How brokers can help small business clients replace escrow agreements

M&A insurance can help small and medium-sized enterprises (SMEs) avoid the need for an escrow agreement, but many small business owners aren’t aware of this possible solution.

Escrow agreements are commonly found in M&A deals in the SME segment (deals under C$15 million) in North America. Under those agreements, 10% to 20% of the business’ purchase price is held by an independent third party to protect the buyer against any future losses due to a breach of representation or warranty by the seller.

But escrows can mean the seller’s proceeds are tied up for months or even years, a less-than-ideal scenario for small business owners who want access to those funds.

“Until recently, there hasn’t been a solution for M&A transactions in the SME segment,” said Angus Marshall, head of transaction liability at CFC Underwriting. “Escrow is pretty much the main way in which buyers get comfortable if there was an issue with the business that was ultimately a breach of representation.

“They know that they can draw down on the escrow to make them whole.”

But your small business client may be able to avoid an escrow if they buy a representations and warranties insurance policy, a type of M&A insurance.

This type of policy also provides additional benefits beyond an escrow. For example, there’s often a gap between what the escrow can pay for and the seller’s total indemnity.

“So instead of remaining liable for that gap between escrow and your indemnity, we can insure [the seller] for the entire indemnity under a single insurance policy,” Marshall said.

In CFC’s case, another benefit is that its SME product is closer (including from an underwriting and price perspective) to a standard commercial insurance policy than a reps and warranties policy.

“There’s been a lot of mythology around reps and warranties insurance,” said Marshall. “Pretty much every commercial lines broker has heard about it, and thought about trying to take advantage of an opportunity that might just come across their desk. But it’s a very different product in the main market [than] what they are used to.”

In the case of M&A insurance, a policy can even be taken out after signing a deal but before the transaction closes, or even after the deal closes, unlike most forms of insurance.

“Part of the difficulty with the main market reps product is not only do you need to know how the underwriting process works, and how to negotiate the policy with usually quite-seasoned M&A lawyers, you’ve got to understand the contract relating to the sale of the company,” Marshall said.

“That’s quite a big target for a broker who’s not in the space,” he added. “That’s not the case with this. Basically, our policy will cover all reps and warranties given.”

CFC believes M&A insurance should be seen as a highly beneficial alternative to escrow agreements in M&A deals.

Not only does it help eliminate the need for an escrow, which allows sellers to invest funds that are otherwise inaccessible, it also protects sellers from the multitude of risks present in M&A transactions.

This article is excerpted from one that appeared in the May issue of Canadian Underwriter. Feature photo courtesy of iStock.com/RomarioIen