When companies look toward inorganic growth in the form of mergers and acquisitions, the frequent questions that arise throughout this process revolve around consideration. Consideration is how sellers get paid and buyers pay. The ways in which a business seller can be compensated in a merger or acquisition are fairly extensive and the structure of each deal can get as complex as the dealmakers desire. The structure of each deal typically includes cash, company stock, a payable note or some combination of the three. From the buyer’s side, the cash may be sourced from either debt or equity.
Cash, Stock & Notes
Whether a buyer uses cash, company stock or a note can be dependent on a number of factors. Does the buyer have enough cash on hand to provide the cash consideration desired by the seller? If not, how will the buyer source the cash to complete the deal? Debt? Equity? If a note is given, what are the terms? How much of the consideration will be provided in the note? What is the interest rate of the note–if any? And, will the note be tied to performance of the business post-close (like in the form of an earn-out)?
If stock is used as consideration in the transaction, will the seller be receiving public or private stock? What are the benefits and risks of either and how will this impact valuation and the deal in general?
Private Stock vs. Public Stock
Private stock is almost completely illiquid. It represents a form of consideration that may never be realized. Public stock, on the other hand, is completely liquid. It can be bought and sold on the open market. Even if the company trades over the counter, the liquidity is much more sure than any private business, regardless of how well the company has been funded by venture capitalists or private equity groups.
People will pay for more liquidity. It’s why we get paid a discount by pre-paying, paying up-front or on-time. It’s essentially the inverse of paying interest. The Liquidity Preference Theory first developed by John Maynard Keynes applies here. In over-simplified terms, the theory illustrates peoples’ leaning toward the more liquid option of two alternatives.
A good example might be the seller who’s given two offers of identical value on a business s/he is trying to sell. One offer includes 30% consideration in cash, 70% in private stock while the other, competing offer includes a deal for 10% cash and 90% in public stock. Even if the private company has a great story and huge potential to eventually do well in an IPO, the liquidity preference theory would likely trump the private stock offer. The exceptions here may include the seller who may already be personally financially secure and may be willing to take a bet on a growing private company. In reality, however, the chances that a seller will chose the less liquid private stock option as consideration for selling the company are slim indeed.
Buyers: Doing Deals & Preserving Cash
Companies and people are almost always constrained by limited resources that can thwart more rapid growth. Taking a company public and using that company’s stock in doing deals can be an excellent source of consideration for the firm looking to perform an industry roll-up via strategic M&A. Going on a buying spree using the company’s public stock can help the business grow its top-line metrics, allow an industry to reap some of the advantages of scale and ultimately move a small, public company into a position of market dominance in a heretofore dispersed and fragmented niche market.
Such a strategy is not for the inexperienced or faint of heart, but it has been the means of creating great wealth for those with the ability and foresight to see untapped opportunities in highly-fragmented industries.
Sellers: Liquidating Public Stock Post-Deal
If, as part of your consideration in selling a company you receive public stock, there may be some guidelines you’ll be required to follow, depending on the amount of stock you were given. If you received an excess of 5% of the total acquiring company’s stock, then you’re considered an “insider.” In that case, you’ll need to work with your transfer agent and broker-dealer to ensure you sell your stock at a pace that meets the requirements laid-down by the SEC. Newly minted insiders cannot dump stock immediately after its receipt in a strategic M&A deal. Doing so can cause irreparable damage to the business and its other existing shareholders.
Another note to insider sellers: it is likely wise to hedge your position in the acquiring company once you take your equity stake. If you’re an insider with >5% equity and you cannot diversify your hefty position in the public company immediately, you can mitigate your immediate exposure to the lack of diversification risk in the public company by purchasing puts and calls on the public stock. Mark Cuban did this when he sold Broadcast.com to Yahoo! in 1999 for $5.7 billion. He did it at the right time too, just before the internet stock bubble burst about a year later. Luckly, Cuban had already locked-in the value of Yahoo’s paper profits. Lack of diversification in public stock is another issue that we’ll not get into completely here, but it’s worth a note as failing to do so could provide major losses to the over-exposed.
Using stock as consideration for completing strategic M&A deals certainly has its risks, but the upside potential to the sophisticated acquirer using public stock as consideration can be huge. Let’s discuss how we can get you there.