American billionaire Alex Spanos once famously said, “Cash is king”, believing that cash was more valuable than any other form of investment tools, like stocks or bonds. However, today buyers choose stock as a form of M&A payment in about a third of transactions. In contrast, 30 years ago less than 2% of major deals were paid for entirely using stock.
So, cash vs stock acquisition — which to choose? This article compares the methods, explores the pros and cons of a stock and cash acquisition, and provides strategic considerations to take into account.
Understanding cash payments in M&A
A cash acquisition involves the acquiring company purchasing another entity entirely with cash, without issuing stock. This type of transaction provides immediate liquidity to the target company’s shareholders and simplifies the deal structure.
For example, in 2016, Microsoft acquired LinkedIn for $26.2 billion solely in cash. The deal demonstrated Microsoft’s commitment to the acquisition and its confidence in the strategic value of LinkedIn.
Here’s a short step-by-step guide on how cash acquisitions work:
- Negotiating acquisition. The acquiring company negotiates with the target company’s management to agree on a purchase price. This price is usually based on factors such as the target’s financial performance, market value, and strategic fit.
- Due diligence. Once the parties agree on a price, the acquiring company conducts due diligence to assess the target’s financial, legal, operational, and other aspects. This process helps identify potential risks or issues that could affect the transaction.
- Deal structuring. Both parties enter into formal agreements, including a purchase agreement, which outlines the terms and conditions of the acquisition. This document specifies the amount of cash to be paid per share or for the entire company. For example, in the case of the Microsoft-LinkedIn deal, the share price was $196.
- Financing. The buyer arranges financing to fund the cash payment. This financing may come from various sources, such as cash reserves, bank loans, bonds, or other forms of debt financing.
- Closing and post-deal integration. The buyer transfers the agreed-upon cash payment to the target company’s shareholders. This payment is typically made through wire transfers or checks. Then the buyer begins the process of integrating the target company into its operations.
Additional read: Want more insights on M&A? Read our articles about the difference between a merger and an acquisition and the advantages of mergers and acquisitions.
Pros of cash acquisitions
At announcement, the returns for all-cash deals beat all-stock deals by 4.7%. Moreover, 57% of cash deals receive positive market reactions as compared to only 35% of stock deals,
comment Deloitte experts in their study.
This is one of several cash transaction advantages. Here are some more:
- Certainty and speed
Cash payments provide certainty to the target’s shareholders as they receive immediate payment for their shares. This can speed up the transaction process and reduce uncertainty compared to stock-based transactions.
- Immediate liquidity
Cash transactions provide sellers with quick access to funds, making them an attractive option for those who want to sell their investments fast or need money for other projects.
- Control
By using cash, the acquiring company retains full control over its capital structure and avoids diluting shareholders’ ownership interests.
- Strategic alignment
Cash payments can demonstrate the acquiring company’s confidence and commitment to the deal.
Cons of cash acquisitions
Now let’s explore the potential drawbacks of cash transactions:
- Financing
Cash acquisitions require the buyer to have sufficient cash reserves. If it doesn’t, it may need to initiate a capital-raising process to fund the acquisition. However, financing sources often come with their own pros and cons. For example, bond offerings are a cost-effective option but require more time to complete, whereas equity offerings are faster but more expensive.
- Tax implications
When the seller receives cash, it’s considered a taxable event, meaning they have to pay taxes on any capital gains. Depending on the seller’s tax situation, this can be quite costly.
- Missed opportunities
Using cash for acquisitions may limit the acquiring company’s ability to pursue other investment opportunities or growth initiatives.
Understanding stock acquisitions in M&A transactions
A stock acquisition is a transaction in which the acquiring company purchases another entity entirely with its own stock, without using cash. In such acquisitions, the target’s shareholders receive shares of the acquirer’s stock in exchange for their shares.
This type of acquisition results in the target’s shareholders becoming shareholders of the acquiring company, thereby combining the ownership interests of both entities. An example of an all-stock deal is Microsoft’s acquisition of GitHub for $7.5 billion in stock in 2018.
The process of a stock deal is similar to cash transactions but with some differences:
- Negotiating acquisition. Companies negotiate the terms, including the exchange ratio, which determines how many shares of the acquiring company will be issued for each share of the target company.
- Due diligence. Due diligence is conducted to assess the financial, legal, and operational aspects of the target to ensure that the exchange ratio accurately reflects the value of the target company’s shares.
- Deal structuring. Both companies sign an agreement, such as a merger agreement or a stock purchase agreement, which outlines the terms and conditions of the acquisition, including the exchange ratio (details about exchange ratios are typically not disclosed to the public). These agreements must be approved by the boards and shareholders of both firms.
- Financing. The acquiring company issues its shares to the shareholders of the target company based on the agreed-upon exchange ratio.
- Closing and post-deal integration. After the transaction is completed, the integration process starts. This may involve combining business processes, systems, and cultures to realize synergies and maximize the benefits of the acquisition.
Pros of stock acquisitions
It allows buyers and sellers to participate equally in the upside or downside, as opposed to getting cashed out,
says Mike Wyatt, Morgan Stanley’s global head of technology M&A, describing one of the advantages of paying for transactions in stock.
Let’s explore some other benefits:
- Shared risk
Since part of the consideration is in the form of stock, the target company’s shareholders become stakeholders in the acquiring company, aligning their interests with the long-term success of the combined entity.
- Growth potential
Sellers may prefer receiving stock if they believe in the growth of the combined entity, which could lead to increased value for their investment over time.
- Tax deferral options
Payment in stock allows sellers to defer taxes, particularly if the deal qualifies for tax-free reorganization treatment under IRS rules. This means sellers may delay paying taxes on any gains from the sale of their shares, providing potential tax advantages compared to cash transactions.
- Cash reserves
Using stock as a form of payment preserves the cash reserves. This allows the acquiring company to retain liquidity for other strategic initiatives and investments.
Cons of stock acquisitions
Now let’s discuss the disadvantages of stock transactions:
- Valuation complexities
Valuation in stock deals can be challenging because of fluctuations in the stock price of the acquiring company. Thus, determining the fair exchange ratio and accurately assessing the value of the target company’s shares requires sophisticated financial analysis.
- Potential uncertainties
The target company’s shareholders may face uncertainty regarding the future performance of the acquiring company’s stock, which could impact the overall value they receive from the transaction. Similarly, the acquiring company may experience uncertainties related to integrating the target company’s operations into its own business.
- Dilution of ownership
Stock-based acquisitions may potentially have a negative shareholder impact. The thing is, when shares are issued to fund the acquisition, existing shareholders’ ownership percentage may decrease, resulting in a loss of control over the company.
Note: There’s also a form of compensation in which an acquirer uses a combination of cash and stock payment. It’s called a mixed offering.
A cash and stock acquisition example is the acquisition of WhatsApp by Facebook for $19 billion in 2014.
Comparing cash and stock payments
Let’s compare stock vs cash acquisition in terms of several aspects.
| Aspects | Cash payments | Stock payments |
|---|---|---|
| 1 Valuation | Typically based on the agreed-upon cash amount per share or total company value in cash. Read more about business valuation methods in our article. | Valuation is based on the exchange ratio determined between the acquiring company’s stock and the target company’s shares. |
| 2 Risk | Lower risk for the acquiring company as cash payments are predictable and don’t dilute ownership. | Higher risk due to potential stock price fluctuations, dilution of ownership, and uncertainties in future stock performance. |
| 3 Financial flexibility | The acquiring company may need to use cash reserves or raise debt for payment, impacting financial flexibility. | Potential for preserving cash reserves and maintaining financial flexibility for other investments or operations. |
| 4 Transaction costs | Typically involves lower transaction costs, as there are no expenses related to issuing or transferring stock. | May involve higher transaction costs due to legal, regulatory, and administrative expenses associated with issuing stock. |
| 5 Taxation | Cash payments result in immediate tax liabilities for both the acquiring company and the selling shareholders. | Stock payments may offer tax deferral opportunities for selling shareholders if structured appropriately. |
| 6 Regulatory approval | Generally involves simpler regulatory approval processes compared to stock transactions. | Stock transactions may require additional regulatory approvals, especially if the issuing company is publicly traded. |
So, cash acquisition vs stock acquisition — which is better? In fact, the final choice will depend on the specific circumstances and objectives of the transaction. For example, cash payments may be more appropriate for acquisitions where financial stability and immediate liquidity are important. In contrast, stock payments may better suit companies looking for long-term growth potential.
Strategic considerations in choosing payment methods
Here are key considerations to take into account when choosing between merger payment options.
1. Strategic goals
If the buyer aims to expand its market presence and make its industry position stronger, it may opt for stock payments. It’ll align the interests of the target company’s shareholders with its long-term growth objectives.
On the other hand, if the acquirer seeks to preserve its cash reserves for future investments and operations or wants to maintain control over its ownership structure, it may prefer cash.
2. Market conditions
In a bullish market environment where stock prices are rising, stock payments may be more appealing to target company shareholders, offering them the potential for future growth.
Conversely, in a bearish market or if the acquiring company’s stock is undervalued, cash payments may be preferred to provide immediate liquidity.
3. Financial health
The financial health of both companies is also a crucial factor in determining the payment method. Acquiring companies with strong cash reserves and free cash flows may prefer to offer cash payments. This is because they have the financial capacity to fund the acquisition without increasing debt.
In contrast, companies facing liquidity constraints or with limited free cash flows may choose stock payments to save cash and reduce financial pressure.
Key takeaways
Let’s summarize the comparison of stock acquisition vs cash acquisition:
- Cash acquisitions involve buying a target entity entirely with cash, providing advantages like certainty, speed, immediate liquidity, and strategic alignment. There are also potential challenges, such as immediate tax liabilities and the need for sufficient cash reserves.
- Stock acquisitions occur when the acquiring company purchases the target entirely with its stock. Pros include shared risk, growth potential, tax deferral options, and preservation of cash reserves. Potential disadvantages are valuation challenges, uncertainties, and dilution of ownership.
- Strategic considerations in choosing payment methods involve assessing strategic goals, market conditions, and financial health of the acquiring company.
