Cash and Non-Cash Considerations in Mergers and Acquisitions
In a recent post, 10 M&A Considerations, we covered off 10 of the most common considerations you will encounter during the M&A process. This post focuses on the payment, Cash and Non-cash considerations. Non-cash considerations are not unusual; in fact, they are fairly normal. It is rare for a seller to receive 100% cash for their business, so if you are waiting for a bag of cash, you might be waiting some time. Seller beware, in general, an acquirer tends to offer equity when they believe their equity is overvalued and cash when the equity is perceived as undervalued. So if a bag of cash turns up, inquire about an equity offer. The most common non-cash considerations for financing an M&A transaction include stock payments, escrow amounts, an earnout, an equity hold and a seller’s note. We will discuss each of these in more detail.
Cash – as good as it sounds?
For the sake of this blog, we will term cash as cash. A cash transfer is the most liquid, least risky (for the target) payment method that exists. However, this type of payment is rare. The reason cash payments are rare is that the risks, for the acquirer, associated with a cash payment form are high. The risks are associated with the fact that contingency payments are often excluded in pure cash payments and thus the financial modeling and valuation need to be very accurate. A cash payment is normally coupled with an earnout consideration, with cash payments coming in once milestones are reached. We cover earnout considerations separately, as they are a non-cash consideration. If you have been offered cash, spend considerable time considering the offer. Look at the acquirer, are they going places? Would WhatsApp have preferred a cash payment or Facebook stock…stock for sure? You also need to keep in mind that for large, listed entities, their stock is as good as cash due to its liquidity.
Non-cash – a buffet of options
Stock
A payment of the acquiring company’s equity, issued to the stockholders of the target, at a determined ratio relative to the target’s value. The issuance of equity may improve the acquirer’s debt rating thereby reducing future cost of debt financings. There are transaction costs and risks in terms of a stockholders meeting (potential rejection of the deal), registration (if the acquirer is public), brokerage fees, etc. That said, the issuance of equity will generally provide more flexible deal structures. Here are a few questions you should ask about stock:
- Public vs private? Publically traded companies are valued by the local market. However, if possible, ask for the local sell side ratings and valuations. The stock in question may be currently under/overvalued by the market. Determining the value of the private stock is more difficult. In this case, you should ask for analysis completed by an independent analyst and get your team to check the assumptions.
- The future path of the acquirer? You are becoming an owner of acquirers business. You should, therefore, approach you decision like you would if you were buying their company. You don’t want to exchange your little star, for a large dog. You should be confident in the management team, the company’s service/product and the future market opportunities.
- How hard is it to turn the stock into cash? If the company is public, there are generally restrictions. These will be market dependent, so check with experts. A common misconception is that publicly listed companies are liquid; this is not always the case. Find out how many shares are traded per year. This will give you a gauge on how liquid it is. Private stock will be hard to exchange for cash. Ask management about a potential IPO or acquisitions in the pipeline. Ask the management what their exit strategy is…they always have one.
Escrow
The purpose of an escrow consideration is to provide recourse for an acquirer in the event there are breaches of the representations and warranties made by the target. We discussed representations and warranties in our blog 10 M&A Considerations. Escrows are standard practice in M&A, but the terms can vary considerably. Typical terms include an escrow dollar amount in the range of 10%-20% of the overall purchase price. This will be generally held by the acquirer. Escrow periods are deal dependent, and things like future sales projections will have a massive impact. In general, the period will range from 1-3 years.
Earnout
Earnout provisions are less common than escrow payments and often used to bridge a valuation gap between the target and the acquirer. Earnout provisions are classically bound to future earnings targets, and generally very strict. Be careful, sales often come slower than expected, and you can get burnt if the earnout provisions are not worded correctly. The acquirer may seem like a friend before the transaction, but they will try avoiding payment if possible. For this reason, make sure the milestones are as objective as possible. Remember, if you are the target, post-deal you lose control over the company and therefore the decisions made.
Equity hold
An equity hold period is the time frame in which the acquirer has to hold on to targets stock post-deal. This is common when a PE firm acquires your company. Equity hold periods typical for a buyout investment range from five to seven years. During the hold period, the PE firm aims to turn a large profit for investors by increasing the recently acquired company. PE firms prefer shorter hold times. Aging investments are less desirable as they lower the rate of return due to discounts on the cash flow. In addition, holding investments past the target period makes it harder to raise new funds as a result of fewer investments exiting the market. Generally, companies valued in the millions of dollars have an average holding period of five to six years, while those valued in the billions have a holding period of seven years or more. Why is this relevant to you? If you are getting paid in stock, of the PE firm, you need to understand their plan with your company.
Seller’s note
A seller’s note is taken back financing used to typically bridge the gap between the purchase price and the financeable asset base of the target company. When companies do not have sufficient assets to securitize senior debt, buyers often provide the seller with a note bearing a set interest and terms of repayment. This strategy essentially results in having the seller self-finance all or part of the transaction. Seller notes are usually unsecured or subordinated to senior debt, which makes the debt riskier and requires a higher interest rate. Some sophisticated buyers will promote seller notes as having a better interest rate than the on-going market rate for similar maturities. However, a seller holding the note must ensure the interest rate is sufficient to make up for the company’s risk profile and its potential inability to generate free cash flow to service and pay off the debt. A seller is better off requiring a set principal repayment schedule which, if not met, would allow the debt to convert to equity through the exercise of an equity kicker.
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