The Consideration in Mergers and Acquisitions

Typical Forms of Payment

There are several typical forms of payments (a combination of several such forms is also possible) for mergers and acquisitions, which may be divided into several categories, following the classifications discussed previously in this book:

  • Cash for shares The acquirer pays the target's shareholders cash for their holdings.

  • Cash for assets The acquirer buys all of the target's assets in cash.

  • Stock for stock The acquirer issues its shares directly to the target's shareholders, who, in return, transfer their shares in the target to the acquirer.

  • Stock for assets The acquirer issues its shares to the target in consideration for the target's assets.

In recent years, a dramatic change has occurred in the customary form of payment in M&A transactions. For instance, whereas in the late 1980s more than 50% of deals above $100 million were made in cash only, this percentage had dropped to under 20% by the late 1990s. It is also possible that this fact resulted from the high stock prices, which in practice enabled large companies to use a "cheap" cash-equivalent (the target stock) to realize the acquisition.

Determining the Price

As discussed in Chapter 9 in the section on value to investors or strategic buyers, the price paid for the acquisition takes the following factors into account: the company's valuation as an independent unit, the target's effect on the acquirer's results of operations, and, ultimately, the cost in the alternative scenario in which a competitor of the acquirer buys the company. The maximum price which the buyer will be prepared to pay is the difference between the acquirer's value in the projected scenario if no acquisition (including the impact of an acquisition of the target by one of the competitors) is made, and the value which incorporates all of the synergies with respect to future cash flows if the acquisition is consummated. If this difference is higher than the company's value to the seller (in the realistic scenario in the case of an acquisition by another entity or, alternatively, in a scenario of continued independent operations), then there is a range of values in which the parties to the deal can find common ground.

The acquisition of a company by another company is an investment which is naturally associated with uncertainty. The basic principle is the same as in any business decision: Buy another company if the totality of the actions associated with it will generate a positive net present value to the company. However, valuating the advisability of the investment is more complex in the case of an acquisition than in other types of investments, since determining the acquisition value calls for an estimate of many parameters in different fields. Following are several of the main problematic parameters in such an estimate that are applicable to the acquisitions of privately held firms:

  • The difficulty in assessing strategic advantages The advantages of the acquisition may be strategic, and the value of the acquisition with respect to its compatibility with the company's strategy or managerial culture is difficult to quantify financially.

  • Legal and accounting uncertainty The acquisition of companies involves complex tax, legal, and accounting aspects, each of which has an impact on the worthiness of the acquisition. For instance, the approval of the transaction by the antitrust authorities or the conditions which such authorities may place on the consummation of the deal are clouded by uncertainties.

  • The difficulties in assessing added value Acquisition-analysis often focuses on the total value of the companies involved after the acquisition. However, the acquisition may change the relative weight of the companies in the totality of the added value created.

In many cases, a portion of the price of the deal is determined as a function of future performance. This component is common when the target's entrepreneurs continue to work in the company for some time. Alternatively, it is sometimes agreed that the final price will be determined after uncertainties, which may be beyond the seller's control (such as the competitive situation of the target market), are resolved. On the other hand, conditioning the price of the transaction on certain events makes it easier for the buyer to pay a higher expected price.

Additional payment arrangements may be formulated in stock transactions to mitigate the risk entailed by a change in the value of the acquirer's stock.

The Advantages of Stock-based Transactions

In a substantial part of the acquisitions made in recent years, particularly in the technology area, the payment included a large stock component. The main reasons for this are:

  • Cheap currency Payment in stock makes possible deals which would not have occurred under other circumstances since the buyer would have been unable to pay the price from its own financial resources. Cash financing is expensive and requires acquirers to deplete cash reserves, or borrow large amounts of money, and thereby change their capital structure or raise capital from the public. Payment in stock enables companies to use a readily available currency, which might also be at high valuation.

    Indeed, such deals are more common in bull markets. In practice, except for the incentive and taxation aspects of exchanges of stock, stock transactions are similar to the issuance of shares by the buyer and their acquisition by the target. In view of the fact that it is not always possible to issue shares in the stock exchange, one of the arguments voiced is that during times of prosperity in the capital markets, companies tend to buy other companies in consideration for a payment which includes larger stock components than at other times, since any such acquisition also effectively includes a quasi-sale of shares to the target's shareholders.

  • Tax advantages Economically speaking, the questions which arise in a merger are: Are the target's shareholders, who sell their shares, liable for tax on their profits? When is such tax due? And are there grounds for the payment of capital gains tax by the company on the sale of assets for a price higher than their book value?

    Generally speaking, under U.S. law, a transaction may be regarded as a reorganization and may be recognized as tax-exempt, i.e., a transaction which defers the tax liability of the shareholders of the target until the date of actual liquidation of the received shares. The U.S. tax treatment is founded upon the concept that shareholders should not be taxed before they realize their profits. Consequently, according to Section 368(a) of the U.S. Internal Revenue Code of 1986, under certain conditions (which are met only in stock transactions), the shareholder is not taxed until actual liquidation. The tax basis for capital gains determination remains as it was, but the payment of the tax is made in accordance with only those components of the consideration which are paid in cash or by debt.

The Risks in Stock-based Transactions

When a transaction is made in the form of stock for stock, the selling party is not fully separated from its company, since the sellers effectively invest the sale proceeds in the acquirer over which they will not necessarily have control. In practice, when a transaction is made in stock, the risk it entails is divided between the seller and the buyer since both parties will bear the consequences of an unfavorable market reaction if the transaction does not yield the anticipated returns. The characteristic risks of stock transactions include:

  • A change in the acquirer's stock price Before they make the move in a stock transaction, both parties to the merger or the acquisition need to examine what effect a failure of the merger would have on the value of the parties' holdings. In other words, they need to examine what the value of the parties' holdings might be if the shares of the acquirer or of the surviving entity/absorbing company plummet after the acquisition. A benchmark for measuring the risk involved in an acquisition is to divide the premium paid (in either cash or stock) above the market price, if the company is publicly held, or above its value in its last investment round, if the company is private, by the acquirer's market value. This can serve as an indication, even if somewhat simplistic, of the measure of risk which the acquirer is prepared to assume, since the premium is paid for the added value expected to be received in the future in the form of residual income, as a result of the combination between the two companies. The higher the benchmark, the higher is the risk entailed by the acquisition to the acquirer, since the required future operating return is higher.

    Sometimes the parties agree that the price to be paid will be stated as a sum rather than a number of shares. In transactions of this type, the seller is protected against any decline in the value of the acquirer's shares, but it may, on the other hand, be harmed if the market rises. A customary method of handling the problem of a change in the market value of the acquirer's shares is to formulate a system of put and call options for different exercise prices. These mechanisms are nicknamed "collars." Collars guarantee, in effect, that if the price of the share drops below a certain level, the sellers will be compensated in the form of additional shares, and if the share price rises above a certain level, the number of shares which the sellers will receive will be reduced.

    On the buyers' side, it is important to understand that stock transactions are not risk-free. Even if the acquirer's managers feel that their company's stock is "over-valued" and that a stock transaction is therefore preferable, they are not necessarily selling their shares at a high price, since the selling company will demand a higher price in view of the fact that the price of the asset with which it is bought is unrealistic. One of the reasons for negative market reactions to announcements of acquisitions in stock is that the premium paid often symbolizes the seller's lack of faith in the acquirer's market valuation. Given that the seller is assumed to conduct a proper valuation of the acquirer, investors infer that the acquirer's stock is indeed over-valued.

    When a company is faced with several possibilities of being acquired, it must examine the economic value of the companies proposing to buy it in order to derive the real economic value proposed by each candidate. In many cases, a company whose shares are low at that time might be preferable to a company offering a higher price but is itself traded at an unrealistically high value.

  • Departure of employees A stock transaction can have a material effect on the issue of employee compensation for several reasons. First, unvested stock options in the seller held by the employees are converted into shares of the acquirer, thus possibly tying the employees to a company for which they did not choose to work. In many cases, the employees demand in the negotiations that all of their options vest, so that they will be able to sell them immediately and leave the company (for example, if the new managerial culture is not to their liking). In addition, a drop in price due to a possible market disappointment from the acquisition could also have very significant effects on the acquirer's employees. It is also common to find nowadays clauses in top employees' contracts which determine accelerated stock vesting in the case of an acquisition.



From Concept to Wall Street(c) A Complete Guide to Entrepreneurship and Venture Capital
From Concept to Wall Street: A Complete Guide to Entrepreneurship and Venture Capital
ISBN: 0130348031
EAN: 2147483647
Year: 2005
Pages: 131

flylib.com © 2008-2017.
If you may any questions please contact us: flylib@qtcs.net