Deal Design and Risk Management – Part I

The deal design process is fundamentally about meeting as many objectives of the parties involved as required to reach overall agreement and determining a risk sharing mechanism.

The buyers may want to pay only reasonable price, use stock in stead of cash, sign non-compete agreement, retain key employees or make a certain percentage of the purchase price contingent on realizing some future events to minimize risk. For example, seller may claim an aggressive growth rate of the business. In this case the buyer may want to hold a certain percentage of payment till the claimed growth is realized.  Seller may be interested in fetching maximum price, tax advantages, rights to license patents or other assets or future reputation of the business.

Whether acquirer would assume all, some or none of the liabilities, disclosed or otherwise, of the target is about sharing of risk. This process can become fairly complex in a large transaction involving a number of parties, payment modes and source of financing.

Form of Payment for an M&A deal

Payment for an M&A deal can exclusively be in cash or shares or a combination of both cash and shares. On an average, cash accounted for 45%, stock for 30% and cash-stock combination for 25% of the total transaction between 1980 and 2006 in USA.

What mode of payment is selected is judged on risk involved and each mode sends different signals to the world outside. A cash payment requires lots of free cash or a strong balance sheet of target or acquirer that could be used to raise capital to finance the deal. The cash can be generated by raising debt or equity or selling some of the assets.

There is usually a negative market reaction to stock purchase resulting in fall in stock price. An acquirer usually pays a premium in an acquisition in anticipation of realizing synergy post-acquisition. If an acquirer is confident of realizing the synergy, he would prefer paying in cash and thus avoid dilution of ownership and reduction of earning per share (if number of shares increases, earning per share will go down) by issuing shares in a stock purchase. Hence cash purchase indicates confidence of the acquirer in the deal.  An acquiring firm with high growth opportunities would prefer using stock for acquisition otherwise it would have to raise debt to finance a cash deal that would limit its flexibility in use of funds.

However, cash transaction has tax implication for seller and hence he may not favor it. Additionally, a seller may have emotional affinity to the business and he may not be ready to cede all control and go away with a pile of cash. So he may ask for a stock deal to retain at least some of the ownership. Some sellers may be concerned about growth prospect of the buyer’s shares, high risk due to historical volatility of the buyer’s share or illiquidity of buyer’s share due to small size of resale market.

Both buyers and sellers may find convertible preferred stock or debt as an attractive option.  A convertible stock offers a seller downside protection by continuing dividends and upside potential if the share price goes up. It also offers benefit of tax deductibility of interest payment to the buyer. However, a seller may perceive debt instruments as less attractive because of high default risk of buyer.

Since a share deal results in fall in share price, an acquirer may 1^st buyback some of the share from the market that would soar the share price. And then he may go for a share deal. This would cancel out the negative reaction associated with a share deal. Typically both buyback and acquisition announcements are made at the same time. Those shareholders who would want to exit would leave at that stage. But in India, an acquirer can’t buyback 1^st and then issue shares within next 24 months. Usually buyback happens when a company has surplus cash whereas share is issued to raise capital. As per Indian law, a company should plan its capex for the next 2 years and then, if still has surplus cash, go for buyback. Buyback followed by issuing shares shows poor financial management of the company. If a company needs capital within 24 months of buyback it can always go for borrowing. So in this sense this rule is good. However, there is no such restriction in USA or UK and hence companies there are allowed to effectively trade in its own shares.