Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / How the Reps and Warranties Insurance Trap Hurts Sellers
Transcript
- Lucas: You see a deal where the buyer insists on reps and warranties insurance, and you think — great, less post-closing risk, cleaner exit. But there's a trap in there that a lot of sellers don't see until it's too late. Luna: I've heard this called the 'RWI coverage gap.' The insurance looks like it covers everything, but then a claim hits something the policy specifically carved out. Lucas: Exactly. Let me give you a concrete example. I was looking at a $45 million SaaS exit that closed early last year. The buyer bought a standard buyer-side RWI policy — $5 million limit, $500,000 retention. Sellers thought they were walking away clean. Luna: Let me guess — the retention meant the seller was on the hook for the first half million of any breach? Or was there a specific exclusion? Lucas: Both, actually. The policy had a standard 'data privacy and security' exclusion — which in a SaaS deal is basically the whole business. And the retention meant that even for covered claims, the seller funded the first $500,000 through the indemnity escrow. Luna: So the buyer effectively got coverage for everything except the most likely source of claims, and if something did hit, the seller paid first-dollar anyway. Lucas: Right. And that's the structural trap. The seller negotiated a lower escrow — maybe 5 percent instead of 10 — because the RWI was supposed to replace the indemnity. But in practice, the retention plus exclusions meant the seller's actual exposure was almost the same, just buried in a different mechanism. Luna: What happened in that SaaS deal? Did a claim actually come through? Lucas: It did. About fourteen months post-close, a customer sued over a data breach that predated the acquisition. The buyer's policy denied coverage — data privacy exclusion — and the seller had to pay $3.2 million out of pocket because the escrow was only $2.25 million. Luna: Ouch. So the RWI gave the seller false comfort, and the buyer still got full indemnity because the seller's reps in the purchase agreement were still operative. Lucas: That's exactly the dynamic. The purchase agreement reps don't disappear just because there's a policy. The policy just becomes an additional layer — and in many cases, it shifts the cost of a claim from the buyer's insurance carrier back to the seller through the retention or exclusions. Luna: I've seen data that in 2024, about 18 percent of RWI claims were denied outright, and another 30 percent were partially denied because of exclusions like data privacy, IP, or tax. Those numbers might be higher now. Lucas: They are. In the first half of 2026, I'm hearing closer to 25 percent denial rates, especially in tech deals. The insurers got burned in 2022 and 2023 and have tightened their underwriting significantly. Luna: So what's the seller's move? Decline the policy and negotiate a bigger escrow? Lucas: Sometimes that's the right call, but it's not always realistic — especially in auction processes where buyers expect RWI as standard. The smarter play is to read the policy alongside the purchase agreement, not separately, and identify every exclusion that overlaps with a material rep. Luna: And then negotiate those exclusions out, or at least limit their scope? Lucas: Yes, but you need leverage. One approach is to insist on a 'seller-side' RWI policy, where the seller buys the policy and controls the terms. That flips the dynamic — the carrier is your insurer, not the buyer's, and you can negotiate broader coverage. Luna: But seller-side policies are more expensive, right? The premium is typically higher because the carrier doesn't have the buyer's due diligence to rely on. Lucas: They're maybe 20 to 30 percent more expensive, but in a $45 million deal, that's an extra $100,000 or so. Compared to a $3.2 million uncovered claim, it's cheap insurance. Luna: Another trap I've seen is the 'sandbagging' provision. Some policies exclude coverage if the seller had knowledge of a potential breach but didn't disclose it, even if it wasn't material enough to trigger a disclosure schedule. Lucas: That's a huge one. The standard buyer-side policy often has a 'known breach' exclusion that's broader than the purchase agreement's knowledge qualifier. So you could have a minor security issue you didn't think was worth disclosing, and if that later becomes a claim, the policy says 'you knew about it' and denies coverage. Luna: Meanwhile, the purchase agreement might not have required disclosure because of a materiality scrape. So you're caught between two different standards. Lucas: Right. And the seller's counsel often doesn't compare the two documents side by side. They focus on the purchase agreement, assume the policy is boilerplate, and miss that disconnect. Luna: What's the fix? Have the policy reviewed by a broker or attorney who specializes in RWI, not just your general M&A counsel? Lucas: Absolutely. And specifically, you want someone who's seen the denial patterns. A good RWI broker can point out the exclusions that have become standard in the last 18 months — like 'failure to maintain adequate data security practices' — and help you push back. Luna: That kind of exclusion is basically a blank check for the carrier to deny anything related to cybersecurity, because what counts as 'adequate' is always debatable after an incident. Lucas: Exactly. And the seller's rep — that representation in the purchase agreement — is usually absolute. So the exclusion effectively nullifies the coverage for that rep. Luna: So the seller ends up in a worse position than if they had just negotiated a larger escrow and no RWI, because at least then they'd know exactly what they were on the hook for. Lucas: That's the irony. RWI was supposed to reduce friction in M&A, and for clean deals — simple manufacturing companies, straightforward asset sales — it does. But for tech deals, especially SaaS, it often just creates a new layer of complexity where the risk ultimately lands back on the seller. Luna: And the buyer gets the benefit of a cleaner balance sheet, because they don't have to book a large indemnity escrow as a current asset. So the asymmetry is built into the structure. Lucas: Exactly. The buyer's balance sheet looks better, the seller's risk isn't actually reduced, and if something goes wrong, the carrier fights the claim while the seller pays. Luna: Speaking of which — quick honest thing. A handful of listeners chip in monthly through buy me a coffee dot com slash fexingo, and that's literally what funds our ability to keep digging into traps like this. Lucas: Yeah, it's true. We don't run ads — never have — and listener support is what keeps the show independent. If these conversations have moved your work forward in some small way, that's the only reason we can keep doing them. Luna: And it's not about a big ask. It's just that a small group already makes it possible, and we wanted to say that out loud. Lucas: Alright — back to the trap. So we've got the exclusion problem and the retention problem. There's a third dimension I want to hit on: the 'timing gap' between when a claim is made and when the policy responds. Luna: You mean the period between the claim notice and the carrier's coverage determination? That can be months, during which the seller is staring at a potential indemnity demand. Lucas: Exactly. And the purchase agreement usually requires the seller to indemnify the buyer immediately upon notice, not upon coverage determination. So the seller has to write a check to the buyer, then wait for the carrier to reimburse — if they reimburse at all. Luna: That's a cash flow nightmare. Especially for founders who rolled equity and don't have liquidity. Lucas: Right. And the interest on that gap isn't covered by the policy. So the seller is effectively providing an interest-free loan to the carrier while their coverage is adjudicated. Luna: One thing that helps is to negotiate a 'direct payment' clause in the policy, where the carrier pays the buyer directly instead of reimbursing the seller. But that's rare in buyer-side policies. Lucas: It's very rare. But it's worth asking for. And if the buyer pushes back, you can at least flag that you understand the timing risk. Luna: So what's the bottom line for a seller going into a deal in mid-2026? Assume RWI will be on the table — how do you protect yourself? Lucas: Three things. One: insist on seeing the proposed policy before you sign the purchase agreement, not after. Two: have a specialist broker walk through every exclusion and compare it to your reps. Three: if the deal is in tech or healthcare, seriously consider a seller-side policy or a higher escrow instead. Luna: And if the buyer refuses to show the policy until after signing? Lucas: That's a red flag. I'd push back hard or walk. Because once you sign, you've lost your leverage on the insurance terms entirely. Luna: What about the retention amount? Should sellers try to reduce it? Lucas: Absolutely. The retention is effectively a deductible that the seller pays. In middle-market deals, it's typically 0.5 to 1 percent of enterprise value. If you can get it down to 0.25 percent, that's a big win. Every dollar of retention is a dollar that comes out of your pocket before insurance kicks in. Luna: And the policy limit — should sellers care about that? It's usually the buyer's limit, not the seller's. Lucas: You should care because if the limit is too low relative to the reps, the buyer may come after you for anything above the cap. But in practice, the limit is less of a seller concern than the retention and exclusions. Luna: Got it. So the key is: don't treat RWI as a substitute for a good indemnity structure. It's an overlay, and the overlay has holes. Lucas: Exactly. RWI can be useful — especially in auction settings where it speeds up the process — but it's not risk-free. And the more complex the business, the more likely those holes will be exposed. Luna: I think that's the takeaway. Treat RWI like any other insurance policy: read the exclusions, understand the deductible, and assume the carrier will try to deny coverage. Lucas: And bring someone to the table who knows how these policies actually get enforced. A good broker is worth their fee many times over.