In almost every M&A transaction, the question of post-closing risk allocation comes down to two mechanisms: holdbacks and representations and warranties insurance (RWI). Both exist to protect the buyer against losses arising from breaches of the seller’s representations. But they work very differently, and choosing between them is not as straightforward as it appears.
A holdback is simple in concept. A portion of the purchase price, typically 10 to 15 percent, is held in escrow for a defined period. If the buyer discovers a breach, they make a claim against the escrow. Whatever remains at the end of the survival period is released to the seller.
RWI transfers that risk to an insurance carrier. The buyer purchases a policy that covers losses from breaches of representations and warranties. The seller gets a clean exit at closing with minimal or no escrow, and the buyer has recourse against the insurer rather than the seller.
The appeal of RWI is obvious. Sellers get more cash at closing. Buyers avoid the awkwardness of clawing money back from the people they just acquired. The relationship starts clean.
But RWI is not a universal solution. Policies have exclusions. Known issues are never covered. Certain representations may be carved out or sub-limited. The underwriting process itself takes time and costs money, typically 2 to 4 percent of the coverage limit.
Holdbacks, by contrast, are blunt but reliable. The money is there. If there is a valid claim, the mechanism for recovery is straightforward.
The right choice depends on the deal. The mistake is assuming that RWI always benefits the seller. Sometimes the comfort of insurance is not the same as the coverage you actually need.