The Art and Science of Not-Quite-Selling
Know someone who might like Capital Gains? Use the referral program to gain access to my database of book reviews (1), an invite to the Capital Gains Discord (2), stickers (10), and a mug (25). Details at the bottom!
One of the persistent puzzles of markets isn’t about how they work, but about why they exist. The thinking goes like this: if it's impossible to have an advantage buying and selling assets, then there's no point in trading. But if it is possible to have an advantage, then you should expect some counterparty to have better data than you most of the time—at the end of the day, markets only clear for you once you outbid every single potential buyer, including the most informed, and when a seller is happy to meet your price.
Of course, markets do clear; even though some traders have more information than others, there are enough traders who make decisions based on noise (or random factors) in the market to ensure that there is still enough profit for everyone who provides liquidity—which means they can provide this liquidity even when they risk trading with someone who is well-informed. But in non-market transactions, like the sale of a company from one private investor to another, a different dynamic applies: the buyer has an incentive to do extensive research, and to represent to the seller that they haven't omitted material facts. Naturally, there’s still room to wonder whether there are intangible reasons for an asset to have a surprising performance.
A notoriously difficult intangible to underwrite has less to do with the asset, and more to do with the traders. The usual situation consists of a) a seller who is financially sophisticated, and b) a buyer with more domain experience.
The solution? Instead of selling 100% of the business, the seller either keeps a stake, or keeps an option to buy back part of it later. This solution, which was apparently popularized by Time Warner CEO Dick Parsons in the early 2000s ($, WSJ), is known as "schmuck insurance”.
The most obvious reading of these deals is that the seller is not quite convinced that they're getting a good deal, but is also unconvinced that they'll be able to close this perception gap in a reasonable timeframe. Getting less cash and keeping more equity is a reasonable substitute for the expensive and uncertain process of getting more confidence instead.
Another way to look at it is that schmuck insurance consists of hiring the buyer as general partner and main investor in a single-asset portfolio. In other words, the buyer is providing management, and most of the capital, but not quite all of it. This can take some of the sting out of selling for too low a price, since it means remaining a co-investor in something run by someone smart.
One of the most frequent users of this technique is not a private equity firm or an investor. It's Amazon (disclosure: I own shares). Amazon is very fond of striking deals with companies in which those companies offer some product or service to Amazon, whether it's air freight from Sun Country or electric vehicles from Rivian.
That’s because at Amazon's scale, any deal that's meaningful from Amazon's perspective is transformative from the other company's perspective. While Amazon could try to back into what Sun Country's economics would look like if their cargo capacity utilization always approached 100%, or what Rivian's economics would look like if they had a large anchor customer for their vehicles, a much simpler and more agile approach would be to negotiate a piece of the upside directly.
Of course, a deal with Amazon is not necessarily going to be a winner for every company; they didn't get so big by leaving lots of money on the table, and over time their model has gotten better at squeezing their biggest category of suppliers, third-party merchants, through ads and through a logistics business that nudges companies towards relying on Amazon for as many services as possible.1 And this is another reason for Amazon to prefer a warrant structure over pure equity: warrants give them exposure to volatility, not just price appreciation, and tying a company's fate to Amazon is nothing if not a way to increase the variance of expected outcomes.
Schmuck insurance is applicable in many other walks of life. If you're planning on leaving a company, for example, making an effort to leave on good terms if it's remotely possible is a decent way to keep some upside. There are a fair number of people who boomerang, especially early in their career—a stint at company X, six months working on startup Y, and then back to company X when they find out that some of the things they hated about it are pretty universal and some of the things they like about it turn out to be unique. (The more direct financial application here is exercising the stock options you were granted instead of letting them expire; I've gotten this one wrong before!)
Transactionally-minded people and transaction-minded writers tend to treat a deal as a discrete event. Someone owned something, and now somebody else does. But they're really part of an ongoing process. And the more often you do deals with people you respect, the less likely you are to want them to get all the upside themselves.
Read More in The Diff
The Diff uses the concept of “schmuck insurance” from time to time:
It’s a component of the CHIPS Act that allows the government to capture some profits from semiconductor subsidies.
Sports apparel rollup Fanatics uses it to allay leagues’ concerns that licensing deals will be one-sided.
When Shopify integrated Affirm, they got equity exposure to Affirm, though Affirm seems to have gotten the better end of the deal.
It also showed up in this writeup of the aircraft leasing industry ($), in a case where the economics of an acquisition were uncertain and the best way to allay that uncertainty was to pay with equity.
A Word From Our Sponsors
If you're seeking new stock investment ideas then we recommend subscribing to Capital Employed, a free newsletter which includes a curation of stock pitches as well as interviews with professional fund managers who share their best ideas.
1. For example, one factor in getting into the "buy box," i.e. being the default seller for a given product listing, is Amazon's assessment of a seller's speed and reliability in shipping. And one way to get a positive assessment from Amazon on this is to outsource logistics to Amazon itself. In a fast-moving category, a seller may simply not have enough time to get a credible track record before consumer interest trails off, so Amazon's fulfillment business gets a steady stream of customers from the structure of their logistics business.
Share Capital Gains
Subscribed readers can participate in our referral program! If you're not already subscribed, click that Get Started button below and we'll email you your link; if you are subscribed, be sure to check out the email version of this edition.
Help us learn more about you!
We'd like your feedback so we know what to cover, so if you haven't already, please fill out this one-minute form.