Representation and warranty insurance (RWI) indemnifies insureds — typically the buyer parties – for breaches of seller representations in a purchase and sale agreement. RWI is useful in a variety of transaction structures and industries, including healthcare, food and beverage, hospitality, and manufacturing businesses.
In virtually every transaction, RWI underwriters will require that insureds perform a standard due diligence exercise on the target company, including a review of the target’s organizational documents, its capitalization table, its financials, its tax profile and history, its IT systems and data privacy compliance measures, its insurance program, and more. Most industries also involve distinct risks on which underwriters will focus, for example, billing and coding audits in the acquisition of a physician practice. In certain cases, a target’s operating structure can also inform the underwriting process. While targets operating a franchise business model are, all else equal, typically insurable, they involve multiple idiosyncratic risks that buyers should be prepared to address in the diligence process to maximize coverage under an RWI policy.
The following list identifies certain specific risks inherent in acquisitions of businesses operating via franchise models; buyers who are alert to these issues will be best positioned to meet carriers’ underwriting expectations.
- Franchise Agreements: Insurance carriers expect buyers to review the franchise agreements to confirm their legal validity and the target’s compliance with their requirements, including with respect to geographic restrictions. Additionally, carriers will expect that the franchise agreement properly allocates franchisee/franchisor liability for franchisee operations.
- Control of Operations: Often, the number of franchisee locations makes conducting diligence on the operations/assets of each location impractical. Accordingly, carriers will want to understand which activities are controlled by the franchisor and which are controlled by the franchisee (e.g., real estate, marketing, IT systems, etc.). If the acquisition agreement contains representations regarding the franchisees’ activities, carriers will want to see thorough diligence at the franchisee level before covering such representations, though coverage on a knowledge-qualified basis may also be available.
- Revenue Model: Buyers should be ready to address questions regarding the revenue sharing model. Typically, the franchise agreement requires franchisee payment of a certain percentage of revenue to the franchisor, though this depends on the industry in which the target operates and the services provided.
- Regulatory Compliance: Buyers often engage separate counsel to conduct diligence on compliance with franchise law on a state-by-state basis, including confirmation that all required state registrations are filed appropriately, that there is proper disclosure to franchisees about financial prospects, and more. This will be an area of significant underwriting focus, and as such, buyers and their advisors should be prepared to address specific questions during the underwriting call.
- Condition of Assets: If the acquisition agreement contains seller representations regarding the condition of assets at franchisee locations, carriers will expect to see diligence confirming the accuracy of those representations. The thoroughness and formality of the review depends largely on the industry, whether the representation refers only to assets owned by the franchisor or if it includes the franchisee assets as well, and the nature of the assets in question. The buyer should also confirm whether the franchisor has procedures in place (e.g., maintenance logs) to track equipment condition and capital expenditure spend across locations.
- Other potential issues: Challenges that may arise depending on the industry and structure include: ownership and use of IP, whether the franchisor has made any guarantees or provided any indemnities to the franchisee and any other industry specific considerations, such as food regulatory, IT/cyber/privacy, inventory matters, and more.
While franchise-model businesses are subject to certain additional diligence requirements, they are eminently insurable. Moreover, most underwriter diligence requirements on franchise deals will dovetail with the diligence franchise buyers would typically perform regardless of the use of RWI on the transaction. As always, the key to a successful RWI placement is engaging a broker with expertise with such transactions.
Disclaimer
WTW hopes you found the general information provided in this publication informative and helpful. The information contained herein is not intended to constitute legal or other professional advice and should not be relied upon in lieu of consultation with your own legal advisors. In the event you would like more information regarding your insurance coverage, please do not hesitate to reach out to us. In North America, WTW offers insurance products through licensed entities, including Willis Towers Watson Northeast, Inc. (in the United States) and Willis Canada Inc. (in Canada).
