Acquisition through Stock or Cash?

In a an acquisition with cash deal, the roles of two parties are clear but in a stock deal, it is less clear who is the buyer and who is the seller.

In cash transactions, acquiring shareholders take on the entire risk that expected synergy value embedded in the acquisition premium will not materialize. In stock transactions, the risk is shared with the selling shareholders; more precisely, the synergy is shared in the proportion to the percentage of the combined company the acquiring and selling shareholders each will own.

For instance, Buyer Inc. wants to acquire the competitor Seller Inc. The market capitalization of Buyer is $5 billion made up of 50 million shares priced at $100 per share. Seller’s market capitalization stands at $2.8 billion-40 million shares each at $70. The managers of Buyer estimate that merging the two companies can create synergy value of $1.7 billion by acquisition of Seller. They announce that an offer to buy all the shares of Seller at $100 per share. The value placed on the Seller is therefore is $4 billion, representing a premium of $1.2 billion over the company’s preannouncement market value of $2.8 billion.

The expected net gain to the acquirer from the acquisition-called as Shareholder Value Added (SVA)-is the difference between the estimated value of the synergies obtained through the acquisition and the acquisition premium. So if Buyer chooses to pay cash for the deal, then SVA for its shareholders is expected synergy of $1.7 billion minus the $1.2 billion premium, of $500 million.

But if Buyer decides to finance the acquisition by issuing new shares, the SVA for the existing shareholders will drop. Let’s assume that Buyer offers one of its shares for each of the Seller’s shares. The new offer places the same value on the Seller as did the cash offer. But upon the deal’s completion, the acquiring shareholders will find that the ownership in Buyer has been reduced. They will own only 55.5% of the new total of 90 million shares outstanding after the acquisition. So their share of the acquisition’s expected SVA is only 55.5% of $500 million, or $277.5 million. The rest goes to the Seller’s shareholders, who are now shareholders in an enlarged Buyer Inc.

Fixed value or Fixed number of shares

Boards and shareholders must do simply more than stock or cash while making or accepting an offer. Companies can either issue a fixed number of shares or they can issue a fixed value of shares.

Fixed shares: The number of shares to be issued is certain, but the value of the deal may fluctuate between the announcement of the offer and the closing date, depending on the acquirer’s share price. Both parties are affected, but changes in the acquirer’s price will not affect the proportional ownership of the parties in the combined company.

Fixed value: In these deals, the number of shares issued is not fixed until the closing date and will depend on the prevailing price. As a result, the proportional ownership of the ongoing company is left in doubt until the closing date. Let’s go back to Buyer and Seller Inc. Suppose that Buyer has made stock offer and its share has fallen exactly by the premium it is paying to the Seller- from $100 to $76 per share. At this price in fixed value deal, Buyer has to issue 52.6 million shares to give Seller’s shareholders $4 billion worth. But that leaves Buyer with just 48.7% of the combined company as compared to 55.5% they would have had in the fixed-share deal.

Questions for the acquirer

There are primarily three questions. First, are the acquiring company’s shares undervalued, fairly valued, or overvalued? Second, what is the risk that the expected synergies will not materialize after the acquisition? The answer to these questions will help in making the decision between a cash and a stock offer. Finally, how likely is it that the value of the acquiring company’s shares will drop before closing? The answer to this question should guide the decision between a fixed-value and a fixed-share offer. Let’s take each question in turn:

Valuation. If market is undervaluing the acquirer’s shares then it should not issue the new shares to finance the transaction because that would penalize the current shareholders. When a company issues stock to finance the transaction, it may give a signal to the market that managers think the stock is overvalued and stock may fall after the information is disseminated. Acquirer may believe that its shares are undervalued, but in real world, it is not easy to convince a disbelieving seller to accept fewer but “more undervalued” shares. In this case it is logical course to proceed with the cash offer.

Synergy Risks. A really confident acquirer would pay for acquisition with cash so that shareholders would not have to give any of the anticipated merger gains, synergy, to the acquired company’s shareholders. But if the managers think that the risks are substantial, they can be expected to try to hedge their bets by offering stock. By diluting the ownership interests, they will also limit the partition in the losses incurred. Hence, stock offer sends two powerful signals to the market: that the acquirer’s shares are overvalued and that its management lacks confidence in the acquisition.

Preclosing market risk: Through a research by Journal of Finance it has been found that more sensitive the seller’s compensation is to changes in the acquirer’s stock price, the less favourable is the market’s response to the acquisition announcement. Hence the greater the potential impact of preclosing market risk, the more the important it is for the acquirer to signal its confidence by assuming some of the risk.

Questions for the seller

In case of a cash offer, the selling company’s board faces a fairly straightforward task. It just has to compare the value of the company as an independent business against the price offered. The only risks are that it could hold out for a higher price or that management can create a better value if company remained independent. For example, Buyer bid for $100, representing a 43% premium over the current price of $70 of Seller. Let us suppose that they can get a 10% return by putting the cash in investments with similar level of risk. After five years, the $100 will compound to $161. If the bid were rejected, Seller will have to earn 18% return on its currently valued $70 share to do as well. So uncertain a return must compete against a bird in the hand. The questions Seller needs to answer are: How much is the acquirer worth? How likely is it that the expected synergies will be realised? and, How great is the preclosing market risk?