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Why SMEs shouldn't rely solely on directors' and officers' insurance to cover M&A risks

Why SMEs shouldn’t rely solely on directors' and officers' insurance to cover mergers and acquisitions risks

After a period of disruption during the height of the COVID-19 pandemic in 2020, mergers and acquisitions (M&A) are very much back on the agenda for small and medium-sized enterprises (SMEs). In fact, M&A activity involving UK companies reached a record number of transactions in 2021, driven by pent-up demand amongst cash-rich investors.1

Interestingly, while the huge, multi-billion-pound deals make the headlines – like Elon Musk’s acquisition of Twitter2 – M&A activity in the SME sector is also sky high. In 2021, SMEs completed 323 M&A deals worth a combined £1.46 billion – respectively, those figures represent 21% and 27.3% increases compared with 2020.1

What’s more, with SME valuations also 61.7% higher than in 2020 – and M&A activity expected to remain robust through-out 2022 and into 2023 – there are likely to be some tempting opportunities for SME owners and shareholders to realise significant value through a business sale.1

Mergers and acquisitions risk for SMEs

However, for any SME owner considering a merger or acquisition, it is important to remember that M&A transactions can be complicated. The opportunity to realise value from years of hard work building a business carries significant risk – there are a huge range of issues that can derail a deal or leave a seller facing the prospect of having to hand back some, or all, of the sale proceeds.3

What’s more, the risks associated with selling a business don’t end when the deal is complete. For instance, if it should emerge that the seller made inaccurate representations about the sold business –the buyer has up to seven years from deal completion (depending on the type of warranty breach and limitation periods stated in the sale agreement) to make a claim. The end result, if a court finds in favour of the buyer, can be significant unforeseen costs – from defence costs to compensation.3

So, if you’re an SME owner or shareholder who’s thinking about selling up, it pays to be prepared. That means understanding the risks and taking steps to minimise them throughout the sale process – and the right insurance can play a vital role.

Why you shouldn’t rely on directors' and officers' insurance to cover mergers and acquisitions risks

Director’s and officers’ (D&O) insurance covers company directors and officers personally for defence costs and awards made against them for ‘wrongful acts’, for instance, in the event that trading standards, environmental or other regulatory claims are made against them personally.4

It’s easy to understand why some may assume this cover therefore offers protection during a business sale – directors and officers are, after all, more exposed to potential liability claims during the M&A process. For instance; claims could arise from decisions around whether to approve or reject possible sale transactions. 

Many of these risks may not manifest for years and therefore D&O run-off cover is often purchased for a period of up to seven years (influenced by the statutory limitation period in the applicable jurisdiction). The premium for run-off cover is fully earned at inception, so the cover can’t be cancelled or amended for the duration of the contract.

D&O run-off cover will not, however, protect against warranty and indemnity liability the seller may have assumed under the sale agreement as a result of giving the buyer financial recourse for a breach of warranty.  Warranties in this context are statements of fact about the business and protect the buyer in the event that they suffer financial losses in circumstances covered by a warranty.

A seller therefore remains at risk for the duration of the warranty period – this is typically two years from the date on which the business is sold for non-tax warranties and up to seven years for tax-related warranties. Therefore, a successful warranty claim post sale could result in the seller being obliged to pay back some or all of the sale proceeds.

Warranty & indemnity (W&I) insurance covers unknown and unforeseen financial losses arising from a breach of a warranty given by the seller to the buyer in the sale agreement. It can help facilitate a clean exit for a seller and enable sale proceeds to be used immediately as the risk has been transferred to a W&I insurance policy.

Here to help

In addition to advising on and placing run-off D&O cover, at Marsh Commercial we have a access to a dedicated Private Equity & M&A (PEMA) team, which supports the investment, M&A community and our clients to de-risk transactions and create value through:

  • Pre-transaction risk and insurance advice.
  • Advising on and placing M&A insurance solutions for unknown and unforeseen risks (W&I insurance) and known and quantifiable risks (Contingent Specific Risk insurance) to facilitate transactions and transfer transactional liabilities to the insurance market.
  • Advice relating to disposal of assets in distress and/or corporate restructurings.

The world of mergers and acquisitions is highly complex. If you’re considering a business sale, find out more about the potential risks and insurance solutions or contact one of our local experts for confidential support and guidance.

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