The cannabis industry has experienced significant growth and transformation in recent years as legalization efforts gain momentum worldwide. However, given external stressors on the cannabis system, M&A in the space has not kept pace. We believe as the industry continues to mature over the next one to two years, it is on track for an uptick in mergers, acquisitions and other strategic transactions in a consolidation boom.
The complex regulatory environments, evolving compliance standards, and inherent operational challenges in the cannabis industry create unique hurdles in such transactions. In such instances, representations and warranties insurance (RWI) emerges as a valuable tool to manage risks, foster growth, and boost the confidence of buyers, sellers and other parties (such as lenders) to such transactions. At Frontier Risk, our team has experience both as brokers placing these policies and as prior operators obtaining RWI and conducting due diligence with outside experts. With insights from both perspectives, this article outlines the costs and benefits of RWI in the cannabis sector.
Understanding Representations and Warranties Insurance
Representations and warranties are fundamental components of any business transaction. They are statements made by the seller or target company regarding the accuracy and completeness of information about their business.
RWI is an insurance product that provides protection to buyers against financial losses resulting from inaccuracies or breaches of representations and warranties after the completion of a transaction. It enables both parties to transfer the risk associated with potential unknown liabilities, increasing confidence and facilitating smoother deals.
Benefits of RWI in the Cannabis Industry
Bridging the information gap: The cannabis industry faces challenges in obtaining accurate and reliable information due to its nascent stage and regulatory complexities. RWI helps bridge this information gap by incentivizing sellers to disclose relevant information, as they are required to make accurate representations. This leads to a more transparent and informed transaction process, reducing information asymmetry.
Enhanced deal certainty
RWI policies can increase the confidence of buyers and their lenders, as they can seek coverage for identified risks and uncertainties. This enhances deal certainty and may even lead to more favorable transaction terms.
Protecting seller interests
RWI policies can benefit sellers as well by providing a source of funds for potential indemnification claims. This helps preserve the value of their proceeds and facilitates a smoother exit. Additionally, it typically eliminates the need for an escrow or holdback at closing (which can be 10% of the purchase price or more) allowing sellers to receive more of the purchase price up front and reducing uncertainty with recourse against the insurer rather than the sellers.
RWI offers a valuable recourse option for buyers if issues arise after the transaction has closed. Instead of entering lengthy negotiations or resorting to litigation, buyers can turn to the insurance policy for financial protection, allowing them to focus on business operations and growth. If the sellers are still involved in the business operations post-closing, this can significantly reduce friction between buyer and seller and avoid a potential post-closing dispute.
Considerations for RWI in the Cannabis Industry
Deal size and pricing
RWI is ideal when enterprise value is greater than $25 million and the parties are purchasing a RWI policy with at least $5 million in coverage. Premiums typically run between 2-4% of coverage.
Regulatory compliance challenges
The cannabis industry operates under a web of complex regulations that vary significantly from jurisdiction to jurisdiction. Insurers may have different risk appetites and underwriting standards for the industry, making it crucial for companies to work with brokers and underwriters experienced in the cannabis space, such as the team at Frontier Risk.
Higher premiums and deductibles
Due to the perceived risks associated with the cannabis industry, RWI premiums may be higher compared to other sectors. Additionally, policies may have higher deductibles or carve-outs for specific risks, such as regulatory compliance or licensing issues. Companies should carefully evaluate the costs and coverage limits to ensure the policy aligns with their risk profile and transaction objectives.
Thorough due diligence
RWI policies are predicated on accurate and comprehensive due diligence. This process may involve assessing compliance with local laws, reviewing financial statements, and evaluating operational practices. Businesses should be prepared to provide detailed information to insurers to ensure a smooth underwriting process. Buyers will have to engage third parties to author reports on the company’s legal, tax, financial, environmental, operations and insurance/benefits standings, which will add additional costs.
Given the unique challenges and risks in the cannabis industry, companies should work closely with insurers to customize the policy to their specific needs. Tailoring the coverage and exclusions to address industry-specific risks, such as product liability or intellectual property disputes, can maximize the benefits of RWI. It is essential to carefully review the terms and conditions of the R&W insurance policy to understand the specific representations covered, policy exclusions, and any limitations on the scope of coverage with a broker experienced in cannabis industry, such as the seasoned professionals at Frontier Risk.
Representations and warranties insurance serves as a valuable risk management tool for the cannabis industry. By bridging information gaps, enhancing deal certainty, and providing post-closing recourse, RWI enables companies to navigate the complexities of mergers, acquisitions, and other strategic transactions. While the cannabis industry presents unique challenges for obtaining coverage, diligent due diligence, collaboration with experienced insurers with representation from an experienced broker, and customization of policies can help businesses unlock the full potential of RWI and drive sustainable growth in this dynamic sector. At Frontier Risk, we utilize our firsthand expertise as both former cannabis operators who have utilized RWI and seasoned insurance professionals to help you determine whether RWI is right for your transaction and help you work through the due diligence and underwriting process from start to finish.