0. Stock or Cash? By A.V. Vedpuriswar
GENERALLY ACCESSIBLE
Stock or Cash?
By A.V. Vedpuriswar
Based on the article by: Alfred Rappaport, Mark Sirower – Harvard Business Review, Nov/Dec 99
June 2008

1. Introduction
In 1988, nearly 60% of the value of large deals- those over $100 million was paid for entirely in cash. Less than 2 % was paid for in stock.
But just ten years later, the scenario changed : 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 has important implications for the shareholders of both acquiring and acquired companies.

2. In a cash deal, the roles of the two parties are clear-cut, and the exchange of money for shares completes a simple transfer of ownership.
But in an exchange of shares, it becomes far less clear who is the buyer and who is the seller.
In some cases, the shareholders of the acquired company can end up owning most of the company 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.
Shareholders of acquiring companies fare worse in stock transactions than they do in cash transactions.
Early performance differences between cash and stock transactions can become much greater over time.

3. Risk Sharing
In cash transactions, acquiring shareholders take on the entire risk that the expected synergy value embedded in the acquisition premium will not materialize.
In stock transactions, that risk is shared with selling shareholders.
In stock transactions, the synergy risk is shared in proportion to the percentage of the combined company the acquiring and selling shareholders each will own.

4. Fixed Shares or Fixed Value
There are two ways to structure an offer for an exchange of shares.
Companies can either issue a fixed number of shares or they can issue a fixed value of shares.

5. Fixed Shares
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 date, depending on the acquirer‘s share price.
Both acquiring and selling shareholders are affected by those changes.
But it does not affect the proportional ownership of the two sets of shareholders in the combined company.
In a fixed-share deal, shareholders in the acquired company are vulnerable to a fall in the price of the acquiring company‘s stock.

6. Fixed Value
The other way to structure a stock deal is for the acquirer to issue a fixed value of shares.
In these deals, the number of shares issued is not fixed until the closing date and depends on the prevailing price.
As a result, the proportional ownership of the ongoing company is left in doubt until closing.
The acquiring company bears all the price risk on its shares between announcement and closing.
If the stock price falls, the acquirer must issue additional shares to pay sellers their contracted fixed-dollar value.

7. So the acquiring company's shareholders have to accept a lower stake in the combined company.
By the same 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.

8. Questions for the Acquirer
An acquiring company should address three questions before deciding on a method of payment
First, are the acquiring company's shares undervalued, fairly valued, or overvalued?
Second, what is the risk that the expected synergies needed to pay for the acquisition premium will not materialize?
The answers to these questions will help guide companies in making the decision between a cash and a stock offer
Finally, how likely is it that the value of the acquiring company's shares will drop before closing?
The answer to that question should guide the decision between a fixed- value and a fixed-share offer

9. The Case of Undervalued Shares
If the acquirer believes that the market is undervaluing its shares, then it should not issue new shares.
Research consistently shows that the market takes the issuance of stock by a company as a sign that the company‘s managers believe the stock to be overvalued.
Thus, when management chooses to use stock to finance an acquisition, there‘s plenty of reason to expect that company‘s stock to fall.

10. Gauging the Risks Involved
The decision to use stock or cash also 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 be expected to pay for the acquisition with cash so that its shareholders would not have to give any of the anticipated merger gains to the acquired company's shareholders.
But if managers believe the risk of not achieving the required level of synergy is substantial, they can be expected to try to hedge their bets by offering stock.

11. By diluting their company‘s ownership interest, they will also limit participation in any losses incurred either before or after the deal goes through.
Once again, though, the market is well able to draw its own conclusions.
Indeed, empirical research consistently finds that the market reacts significantly more favorably to announcements of cash deals than to announcements of stock deals.

12. Stock offers, then, send two powerful signals to the market
That the acquirer‘s shares are overvalued
That its management lacks confidence in the acquisition
A company that is confident about integrating an acquisition successfully, and that believes its own shares to be undervalued, should always proceed with a cash offer.
A cash offer neatly resolves the valuation problem for acquirers that believe they are undervalued as well as for sellers uncertain of the acquiring company‘s true value.

13. But it‘s not always so straightforward.
Quite often, for example, a company does not have sufficient cash resources- or debt capacity- to make a cash offer.
In that case, the decision is much less clear-cut, and the board must judge whether the additional costs associated with issuing undervalued shares still justify the acquisition.

14. A board that has determined to proceed with a share offer still has to decide how to structure it.
That decision depends on an assessment of the risk that the price of the acquiring company‘s shares will drop between the announcement of the deal and its closing.
Research has shown that the market responds more favorably when acquirers demonstrate their confidence in the value of their own shares through their willingness to bear more pre- closing market risk.

15. A fixed-share offer is not a confident signal since the seller‘s compensation drops if the value of the acquirer‘s shares falls.
Therefore, the fixed-share approach should be adopted only if the pre-closing market risk is relatively low.
That‘s more likely (although not necessarily) the case when the acquiring and selling companies are in the same or closely related industries .
Common 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.

16. But there are ways for an acquiring company to structure a fixed-share offer without sending signals to the market that its stock is overvalued.
The acquirer, for example, can protect the seller against a fall in the acquirer‘s 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 floor not only reduces pre-closing market risk for sellers but also diminishes the probability that the seller‘s board will back out of the deal or that its shareholders will not approve the transaction.

17. 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 entire cost of any decline in their share price before closing.
If the market believes in the merits of the offer, then the acquirer‘s price may even rise, enabling it to issue fewer shares to the seller‘s stockholders.

18. As with fixed-share offers, floors and ceilings can be attached to fixed-value offers.
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 price rise appreciably.