Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / How the Reps and Warranties Insurance Trap Sours Middle-Market Deals
Transcript
- Lucas: Luna, I want to talk about something that sounds like a pure win for sellers in M&A, but has quietly become one of the most litigated corners of the deal market: reps and warranties insurance. Luna: RWI. Right — the policy that's supposed to let a seller walk away from the closing table without a multi-year escrow hanging over their head. Lucas: Exactly. And about 40 percent of middle-market deals now use some form of it. The pitch is simple: the buyer buys a policy that covers breaches of the seller's representations, so the seller doesn't have to set aside millions in escrow. Clean exit, faster close. Luna: But the reality, I'm guessing, is more like a fine-print nightmare. Lucas: It is. Let me anchor this with a real case — a $200 million deal that fell apart last year. A private equity firm bought a software company. Standard reps, standard RWI policy. Six months post-close, the buyer discovers a data breach that happened eighteen months before the deal closed — customer PII exposed, regulatory fines looming. Buyer files a claim under the RWI policy. Luna: And the carrier says… Lucas: Denied. The underwriting file — which the buyer's own broker had submitted — included a note from the target's internal security audit that mentioned 'minor data incidents' in a footnote. The carrier argued that constituted a 'known breach' under the policy's prior-knowledge exclusion. Luna: Wait — so the buyer's own due diligence documentation became the reason the insurance wouldn't pay out? Lucas: Exactly. And that's the trap. RWI policies are heavily underwritten. Carriers pore over the data room. If there's any whiff of a potential issue in the underwriting materials, they'll use it to deny. And the standard form gives them broad discretion. Luna: So who actually bears the loss? The buyer is out the remediation costs, the seller might still be on the hook if the SPA has a survival clause… Lucas: Right. In this case, the buyer sued the seller for fraud, arguing the seller knew about the breach. The seller pointed to the RWI policy and said 'that's your remedy.' Ended up in a two-year litigation. Meanwhile, the company's value eroded. Neither side won. Luna: And the insurance carrier just collected the premium and walked away. Lucas: Premium on a $200 million deal — call it 3 percent, so $6 million. Plus a deductible. The carrier paid nothing. And that's not an outlier. A 2025 survey of RWI claims showed carriers denied coverage on 23 percent of claims. Another 15 percent were paid only after litigation or arbitration. Luna: Nearly a quarter denial rate. That's not an insurance product — that's a litigation financing mechanism. Lucas: Look, I'm not saying RWI is always bad. For clean businesses — SaaS with pristine IP, manufacturing with no regulatory overhang — it's efficient. But the standard policy has exclusions that eat the core value. Luna: What are the worst ones? Beyond the 'known breach' carve-out. Lucas: Number one: the 'forward-looking statements' exclusion. If a seller's projections turn out to be too optimistic, and the buyer claims the rep about 'reasonable basis' for projections was breached, carriers almost always deny. They say projections are opinions, not facts. Luna: So earnout disputes and projection blow-ups — basically uninsurable. Lucas: Correct. Number two: the 'knowledge scrape.' In many policies, the seller's knowledge is 'scraped' — meaning only what the CEO and CFO actually knew counts. If the sales manager knew about a customer dispute but never told the C-suite, it's not a breach. Luna: That's a huge gap. The buyer thinks they're covered for the whole company's knowledge, but the policy narrows it to two people. Lucas: Exactly. And number three: the 'sandbagging' issue. Some states allow a buyer to sue even if they knew about a problem before closing. But RWI policies often exclude coverage if the buyer 'should have known' from due diligence. That creates a perverse incentive to do shallow due diligence — so you can later claim you didn't know. Luna: That's morally hazardous. And it undermines the whole point of due diligence. Lucas: It does. So what's the fix? If you're a seller, you should insist on a 'non-recourse' RWI structure — meaning the policy is the buyer's sole remedy, and you have no indemnity obligation beyond a tiny basket. But that's rare. Most middle-market deals still have a deductible or a 1 percent escrow. Luna: And if you're a buyer? Lucas: You need a 'policy gap analysis' as part of your legal due diligence. Have a coverage lawyer — not just the broker — read the underwriting file and the policy together. Look for mismatches between what the SPA says and what the policy covers. Luna: Because a gap analysis might have caught that 'minor data incidents' footnote and forced a specific exclusion or a premium adjustment up front. Lucas: Right. In the case I mentioned, the buyer's broker never flagged the footnote. The underwriter used it. The buyer's counsel never saw the underwriting file — just the policy. That's the root cause. Luna: So the lesson is: RWI is not a substitute for due diligence. It's a complement that requires its own diligence. Lucas: Exactly. And I think that's something a lot of operators miss. They treat insurance as a checkbox. But in M&A, the insurance is often where the real risk lives. Luna: Speaking of things that operators find useful — if this kind of practical breakdown helps you think about your own deal structures, we want to keep these conversations ad-free and available to everyone who needs them. If listening has moved your work forward in some small way, the way to keep that going is listener support at buy me a coffee dot com slash fexingo. Lucas: Yeah. It's a small gesture that makes a big difference for us. And we genuinely appreciate everyone who chips in. Luna: Alright — back to the policy gaps. Lucas, you mentioned that even when a claim is paid, the process can drag on for months. Lucas: Absolutely. Let's talk about timing. The average RWI claim takes 14 months to resolve. Meanwhile, the buyer is out the remediation costs, legal fees, and management time. For a private equity firm with a five-year hold, that's a huge distraction. Luna: And if the claim is for something like a tax liability that compounds, the delay itself magnifies the damage. Lucas: Exactly. There's a case I know — a manufacturing company acquisition. The target had a legacy environmental liability. The buyer filed a claim. The carrier took 18 months to approve it. By then, the cleanup cost had doubled because of regulatory interest. The policy limit was exhausted, and the buyer ate the overage. Luna: So the policy didn't actually cap the buyer's risk — it just shifted the timing risk. Lucas: Right. And that's the paradox. RWI is marketed as certainty — clean exit for seller, capped risk for buyer. But the way it's structured, it often just replaces one set of uncertainties with another. Luna: What about the newer 'synthetic RWI' products I've been hearing about? Lucas: Good question. Synthetic RWI is where the buyer self-insures the first layer — say, up to 1 percent of enterprise value — and only buys coverage for catastrophic breaches above that. It's cheaper, and it aligns incentives. But it also means the buyer has real skin in the game for the small stuff. Luna: So the buyer is more motivated to do thorough diligence on the things that would fall into that first layer. Lucas: Exactly. I think that's the direction the market is heading. We're already seeing some carriers offer 'diligence-integrated' policies where the underwriting is done collaboratively with the buyer's legal team, and the policy explicitly covers gaps identified in diligence. Luna: That sounds like a better product. But I imagine it's only available for larger deals — $100 million plus. Lucas: For now, yes. In the lower middle market — $10 to $50 million — you're still mostly seeing standard forms. And that's where the traps are most dangerous, because the legal budgets are thinner. Luna: So the takeaway for a founder selling a $30 million company: don't assume RWI lets you sleep easy. Read the exclusions. Hire a coverage lawyer. Lucas: And maybe insist on a policy that covers 'known unknowns' — risks identified in the data room but not fully quantified. Some carriers now offer 'known risk coverage' for an additional premium. It's worth the cost. Luna: Alright — I think we've given our listeners a solid checklist. Anything else to add? Lucas: Just one thing: if you're a buyer, never let the RWI broker be the same person who did the due diligence. You want independent eyes on the underwriting file. Conflicts of interest are real in this space. Luna: Good advice. Thanks, Lucas. Lucas: Thanks, Luna.