By Owen D. Kurtin
Last month, we discussed the dynamics underlying an acquirer's offer of cash versus stock for a merger and acquisition target in the context of December's announcement that SES Global agreed to acquire New Skies Satellites Holdings. That the SES Global deal, like the previously announced Intelsat acquisition of Panamsat, used cash and not stock as acquisition currency highlights some of the issues facing acquirers in deciding how to structure a proposed transaction.
If an acquirer has ready cash sufficient to finance its acquisition, the transaction is almost by definition not a "merger of equals." As detailed last month, in a "merger of equals" scenario, the use of a "fixed exchange" ratio, rather than a "fixed value," is most common, making both parties share the risk of share price movement and therefore the ultimate acquisition price. An acquirer able to offer cash would, if opting to use stock as acquisition currency instead, probably use a "fixed value" measure, with an exchange ratio that floats and an acquisition price that stays the same.
Tax considerations can drive the decision to use cash or stock. The U.S. Internal Revenue Code provides several means for structuring "tax-free" business combinations. The term "tax-free" is a misnomer; the methods provided are generally based on stock exchanges and, when properly followed, allow the seller to avoid treating the acquisition consideration as income. However, tax is generally assessable when the acquirer stock received by the seller is eventually sold.
Another consideration is whether the acquirer believes that the market is undervaluing, overvaluing or fairly pricing its own stock. The issuance of new stock to finance an acquisition is generally interpreted by the market as an indication that the acquirer believes its shares are overvalued, in other words, inflated or cheap currency, often leading to a drop in stock price. However, if the company believes the market is undervaluing its shares, then issuance of new stock is likely to penalize existing acquirer shareholders.
Yet another issue is the "credit card" effect. Often, even in significant transactions structured by disciplined managers and expert professional advisors, paying with stock instead of cash somehow does not feel like paying with real money. In both cases, of course, it is, and the bill comes later. One way is that companies paying in stock and their targets often unconsciously or tacitly collude in an inflated purchase price. The seller wants a risk and liquidity premium for accepting stock as payment; the acquirer feels able to pay more than it would in cash. If the acquirer believes rightly that the market is undervaluing its stock, when the stock value adjusts upward, the effective purchase price goes up.
As we noted last month, an acquirer paying cash accepts all the pre-closing market risk that the target's stock value will not fall before closing. A stock deal apportions the pre-closing market risk between acquirer and target and effectively hedges the acquirer against that risk. Therefore, a cash offer sends a confident signal to the market that the acquirer believes the pre-closing market risk is low; a stock offer signals some lack of confidence.
Acquirers generally expect that their share value will rise as a result of the deal because the merged companies will be more profitable than each combined was before the deal, whether owing to realization of synergies, increased market share, solidified vertical or horizontal relationships or for other reasons. A market perception that stock offers indicate an acquirer lack of confidence in its own stock valuation and the logic of the transaction itself can have real ramifications, and can be reduced in several ways. A fixed value offer clearly sends a more confident signal than does a fixed exchange offer. The use of price protection provisions in the transaction such as floors, ceilings and collars that effectively guarantee a price range are another technique. A "cash election" merger structure, in which the target shareholders can choose prior to closing to sell their shares for acquirer's stock, for cash or for a combination of the two, also sends a more confident signal.
Often, sending the right signals to the market at the outset sets the tone for the subsequent success of the deal and the twenty-twenty hindsight that follows. Of course, that is the easy part; the actual integration of merged company operations is where the rubber really meets the road.
Owen D. Kurtin is a partner in the New York office of law firm Brown Raysman Millstein Felder & Steiner LLP and a member of the firm's Technology, Media & Communications and Corporate Departments. He may be reached at +1.212.895.2000 or by e-mail at okurtin @brownraysman.com.