Monday, May 5, 2014

How Do I Pay: Stock, Cash or Combination?

The selection of the acquisition payment currency has important implications for both the seller and buyer. So far in this century about 55% of deals are cash, 23% combination and 22% stock. The proportion of cash and combination deals has increased since the elimination of Pooling of Interests accounting in 2001. Like all M&A items, the selection is negotiated and depends on the relative points of views of the buyer and seller regarding whether the risks and rewards of the acquisition should be shared. The simplest approach is use cash, but sometimes that is not always possible.

Buyer considerations regarding the use of stock in whole or part include the following:

1)   Valuation: consider not only the seller’s valuation, but also that of the buyer’s post transaction value to gauge the exchange ratio impact. The buyer should never use its shares if it believes them to be undervalued; whereas, it should use its shares if it believes them to be over-valued and the seller will accept them. An extreme example of this is AOL’s purchase of Time Warner.

2)   Synergy Risk: use cash if synergy risk is deemed low to keep the upside and stock if high to share the risk. Facebook’s recent high priced acquisitions are primary stock transactions. This helps cushion the downside should the early stage technology targets fail to work out as planned.

3)   Market Risk: if shares are used then you need to decide who bears the market risk of the shares changing price after the offer is made but pre close. The options include a fixed price deal where the buyer assumes the risk, a fixed share arrangement where the seller takes the risks or using collars and caps to share the risk. (See our post Acquisition Risk, Collars, and the Comast Time Warner Deal.)

4)   Dilution: this includes both ownership and earnings dilution. Whenever new shares are issued the relative ownership positions of existing shareholders declines. This can be an important control issue for middle market firms and argue for a cash deal. Buyer earnings and earnings per share (EPS) always increase in a debt financed cash transaction provided the target’s earning exceed the incremental after tax interest cost on the debt. In stock transactions the new shares issued can cause a decline (dilution) in EPS if the seller’s price-earnings ratio exceeds that of the buyer. Over time, the EPS dilution should decline as earnings grow. Usually, buyers prefer a breakeven dilution of 2-3 years.

5)   Taxes: the buyer prefers a taxable transaction involving all or a substantial portion of the price to be in cash. This allows the write-up of the assets acquired by the buyer and higher future tax deductions. Other considerations include changing tax domicile to lower tax rates as in the Pfizer-AstraZeneca  bid.

6)   Credit Rating: debt financed cash transactions impact the buyer’s target debt rating.

Seller considerations include:

1)   Valuation: the seller needs to value the buyer’s shares on a post acquisition basis to determine what if any premium it actually receives. This means doing due diligence on the buyer. These valuation issues explain why targets in hostile takeovers prefer cash over stock as AstraZeneca is now demanding from Pfizer. Remember the old joke - daddy I sold my bike for $20,000- I traded it for 2 $10,000 marbles. The value of marbles, like the buyer’s shares, is an opinion. Cash, however is a fact.

2)   Taxes: sellers can defer capital gains taxes if the transaction is structured as a tax free share exchange. Unfortunately, this has negative tax implications for the buyer which will probably be reflected in the offer price.

3)   Liquidity: the focus is on the float of the shares to be received, lock-ups and registration rights.

Bottom line for me is the KISS principle (keep it simple stupid). It is usually cheaper for the buyer to pay in cash. This may reflect Warren Buffett’s apparent preference for cash purchases. Sellers will have an easier task of evaluating the offer and less risk in cash deals. Thus, being a simple guy, I recommend cash transactions whenever possible. If not using cash, be sure you are at least as smart as the other side.


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