Now that the cannabis industry in maturing the market is seeing more and more mergers and acquisitions. There are numerous reasons for this trend ranging from a need for consolidation as companies become MSOs (multi-state operators), vertical integration in order to control processes and efficiencies and simply consolidating for the reason of leveraging power over retailers while streamlining distribution.
In the first couple of weeks in March alone we have seen these headlines:
- Left Coast Ventures Announces Acquisition of Sisu Extracts
- SLANG Worldwide Inc. Announces Agreement to Acquire Cultivate Brands Corp.
- Harvest One Announces Sale of Non-Core Interest in Burb and Lillooet Property for Total Proceeds of $2.3 Million
- Emerald Health Therapeutics Signs LOI with Sigma Analytical Services
- BR Brands and Dixie Agree to Combine to Create CPG Platform
Even with the best interests of both parties fully represented there are still inherent risks in any M&A deal. The question most people ask is ‘does it make sense to insure these risks?’
Let’s first identify exactly what M&A insurance is and what it does and does not cover. M&A insurance or representations and warranties (R&W) insurance refers to a type of coverage designed to guarantee the representations (contractual) made by sellers associated with corporate mergers and acquisitions. According to the International Risk Management Institute (IRMI), “the key benefit of the policies is that they provide a viable alternative to escrow funds, which have traditionally used to satisfy claims associated with representations and warranties contained in merger and acquisition documents.” Tailored coverage helps protect buyers and sellers from financial loss if misrepresentations or inaccuracies in representations or warranties occur. Buyers can distinguish bids, sellers can reduce indemnity obligations – both can close more efficiently.
When entering into an acquisition agreement the seller will make representations such as the validity of the audited P&L statement or the current contracts that are in place and both parties will negotiate based off the R&Ws. Traditionally the seller (or its shareholders) agrees to indemnify (compensate for harm or loss) the buyer with limited time frames, exclusions and caps for breaches of the seller’s representations and warranties. Typically, this would be accomplished in escrow by holding back 10-15% of the proceeds payable at closing for a term of one to two years. R&W insurance modifies or replaces this practice.
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The risks are simply the things you don’t really know however, you need to understand, measure and mitigate transactional risks because you simply can’t guarantee that the seller is representing themselves accurately. Think about the real-life scenario of dating. At first both parties put their best foot forward and not until after some time has elapsed do both parties see the blemishes of the other.
Key points about the R&W policy:
- The fees – typically 2-3% of the coverage limits so if the coverage is 1M then the cost would be around $25k. There could be a minimum and there could also be an underwriting fee charged by the insurer. Depending on the structure you may also be faced with a broker fee on top of the premium for conducting their professional services. The payments are typically one time and paid up front.
- Coverage is typically 10% of the sale price so if you sell for $20m you will want to purchase $2M in coverage.
- The policy term is typically for 3 to 6 years, to be negotiated with the insurer.
- Like most insurance policies be aware that there will be a deductible which is usually 1% of the purchase price so in this example the deductible would be $200k.
- Like most insurance policies there are exclusions as well. Some will be standard like the policy will not cover a change in selling price and there very well could be more exclusions added by the underwriter. We’ll cover more of that later.
- The process for obtaining a policy usually starts with the buyer or seller approaching an insurance broker to solicit quotes from insurers. An application for insurance must be completed.
- Once the insurer’s due diligence process is complete, the insured will then negotiate the specific terms of the policy. I.e. scope and exclusions.
- Typically, there are two parts on the process. First, an initial non-binding indication of interest at 0 cost followed by an underwriting/due diligence process that will require a payment that could be between $10-50k depending on the complexity.
- In Letters of Intent or Term Sheets, buyers who agree to obtain M&A representations and warranties insurance may seek to include clauses requiring the seller or its stockholders to bear some portion (usually one half) of the cost of obtaining the insurance policy and the cost of the retention.
One in 5 deals will give notification of a claim on a global basis. Overall, 74 percent of claims are notified within the first 18 months and 29 percent of claims notifications are expected within the first six months from policy inception. “The critical period is the first 18 months because that is when the target company and the new buyers have taken over management of the operation and have gone through an entire audit cycle,” explains Darren Savage, ”which is often when you start to find problems.”
There are benefits to both the seller and buyer in the transaction. As mentioned earlier an insurance policy can reduce or eliminate the need to holdback capital held in an escrow that would reduce the proceeds received by that shareholders at closing for a significant amount of time. It can eliminate or reduce the seller’s indemnity for breach or R&Ws while creating a cleaner exit with fewer contingent liabilities. It can extend the time for duration of the representations and warranties, giving the buyer additional time to discover problems with the acquired business.
The use of R&W insurance usually simplifies and speeds up the negotiation of the acquisition agreement since the seller has less interest in negotiating the scope of its representations, particularly if they do not survive closing. This benefits both parties. Additionally, in a contract where there will be some restricted post-closing indemnification by the seller’s stockholders, the seller has less interest in resisting materiality caveats where the insurance will cover all losses, and therefore this aspect of the deal negotiation also can be concluded relatively quickly.
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There are “standard” exclusions to coverage; for example, the insurance does not cover covenant breaches by the seller or purchase price adjustments, and there may be specific exclusions based on the results of the insurance company’s due diligence/underwriting.
Buyers and sellers need to understand that representations and warranties insurance is not a black-and-white alternative to the traditional post-closing indemnification, escrow/holdback and survival of representations and warranties structure of private-company M&A deals. Representations and warranties insurance policies typically contain the following exclusions and limits:
The policy covers up to a certain dollar amount for losses, typically 10% of the M&A deal consideration. Therefore, the buyer can be at risk for much higher losses.
The policy does not cover breaches of the seller’s covenants in the acquisition agreement as stated above.
The policy does not cover purchase price adjustments and the policy will exclude losses due to breach of representations and warranties of which the buyer had knowledge. This is typically defined as “actual knowledge”.
The policy may exclude certain tax-related issues, including taxes accrued on the balance sheet for pre-closing periods, transfer taxes, tax credits and don’t forget about 280e audits!
R&W coverage may be the best way to transfer the risk of a M&A deal but the situation is the boss so the best advice to contact a professional that can help you in the process. Remember that the first step is at zero cost and will help with the due diligence process.
About the Author
Jim Sprouse
Jim Sprouse is an industry insider that began in the cannabis industry in 2014 after having run insurance agencies for a Fortune 500 company over a 15-year span. He started Cannabis Tax and Accounting Services then began a 3 year plant touching project in Southern California where the company completed a full EIR, was issued 4 licenses and just recently opened a retail shop. Jim continues to serve as a consultant in a limited capacity. His understanding of the cannabis industry is deep and the same can be said about his connections. From 280e to scaling human capital his expertise is sought after as he also known for his high moral standards.