What Happens to Stocks When a Company Is Bought
The legendary merger mania of the 1980s pales beside the M&A activity of this decade. In 1998 solitary, 12,356 deals involving U.Southward. targets were announced for a total value of $1.63 trillion. Compare that with the 4,066 deals worth $378.9 billion announced in 1988, at the top of the 1980s merger motion. But the numbers should be no surprise. Later on all, acquisitions remain the quickest route companies accept to new markets and to new capabilities. As markets globalize, and the pace at which technologies change continues to accelerate, more than and more companies are finding mergers and acquisitions to be a compelling strategy for growth.
What is hitting almost acquisitions in the 1990s, however, is the fashion they're being paid for. In 1988, well-nigh 60% of the value of big deals—those over $100 meg—was paid for entirely in cash. Less than 2% was paid for in stock. But simply 10 years later on, the contour is well-nigh reversed: 50% of the value of all large deals in 1998 was paid for entirely in stock, and only 17% was paid for entirely in cash.
This shift has profound ramifications for the shareholders of both acquiring and acquired companies. In a cash deal, the roles of the two parties are clear-cutting, and the exchange of money for shares completes a simple transfer of buying. Only in an commutation of shares, information technology becomes far less clear who is the buyer and who is the seller. In some cases, the shareholders of the acquired company can end upwardly owning most of the visitor that bought their shares. Companies that pay for their acquisitions with stock share both the value and the risks of the transaction with the shareholders of the company they acquire. The decision to use stock instead of cash tin can also touch shareholder returns. In studies covering more than 1,200 major deals, researchers accept consistently found that, at the fourth dimension of annunciation, shareholders of acquiring companies fare worse in stock transactions than they do in cash transactions. What'southward more, the findings bear witness that early on performance differences between greenbacks and stock transactions become greater—much greater—over fourth dimension.
In a cash bargain, the roles of the two parties are clear-cut, but in a stock deal, it's less clear who is the buyer and who is the seller.
Despite their obvious importance, these issues are ofttimes given brusk shrift in corporate board-rooms and the pages of the financial press. Both managers and journalists tend to focus mostly on the prices paid for acquisitions. It's not that focusing on price is wrong. Price is certainly an of import issue confronting both sets of shareholders. Merely when companies are considering making—or accepting—an offer for an exchange of shares, the valuation of the visitor in play becomes just one of several factors that managers and investors need to consider. In this commodity, we provide a framework to guide the boards of both the acquiring and the selling companies through their decision-making process, and we offer 2 simple tools to help managers quantify the risks involved to their shareholders in offering or accepting stock. But first let'due south expect at the basic differences betwixt stock deals and greenbacks deals.
Cash Versus Stock Merchandise-Offs
The main distinction betwixt cash and stock transactions is this: In cash transactions, acquiring shareholders take on the unabridged risk that the expected synergy value embedded in the conquering premium volition non materialize. In stock transactions, that risk is shared with selling shareholders. More precisely, in stock transactions, the synergy gamble is shared in proportion to the pct of the combined company the acquiring and selling shareholders each will own.
To come across how that works, let's await at a hypothetical example. Suppose that Heir-apparent Inc. wants to acquire its competitor, Seller Inc. The market capitalization of Buyer Inc. is $5 billion, made up of 50 meg shares priced at $100 per share. Seller Inc.'s market capitalization stands at $2.8 billion—40 1000000 shares each worth $70. The managers of Buyer Inc. guess that by merging the two companies, they tin create an additional synergy value of $1.7 billion. They denote an offer to buy all the shares of Seller Inc. at $100 per share. The value placed on Seller Inc. is therefore $4 billion, representing a premium of $ane.2 billion over the company's preannouncement marketplace value of $ii.8 billion.
The expected cyberspace gain to the acquirer from an acquisition—nosotros call it the shareholder value added (SVA)—is the difference betwixt the estimated value of the synergies obtained through the acquisition and the acquisition premium. And so if Buyer Inc. chooses to pay cash for the deal, then the SVA for its shareholders is merely the expected synergy of $one.7 billion minus the $1.ii billion premium, or $500 million.
Merely if Buyer Inc. decides to finance the acquisition by issuing new shares, the SVA for its existing stockholders will drop. Let'south suppose that Buyer Inc. offers one of its shares for each of Seller Inc.'due south shares. The new offer places the aforementioned value on Seller Inc. as did the cash offer. Only upon the deal'due south completion, the acquiring shareholders will find that their ownership in Buyer Inc. has been reduced. They will ain but 55.v% of a new total of 90 million shares outstanding afterward the acquisition. So their share of the acquisition's expected SVA is merely 55.v% of $500 million, or $277.5 meg. The rest goes to Seller Inc.'due south shareholders, who are now shareholders in an enlarged Buyer Inc.
The only fashion that Buyer Inc.'s original shareholders can obtain the aforementioned SVA from a stock deal as from a greenbacks deal would be by offering Seller Inc. fewer new shares, justifying this by pointing out that each share would exist worth more if the expected synergies were included. In other words, the new shares would reflect the value that Buyer Inc.'south managers believe the combined company will exist worth rather than the $100-per-share preannouncement market value. Only while that kind of deal sounds fair in principle, in practice Seller Inc.'s stockholders would exist unlikely to accept fewer shares unless they were convinced that the valuation of the merged visitor will turn out to exist even greater than Buyer Inc.'due south managers estimate. In calorie-free of the disappointing runway tape of acquirers, this is a difficult sell at best.
On the face of information technology, then, stock deals offering the acquired visitor's shareholders the chance to turn a profit from the potential synergy gains that the acquiring shareholders wait to make higher up and across the premium. That's certainly what the acquirers volition tell them. The problem, of grade, is that the stockholders of the acquired company also take to share the risks. Let'due south suppose that Heir-apparent Inc. completes the purchase of Seller Inc. with an exchange of shares and and then none of the expected synergies materialize. In an all-cash deal, Buyer Inc.'southward shareholders would shoulder the entire loss of the $1.2 billion premium paid for Seller Inc. But in a share bargain, their loss is simply 55.5% of the premium. The remaining 44.five% of the loss—$534 1000000—is borne by Seller Inc.'s shareholders.
In many takeover situations, of grade, the acquirer will be then much larger than the target that the selling shareholders will end up owning only a negligible proportion of the combined company. But equally the show suggests, stock financing is proving particularly popular in large deals (see the showroom "The Popularity of Newspaper"). In those cases, the potential risks for the acquired shareholders are large, as ITT'southward stockholders constitute out after their company was taken over by Starwood Lodging. Information technology is one of the highest profile takeover stories of the 1990s, and it vividly illustrates the perils of beingness paid in paper.
The Popularity of Paper Source: Securities Data Company
The story started in January 1997 with an offering by Hilton Hotels of $55 per share for ITT, a 28% premium over ITT'due south preoffer share cost. Under the terms of the offer, ITT's shareholders would receive $27.l in cash and the residuum in Hilton stock. In the face up of stiff resistance from ITT, Hilton raised its bid in Baronial to $lxx per share. At that point, a new bidder, Starwood Lodging, a real manor investment trust with all-encompassing hotel holdings, entered the fray with a bid of $82 per share. Starwood proposed paying $15 in cash and $67 in its ain shares.
In response, Hilton announced a bid of $80 per share in this grade—ITT shareholders would receive $80 per share in cash for 55% of their shares and two shares of Hilton stock for each of the remaining 45% of their shares. If the stock did not attain at least $40 per share 1 year afterward the merger, Hilton would make up the shortfall to a maximum of $12 per share. In essence, then, Hilton was offering the equivalent of an all-cash bid that would be worth at least $lxxx per share if Hilton'southward shares traded at $28 or higher one yr later the merger. Hilton's management believed it would clinch the deal with this lower bid by offering more greenbacks and protecting the future value of its shares.
Starwood countered by raising its offering to $85 per share. This fourth dimension, information technology gave ITT's shareholders the option to take payment entirely in stock or entirely in cash. But there was a grab: if more than 60% of the stockholders chose the cash option, and so the cash payout to those shareholders would be capped at merely $25.l, and the balance would exist paid in Starwood stock. Despite this grab, ITT's board voted to recommend the Starwood offering over the less risky Hilton offer, and it was and so approved past shareholders. Ironically, while ITT's board chose the offer with the larger stock component, the stockholders actually had a strong preference for cash. When the votes were counted, almost 75% of ITT'due south shareholders had selected Starwood's cash option—a percentage far greater than publicly predicted by Starwood's management and which, of course, triggered the $25.50 cap.
As a consequence of accepting Starwood'due south offer, ITT'south shareholders ended upwards owning 67% of the combined company's shares. That was considering fifty-fifty before the bid was announced (with its very substantial premium), ITT'due south market value was almost twice as large as Starwood's. ITT's shareholders were left very exposed, and they suffered for it. Although Starwood's share price held steady at effectually $55 during the takeover, the price plunged after completion. A yr afterwards, it stood at $32 per share. At that cost, the value of Starwood'due south offer had shrunk from $85 to $64 for those ITT shareholders who had elected cash. Shareholders who had chosen to be paid entirely in stock fared fifty-fifty worse: their packet of Starwood shares was worth only $49. ITT'due south shareholders had paid a steep cost for choosing the nominally college just riskier Starwood offer.
Fixed Shares or Fixed Value?
Boards and shareholders must do more than only cull between cash and stock when making—or accepting—an offer. At that place are two ways to structure an offer for an exchange of shares, and the choice of one approach or the other has a significant touch on on the allotment of take chances betwixt the two sets of shareholders. Companies can either issue a stock-still number of shares or they can issue a stock-still value of shares.
Fixed Shares.
In these offers, 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 engagement, depending on the acquirer'southward share price. Both acquiring and selling shareholders are affected past those changes, merely changes in the acquirer's price will not affect the proportional ownership of the two sets of shareholders in the combined company. Therefore, the interests of the 2 sets of shareholders in the deal'southward shareholder value added do not alter, even though the actual SVA may turn out to be unlike than expected.
In a stock-still-share deal, shareholders in the acquired company are specially vulnerable to a fall in the price of the acquiring visitor's stock because they have to bear a portion of the cost adventure from the time the deal is announced. That was precisely what happened to shareholders of Green Tree Financial when in 1998 it accepted a $vii.2 billion offer by the insurance company Conseco. Under the terms of the bargain, each of Dark-green Tree's mutual shares was converted into 0.9165 of a share of Conseco common stock. On Apr 6, a day before the deal was announced, Conseco was trading at $57.75 per share. At that toll, Green Tree'due south shareholders would receive just under $53 worth of Conseco stock for each of their Green Tree shares. That represented a huge 83% premium over Green Tree's preannouncement share price of $29.
Conseco'south rationale for the deal was that information technology needed to serve more than of the needs of middle-income consumers. The vision articulated when the deal was announced was that Conseco would sell its insurance and annuity products along with Green Tree's consumer loans, thereby strengthening both businesses. But the conquering was not without its risks. Offset, the Green Tree bargain was more than eight times larger than the largest bargain Conseco had always completed and almost twenty times the average size of its past 20 deals. 2nd, Green Tree was in the concern of lending money to buyers of mobile homes, a business concern very unlike from Conseco's, and the deal would require a plush postmerger integration effort.
The marketplace was skeptical of the cross-selling synergies and of Conseco'due south ability to compete in a new business. Conseco's growth had been congenital on a serial of highly successful acquisitions in its core businesses of life and health insurance, and the marketplace took Conseco's diversification as a signal that conquering opportunities in those businesses were getting scarce. And so investors started to sell Conseco shares. By the fourth dimension the deal closed at the finish of June 1998, Conseco'south share price had fallen from $57.75 to $48. That fall immediately hitting Dark-green Tree'southward shareholders equally well as Conseco'southward. Instead of the expected $53, Green Tree's shareholders received $44 for each of their shares—the premium had fallen from 83% to 52%.
Green Tree's shareholders who held on to their Conseco stock after endmost lost even more. By April 1999, one year after annunciation, Conseco'due south share price had fallen to $xxx. At that price, Green Tree'southward shareholders lost not only the entire premium but likewise an additional $i.50 per share from the preannouncement value.
Fixed Value.
The other way to structure a stock deal is for the acquirer to consequence a stock-still value of shares. In these deals, the number of shares issued is not fixed until the endmost date and depends on the prevailing price. Equally a outcome, the proportional ownership of the ongoing company is left in dubiousness until closing. To see how fixed-value deals work, permit's go back to Buyer Inc. and Seller Inc. Suppose that Heir-apparent Inc.'south offer is to be paid in stock but that at the closing date its share price has fallen by exactly the premium it is paying for Seller Inc.—from $100 per share to $76 per share. At that share price, in a fixed-value deal, Buyer Inc. has to issue 52.half dozen million shares to give Seller Inc.'southward shareholders their promised $4 billion worth. Only that leaves Buyer Inc.'due south original shareholders with only 48.vii% of the combined company instead of the 55.5% they would have had in a fixed-share deal.
As the illustration suggests, in a stock-still-value deal, the acquiring company bears all the cost risk on its shares betwixt proclamation and closing. If the stock toll falls, the acquirer must issue boosted shares to pay sellers their contracted stock-still-dollar value. So the acquiring company's shareholders have to accept a lower stake in the combined visitor, and their share of the expected SVA falls correspondingly. Nonetheless in our experience, companies rarely comprise this potentially pregnant risk into their SVA calculations despite the fact that the acquirer'due south stock price decreases in a substantial bulk of cases. (Run across the tabular array "How Take a chance Is Distributed Between Acquirer and Seller.")
The way an conquering is paid for determines how the risk is distributed between the buyer and the seller. An acquirer that pays entirely in cash, for case, assumes all the risk that the toll of its shares will drop between the announcement of the deal and its endmost. The acquirer also assumes all the operating risk afterwards the deal closes. Past contrast, an acquirer that pays the seller a fixed number of its own shares limits its take chances from a drib in share price to the percentage it will own of the new, merged company. The acquirer that pays a fixed value of shares assumes the entire preclosing market place gamble simply limits its operating hazard to the percentage of its postclosing ownership in the new visitor.
Past the aforementioned token, the owners of the acquired company are better protected in a fixed-value deal. They are not exposed to any loss in value until after the deal has closed. In our case, Seller Inc.'s shareholders volition non accept to carry any synergy gamble at all because the shares they receive now incorporate no synergy expectations in their cost. The loss in the share price is fabricated up by granting the selling shareholders extra shares. And if, after closing, the marketplace reassesses the acquisition and Buyer Inc.'s stock price does ascension, Seller Inc.'s shareholders will enjoy higher returns because of the increased percentage they own in the combined visitor. However, if Heir-apparent Inc.'s stock price continues to deteriorate after the closing appointment, Seller Inc.'southward shareholders will comport a greater percentage of those losses.
How Can Companies Choose?
Given the dramatic effects on value that the method of payment tin have, boards of both acquiring and selling companies have a fiduciary responsibility to comprise those effects into their decision-making processes. Acquiring companies must be able to explicate to their stockholders why they have to share the synergy gains of the transaction with the stockholders of the acquired company. For their function, the caused company's shareholders, who are being offered stock in the combined company, must exist fabricated to sympathize the risks of what is, in reality, a new investment. All this makes the job of the board members more circuitous. We'll await commencement at the bug faced by the board of an acquiring company.
Questions for the Acquirer.
The management and the board of an acquiring company should accost three economical questions earlier deciding on a method of payment. Outset, are the acquiring company's shares undervalued, fairly valued, or over-valued? Second, what is the risk that the expected synergies needed to pay for the acquisition premium volition not materialize? The answers to these questions will assist guide companies in making the decision between a cash and a stock offering. Finally, how likely is it that the value of the acquiring visitor's shares will drop before closing? The answer to that question should guide the conclusion between a fixed-value and a stock-still-share offer. Let'southward look at each question in turn:
Valuation of Acquirer'due south Shares
If the acquirer believes that the market is undervaluing its shares, and so it should not issue new shares to finance a transaction because to do and then would penalize current shareholders. Inquiry consistently shows that the market place takes the issuance of stock by a company every bit a sign that the company'due south managers—who are in a better position to know almost its long-term prospects—believe the stock to be overvalued. Thus, when management chooses to use stock to finance an conquering, there'south enough of reason to expect that company'south stock to fall.
If the acquirer believes the market is undervaluing its shares, it should not issue new shares to finance an conquering.
What's more, companies that use stock to pay for an conquering often base the toll of the new shares on the current, undervalued market place price rather than on the college value they believe their shares to be worth. That tin crusade a company to pay more than information technology intends and in some cases to pay more than the acquisition is worth. Suppose that our hypothetical acquirer, Buyer Inc., believed that its shares are worth $125 rather than $100. Its managers should value the xl one thousand thousand shares information technology plans to issue to Seller Inc.'south shareholders at $5 billion, not $four billion. Then if Heir-apparent Inc. thinks Seller Inc. is worth only $iv billion, it ought to offer the shareholders no more than 32 million shares.
Of course, in the real globe, information technology's not easy to convince a disbelieving seller to have fewer only "more valuable" shares—equally we have already pointed out. So if an acquiring company's managers believe that the market significantly undervalues their shares, their logical class is to proceed with a greenbacks offering. Yet we consistently observe that the same CEOs who publicly declare their visitor's share price to be too depression will cheerfully issue large amounts of stock at that "also low" price to pay for their acquisitions. Which signal is the market more than likely to follow?
Synergy Risks
The decision to use stock or cash as well sends signals about the acquirer's estimation of the risks of failing to achieve the expected synergies from the deal. A really confident acquirer would exist expected to pay for the acquisition with cash so that its shareholders would non have to requite any of the anticipated merger gains to the caused company's shareholders. But if managers believe the take a chance of not achieving the required level of synergy is substantial, they can be expected to try to hedge their bets by offering stock. By diluting their visitor'south ownership interest, they will also limit participation in whatever losses incurred either before or after the deal goes through. Once again, though, the market place is well able to describe its own conclusions. Indeed, empirical inquiry consistently finds that the market reacts significantly more favorably to announcements of greenbacks deals than to announcements of stock deals.
A actually confident acquirer would be expected to pay for the acquisition with greenbacks.
Stock offers, and so, send two powerful signals to the market: that the acquirer's shares are overvalued and that its management lacks confidence in the acquisition. In principle, therefore, a company that is confident about integrating an acquisition successfully, and that believes its own shares to be undervalued, should always keep with a cash offering. A greenbacks offer neatly resolves the valuation problem for acquirers that believe they are undervalued besides as for sellers uncertain of the acquiring company's true value. But it's not always so straightforward. Quite often, for example, a company does non take sufficient greenbacks resource—or debt chapters—to brand a cash offering. In that case, the determination is much less clear-cutting, and the board must judge whether the boosted costs associated with issuing undervalued shares still justify the conquering.
Preclosing Market Risk
A board that has determined to go on with a share offer nevertheless has to make up one's mind how to structure it. That decision depends on an assessment of the risk that the cost of the acquiring company's shares will drop between the announcement of the bargain and its closing.
Research has shown that the market responds more than favorably when acquirers demonstrate their confidence in the value of their own shares through their willingness to acquit more preclosing market gamble. In a 1997 article in the Journal of Finance, for example, Joel Houston and Michael Ryngaert constitute in a large sample of cyberbanking mergers that the more sensitive the seller'south bounty is to changes in the acquirer's stock cost, the less favorable is the market's response to the acquisition announcement. That leads to the logical guideline that the greater the potential impact of preclosing market adventure, the more important it is for the acquirer to signal its confidence past bold some of that chance.
A fixed-share offering is not a confident indicate since the seller's compensation drops if the value of the acquirer's shares falls. Therefore, the fixed-share approach should be adopted just if the preclosing marketplace risk is relatively low. That'southward more probable (although not necessarily) the case when the acquiring and selling companies are in the same or closely related industries. Mutual economic forces govern the share prices of both companies, and thus the negotiated exchange ratio is more likely to remain equitable to acquirers and sellers at closing.
But at that place are ways for an acquiring company to structure a fixed-share offering without sending signals to the market that its stock is overvalued. The acquirer, for instance, can protect the seller confronting a fall in the acquirer'southward share price below a specified floor level by guaranteeing a minimum price. (Acquirers that offer such a floor typically also insist on a ceiling on the total value of shares distributed to sellers.) Establishing a flooring not only reduces preclosing market risk for sellers but also diminishes the probability that the seller's board will back out of the deal or that its shareholders volition not corroborate the transaction. That might have helped Bell Atlantic in its bid for TCI in 1994—which would take been the largest bargain in history at the time. Bong Atlantic'south stock fell sharply in the weeks following the announcement, and the bargain—which included no market place-adventure protection—unraveled as a consequence.
An even more confident signal is given by a fixed-value offer in which sellers are assured of a stipulated market value while acquirers bear the unabridged toll of any pass up in their share price before endmost. If the market place believes in the merits of the offer, then the acquirer's price may even rise, enabling it to upshot fewer shares to the seller's stockholders. The acquirer's shareholders, in that event, would retain a greater proportion of the bargain's SVA. As with fixed-share offers, floors and ceilings can be fastened to fixed-value offers—in the course of the number of shares to exist issued. A ceiling ensures that the interests of the acquirer's shareholders are not severely diluted if the share price falls before the deal closes. A floor guarantees the selling shareholders a minimum number of shares and a minimum level of participation in the expected SVA should the acquirer's stock cost ascension appreciably.
Questions for the Seller.
In the case of a greenbacks offer, the selling visitor's board faces a fairly straightforward task. It only 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 could create amend value if the company remained independent. The latter example certainly tin exist hard to justify. Let's suppose that the shareholders of our hypothetical acquisition, Seller Inc., are offered $100 per share, representing a 43% premium over the current $70 price. Allow'southward also suppose that they can become a 10% return past putting that cash in investments with a similar level of adventure. After 5 years, the $100 would chemical compound to $161. If the bid were rejected, Seller Inc. would have to earn an annual render of 18% on its currently valued $70 shares to do too. So uncertain a return must compete against a bird in the hand.
More than likely, though, the selling company'south board will be offered stock or some combination of greenbacks and stock so will also take to value the shares of the combined company being offered to its shareholders. In essence, shareholders of the acquired company volition exist partners in the postmerger enterprise and will therefore take as much interest in realizing the synergies as the shareholders of the acquiring company. If the expected synergies do not materialize or if other disappointing information develops after closing, selling shareholders may well lose a significant portion of the premium received on their shares. So if a selling company's board accepts an exchange-of-shares offer, it is not only endorsing the offer as a fair cost for its ain shares, it is likewise endorsing the idea that the combined visitor is an attractive investment. Essentially, then, the board must act in the role of a heir-apparent likewise equally a seller and must go through the same decision process that the acquiring company follows.
At the finish of the day, however, no affair how a stock offer is made, selling shareholders should never assume that the appear value is the value they will realize earlier or later on endmost. Selling early may limit exposure, but that strategy carries costs considering the shares of target companies almost invariably trade below the offer price during the preclosing flow. Of class, shareholders who await until subsequently the closing date to sell their shares of the merged company have no style of knowing what those shares volition be worth at that time.
The questions we have discussed here—How much is the acquirer worth? How probable is it that the expected synergies will be realized?, and How great is the preclosing market hazard?—address the economic problems associated with the decisions to offering or take a detail method of paying for a merger or conquering. There are other, less important, issues of revenue enhancement treatment and accounting that the advisers of both boards volition seek to bring to their attending (see the sidebars "Taxation Consequences of Acquisitions" and "Accounting: Seeing Through the Smoke Screen"). Only those concerns should non play a key office in the acquisition decision. The actual touch on of taxation and accounting treatments on value and its distribution is not as great as it may seem.
Shareholder Value at Chance (SVAR)
Before committing themselves to a major deal, both parties volition, of course, need to assess the effect on each visitor's shareholder value should the synergy expectations embedded in the premium fail to materialize. In other words, what percentage of the company's market value are you betting on the success or failure of the acquisition? We present two simple tools for measuring synergy risk, one for the acquirer and the other for the seller.
A useful tool for assessing the relative magnitude of synergy risk for the acquirer is a straightforward calculation nosotros call shareholder value at gamble. SVAR is simply the premium paid for the conquering divided by the market value of the acquiring company before the declaration is fabricated. The index can too be calculated as the premium percentage multiplied by the market value of the seller relative to the market value of the buyer. (Run across the table "What Is an Acquirer's Risk in an All-Cash Bargain?") We think of it as a "bet your visitor" alphabetize, which shows how much of your company'south value is at hazard if no postacquisition synergies are realized. The greater the premium percent paid to sellers and the greater their marketplace value relative to the acquiring company, the higher the SVAR. Of course, as we've seen, it'south possible for acquirers to lose even more than than their premium. In those cases, SVAR underestimates hazard.
What Is an Acquirer'southward Take chances in an All-Cash Deal? An acquirer's shareholder value at risk (SVAR) varies both with the relative size of the acquisition and the premium paid.
Let'southward run into what the SVAR numbers are for our hypothetical deal. Heir-apparent Inc. was proposing to pay a premium of $one.two billion, and its own marketplace value was $v billion. In a cash deal, its SVAR would therefore be i.two divided by 5, or 24%. Simply if Seller Inc.'southward shareholders are offered stock, Buyer Inc.'s SVAR decreases because some of the adventure is transferred to the selling shareholders. To calculate Buyer Inc.'s SVAR for a stock deal, you must multiply the all-cash SVAR of 24% by the percentage that Heir-apparent Inc. volition ain in the combined company, or 55.5%. Buyer Inc.'s SVAR for a stock deal is therefore just 13.3%.
A variation of SVAR—premium at risk—can assistance shareholders of a selling company assess their risks if the synergies don't materialize. The question for sellers is, What percent of the premium is at run a risk in a stock offer? The answer is the percentage of ownership the seller will have in the combined visitor. In our hypothetical deal, therefore, the premium at risk for Seller Inc.'southward shareholders is 44.5%. Once again, the premium-at-adventure calculation is really a rather conservative measure out of risk, as it assumes that the value of the independent businesses is safe and only the premium is at risk. But equally Conseco'due south conquering of Greenish Tree Financial demonstrates, unsuccessful deals can toll both parties more just the premium. (Run across the tabular array "SVAR and Premium at Take a chance for Major Stock Deals Announced in 1998.")
SVAR and Premium at Take a chance for Major Stock Deals Announced in 1998 Information for calculations courtesy of Securities Data Company. The cash SVAR percentage is calculated as the premium percentage multiplied by the relative size of the seller to the acquirer. The stock SVAR percentage is calculated as the cash SVAR percent multiplied by the acquirer'south proportional ownership.
From the perspective of the selling company's shareholders, the premium-at-take a chance calculation highlights the bewitchery of a fixed-value offer relative to a stock-still-share offering. Allow'south go back to our two companies. If Buyer Inc.'s stock price falls during the preclosing menstruum by the entire premium paid, then Seller Inc.'s shareholders receive additional shares. Since no synergy expectations are congenital into the price of those shares now, Seller Inc.'s premium at run a risk has been completely absorbed past Buyer Inc. In other words, Seller Inc.'southward shareholders receive not only more shares just likewise less risky shares. Only in a fixed-share transaction, Seller Inc.'s stockholders have to bear their total share of the value lost through the fall in Heir-apparent Inc.'s price right from the announcement date.
Although we accept taken a cautionary tone in this commodity, we are not advocating that companies should ever avert using stock to pay for acquisitions. We have largely focused on deals that accept taken place in established industries such equally hotels and insurance. Stock issues are a natural style for young companies with limited access to other forms of financing, specially in new industries, to pay for acquisitions. In those cases, a high stock valuation tin can be a major reward.
Even managers of Cyberspace companies like Amazon or Yahoo! should non be beguiled into thinking that issuing stock is risk-free.
But it is a vulnerable one, and even the managers of Internet companies such as America Online, Amazon.com, and Yahoo! should not be beguiled into thinking that issuing stock is risk-free. In one case the market has given a thumbs-down to 1 deal past mark down the acquirer'due south share price, it is likely to be more guarded about future deals. A poor stock-cost operation can also undermine the motivation of employees and slow a visitor's momentum, making the hard task of integrating acquisitions even harder. Worse, information technology tin trigger a spiral of turn down because companies whose share prices perform badly find it hard to concenter and retain proficient people. Internet and other high-technology companies are especially vulnerable to this situation because they need to be able to offering expectations of large stock-choice gains to recruit the best from a scarce pool of talent. The selection betwixt greenbacks and stock should never exist made without full and careful consideration of the potential consequences. The all-also-frequent disappointing returns from stock transactions underscore how important it is for the boards of both parties to understand the ramifications and be vigilant on behalf of their shareholders' interests.
A version of this article appeared in the November–December 1999 consequence of Harvard Business concern Review.
Source: https://hbr.org/1999/11/stock-or-cash-the-trade-offs-for-buyers-and-sellers-in-mergers-and-acquisitions
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