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The Securities Edge Securities Blog for Middle-Market Companies

Has stock returned as the currency of choice in mergers and acquisitions?

Posted in Mergers and Acquisitions

Business CombinationsCash may be king, but the use of stock to buy a target company can be very advantageous.  The practice of using stock to purchase a target company never really went away, but it did become less desirable to target company shareholders during the recent economic downturn.  With stock values dropping and access to credit diminishing, mergers and acquisitions that did close were often done in cash.  However, as markets have become more stable and many stocks have risen to higher valuations, purchasers are looking more and more to again use their stock to buy companies.

In a typical merger, the question of whether to use cash, stock, a combination of the two or some other form of consideration is a business decision to be negotiated by the purchaser and target companies, with the consultation of professionals. Despite the recent economic downturn and its effect on market volatility, reduced market volatility over the last three years, combined with a legislative push to assist small businesses in raising capital, has made stock a more attractive form of consideration for buyers and sellers alike.

There are many benefits to using stock in a deal.  Perhaps the most important benefit stems from qualifying the transaction as a tax-free “reorganization,” provided that the transaction is structured properly. As a tax-free reorganization, the target shareholders would generally not have to realize gains on the exchange of their stock for the purchasers stock.  In contrast, target shareholders would normally have to realize gains to the extent they receive cash for their shares in a merger.  So the use of stock in a deal can be very advantageous to seller shareholders for tax reasons.

The use of stock consideration can also assist in addressing possible absolute and relative valuation issues by allowing the parties to negotiate with an eye toward the market. Further, stock consideration can help to minimize deal risks that arise in transactions where all or part of the cash component relies on debt financing.  Essentially, the option of using stock consideration provides a purchaser with an alternative transaction currency that is especially beneficial to those purchasers that may not have sufficient cash on hand.

There are other factors as well.  For example, in an all cash acquisition, the risk that the expected synergy value embedded in the acquisition premium will not materialize is all on the acquiring shareholders. By using stock consideration in the deal, however, the purchaser can shift some of this performance risk from its own shareholders to those of the target company because, once the deal is closed, the target company shareholders have a financial interest in the success of the purchaser. These situations also give target shareholders the opportunity to participate in the potential upside of the acquiring company.  Notably, such considerations can be especially important in strategic, as opposed to financial, transactions, where the payment of stock, as opposed to a cash buyout, could incentivize acquiring and target companies to accept the deal because of the implied risk sharing and the opportunity to participate in the upside of the combined company.

From the standpoint of the target company shareholders, the appeal of receiving stock as consideration may increase where the acquiring company may soon go, or already is, publicly traded.  For example, after receiving privately held Google stock in consideration for their shares in Pyra Labs, Inc. in 2003, the Pyra Labs shareholders later reaped the benefits of Google’s success (via stock appreciation) when the company went public in 2004. Further, when Summize, Inc. sold its search service to Twitter, Inc. in 2008, the Summize shareholders received (public) Twitter stock (and some cash) as consideration, and that Twitter stock has appreciated significantly since.  In addition, receipt of publicly traded stock as consideration in an acquisition provides target company shareholders with instant liquidity (provided there are no restrictions on the stock), as well as the option to hedge their share of the performance risk with puts and calls.

Further, in the case of emerging growth companies, the upside opportunity can be substantial. Given Congress’ recent aim to improve and encourage access to the public capital markets for emerging growth companies under the JOBS Act, the increased appeal of stock consideration may particularly benefit smaller or emerging growth companies in their acquisition aspirations.

While the benefits of using stock as consideration in mergers and acquisitions are substantial, downsides do exist.  First, and perhaps most important, valuation of the stock is often difficult and sometimes uncertain, especially when non-public stock is used.  In addition, the use of only stock in the transaction can implicate various SEC compliance obligations and corresponding liability. Further, dilution and subordination issues can arise with regard to acquiring company shareholders, and the complication of dealing with and/or receiving securities that carry special rights or restrictions can impose a heavy burden on both buying and selling companies. Also, for target shareholders, the advantage of participating in the upside of the acquiring company exposes them to the risk of the acquiring company’s downside and possible failure.  Essentially then, the use of stock as consideration in mergers and acquisitions has the potential to make the transaction more complex, and ultimately, more costly.

But despite potential negatives, the combination of the benefits of using stock (and especially public or soon to be public stock) as consideration in mergers and acquisitions, the JOBS Act incentives for emerging companies to go public, and our more stable markets, provides a more favorable environment at this time for the use of stock consideration in mergers and acquisitions for buyers and sellers alike, especially those that qualify as emerging growth companies.