When owners want to sell their company there are two ways they can do it:
- Sell the assets of the company, including the equipment, product inventory, customers, and the like. In this case, the Seller retains the “shell” of the corporation to either shut down or use in another business.
- Sell the stock of the company. In this case, the Buyer gets everything, and the Seller simply walks away with nothing – but the proceeds of the sale, of course.
As with many aspects of M&A deals Buyers and Sellers have opposing ideas about the preferred method of conducting the transaction.
Sellers prefer a stock purchase because there is a huge tax benefit. If you sell your stock, the proceeds from the sale are taxed at the capital gains rate, which is significantly less, in most jurisdictions, from your ordinary income. Asset sales are taxed as ordinary income.
It’s such a significant amount that often Sellers are willing to take a lower purchase price if the Buyer will agree to a stock transaction.
There is another benefit for Sellers as well. If the owner wants a clean exit, without filing an LLC tax return for the company ever again, the stock purchase grants that wish. It’s as if you sold a car, and you no longer have to pay for the registration or insurance. Plus, the Seller is no longer responsible for any potential liabilities against the target company. This is key, as you’ll see in a moment.
As you might expect, this means that Buyers much prefer an asset sale in many cases.
For one, when you buy the assets only, you’re not picking up any unknown liabilities that could be lurking around the corner. Stock purchases, therefore, make Buyers uncomfortable to say the least.
Another reason they like buying assets is that it can be easier to calculate the value of the company’s assets, rather than its stock, which is then used to come up with their offer price.
But really, it’s those unknown liabilities, like skeletons in the closet, that are the real concern. Granted, for a small company that’s been around for 10 years or so, the liabilities couldn’t be that big, right? But it’s an unknown.
Thus, we have that tug of war between Buyer and Seller on which route to take.
It’s why Buyers, in stock sales, can demand a lower price. And why they have their attorneys hedge their bets, if you will, and draft clauses in their purchase agreement that hold the Seller responsible for unknown liabilities.
As you might expect, Sellers are opposed to those clauses because they want a clean exit.
This is exactly why Representations and Warranty (R&W) insurance was invented. To give the Sellers that clean exit, while also giving Buyers peace of mind that they would be protected and compensated if they were harmed by unknown liabilities – by filing a claim with the insurer.
R&W insurance has really changed the game in the last seven or eight years, smoothing out potentially contentious transactions. It transfers the risk away from either party to the insurance company.
One problem. It’s not made for smaller deals.
Enter a new type of transactional insurance specifically made for smaller deals. Here’s a quick snapshot to bring you up to speed:
Transaction Liability Private Enterprise, or TLPE, is Sell-Side insurance, unlike traditional R&W coverage where the Buyer is usually the policyholder. In case of a breach of representations in the Purchase and Sale Agreement, the Buyer makes a claim against the Seller, who in turn notifies Underwriters of the breach and has the Insurer negotiate with the Buyer to settle the Claim. . Easy.
Sellers also benefit from TLPE coverage as it reduces escrow levels from 10% of the purchase down to 1% (or less) of the purchase price. (The cost of TLPE is only $10,000 to $20,000 per $1M in Limits.)
For M&A transactions with Transaction Value (TV) under $20M – all the way down to $250,000, TLPE insurance is ideal in many cases.
How TLPE Made This Deal Happen
There was a recent case in which a Seller, based in California, wanted to sell their small ($1M EV) software firm through a stock sale, a common request in a high-tax state for an arguably squeaky clean deal.
However, the Buyer was leery, fearing the unknown liabilities that would come with a stock purchase and seeking to minimize the purchase price.
The deal would not move forward. Until…
The Buyer learned from their advisor about TLPE and how it would protect the transaction from unknown liabilities (particularly IP infringement in the case of this software company). In short, the Buyer agreed to restructure the transaction from an asset to a stock deal.
And, just recently, the deal has gone through. Buyer and Seller both got what they wanted, and everybody has peace of mind.
If you’re a Buyer concerned about unknown liabilities in your next lower middle market deal (or a Seller with a concerned Buyer on your hands), it pays to take a close look at how TLPE coverage could transform your transaction.
At Rubicon Insurance, we have experience with this revolutionary new insurance product and will be happy to fill you in on the details. Please contact me, Patrick Stroth, for more information on TLPE and other M&A insurance options at pstroth@rubiconins.com.