarial data and claims data now out there. Certain classes of business tend to be more challenging to underwrite than others or heavily, you know, regulated businesses, businesses that are a little bit more complex from a, you know, regulatory or compliance perspective might be more challenging for certain insurers.
Those factors, you know, come into play, the size of the transaction, which correlates to how much insurance you’re looking for, right? The current owner of the transaction of the business that’s being, you know, transacted carries some weight. All those are factors in pricing, but at the end of the day, it’s a market like any other now and it’s operating like a real kind of elastic responsive market to not just things that are happening around rep and warranty insurance, but things that are happening around M&A, you know, more broadly.
The underwriting of these policies is very much sort of driven by the buyer’s due diligence efforts, right? So, you mentioned, you know, kind of the business being sort of a, you know, living, breathing thing, right? And how do you get your arms around that in a relatively short period of time?
And the answer from the insurer’s point of view is they’re really looking to build upon the work that the buyer is already doing, right? So, they’re not going to come in and kind of, you know, turn over every stone and look at every document, but they want to talk to the people who did that work and understand that, you know, even in the best sort of circumstances where you have the most robust scope of diligence, there could be things that are either not disclosed or that are just missed, right? And that’s real risk that the insurer is taking on every day, but much of their underwriting is kind of very simply saying, did this buyer kind of kick all of the right tires, right, in evaluating this business?
And when they kicked those tires, are there material kind of known issues that they learned about or grappled with, right? That’s very simply kind of what our underwriting looks like.
Armando (14:39 – 14:44)
Okay. So, you’re building on the due diligence the buyer has already done.
Gaurav (14:45 – 15:52)
That’s right. And it’s another question we get, you know, from sellers kind of saying, this sounds interesting. It certainly makes for a better economic proposition for us, but are we now going to have not only the buyer asking us a whole bunch of questions and their advisors asking us a whole bunch of questions, but the insurer also asking us a whole bunch of questions?
The answer is no. You know, the way this process works is the insurer kind of sits behind the buyer and the buyer’s diligence. And, you know, they’re of course going through their own process, but it’s very much derivative of and, you know, really directly built upon the work that buyer’s already doing.
So, what I always assure sellers is they’re not going to get kind of, you know, diligence request list from the buyer, another diligence request list from the insurer now, and, you know, time is limited and always a scarce resource in, you know, in negotiating transactions. And sellers should know that this is not going to, you know, if things are going as they should on the buyer’s side of the table, where the buyer’s kind of utilizing this insurance, this should be largely invisible to the, you know, to the seller.
Armando (15:53 – 16:10)
So, you also mentioned bespoke custom insurance for very, maybe very specific, unusual things. Can you give an example of, and that’s separate from the rep and warranty insurance, is it right? It’s custom designed for a specific potential risk?
Gaurav (16:11 – 19:39)
That’s right. That’s right. So, kind of our world is rep and warranty insurance and then sort of everything else, right?
And rep and warranty insurance is where, again, the seller is not aware of anything. The representations are being made. More importantly, the buyer is not aware of anything, right?
So, the buyer kind of says, I’ve done my diligence. I’ve asked my questions. I’ve negotiated this transaction.
I have no reason to believe that these reps can’t be made to me today. Now, again, you learn things post-closing that you didn’t know pre-closing and that’s what the policy is there for. But yeah, everything else is, that we do is kind of, you know, falls into the category in the M&A space sort of falls into the category of known issues, right?
So, we have a practice, a growing, you know, vibrant part of our practice now around tax insurance. And this is just sort of looking at uncertain tax positions that a seller may have taken. And they may come to the table kind of, you know, having taken this position year after year after year, the buyer sort of looks at it and says, you know, there’s some inherent uncertainty with what you’ve done there.
I get it. You’ve gotten guidance on this and that’s great. But it’s my audit risk going forward, right?
And, you know, tax issues can be fairly severe and, you know, fairly material to the way you’re pricing a business, right? If the buyer is also inheriting a tax bill that they didn’t anticipate or didn’t price it actually. And so, looking at that, you know, that position that again is an identified thing, right?
And at the end of the day, there’s only one opinion that matters and that’s the tax authority or the IRS, right? Looking at that sort of issue and sort of building a product around that eventuality, so providing cash recourse to the buyer should that position, that tax position that the seller has taken, you know, be not respected at the end of the day by the IRS, right? And the way that spins off tax interest, you know, penalties exposure that the buyer just never anticipated, never pressed into the deal.
So tax insurance is a big part of that. Another vertical is just, you know, what we call broadly kind of, you know, contingent liability or litigation insurance, which is the seller is transacting, right? They’re selling the business, but they are the subject of some pending litigation that they think has little to no merit, right?
But it’s hanging out there over the transaction and it’s not going to be resolved before the transaction closes. And the buyer comes in and says, you know, maybe they also say, I think this has very little merit and it, you know, it seems like a frivolous case, but at the same time, I’m buying an operating business here. I’m not buying a piece of litigation or taking a bet on a piece of litigation.
That type of conversation can stall a transaction entirely, right? It can be the true kind of deal breaker type of, you know, type of issue. And so coming in and looking at it from sort of an objective point of view and saying, you know, maybe there’s an insurance product that can kind of price this risk, right?
So that the parties can go on and transact. And if that litigation goes kind of in a direction that nobody seems to think it’s going to go, but if it does and it turns out to be, you know, a liability for the company, there’s insurance recourse for it, but the parties could kind of carry on, you know, doing the deal.
Armando (19:41 – 20:13)
Wow. Wow. So then are there, as you’re going through and doing your work to, you know, to help add that efficiency to a sale the way that, you know, are there common surprises as you’re talking with the buyer and seller about, you know, what you’re seeing and how you’re, you know, your perspective, your viewpoint or the price, you know, are there, are there surprises for them that, that recur, that are common, that you hear from them in this process?
Gaurav (20:14 – 22:08)
Yeah, I think, you know, I mean, the heart, the place where we sit at this stage in our, in the sort of evolution of these, these products, the place where we, you know, are spending on the brokerage side at Lockton, where we’re spending kind of the majority of our time is sort of getting our arms around, I don’t know if they’re surprises, but the inevitable kind of identified issues, right? So the buyer goes out and they hire an advisor, that advisor takes a, you know, an appropriate, but maybe somewhat conservative view of a particular issue, right? And then the insurer is kind of saying, I don’t know if I can step into this, you know, issue and sort of really getting to the root of kind of understanding what, you know, what that issue actually is, what the probability of it, you know, coming to pass actually is, if it does come to pass, what the magnitude of that exposure really looks like, right?
And, and sort of understanding, is this kind of a true sort of unknown, you know, unforeseen type of exposure, or is this something that’s kind of nearing a little bit more towards just that kind of, we’re all aware of this now, and the buyer just needs to kind of price this into the transaction as opposed to, you know, parking it with the insurer. Those issues, and the complexity of them, you know, continue to come up on these transactions. And that’s really where we spend a lot of our time is kind of negotiating on behalf of our clients, on behalf of the buyer, most typically, right?
But in a way that benefits both the buyer and the seller, right? So every dollar of risk that is parked with an insurer is a dollar of risk that’s not falling on the seller’s shoulders, right, is one way to think about it. And so another question we’ll often get from, from sellers is kind of who are you representing here, right?
Whose side are you on? Right.
Armando (22:08 – 22:10)
And, you know, it’s like a fair question.
Gaurav (22:11 – 23:13)
Totally fair question. And as a, you know, as a technical matter, we are the insured under substantially all of these, these policies, at least rep and warranty policies is the buyer, right? So they’re the contractual beneficiary.
But I think about this product, there’s, you know, the seller is also a beneficiary of the policy in that, you know, absent the insurance policy, this would be, this would be kind of falling on the seller, right? So in some manner, they would be required to indemnify for this. And so even though they’re not a contractual beneficiary under this insurance policy, the sellers really are, when you look at the deal holistically, they are benefiting tremendously from the use of the insurance, right?
And so in that sense, we’re all aligned, right? We’re trying to kind of, again, take that, you know, unknown risk, pull it out of the deal, park it with the insurer. And that’s, that’s in the buyer’s best interest, that’s in the seller’s best interest.
And that’s, you know, that’s, that’s kind of what we’re working towards on any deal.
Armando (23:13 – 23:44)
And then Gaurav, you said there’s a kind of a demarcation point that this is for things that have already taken place up until that sale purchase agreement is signed. And then at that point, anything in the business happens afterwards, that’s really on the buyer. But you’re looking with these insurance policies, you’re looking at what happened over the, over the course of normally operating that business up until the point where it transitions from the seller to the buyer.
Gaurav (23:45 – 26:46)
That’s right. Yeah. So, so it’s, you know, we use terms like sort of your watch, my watch, right?
In the, in the M&A world, right? And, and the seller, of course, from, from an exposure perspective, as they think about kind of, you know, sleeping at night, post-closing, they’re, they’re worried about their, their own watch, right? So if the buyer, you know, the next day after closing goes out and makes, you know, some questionable business decisions, or, you know, does that, that’s, that’s the buyer’s prerogative, right?
Or, you know, worse if, if, if they’re not making those decisions, but something just, you know, happens to, to the business that’s unforeseen and unfortunate. That’s really kind of the risk that the buyer is taking on now they, they, they own the asset. And so, yes, in, in, in representation, warranty insurance, and really, really the, the sort of, you know, crux of a representation in the purchase agreement is, is a statement that the seller is going to make to the buyer as of a specific point in time, and that specific point in time is either the signing or the closing, or sometimes both of those things of, of the transaction, right?
Where the seller is kind of saying at this moment in time, from where I sit today, you know, the, the following contracts are in full force and effect, right? At this point in time, from where I sit today, we don’t know any taxes that we haven’t already told you about, right? Those, those types of statements.
And so where the seller thinks about kind of their exposure, you know, for the months and years that follow kind of exiting a business, it’s really those things that predated closing that come to roost, you know, post, post-closing. Now, you know, buyers will look when, whenever anything kind of, you know, takes a turn for the worst, or, or even a slight turn for the worst post-closing, there’s always an inclination to kind of look back to that purchase agreement and kind of say, was there something going on here pre-closing that, that led to this, you know, this less than optimal kind of situation now post-closing. And so that’s where, you know, many of our claims conversations under rep and warranty policy start, right?
Which is kind of, you know, here’s what we’ve learned post-closing. Now let’s go back and look at what, you know, what we based this investment on and collectively kind of ask ourselves, was that statement true at the time it was made to you, or was there something going on that you didn’t know about that kind of brings into question the accuracy of what, you know, what, what you were told at the time of closing. And these representations are, they’re very broad and they’re far reaching, right?
So there’s often many avenues to kind of say, you know, I think this one was untrue, right. Or I think it could have been untrue at least, right. And that’s what I think where a lot of sellers kind of, you know, rightfully kind of spend a lot of time sort of thinking about these representations, thinking about how they need to be qualified to make sure that they’re, you know, statements they’re actually comfortable making.
Armando (26:48 – 27:02)
Well, it sounds like a lot of writing on that due diligence, the buyer’s due diligence, that if they didn’t ask a question or didn’t do enough homework in a particular area, that it could come back later to be a problem.
Gaurav (27:03 – 28:13)
Yeah, that’s, that’s, that’s exactly right. So much of our processes is diligence driven, really based on the buyer’s diligence. We get the question all the time, you know, this product sounds great.
Now, you know, does the buyer still have to do diligence, or is this all just going to the insurer? And the answer is, you know, absolutely. The only way we can achieve kind of the pricing and sort of the outcome that we’re getting with, you know, with this product is on the understanding that it’s not a replacement by any means or a gap filler for the buyer’s diligence, right?
Kind of doing that work. And this is not controversial, because again, most investors, most buyers are not going to, you know, transact without doing their own work. It’d be abnormal for somebody to kind of say, oh, this is great.
You know, we have the insurance now, we don’t have to, you know, sort of check all these boxes or read all these documents or ask all these questions, right? But the process of kind of, you know, demonstrating that work, sharing that diligence or downloading it to the insurer in, you know, in an artful, kind of effective manner is where, you know, it’s where we’re spending a lot of our time.
Armando (28:14 – 28:46)
Okay. Okay. So are there, you’ve talked about some of the common things that come up.
And I think you touched this also, you know, sometimes businesses have, there are regulatory changes that are completely outside of their control, but they happen and they can destroy a business that since it is completely out of either buyer or seller’s control, it could certainly negatively impact the company, but really that it would have nothing to do with any of the rep and warranty insurance, right?
Gaurav (28:47 – 29:43)
I think that’s right. It would be a real challenge to make that type of claim. That is something we characterize.
And I think most would characterize as business risk, right? And business risk, it’s a generic term, but it really sits outside the bounds of kind of rep and warranty insurance, right? So if you’re kind of going into a class of business that you know is under some regulatory scrutiny, right, and things may change post-closing, and if those things change, they may impact, you know, the viability or at least the profitability of the business that you’re buying, that’s risk that you’re taking on, right?
You could argue, you know, in any number of situations, it could go the other direction, right? There could be some regulatory change that really works in your favor and, you know, sort of changes the profile, the economic profile of the asset that you bought. That’s also business risk, right?
And there’s a side to it and there’s downside.
Armando (29:45 – 30:30)
Okay. So in the rep and warranty insurance, it sounds like there’s a lot in there and a lot of a lot of homework that’s done to really get that policy to come about. And starting, of course, as you said, with the buyer’s due diligence, looking at what they’ve done and building on that.
Are there other things that come into play as you’re building that out? And what would those be? Are you wondering if you’ve missed anything in your planning?
We hear that a lot from very smart, very successful people. And that’s why you may be interested in our Founder Stress Test, even if you’ve already sold your business years ago. For more information, go to axiomcorp.com.
Gaurav (30:31 – 33:19)
Yeah. So before we get to the buyer’s, you know, diligence and the actual underwriting, we’re marketing these transactions to our market, to the transaction liability market, the rep and warranty market, which today is nearly 30 players. So 30 dedicated sources of insurance capital out there that are active in this space.
That process of marketing typically happens once we first engage with the buyer. So understand their kind of view of the transaction, their sort of approach to diligence, and their general kind of timeline to a signing of the deal. It’s not uncommon for our first point of contact, though, going back to kind of the question around who’s really benefiting from the use of this product, not uncommon for our first point of contact to be on the seller side of the table.
This tends to be sort of a term sheet or a letter of intent stage conversation where a buyer kind of arrives at evaluation. And then the next question is, okay, how are we going to structure that consideration? How much of it are we seller going to see today?
Is a portion of it going to be deferred? Is there going to be an earn out? And that’s kind of where the right time, and this is where our phone tends to ring, is where parties are saying, look, our seller might be saying, look, we’d like to push back on their ask for an escrow or a holdback of some portion of the purchase price.
But before we do that, we kind of want to make sure that the insurance market would sort of support this transaction. We want to get a sense for how much it would cost. And that’s kind of our entry point into many deals is sort of hopefully providing some comfort that, yes, this is an asset that we think the market would have interest in.
You’re likely to see pricing in the following range. You’re likely to see kind of a deductible right in the following range and give the right data points in order to finish that letter of intent negotiation, hopefully, and get buy-in that the buyer will explore or utilize the insurance. And that sometimes is happening weeks or even months prior to actual signing of the transaction.
So this tends to become, even though much of our work is happening in the hours, days, leading up to signing of the transaction, this tends to become an issue that comes to the surface really very, very, very early on.
Armando (33:21 – 33:38)
Okay. And so then shopping it amongst different carriers to see is there an appetite for it? And if so, like you said, what might that premium end up being for whoever’s going to pay it, the buyer or the seller or a combination thereof?
Gaurav (33:38 – 34:50)
Right. Yeah. That’s really the first kind of formal step is that marketing.
And if you add all the pieces of our process up together, you end up with kind of a sort of 10-day to two-week type of runway in terms of actual work that we’re doing on any given transaction, the actual sort of heavy lifting. But very rare for that 10 days or two weeks to sort of unfold in a linear manner. So oftentimes it’ll be a few days of marketing.
Then we sit tight for a few weeks while the diligence kind of progresses. Then a few days of kind of iterating on the best partner for a particular transaction, negotiating those terms. And then we might sit tight again as the purchase agreement is being negotiated a little bit further.
And then invariably there comes a point in time where the diligence is largely done and the purchase agreement has kind of gone through a few cycles. And we’re just sprinting to the finish line along with everybody else, sort of completing that underwriting, negotiating the policy, kind of bringing all these pieces together.
Armando (34:50 – 35:18)
Okay. So you mentioned the LOI and this, I want to make sure I’m clear, Gaurav, the looking for the app on your end, looking for the appetite for this, for the carriers and getting somewhat of a price range on that, that gets done so that when the LOI is presented, it’s already baked into the LOI. Is that the idea or?
Gaurav (35:19 – 37:10)
It can be. Yeah. So some parties want as much detail as possible, right?
If they’re a little bit less familiar with our kind of corner of the world, they’ll want to say, I want to know with some formality that there is a market for this transaction. I want to know with some precision what that pricing is going to look like. We want to bake that into the economic discussion in the LOI.
There’s other parties that may have some familiarity or may just have some more comfort around it. And it’s just a preliminary kind of conversation with us. And we live and breathe in this market.
We can give you a very good directional sense of what those economic terms would look like with just a few questions around sort of the nature of the business, the general structure of the transaction itself and some of the dynamics around the deal. We have a pretty good idea of what the market will bear on any given deal. And sometimes that’s just that sort of off the cuff advice is sufficient at the LOI stage.
Really kind of a preference of the parties. But this is an issue that if it’s going to be a part of a transaction, much more often than not, it’s coming up in the relatively early days. Because again, as a seller, you sort of say, this is great.
This is a valuation that we’re happy with. We have a handshake on the deal. But then as with anything, the devil is in those details.
And it’s kind of like, okay, now we have this headline purchase price number. But how much of that are we actually going to see at closing? How much of it is contingent upon other things?
And that’s where this conversation really plugs right in.
Armando (37:10 – 37:18)
Okay. I’m getting a better sense of how all the rep and warranty work. So thank you for that.
Gaurav (37:19 – 37:33)
Yeah. It’s a strange corner of the M&A world and the insurance world that we live in. But this is sort of what we do all day, every day.
Armando (37:33 – 38:07)
And it sounds like, just like you said, that this is one of those negotiation points. Who’s going to pay for it? And is it going to be, like you said, is it going to be money still left in or an earn out or how much cash down?
But it’s just one of those other negotiable points in that hole on the table that needs to be talked about. So that at the end, the buyer and seller both feel good about, hopefully both feel at least, if not good, they feel good enough that they can go forward with their deal.
Gaurav (38:08 – 39:05)
Yeah. There are just so many levers in a transaction around sort of sharing expenses and cost and the purchase price itself and how that gets structured. This is just another one of those levers.
And we see it kind of being horse traded for all kinds of other expenses and sort of puts and takes. And so this is where kind of having that data point or that directional sense, especially if you’ve not been involved in this market or involved in it recently, can be very helpful at an early stage just to know that the buyer seems receptive to using rep and warranty insurance, but they want us, the seller, to pay for it. Or there’s going to be some sharing and that’s what it means for us.
Coming to ground on those issues earlier can be very helpful.
[Speaker 3] (39:06 – 39:06)
Okay.
Armando (39:07 – 39:15)
And Gaurav, before this, you were in the merchant acquisition space as an attorney. How does that help you with the work you’re doing now?
Gaurav (39:15 – 43:33)
Yeah. I mean, it’s helped tremendously. I don’t think this product or this kind of marketplace would be where it is today if there weren’t many sort of experienced, smart, thoughtful M&A lawyers in and around this industry.
Because really, again, at the root of kind of what we’re doing is the same thing that buyers and sellers do every day except without the insurance. But there, you’re trying to kind of box everything into the four corners of a purchase agreement, right? So I spent my entire legal career really doing M&A work.
And when I was representing a buyer, I was making sure that the indemnification article, really the most heavily contested portion of a purchase agreement, was as strong and expansive as possible, right? Because I want my client, the buyer, to have as much protection as possible for, again, the things they know about, the things they don’t know about, sort of everything that might sort of come to the surface post-closing. Conversely, when I was representing a seller, still, all eyes on that indemnification article of the purchase agreement and trying to make sure it’s as tight and narrow as possible, right?
So there’s this as-view sort of avenues to kind of get back to the seller post-closing as possible, giving my client kind of as much comfort as they can have post-closing that they’ve kind of exited the business in a clean and successful way. Part of what drew me to this industry was how much time as a deal lawyer you spend on kind of that risk allocation, right? You look at a purchase agreement just sort of physically, and you have a 100-page document, 50 pages of that is representations and warranties, another 30 pages are sort of indemnification language, right?
So there’s a little bit of economics upfront in a purchase agreement, there’s some boilerplate at the back, and then everything else is just reps, warranties, disclosures against them, indemnification, right? It’s where you’re spending most of the time is right there. And that’s what was really interesting about kind of the very concept of rep and warranty insurance was sort of saying, there’s a lot of time spent on these issues.
And at the end of the day, of course, there’s issues post-closing and there’s claims, but it’s a good risk for businesses that are healthy, attractive assets that are trading hands, that have been diligenced in an appropriate kind of thoughtful way. Knowing nothing about insurance, it struck me as kind of a great insurance solution, right? Where you kind of have these sometimes very severe losses, but relatively low frequency of that, right?
And yet on the flip side, you have lawyers and other advisors spending all of this time, so much kind of human capital kind of negotiating these issues in a purchase agreement. And I said, somebody should really figure this out, right? This should be an insurable product, right?
This is definitely an insurable interest. And that’s really what led me to this. It was kind of an opportunity to kind of be one of those people who really sort of expanded this market and made the product kind of a little bit more user-friendly, a little bit more dynamic, sort of grow the size of the market and allow us to do things like we do today, which is touching transactions really across every industry vertical you can think of, looking at transactions ranging from the very low end of the middle market to some of the largest sort of highest profile deals you see out there that are kind of utilizing this product. It’s been really kind of a rewarding experience to sort of see this market grow up.
Armando (43:34 – 43:51)
Wow. Well, it sounds like it’s interesting for you, but also very valuable for that seller and that buyer to get this in place. As you said, it really is covering, addressing risks on both sides of the table there.
Gaurav (43:52 – 44:20)
Yeah. If the product is being kind of structured in the right way and underwritten in the right way, it really should be one of those things that’s working, one of the few things in a deal context, right, that’s working to the advantage of both sides. I know there’s a lot of negotiating any transaction, a lot of kind of give and take, and one side wins a point and the other side loses a point.
This is one of those few things where this should be in everyone’s best interest.
Armando (44:20 – 44:42)
And so, Gaurav, with the seller, who’s not gone through this before, are there a few key points that he or she should be looking at in this REPA warranty insurance that really needs to draw their attention so they at least look at a couple or three bullet points there that are really critical for them?
Gaurav (44:43 – 49:12)
Yeah. So, one I would say is just understanding the cost structure of the policy. And when I say that, it’s not just the transaction expense, but these policies do have what we call retentions, or you can think about just like a deductible under them, right?
And sometimes the buyer is bearing that retention, sometimes the seller is bearing that deductible or retention. Sometimes they’re sharing it, right? That’s, again, a negotiated point, but can be very impactful to a seller.
So, really making sure that as a seller, again, even though your name’s not going to be on the policy as kind of the named insured, that you sort of understand how the sort of levers of that policy are working and what it means to you. So, that’s an important thing sort of early on because you need that in order to cut any type of business deal around using the insurance in the first place. And then the other, I guess, maybe two other things for a seller.
One is once you get into that kind of underwriting phase, just making sure that if there are carve-outs or exclusions from the policy, right? Things where the insurer is saying, this is just an identified issue of material significance to us and it’s going to be carved out of the policy. Those types of things have a way of kind of working their way back to the seller where the buyer says, look, we went out, we got this insurance, but they’re not covering this one tax issue that you have, right?
And our advisor told us about it and we talked to you about it and you sort of seem to maybe agree or maybe disagree, right? But it’s on the table, it’s just kind of an identified thing. Being prepared for that conversation doesn’t happen by any means on every transaction or even most transactions, but there is a little bit of understanding if there are things that have been identified by the buyer that the buyer may still look for some protection for from the seller.
And that’s a conversation, it’s a conversation that involves the insurer as well, right? Because we’re going to negotiate that the insurer should maybe rethink their approach to that or kind of take a different way of cutting the issue. And then the last thing that a seller should kind of keep in mind, so I guess it’s sort of the upfront kind of structure of the policy.
Once it’s underwritten, understanding what is not covered under the policy, because that’s what may have a way of finding its way back to the seller, maybe not. And then the third thing that a lot of sellers will ask is, this sounds great, but does the insurer now have recourse to me, the seller, right? So if something goes wrong, the buyer brings a claim against the insurer, the insurer pays the buyer.
This is getting at the concept of subrogation, is that under kind of common law where the insurer can step into the shoes of the insured and they get all the recourse that the insured has, right? Importantly, in rep and warranty insurance, a critical part of any policy, and this is not really kind of the topic of conversation anymore, it’s very well accepted, the insurer waives their subrogation rights against the seller. So they’re basically going to say, we can’t go after the seller.
There’s one exception to that, which is fraud. So the insurer will say, if there’s a fraud situation and we pay the buyer, all bets are off, right? We’re going to go try to recoup what we paid.
But it’s really very, very limited and it’s limited to precisely that, right? It should be common law fraud. Other than that, the insurer is kind of taking that risk on, right?
So the buyer brings a claim, the insurer pays the buyer, whatever the damages are agreed. The insurer really has no ability to kind of then turn around and say, that was an awful outcome. We had to pay a lot of money.
Let’s go find those sellers and get them. They would need to have the sort of makings of a fraud claim, right? Very, very hard thing to prove, very, very extreme thing for them to even attempt to do that.
Armando (49:12 – 49:31)
Yeah. So if it’s an honest mistake or just wasn’t seen and people make mistakes, then that’s just how it is. But if there’s fraud, which is intentional, deceptive, something that’s different and that makes sense.
It’s like the statute of limitations. If there’s fraud, there is no statute of limitations.
Gaurav (49:32 – 50:11)
Yeah. And that, again, totally not controversial, but it is a question we get a lot from sellers. And it’s a great question, which is just, this sounds fantastic, but if I had to pick who’s going to be knocking on my door post-closing, I think I would rather pick my business partner or the buyer than a big insurance company kind of coming after me.
And so I’m always happy when people think of that far ahead or think that question, because it is really kind of a critical part of this product is just that waiver of subrogation rights from the insurer.
Armando (50:11 – 51:11)
Okay. So just a quick recap, the seller wants to make sure to understand what’s the structure of this, what’s the retention, which really we might call a deductible to the seller. Are there carve-outs, are there things that are maybe being mentioned that are not going to be covered by the policy?
Again, understanding what those are, so that eyes open going into this transaction, they know what those are. And that you’re not replacing the buyer with the insurance company to come after you because the insurance company waives its right to do that. But if there’s fraud, that’s a whole different boat.
And then that’s just a different story. But those three areas. Good.
That sounds great. Just a little bit of a heads up for that seller to be, if you look at nothing else with these thousands of documents during this sale transaction, make sure to understand what those three areas are with this rep and warranty insurance.
Gaurav (51:12 – 51:26)
That’s right. That’s right. And again, if it’s all transpiring in the right way, it should really be a process between us or amongst us, the buyer and the insurer, much more than involving the seller.
Armando (51:26 – 52:02)
Okay, good. Anything, Gaurav, that we haven’t talked about related to rep and warranty insurance? Again, when a seller goes through this for the first time, this is all brand new.
And it can be very overwhelming having all these things to understand and all these attorneys, all these CPAs, all these people who are part of the picture. And anything within your space, and I’m thinking rep and warranty insurance, but anything else within the, as you mentioned, the bespoke, the custom policies that might be required or this warranty insurance that we haven’t touched on yet?
Gaurav (52:04 – 52:46)
Yeah, no, I think we’ve covered a lot of ground. I would just say, it is undoubtedly an overwhelming process. I can only imagine to be selling a business, especially for the first time.
This is one of those sort of products that it’s as close to kind of from the seller’s perspective, at least, to kind of a no-brainer as is out there, right? This is one of those things that should make, you know, take a few items off the seller’s list versus adding more to it, right? If it’s, you know, kind of done correctly and initiated at an early stage in the process.
Armando (52:47 – 53:30)
And one last thought in terms of price, if that seller is selling his or her company for, say, $10 million and there’s a 10% holdback for 12 months, getting this rep and warranty insurance in there frees up that million dollars that was going to be held back that the seller can can get that in his pocket, his or her pocket sooner. But I’m wondering about how this is priced. For that million dollars that they get to keep in their pocket, are they going to put out $100,000, $200,000, half a million?
How does that equate? I’m not sure how to really look at that.
Gaurav (53:31 – 55:04)
Yeah, yeah. So, you know, the minimum, I won’t suggest kind of a minimum deal size or a it continues to change, you know, in both directions, depending on the market. So whatever I say probably will be irrelevant in the not so distant future.
Today, I can say, you know, we see kind of minimum premium levels, so minimum kind of cost sitting in the sort of plus or minus, you know, $200,000 range. And that’s generally working out to something on the order of, you know, maybe a $2 million kind of cap or limit of liability under the policy. Again, that’s today.
There could be a different, you know, different story sort of, you know, tomorrow, our market is very, very, very fluid. But broadly speaking, if you look back at the last, you know, five, seven years, pricing for this product has sort of swung in the general range of kind of, you know, two and a half to 5% of the insured amount. So two and a half to 5% of whatever that cap or limit of liability is under the insurance is sort of how you want to, you know, generally sort of think about it.
Again, there’s a lot of room in there. And of course, there’s the other lever of the deductible or retention. So it tends to be very, very transaction specific, generally.
But that’s largely where we’ve been for quite some time.
Armando (55:04 – 55:39)
Okay, great. Gaurav, this has been really, really helpful. Thank you for just having this conversation with me about this sale and the reputable warranty insurance and the things that go into that so that the seller can get a better grasp of what this really looked like and what should he or she be really thinking about as they go through this process.
If somebody has questions, I think you’re going to email me a link. Is that right? Where I can put that in the wording down below this.
So people, if they have questions, they can reach out to somebody or get more information through your Lockton website.
Gaurav (55:40 – 55:42)
Sure, sure. Yeah, that’s great.
Armando (55:42 – 56:22)
That’s great. Okay, that sounds great. Well, again, Gaurav, thank you so much for the conversation.
Really appreciate it. And I hope that as you’re going forward, that things go as planned versus the surprises that come up every so often. And thank you for what you’re doing in this marketplace, because as we work with founders who are selling for the first time, this is often a once in a lifetime thing.
They’ve got to get it right. They’ve got to make sure they really understand so that when it’s all done, they feel good. They feel confident.
They feel they made all the right decisions and they did what they needed to so they can walk away feeling like it was a successful exit for them. So thank you for that.
Gaurav (56:23 – 56:33)
Yeah, no, absolutely. We look for the surprises so that our clients don’t have to endear them. That’s the world we live in.
So thank you. Thank you very much for having me.
Armando (56:33 – 57:11)
This has been excellent. Thank you. Hope you enjoyed this episode of the Founder’s Guidepost.
Whether exit is on your immediate horizon or maybe 10 years down the road, there’s something here for you. And remember, we all have an expiration date. We just don’t know when that will be, which is why planning ahead is critical.
And if you’re wondering if you’ve missed anything in your planning, contact me to schedule your founder’s strategy call. You may call our office at 480-367-9000 or schedule a call at axiomcorp.com. Here’s to your American success story.
Leave a Reply