In a mergers and acquisitions deal a firm can consider an all-stock deal, a combination cash/stock deal, or an all-cash transaction.
The acquirer in an M&A deal will tend to offer a compensation package to the target company’s board of directors based on the incentives at work.
If the acquirer believes the price of its current shares to be undervalued it will likely prefer to use cash in the transaction.
If shares are perceived to be undervalued, it may believe that providing its own stock as compensation would therefore be overpaying relative to its true value.
However, if the target company’s board of directors also perceives the acquirer’s share to be undervalued, it may see value in including equity in the transaction and demand that shares be added to the compensation package accordingly.
Naturally, a negotiation process would ensue – assuming the target company is open to the deal in the first place – regarding the mix of cash and equity involved in any prospective transaction.
On the opposite side of the spectrum, if the acquirer believes its shares are currently overvalued, it might want to include equity as part of the deal given that it might be more financially appealing than including cash as part of the transaction.
But again, if the target company perceives this to be the case it may feel that from its end of the bargain, the acquirer’s equity is too expensive and demand that cash be included.
Equity is also inherently a riskier form of compensation (unless we’re also dealing with exchange rates) given that by the time a deal is announced and by the time the transaction is completed, share prices might rise and fall and throw the agreed upon compensation terms out of sync from what they were initially.
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Structure of M&A Transactions
Naturally, finding an agreed upon distribution of equity and cash is an integral component of structuring an M&A deal.
Back in the 1980’s, transactions were mostly all-cash (60%), with very few being all-stock (2%). By the late-1990’s, this shifted in favor of all-stock (50%), with a markedly smaller proportion being all-cash (17%).
Moreover, in about two-thirds of M&A deals, the acquirer’s stock price falls after the announcement based on investor skepticism that the acquirer will be able to achieve the synergy aimed for in the transaction.
Given M&A fees are paid for upfront rather than in stages, investors will naturally expect performance upticks almost immediately rather than face a settling in period where synergies don’t manifest until sometime after the deal has occurred.
Moreover, in cross-border deals that largely became prominent in the 1990’s, the target company’s domestic currency rose in response to the news, while the acquirer’s domestic currency depreciated in value.
The news of all-cash transactions will be more positively absorbed by investors than all-stock transactions or a combination of the two payment forms.
All-cash transactions will yield the most accretive pro forma EPS impact, while all-stock transaction will be the most dilutive.
Of course, both forms of transactions can be accretive and both can be dilutive.
But occasionally the difference between an accretive and dilutive transaction, at least initially, can be a simple difference in the allocation of stock and cash in the deal.
For purposes of this article, let’s assume that we have a deal involving 100% cash. Perhaps both parties have relatively high-beta (volatile) stocks, overvalued shares, or a host of other factors that could cause a company’s board of directors to prefer the route afforded by cash. How would the math look in this case?
Before the Transaction
As in our previous article discussing an all-stock transaction, we will keep the details the same, including the hypothetical company names. Atlas is the acquirer. Burbank is the target. Of course, in this case, we are moving to an all-cash from an all-stock transaction.
Atlas has the following financial characteristics:
- Share price = $100
- Shares outstanding = 1,000,000
- Market capitalization = $100,000,000
- Net income = $5,000,000
- Earnings per share (EPS) = $4.00
- P/E = 25.0
Burbank has the following financials:
- Share price = $35
- Shares outstanding = 500,000
- Market capitalization = $17,500,000
- Net income = $1,500,000
- EPS = $1.65
- P/E = 21.2
Atlas is paying a 50% premium to acquire Burbank and therefore would pay 1.5 * $35 = $52.50 for each one of its shares. With Burbank currently having 500,000 shares outstanding, Atlas would pay Burbank $52.50/share * 500,000 shares = $26,250,000.
In an all-cash transaction, we simply add the net incomes and divide by the number of shares currently outstanding for Atlas, the acquiring company:
Pro forma EPS (Atlas-Burbank) = ($5,000,000 + $1,500,000) / 1,000,000 = $7.50/share
Burbank’s shares are not included in the denominator as they are in an all-stock transaction, given they are being purchased by Atlas.
To perform the accretion/dilution analysis, we take the pro forma EPS of Atlas-Burbank (i.e., the combined firm) and multiply by its P/E ratio of 25.0:
New share price = Pro forma EPS * P/E = $7.50 * 25.0 = $187.50
Analyzing the transaction
In an all-stock transaction, we determined that this would have a 4% dilution on Atlas’ EPS. However, in this case, we can see a new stock price of $187.50 coming forth as a result of this transaction.
This provides an 87.5% accretion rate ($187.50/$100.00). Moreover, by paying all cash, Atlas shareholders now own 100% of Atlas-Burbank as opposed to merely the 51.2% they would own as part of the all-stock transaction.
In this case, paying in all cash would provide a much more compelling deal for Atlas shareholders. The stock price would increase to $187.50 versus the $96.04 it would be in an all-stock deal.
However, Burbank’s board of directors might not be likely to accept this deal. If they do, it would be termed a “friendly takeover”; if Burbank’s board of directors refuse the deal and Atlas goes to the shareholders themselves and proposes the deal, this transaction would be deemed a “hostile takeover.”
While Atlas’ shareholders would own 100% of Atlas-Burbank and at a new price that’s 87.5% above the previous one, Burbank shareholders would have to settle for a collective payout of $26,250,000, or $52.50 per share.
This would be 50% above the price at which Burbank is currently trading, so chances might be reasonably strong that Burbank shareholders would agree to such a high premium.
This is one of the factors why control premium is so common mergers and acquisitions deals. Offering face value to Burbank would be infeasible as it would essentially be giving Burbank shareholders the current price for their stock.
This would not work considering if they felt the current price represented its fair price, they wouldn’t own the stock in the first place. It’s irrational to hold a stock if you feel it won’t increase in value and provide a return on your investment.
Consequently, there must be some type of control premium involved for Atlas to come in and take over Burbank while paying off its shareholders in a high enough amount to part with the investment.
Normally, M&A deals see a 30%-40% premium involved. Atlas could begin the negotiations with an offer toward the lower end of this spectrum.
If Burbank doesn’t bite they could gradually improve the offer. Or Burbank could respond by insisting that equity becomes part of the deal, or 100% of the deal depending on factors already mentioned.
Atlas, to counteract, could either acquiesce to some or all of the demands or raise the control premium being offered in order to get demands more in line with its expectations from the deal.
An all-cash deal might seem like a huge improvement for Atlas’ sake over an all-stock deal. A simple change in compensation altered the accretion/dilution percentage by over 91%, from 4% dilution to 87.5% accretion.
However, this improvement certainly didn’t come for free. Instead of financing the deal through stock considerations, Atlas must pay out of pocket. We calculated this value to come in at $26,250,000.
If we look at the net income of Atlas, we see it comes in at just $5,000,000. Needless to say, this is a sizable gap. Paying out 525% of the amount of your annual net income is a massive amount of money and would likely have to be funded through debt assuming the cash is unavailable, which it would likely not be.
Of course, if debt is taken out, this comes at an interest cost, roughly equal to the firm’s cost of debt. Whether this would be viable or worth the cost depends on the benefits of the deal.
As a result, Atlas might feel compelled to add equity to the deal’s compensation structure to alleviate the burden of needing to procure such a large sum of money.
But assuming a loan could be obtained, the cost could be financed over a period of time instead of directly upfront.
It would increase shareholder wealth by 87.5% off the bat, and perhaps eliminate a competitor to get ahold of its technology, infrastructure, assets, talent, and improve revenue and/or cut costs, but at the cost of 525% of one year’s net income.
It would be up to Atlas’ board of directors and internal decision-makers to determine if the cost is worth the reward.
There are also the complications of whether Burbank’s board/shareholders would accept the proposition and any negotiated counteroffer. As a consequence, M&A deals could take anywhere from months to over a year to complete.
From this example, we can observe that an all-cash transaction provides the most accretive effect on pro forma EPS.
Atlas-Burbank was 87.5% accretive in an all-cash deal as opposed to the all-stock transaction laid out previously, which was 4% dilutive. (For ease of simplicity, we are not taking into account advising or financing fees, any loan interest, synergy, the true value of control, etc.)
While all-cash deals are more accretive in nature, they can come at a hefty price.
Being the firm’s own equity is not used, the firm must finance the deal by likely taking on more debt. On the other hand, if a deal is funded through an all-stock transaction, Atlas would have had to issue $50 million worth of equity versus the $26.25 million paid in cash.
The “fair value” of this equity would depend on Atlas’ interpretation of the approximate value of its stock. If it is overvalued, asking for stock would effectively lower the cost involved assuming its valuation projections are correct.
A company can also request a stock/cash combination, which is a type of situation we discussed in the following article.