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.

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. This can be beneficial to the seller’s shareholders, since they do not pay income taxes until they receive the debt payments.

The seller should not accept this form of 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.