Representations and Warranties Insurance in Franchise M&A: What Canadian Buyers and Sellers Need to Know

For the purchase and sale of franchise systems, representations and warranties insurance (“RWI”) is a useful risk allocation tool, helping reduce the risks of buying a business while facilitating smoother and more efficient transactions. That being said, the topic of RWI in the franchise M&A space receives limited attention, especially in Canada. Purchasers and sellers of franchise systems should understand the key advantages RWI policies can provide when structuring potential transactions.

This article is split into three parts and focuses on the mechanics and benefits of RWI in the franchise system M&A context. The first part presents a brief overview of the benefits and utility of RWI in general. The second part discusses the mechanics of a typical RWI policy. The third and final part sets out why franchise systems are an attractive investment, and discusses how RWI can facilitate more efficient and stress-free transactions.

What Is Representations and Warranties Insurance and Why It’s Beneficial?

In short, RWI shifts the risk of purchasing a business from the buyer to a third party insurer in exchange for a price, also known as an insurance premium.

In purchasing a business, the purchaser and seller each make certain representations and warranties (together, “Rep” or “Reps”) under the transaction agreement to induce the other party to enter into the transaction. Reps are set out in the purchase agreement and cover a wide range of concerns relating to the transaction, spanning matters like the financial valuation of the target entity, environmental concerns, tax liability, employment matters, material contracts, and beyond. To determine which party bears liability in the event of a breach or misrepresentation of a Rep, purchase agreements often contain at least one, or a combination, of the following risk allocation mechanisms:

• Purchase price holdbacks or escrow amounts, payable upon the fulfillment of certain conditions set out in the purchase agreement;
• Indemnification provisions, whereby the indemnifying party agrees to pay the damages or liabilities suffered by the party to the agreement who relied on a misrepresentation or breach of a Rep; and
• RWI, which is a policy that a party to the agreement (most often the purchaser) takes out from an insurance provider to cover claims of misrepresentation or breach of Reps made in the course of a transaction.

To buyers and sellers, RWI presents numerous benefits with respect to risk allocation.[1] From a buyer’s perspective where there is indemnity coverage in the purchase agreement, RWI mitigates the risk of the indemnifier failing or delaying to pay out claims after a breach or misrepresentation is proven. It also allows the purchaser to reduce the indemnification obligation of the seller in exchange for favourable terms in the purchase agreement such as broader limitation of liability clauses or longer Rep coverage terms. By reducing or eliminating the seller’s indemnification obligations, the purchaser minimizes the risk of becoming involved in costly and adversarial indemnification claims, while preserving a source of recovery through RWI.[2]

From a seller’s perspective, RWI reduces indemnification obligations and the potential liability under such a provision. It also minimizes the holdback or escrow amounts in the transaction, allowing the seller to receive more of the purchase price sooner. RWI further affords the seller a cleaner exit by minimizing post-closing obligations and reducing the risk of future indemnification claims.[3]

How Does RWI Work in a Franchise Acquisition?

Although common perceptions are that RWI is reserved for large market transactions (starting at valuations around $25 million or more[4]), that is not always the case. Middle to small market transactions, still benefit from the use of RWI.[5]

RWI policies typically have a duration of three to six years depending on the type and nature of the Rep in question (compared to twelve to eighteen months under a customary seller’s indemnity).[6] For instance, Reps more fundamental to the purchaser entering into the transaction, such as the financial valuation of the target entity, will often have a longer coverage term than general or less fundamental Reps. The coverage often offered for RWI is for ten percent of the purchase price,[7] but depending on the circumstances, up to one-hundred percent coverage can be obtained.[8]

Coverage exclusions from RWI policies range from the general to the deal specific. A general coverage exclusion may be where the buyer has actual knowledge of a breach of a Rep.[9] Insurers may also add exclusions if they are uncomfortable with the level of disclosure or the quality of diligence around a suspected area of risk.[10] Deal specific coverage exclusions are uniquely drafted for the particular transaction, and include issues discovered in the due diligence process of a deal.[11]

Franchise-Specific Considerations for RWI and Due Diligence

As benefits of franchise systems abound, so do the risks. In addition to RWI, having experienced counsel in franchise law is critical to understanding – and avoiding – the risks. Below are examples of Reps to look out for and consider while forming the RWI policy and due diligence process.

• Franchise Agreements in Good Standing. Purchasers should diligently examine the franchise agreements for each target franchise location (including any area development/master franchise agreements) and assess the terms for any inconsistent or troublesome provisions, as well as ensuring that such agreements have been fully executed and are in good standing. Notable terms in franchise agreements include franchise fees, royalty payments, termination obligations, non-competition clauses, and the exclusive territory given to the franchisee (if any). In addition to the franchise agreements, other material contracts common to franchise grants which should also be reviewed include general security agreements, personal guarantees, and leases. While proper diligence will help mitigate these risks for a purchaser, RWI provides additional certainty for the purchaser and seller alike.
• Franchise Disclosure Legislation Compliance. The mechanics, process, and timing of each franchise grant should also be reviewed to uncover any outstanding liabilities under Canada’s provincial franchise acts, including live rescission claims. Franchise legislation provides an extraordinary remedy for franchisees in the event they have not received adequate disclosure. A franchisee can rescind their franchise agreement, leave the franchise system, and be fully reimbursed for all investments made into such franchise, if a franchise disclosure document is not provided to the franchisee in the acceptable form and timeframe prescribed by applicable legislation. Potential purchasers of franchise systems should closely review the franchise disclosure documents of any franchise grant made within the last two years.

Franchises are regulated on a provincial basis in Canada. Currently, there are seven provinces which have legislated franchise law regimes: Ontario, Manitoba, Alberta, British Columbia, New Brunswick, Prince Edward Island, and Saskatchewan. The acceptability of the franchise agreement and ancillary documents (like the general security agreement, and guarantee) should be reviewed in each jurisdiction for potential liabilities.

• Unit Economics: Assessing the unit economics across the franchise system is critical. After parsing out the obligations of each franchisee under each respective franchise agreement, the flow of funds for the royalty streams, franchise fee, working capital needs, should be reviewed to see whether the financial mechanics of the franchise system work on a consistent and regular basis. It should be ensured that the Reps provided to the purchaser by the seller accurately reflect the on-the-ground performance of its units, barring which RWI may provide both parties with additional certainty in the event of an error or misrepresentation.

Though the benefits of purchasing a franchise system are substantial, so too are the risks if such a transaction is not carefully planned and executed. While expensive, the presence of RWI in a purchase transaction can soften the costs and discomfort caused by incorrect or inaccurate Reps made in a purchase of a franchise system. Where economically viable, RWI should be strongly considered by both the purchaser and seller of a franchise system as part of a transaction.

If you are considering the acquisition or sale of a franchise system in Canada, our team can advise on transaction structure, franchise-specific due diligence, purchase agreement risk allocation and the role RWI may play in the transaction.

About the authors

Jason Brisebois is a corporate and commercial lawyer whose practice focuses on mergers and acquisitions and franchise law. He advises franchisors, investors and privately held businesses on the acquisition and sale of franchise systems and other corporate transactions. Qualified to practise in Ontario and New York State, Jason has been recognized by the Canadian Legal LEXPERT Directory, Lexology Index: Canada and Best Lawyers in Canada, and received the 2024 Lexology Client Choice Award for Franchising in Canada.

Sam Fata is a corporate and commercial lawyer whose practice includes mergers and acquisitions, corporate finance and securities law. He advises businesses on acquisitions, dispositions and other corporate and commercial transactions across a range of industries.