Deciding on a method of payment for M&A
Hi everyone,
I have recently taken an M&A class in which I had to create a pitch deck presentation related to a deal between two public companies. The target company entered a scheme of arrangement with another company on a cash+stock deal. When deciding on the payment, I noticed that the acquirer had strong cash levels, good credit rating and undervalued stock, so my intention was to pursue a debt-financed 100% cash deal due to the implied low cost of debt as well as my offer being more liquid to the target shareholders than the one presented by the other firm.
However, while receiving feedback, I was told that I missed the context of the transaction as the target company has a lot of inside ownership (employees) and stockholders might not be willing to let go of a company in which they got their life savings invested in. This was definitely a fair point.
So, I know this might be something that I don't need to know yet and I'll learn on the job. But I would be interested in learning, generally, what are the main factors that you need to take into account (besides inside ownership) when deciding on the payment method (cash, stock, stock+cash, etc)?
Some considerations below when evaluating consideration mix.
Acquirer's acquisition debt capacity based on current / PF leverage, ratings impact and cost of debt
Acquirer's cost of equity
Ownership split, management and governance rights between target and acquirer
Desire of target's shareholder base for liquidity vs. participation in potential upside
Tax implications of cash consideration vs. tax deferment from stock consideration
The only case in which the feedback you got might make sense is if the two public companies (target and acquiror) are about equal in size. In that case, yes, one might argue for an all-stock merger of equals to give each set of owners some control.
But if this was a (more typical) case of a very big company swallowing up a smaller company, the consideration is far less relevant. The employees/shareholders of the target will get liquidity and a control premium, and reloaded with stock options in the combined company.
Main reason I wouldn't use cash in this deal is that the target employees (at least some of them) need to stay on to work for the acquirer after the deal. If you cash them out, they have no wealth left in the new company and nothing tying them down. Furthermore, they may be suddenly rich and more inclined to do something else completely.
I think that might be what your feedback person was trying to convey, although it sounds like it came out a bit different.
The other consideration (and this is more applicable to most situations, while the above consideration is unique to yours) is whether the acquirer stock is overvalued or undervalued. If you're an acquirer with cheap stock, you don't want to be issuing more of it. As a value investor with some activist leanings, I can tell you that I personally would lose my shit and write an angry letter if any of the companies in my portfolio used stock to acquire someone, because I feel the stock is undervalued. If anything they should be buying it back, not issuing more of it
On the other hand if the stock is overvalued, you want to take advantage and do all the buying you can with overvalued currency, just like any traveler who goes hog wild on vacation because the country he's visiting has depressed currency.
This doesn’t seem to make sense. Cash or stock has tax implications, but assuming the acquirer is liquid on an exchange then the target shareholders could easily cash out any stock from the deal. Employment would need to be incentivized BEYOND the acquisition premium.
It’s a classroom situation, not a fully blown real life deal. So there are limits on the depth of details to be considered. I’m obviously not in the class so don’t know all assumptions, but I took a clue from OP who said that the confusing feedback was given re: personal wealth tied up in the target and that fact favoring stock. Working with that, I offered what I felt was the most likely guess as to what the feedback provider meant.
Yes, if you want people to retain stock you need to tie them up. Let me know where to send the cookie.
Also if you’re going to just lob in “tax considerations” without explaining it, I mean, what is that other than weak flexing that doesn’t help OP at all.
For those who may now be wondering about tax, yes stock can be advantageous to the seller because it allows for gains tax to be deferred and that gain may be quite large if the seller has a low basis. Of course then we get into asset vs stock purchase and 338h10 and all that shit so I thought maybe better to just assume OP’s class hasn’t reached that chapter yet, because all the clues indicate that we’re on a more basic level here.
Agree. I realize it was just a classroom exercise but it's really not accurate to suggest that a stock deal preserves all or even any of the target management team's pre-deal motivations. If the business is worth X, you have to pay the people who built it their share of X. If you want them to stick around and increase the value, you need to load them up with new incentives, same as you would for a brand new management team. It's naive to think that a deal can be structured that will simultaneously give passive investors the premium they require but have the management team carry on as though nothing had changed.
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