Acquisition payment methods
/Paying for an Acquisition With Cash
The form of payment generally preferred by the shareholders of the acquiree is cash. It is particularly appreciated by shareholders who are unable to sell their stock by other means, which is the case for most privately-held companies. In addition, they no longer have to worry about the future performance of their company impacting the amount that they will be paid. The degree to which cash is preferred is indicated by the extent to which sellers are generally willing to accept a smaller amount of cash rather than a larger payment in stock or debt. However, a cash payment also means that the selling shareholders must pay income taxes on any gains immediately.
From the perspective of the acquirer, a cash payment presents both pluses and minuses. One advantage is that, in a competitive bidding situation, the bid of the buyer willing to pay cash is more likely to be accepted by the seller. Also, not paying in stock means that any future upside performance generated by the acquisition accrues solely to the existing shareholders of the acquirer – the shareholders of the acquiree are taking cash instead, so they are blocked from the gains.
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Paying for an Acquisition with Stock
In a stock-for-stock exchange, the shareholders of the selling entity swap their shares for the shares of the acquirer. A stock-for-stock exchange is useful for the seller when its shareholders do not want to recognize taxable gains in the near term. Instead, they pay income taxes only when they sell the shares paid to them by the acquirer. They will pay taxes only on the difference between their cost basis in the stock of the acquiree and the price at which they sell the stock of the acquirer. However, this also means that shareholders will not have liquid investment positions in the short term.
In a stock-for-stock exchange, the seller shares with the acquirer the risk that the benefits of the acquisition are not realized. Thus, if the acquirer derives a purchase price based on the realization of synergy gains and those gains are not achieved, it is quite possible that the market will then force down the price of its shares. If the seller’s shareholders now own some of those shares, the value of the payment to them will decline.
Paying for an Acquisition With Debt
The acquirer may include debt in the structure of its deal to buy the acquiree. There are both advantages and disadvantages associated with doing so, which are outlined below.
Advantages of Paying for an Acquisition with Debt
There are several advantages associated with the use of debt to pay for an acquisition. They are as follows:
Retain upside potential. By paying with debt, the buyer gets to retain all of the upside potential of keeping its own stock.
Higher potential return on investment. If the acquisition generates cash flows that exceed the cost of debt, the acquisition can yield a high return on investment, benefiting shareholders. The debt becomes a mechanism to amplify returns as long as the acquisition cash flows exceed the cost of servicing the debt.
Preserve ownership. By paying with debt, the current owners of the acquirer can avoid diluting their ownership interests. This is especially important for privately-held family businesses.
Shields taxable income. By paying with debt, the associated interest payments are usually tax-deductible. This shields the acquirer’s income from income tax liabilities.
Flexibility for future financing. By paying with debt, the acquirer preserves its equity for other purposes, such as future acquisitions.
Hedges against inflation. If an acquisition is financed with fixed-rate debt and inflation rises, the real value of the debt repayment decreases over time. This can make debt an attractive option if inflation is expected to increase, effectively reducing the cost of the acquisition in real terms.
Disadvantages of Paying for an Acquisition with Debt
The seller should not accept a debt payment unless it is very certain of the financial condition of the acquirer. Otherwise, if the acquirer were to enter bankruptcy, the seller’s shareholders would simply be categorized among other creditors to be paid out of any remaining assets. The seller can mitigate this risk to some extent by placing the holders of the debt in the most senior position of all debt holders. However, most companies already have assigned senior debt positions to other lenders, so the shareholders are placed in a junior debt position. The seller could place a lien on the assets of the acquiree, but the seller will have no control over those assets once the purchase agreement is finalized; this means that the acquirer could sell off the assets and use the proceeds, or simply let the equipment run down over time without proper maintenance, leaving little for the seller’s shareholders to recover.
Summary of Acquisition Payment Methods
An acquirer is more inclined to offer stock-for-stock deals when it believes its stock price is unusually high. During these times, it can offer fewer shares to pay for an acquisition. Conversely, if it feels that the market is assigning it an unusually low share price, it will be less inclined to pay with stock, for it must issue more shares. The seller is placed in the reverse situation if it believes the acquirer’s stock to be selling at too high a level, since there is a higher risk that the share price will subsequently decline, and along with it the effective price paid to the seller.
If the acquirer believes that it has obtained a good (i.e., low) price for an acquisition, it will be less inclined to pay with its own stock. If it were to do so, the price of the stock should increase, and the shareholders of the seller would share in that increase. In such a situation, the acquirer should be more interested in buying for cash; doing so means that all share price increases will accrue to the benefit of existing shareholders.