Skeletons in the Closet: How to Avoid Risk Management Pitfalls When Doing a Deal
Smart buyers structure transactions and conduct a detailed risk and insurance risk assessment as part of their due diligence, but there are a few key things they tend to miss.
I’ve managed risk and corporate insurance for a while now, and I’ve seen plenty of deals. More often than not, both buyers and sellers see risk management and insurance as an after-thought — at least until they've been burned by unexpected issues during due diligence. The typical response to these disasters is, "I didn’t understand what the risk was" or "I thought that was covered."
When it comes to buying or selling a company, the last thing you want is skeletons in the closet. Risk management and insurance are two things you shouldn't leave to chance. If you do, you run the risk of being haunted by them later. A little preparation goes a long way toward keeping the ghosts of deals past at bay.
So how can buyers and sellers do a better job of managing risk when it counts? Here are some pointers.
Risk? What Risk?
First, let’s define this beast called risk. Risk, in the context of a deal, refers to financial consequences — and which party in the deal bears them. Generally, sellers and buyers alike strive to either a) reallocate risk to the other party, or b) get paid for bearing the risk.
Risk management simply means figuring out what the risks are to begin with and then coordinating resources to reduce the likelihood that a particular risk will materialize. These risks come in the form of uninsured losses that either the buyer or the seller has to bear. Fortunately, these can easily be avoided with a thorough review and gap analysis of the risk and insurance management programs.
Someone has to pay for uninsured losses, so it’s best to avoid them in the first place.
How Buyers Manage Risk When Structuring a Deal
The most common method for buyers to manage uninsured losses is by structuring the deal as an asset sale. This basically leaves all the pre-transaction risk of uninsured losses with the seller company. Buyers do this by incorporating a new company that buys only specific assets, leaves behind liabilities and, more importantly, does not bring forward the selling company’s claim history.
Basically, buyers look to have a clean slate with an asset sale. That way, they're only responsible for managing the risks related to post-transaction operations. This is smart practice. Therefore, sellers need to understand that an asset sale means that all risks stay with the seller. If there's any potential litigation or warranty exposures, the seller continues to be responsible for them. If there are any outstanding claims, it's up to the seller to resolve them. This is why sometimes it makes better sense for sellers to push for a share deal rather than an asset deal. Essentially, this allows the seller to push these risks onto the buyer.
The Top 5 Risk Management Steps Buyers Overlook
When it comes to buying a business, there are a few key things buyers tend to overlook — to their peril. Stay ahead of the curve and stay on top of these key risk management steps.
- Valuation of Assets
In asset deals, determining the value of the asset being acquired or purchased is common. An appraisal is usually completed on a fair market value (FMV) basis. That's great in terms of getting the deal closed, but does it align with the appropriate limit for insurance purposes? Does the FMV valuation align with replacement cost, which is what the insurance program is based on?
Sellers need to think about this from their perspective, too. What is the FMV of the assets being sold? Are you over- or under-insuring your asset base? What happens to prepaid premiums if the company is sold through an asset deal?
- Efficient Replacement or Runoff of Policies
Some insurance policies have provisions that require the insured to contact the insurer after a change in control. If timely notice is not provided, the insurer could have an argument to deny future claims. Also, the deal structure might necessitate a complete change to the insurance program. For instance, an asset transaction can require replacement of all policies in conjunction with the close of the transaction.
- Environmental Liability
There is constant change to legal precedent regarding who is financially responsible for historical environmental liabilities. More and more often, the power of indemnification wording in an asset purchase agreement is being limited as the courts continue to blanket everyone to address contamination issues, regardless of who is to blame for the original incident. Courts have increasingly found ways to drag successor parties into an environmental situation. This applies to other areas of liability as well, even if a buyer has structured a tight purchase agreement. At a minimum, defense expense exposures are likely. Therefore, buyers should review this risk to protect the balance sheet against legacy contamination issues that could be discovered after the deal has closed.
- Operational Differences
The buyer's insurance program should be scalable to allow the addition of new companies, new geographies, new client bases and new revenue streams. This is particularly important for roll-ups, which establish a platform company to add new companies. Buyers often forget that not all insurance companies have the same appetite for scalable insurance policies that can accommodate these various risks.
- Exposure Information and Documentation Gathering
During due diligence, buyers often miss gathering past claims histories, contracts, negotiated leases, the structure of acquired liability limits and various other indemnities or agreements of risk. This ends up creating post-transaction problems that could easily be mitigated if proper attention had been paid to reviewing this prior to the closing date.
So What Does This All Mean to a Seller?
Simple: preparation usually leads to a better deal.
If there are risks that you prefer the buyer to take on, then a share deal may be a better structure even if the purchase price is lower to accommodate this risk transfer. Alternatively, if an asset deal is still the way to go, then prepare all the information and help the deal along. This can lead to a better valuation for your company as the buyer realizes that overall risk is diminished.
An insurance review that takes place pre-close is the best way to ensure that important insurance and risk management items are addressed. There are many moving pieces to each unique deal. That said, worthwhile items can still be addressed post-close; it's not ideal, but it is better than not reviewing the program at all. A post-close review can be a useful tool with regards to cost budgeting and overall management or identification of risk and insurance program design. The scope of the review will be slightly different, but the basic objectives will remain the same: check for skeletons and scare every one of them you can out of the closet.
Written by Terence Hogan