How RWI Supports ESOP Transactions

In today’s complex business environment, Employee Stock Ownership Plans (ESOPs) have become a popular way for family-owned and closely held companies to provide liquidity and reward employees with ownership stakes. At the same time, managing risk in these transactions is critical. Representations and warranties insurance (RWI) has emerged as a valuable tool to protect all parties involved, helping to ensure smoother ESOP formations and greater confidence in the deal.

Understanding RWI Insurance

Representations and warranties insurance (RWI) is obtained in most private M&A deals above $10 million in enterprise value.  RWI enables a clean walk-away for the Seller and provides the Buyer with an investment grade counterparty in the event a breach occurs.

Understanding ESOPs

ESOPs serve two main purposes: providing liquidity in a family or closely held corporation (in a potentially tax-advantaged fashion) and offering employees equity in the business. These plans may take a minority ownership stake in a company or may acquire up to 100% of the company’s equity. ESOPs typically fund their purchase of equity via either notes issued by the ESOP to the Company, or by the company engaging in a leveraged repurchase of its shares from existing shareholders alongside a nominal equity investment by the ESOP (again with such investment usually funded by an ESOP note). The ESOP itself is a trust, and the trust is administered by an ESOP trustee.

Use of RWI in ESOP Formation Transactions

It is increasingly common for ESOP trustees or legacy shareholders to require RWI to be put in place to cover representations or warranties (R&W) contained within the formation documents.  These R&W are typically contained in the redemption agreement between the company and the legacy shareholders, between the company and the ESOP, or in both agreements.

Observations and Considerations When Using RWI in an ESOP Transaction

• Insured: In a typical RWI transaction, both the Buyer and the target company are insured (the Buyer is typically named-insured, with target becoming an additional insured post-close). If the ESOP transaction is between the company and the ESOP, then the company cannot be treated as an insured under the policy (because the potentially breaching party can’t be an insured).  The change to the typical insured under the policy makes it important to focus on the definitions of breach and loss in the RWI policy.
• Limit: In a typical RWI transaction, the coverage limit is computed as a percentage (typically 10-20%, but could be more) of the enterprise value, as the EV typically represents the amount of consideration paid by the Buyer. In many ESOP transactions, the amount of consideration paid by the ESOP is considerably lower than the pre-transaction enterprise value of the ESOP.  For example, consider a stock redemption transaction whereby the legacy shareholders of the company have their shares repurchased in exchange for company-issued notes.  In this case, the leveraged nature of the repurchase results in an ESOP admission value that could be nominal.  Some insurers may be uncomfortable with insuring to a limit that is significantly higher than the notional transaction value in the ESOP admission.
• Knowledge: In a typical M&A transaction, a buyer signs a “No Claims Disclosure” (NCD) wherein a representative of the buyer’s deal team certifies that they have no actual knowledge of any breach or potential breach or discloses any breach or potential breach of which they are aware. Importantly, only actual knowledge of a breach or potential breach by the deal team triggers an obligation to disclose.

  In an ESOP transaction, the ultimate beneficiaries of the ESOP are the employees of the Company.  Because these employees are in a position to know of a breach or potential breach and are indirect beneficiaries of the RWI policies, insurers will typically want to include at least senior executives of the Company as “knowledge persons” and have them execute a “Management NCD” alongside the more typical Deal Team NCD.

• Diligence Scope: In a typical transaction, the Buyer will engage several third-party service providers to perform fulsome due diligence on the Target. This diligence will typically include financial, tax, legal, IT/data privacy and environmental, but may also include “condition of assets” or other subject matter that is target specific.

In an ESOP transaction, due to the employee’s understanding of the company that they will ultimately be indirect owners of following the ESOP transaction, the ESOP trustee may intend to rely on the ESOP fairness opinion in lieu of fulsome subject matter diligence.  If the ESOP trustee plans on obtaining RWI for the transaction, they will need to plan on increasing their diligence activities to be in line with insurers’ expectations.

Final Thoughts

Representations and warranties insurance is playing an increasingly important role in ESOP transactions. By providing financial protection against breaches of key representations, RWI helps reduce risk for sellers, buyers, and trustees alike. This insurance fosters trust, smooths negotiations, and supports successful employee ownership transitions. For companies considering an ESOP, understanding how RWI fits into the transaction can be a critical step toward achieving a secure and efficient deal.

If you are considering an ESOP transaction or want to learn more about how representations and warranties insurance can protect your deal, please reach out to our M&A team for expert guidance and support.