W&I Insurance in the Light of Venture Capital Transactions – a tool to balance conflicting interests?

Warranty and indemnity insurance (W&I insurance) is designed to cover certain risks with regard to the representations, warranties and indemnities given by the seller or its representatives in favor of the purchaser in the context of M&A transactions. As such, W&I insurance can constitute an effective means of achieving a practical balance between the conflicting interests of the parties in M&A transactions.¹ This article shall highlight the particular suitability of W&I insurance for Venture Capital transactions.

1. Conflicting interests in M&A transactions

In the context of M&A transactions, the involved parties regularly waive or amend the statutory warranty and liability regime and substitute or supplement it by way of a set of individually negotiated representations, warranties and indemnities. Not surprisingly, this section of the transaction documentation is regularly at the heart of the negotiations and fiercely contested.² The sell-side will usually endeavor to provide representations, warranties and indemnities as restricted in scope and time as possible.³ This is particularly true in cases where not the seller, i.e. the owner of the shares in the target, but rather the target’s management or other representatives shall issue certain representations and warranties due to their individual knowledge of the relevant circumstances. Unless they have any equitable stake in the target or receive any other benefit within the context of the transaction, the target’s management or other representatives most likely will not be willing to incur any liability at all.⁴ The purchaser on the other side will regularly request rather extensive representations, warranties and indemnities.⁵

This conflict of interest between the sell-side and the purchaser is primarily due to asymmetric information inherent in M&A transactions: While the purchaser may conduct the most comprehensive due diligence, the sell-side will likely still have more information or a better understanding of the target’s business operations, technology, value drivers and risks. In any case, from the purchaser’s perspective there will always remain a risk that the sell-side – knowingly or unknowingly – withholds certain relevant information. However, extensive representations, warranties and indemnities may at the same time be too burdensome for the seller and particularly the target’s management and other representatives and still be insufficient from the purchaser’s perspective given a potential lack of sufficient funds of the sell-side for potential violations.⁶

In typical M&A transactions, such conflicting interests can be resolved or at least reduced by (i) escrow arrangements pursuant to which a portion of the purchase price is paid into an escrow account for a certain period in time as security for breaches of representations and warranties, (ii) third party guarantors (e.g. parent companies) granting joint liability with the sell-side and / or providing additional securities or (iii) W&I insurance.⁷

2. General concept of W&I insurance

In principle, W&I insurance is available as sell-side and / or buy-side policies.⁸ Sell-side W&I insurance primarily covers the seller and its representatives against claims of the purchaser or a third party, which may arise as a result of breach, incorrectness or inaccuracy of certain representations, warranties or indemnities given by the sell-side. In addition, such policies may also cover the costs for a potential defense against unfounded claims of the purchaser or third parties. However, sell-side W&I insurance is rather the exception in practice.⁹ In contrast, buy-side W&I insurance taken out by the purchaser is more and more sought after in recent years.¹⁰ Under a buy-side W&I insurance, the purchaser’s potential claim for damages for breaches of representations or warranties of the sell-side is directed directly against the respective insurer issuing the policy. Therefore, the purchaser does not bear the risk of the claim not being enforceable against the seller or its representatives. In addition, buy-side policies in principle may also cover deliberate or grossly negligent misrepresentations by the sell-side. Subject to contractual arrangement, the insurer in such cases may be entitled to (limited) recourse against the sell-side.¹¹ If the parties of an M&A transaction intend to take out W&I insurance, this should be addressed at an early stage as the parties not only have to consider the additional costs of the insurance premium, but the involvement of W&I insurance potentially also requires certain adjustment of the transaction process.¹²

3. W&I insurance in Venture Capital transactions

In Venture Capital transactions, the conflict of interests of the involved parties with regard to representations, warranties and indemnities is particularly relevant. This is true for both, the initial investment of the Venture Capital investor as well as its potential exit at a later stage.

Venture Capital investments are commonly effected via investment rounds. While an initial Venture Capital investment may generally also take the form of an acquisition of existing shares held by another shareholder in the target, typical Venture Capital investment structures include a capital increase and the issuing of new shares of the target.¹³ Regardless of how Venture Capital transactions are structured, they are usually characterized by the fact that the investor shall become a new shareholder while the existing shareholders remain invested in the target and potentially also participate in the investment round and increase their stake. Such transactions therefore differ from typical disposals or acquisitions in which the seller usually transfers all of its shares to the purchaser and the parties therefore take opposing roles not only during but also after the transaction. As in any joint venture, it is critically important for successful Venture Capital transactions to balance and ideally align the interests of the involved parties becoming co-shareholders. Having said this, the interests of the existing shareholder base and new Venture Capital investors typically still conflict: The existing shareholders will regularly have better or additional information about their business operations, technology and value drivers and seek the highest possible valuation. This might incentivize the sell-side to overemphasize business prospects and downplay certain risks (moral hazard).¹⁴ However, particularly in early-stage investment rounds of start-ups, the existing shareholder base often includes the founders and other natural persons. Potential personal liability may prevent such natural persons from providing comprehensive representations, warranties and indemnities while the investor at the same time might be concerned about the recoverability and enforceability of its potential claims in cases of breaches.¹⁵ Further, a potential enforcement of claims against co-shareholders will likely affect the relationship between the co-shareholders and threaten the success of the venture.¹⁶ This is particularly true in young start-ups where the involved founders or other natural persons are crucial for the current and future business operation.¹⁷

The respective representations, warranties and indemnities might to a certain extend be given by the target itself. However, particularly where the target is a German limited liability company (Gesellschaft mit beschränkter Haftung – GmbH) or German stock corporation (Aktiengesellschaft – AG), such arrangements might violate statutory capital contribution and maintenance provisions. In addition, any claims against the target itself will likely also impair the value of the investor’s shareholding in the target. In case of relatively young start-ups, finding a third party guarantor such as an affiliated company or banks in order to provide further security or collateral might not be a realistic option. Escrow arrangements would principally be feasible. However, the target in Venture Capital transactions regularly is in urgent need of fresh capital so that a partial retention of the investment amount will likely be contrary to the inherent purpose of the investment round. Therefore, W&I insurance is particularly suitable to provide clear risk allocation without adversely affecting the relationship between the future co-shareholders and thus balance the existing conflict of interests in Venture Capital investments in the context of which a new anchor investor joins the existing shareholder base.¹⁸

When exiting from an investment, Venture Capital investors likely do not want to provide extensive representations, warranties and indemnities either, as they typically intend to promptly monetarize their investment without having to account or even build reserves for potential trailing liabilities. This is particularly true in cases where they have themselves only received limited representation, warranties and indemnities upon their initial investment in the target. Third party guarantees from parent companies or banks are also unlikely to be provided in an exit scenario. Escrow arrangements as in typical M&A transactions would result in a delay of the payments of the investment proceeds, which will most likely be rejected by the investors behind a Venture Capital fund exiting an investment.¹⁹ In addition, Venture Capital investment vehicles are often structured as funds or special purpose vehicles. Upon exit from an investment and distribution of the respective profits, this may – due to a lack of substantial assets – result in limited recoverability and enforceability of potential claims of the purchaser.²⁰ Therefore, W&I insurance is also suitable to balance the opposing interests of a Venture Capital investor exiting from an investment and the remaining shareholder base in such exit scenarios.

4. Summary

W&I insurance can be a viable option to provide clear risk allocation in Venture Capital transactions without the need for a retention of funds or the provision of additional third party security in both, the initial investment stage as well as a potential exit scenario. Particularly with regard to the initial Venture Capital investment of a new anchor investor, the involved parties should consider W&I insurance in order to not adversely affect their relationship as future co-shareholders. However, the benefits of W&I insurance need to be weighed against its additional costs and timing implications in each individual case, particularly taking into account the usual tight timeline of financing rounds in Venture Capital transactions.