Cash vs Stock Acquisition

When a company plans an acquisition, executives face a critical decision: how to acquire the seller. Should they use cash, stock, or a combination of both? If an acquisition is made entirely with cash, it’s called an all-cash deal. Conversely, if the acquirer offers only its own shares instead of cash, it’s known as an all-stock deal. This blog delves into the various factors that influence the final capital structure of an acquisition.

Why Is Determining the Right Capital Structure for Acquisition a Challenge?

Before exploring the strategic considerations in choosing the appropriate payment methods, it’s essential to understand two key factors that influence the choice between cash and stock: dilution in stock for the acquirer’s existing shareholders and the cost of using cash for acquisition.

Impacts of Using Shares

Dilution in Earnings Per Share (EPS)

When a company makes an acquisition, the deal is considered EPS-accretive if the combined entity’s EPS is higher than the acquirer’s standalone EPS. Conversely, it’s EPS-dilutive if the combined EPS is lower. In an all-stock deal, assuming no transaction costs, whether the deal is accretive or dilutive largely depends on whether the acquirer is buying a company with a higher or lower P/E ratio compared to itself. If the acquirer buys a company with a higher P/E ratio than its own, the deal typically becomes EPS-dilutive. On the other hand, if the target company has a lower P/E ratio than the acquirer, the deal is likely EPS-accretive.

For instance, as seen in the example below – acquiring a higher P/E company, the EPS typically decreases. If the market doesn’t re-rate the combined entity’s P/E ratio soon after the acquisition, the overall valuation could drop in line with the EPS reduction. This decline can negatively impact investor sentiment.

Dilution in Shareholding

Dilution occurs when an acquisition is financed by issuing new shares. For example, if an acquirer has 500 outstanding shares and requires the issuance of 200 shares to acquire a target company, the existing shareholders’ ownership percentage drops from 100% to 71.4%.

This reduction, known as dilution, might not be acceptable to key shareholders, especially if it affects their board seats or influence. For example, if a major shareholder originally held a controlling stake but is diluted below a critical threshold (such as 75%), they may lose the ability to unilaterally make special resolutions or exert significant influence over key decisions. This loss of influence can dramatically decrease the strategic value of their holding.

Dividend Cost

Dividends represent a long-term expense associated with issuing shares. Empirical evidence shows that investors generally react negatively to a decrease in dividends per share, so companies tend to only increase dividends over time. When a company uses stock to finance an acquisition, it commits to paying dividends on those additional shares. This commitment adds an extra cost that could otherwise be reinvested back into the company to support capital expenditures or other growth initiatives.

Although dividend payments do not appear directly on the profit and loss statement, they do reduce the company’s cash, cash equivalents, and other short-term investments. In effect, paying dividends diminishes the financial resources available for reinvestment, impacting the company’s capacity to fund future projects.

Cost of Cash

Often, an announcement of an all-cash transaction means the seller will receive cash for their shares, but that cash is typically financed by debt rather than coming entirely from existing cash reserves. Companies rarely hold large amounts of cash solely for acquisitions. Instead, the cash on hand is reserved for critical purposes, such as maintaining a Debt Service Reserve Account (DSRA), funding working capital, or managing financial risk. Using a large portion of cash for an acquisition can limit resources available for these essential functions. Raising debt introduces fixed costs and can be challenging if the company faces leverage limits or has commitments to reduce debt.

This balance between using cash reserves, issuing debt and issuing shares for an acquisition, while aiming for sustainable growth and financial stability, is a key factor in deciding how to structure an acquisition.

Balancing these financial challenges is crucial, but the decision between cash and stock also hinges on several strategic factors that influence the overall success of the acquisition.

• Synergy realization
• Size of the transaction
• Market cycle – bullish or bearish
• Whether the acquirer is listed on a stock exchange
• Taxation

Synergy Realization

Before planning to acquire a seller, the acquirer assesses the potential synergies and builds expectations around their realization. For example, an oil mining company might want to acquire an oil marketing company valued at $5bn which offers a potential cost synergies with present value of $1.2bn. Let’s say the acquirer allocates $200mm for the acquisition premium, which will be distributed to the seller’s shareholders at the acquisition, bringing the total acquisition cost to $5.2bn.

After the merger, there’s potential to capture about $1bn in synergies. If the deal is financed with cash, the acquirer’s shareholders would retain all of that upside. On the other hand, if the acquisition is made using stock, the benefits from realizing these synergies would be shared between the acquirer’s and seller’s shareholders in proportion to their ownership stakes in the combined company. Let’s understand, how this decision would be made.

When There is a High Synergy Potential

If the acquirer is confident in achieving the expected synergies, they may choose an all-cash deal to avoid sharing future profits with the seller’s shareholders. In this scenario, if $1bn in synergies is realized, 100% of it benefits the acquirer’s shareholders. This maximizes the return on the acquisition by fully capturing the anticipated efficiencies and cost savings that accrue to the acquirer’s shareholders.

When There is an Uncertainty for Synergy Realization

If the acquirer believes the acquisition is risky, they might prefer involving the seller by offering stock. This way, both the acquirer and seller share the risks and rewards. For instance, in a deal where acquirer shareholders hold 83.3% and seller shareholders hold 16.7% post-merger, any value from synergies or losses is shared proportionately. This reduces the financial burden on the acquirer if synergies do not materialize as expected, as the seller shareholders also have a stake in the outcome.

Size of the Transaction

The size of the transaction plays a crucial role in deciding between cash and stock. One effective way to gauge the size of a transaction is by examining its impact on the debt/EBITDA ratio, assuming the deal is funded via debt.

For example, consider two scenarios where a company acquires another firm using debt:

Large Transactions (Scenario A)

In a large acquisition, the required debt significantly increases the debt/EBITDA ratio, rising from 2.00x to about 2.71x. Because of this substantial impact on financial leverage, companies often prefer to use stock or a combination of cash and stock. This approach helps mitigate the burden of additional debt and preserves cash for other uses.

Smaller Transactions (Scenario B)

In a smaller acquisition, the impact on the debt/EBITDA ratio is more moderate, rising from 2.00x to around 2.08x in our example. Such transactions don’t strain the company’s financial leverage as much, making the choice between cash and stock less critical. In these cases, either financing method can be more flexibly considered based on other strategic factors.

Market Cycle – Bullish or Bearish

The current market cycle, whether bullish or bearish, significantly influences how a company structures its capital when acquiring another business.

Bullish Market

In a rising (bullish) market, companies often prefer to use their own shares as currency for acquisitions. This is because their stock valuations are high, making it cost-effective to issue shares instead of using cash. If the acquiring company believes its shares are overvalued, opting for an all-stock deal becomes even more sensible. A prime example of this is the 2000 merger between AOL and Time Warner, one of the largest mergers of its time. AOL proposed creating a new entity through an all-stock deal, offering AOL shareholders 1 share and Time Warner shareholders 1.5 shares of the new company. Although it was marketed as a “merger of equals,” AOL was actually the dominant party, with its stock being more valuable and its leadership in the internet sector. The combined entity was valued at $350bn, and the initial share price of AOL-Time Warner was around $152 per share in January 2001, reflecting the high market optimism during the dot-com boom. However, by the end of 2002, the stock had plummeted to between $10 and $15 per share. This dramatic decline highlighted the challenges the merged company faced in integrating its diverse operations and the initial overvaluation during the peak of the merger.

Bearish Market

In a declining (bearish) market, companies typically prefer to use cash for acquisitions, especially if their own stock is trading below its fair value. From the seller’s perspective, cash transactions are also more attractive in a bearish market because they are simpler and more straightforward. Additionally, when the sentiments of equity markets are negative, sellers are more likely to favor cash deals to avoid the uncertainty and potential drop in acquirer’s share price.

Additionally, debt markets also play a critical role. Rising interest rates and tighter credit conditions can make financing more expensive and less accessible. These factors often contribute to a slowdown in M&A activity, as companies find it more challenging to secure affordable debt or choose to preserve cash for strategic flexibility. The recent downturn in M&A in 2023 and 2024 was partly due to such issues in the debt markets, where increasing borrowing costs made large transactions more difficult to finance.

Acquirer Not Listed on a Stock Exchange

When the acquiring company isn’t publicly traded, it can be challenging to persuade the seller’s board to accept the acquirer’s shares as part of the deal. This is mainly because the acquirer’s stock lacks liquidity. Low liquidity also complicates price discovery, further discouraging the use of equity in the transaction. As a result, cash becomes the preferred method for acquisitions in these situations. A notable example from 2024 is when Mars, a privately held company, acquired Kellanova for $35.9bn entirely in cash. If Mars had instead offered its own shares, Kellanova’s shareholders would have struggled to assess their true value, since there’s no open market to easily price unlisted Mars stock.

Taxation

All-Cash Deals

• For the Acquirer: When a deal is financed with debt, interest expenses directly affect the combined company’s income statement. Interest payments lower taxable income, which reduces tax liability, but they also decrease overall earnings.
• For the seller: In transactions paid entirely with cash, selling shareholders must pay capital gains tax on the proceeds they receive. This means they incur an immediate tax liability based on the profit from their investment.

All-Stock Deals

• For the acquirer: Issuing new stock as payment generally doesn’t trigger immediate tax consequences for the acquiring company.
• For the seller: When the acquisition is made with stock, selling shareholders do not face any immediate tax obligations, even if they receive a premium over their company’s current share price. This deferral of taxes can make stock deals more appealing to sellers, as they can choose to manage their tax liabilities at a later date.

Disclaimer: Tax implications vary by country and can change rapidly.

Strategic vs. Financial Acquirers in M&A

The choice between cash and stock consideration primarily applies to strategic acquirers, not financial acquirers.

Strategic Acquirers

These are companies within the same industry looking to grow through vertical or horizontal integration. For example, in June 2024, Home Depot acquired SRS for enterprise value of about $18.25bn in an all-cash deal, which required raising ~$12.5bn in acquisition debt. SRS is a leading residential specialty trade distribution company that serves professionals like roofers, landscapers, and pool contractors. This acquisition allowed Home Depot to expand its addressable market by an additional $50bn, strengthening its market position and broadening its service offerings.

Financial Acquirers

These include private equity firms and investment holding companies, which use mainly cash for acquisitions, often financing deals by leveraging the target company’s balance sheet. However, it’s common for such firms to use shares in specific situations, such as management rollovers, where existing management retains a stake in the business post-acquisition. For example, in May 2023, Apollo Global acquired MGM Resorts International in a roughly $17bn cash deal. This transaction involved significant debt financing, a common approach in leveraged buyouts (LBOs), to maximize returns on equity. The steady cash flows from MGM Resorts’ operations were sufficient to support the debt taken on for the acquisition.

Fixed Shares vs. Fixed Value

When structuring an acquisition, companies can choose between fixed shares or fixed value arrangements. Each approach has its own implications for both the acquirer and the seller.

Fixed Shares

In a fixed shares deal, the number of shares that will be issued to the seller’s shareholders is set at the time of the announcement. This is typically expressed as an exchange ratio in the deal details. For example, in February 2024, Capital One announced a $35bn acquisition of Discover. Discover shareholders were to receive 1.0192 Capital One shares for each Discover share they owned. While the exchange ratio was fixed, the actual value Discover shareholders received depended on Capital One’s stock price at the time of the transaction completion. This means that if Capital One’s share price fluctuated after the announcement, the final value for Discover shareholders could increase or decrease. As a result, the fixed exchange ratio structure adds to seller risk because they are exposed to potential changes in the acquirer’s stock price.

It’s worth noting that a cash deal is inherently a fixed value structure, as the seller knows exactly how much they’ll receive. This certainty aligns with seller preferences, making cash deals attractive, especially in cases where sellers want to avoid any post-deal completion fluctuations in value. Acquirer financing choices are often influenced by these seller preferences for stability and predictability.

Fixed Value

Alternatively, in a fixed value deal, the value of the shares offered to the selling shareholders is predetermined, rather than the number of shares. For example, suppose an acquirer announces that it will offer $100 worth of its own shares for each share of the seller. This guarantees that the sellers receive a specific monetary value worth shares, regardless of any changes in the acquirer’s stock price after the announcement. Hence, fixed value structure adds to acquirer risk.

It’s worth noting that a cash deal is inherently a fixed value structure, as the seller knows exactly how much they’ll receive. This certainty aligns with seller preferences, making cash deals attractive, especially in cases where sellers want to avoid any post-deal completion fluctuations in value. Acquirer financing choices are often influenced by these seller preferences for stability and predictability.

Conclusion

Choosing between cash and stock in acquisitions is a complex decision influenced by financial factors like dilution and the cost of cash, as well as strategic elements such as synergy realization, transaction size, market cycle, whether the acquirer is publicly listed, and tax implications. Strategic acquirers often balance these factors using a mix of cash and stock to drive growth, while financial acquirers typically leverage cash and debt to maximize returns. By carefully evaluating these dimensions, companies can structure acquisitions that align with their long-term goals and enhance value for all stakeholders involved.

Additional Resources

Investment Banking Courses

M&A Explained

Merger Structures

Valuing Synergies

Stages of the Economic Cycle

Business Cycles

Leveraged Buyout