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Stock options during acquisition

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stock options during acquisition

Companies are increasingly paying for acquisitions with stock rather than cash. But both they and the companies they acquire need to understand just how big a difference that decision can make to the value shareholders will get from a deal. In alone, 12, deals involving U. But the numbers should be no surprise. After all, acquisitions remain the quickest route companies have to new markets and to new capabilities. As markets globalize, and the pace at which technologies change continues to accelerate, more and more companies are finding mergers during acquisitions to be a compelling strategy for growth. But just ten years later, the profile is almost reversed: This shift has profound ramifications for the shareholders of both acquiring and acquired companies. In a cash deal, the roles of the two parties are clear-cut, and the exchange of money for shares completes a simple transfer of ownership. But in an exchange of shares, it becomes far less stock who is the buyer and who is the seller. In some cases, the shareholders of the acquired company can end up owning most of the company that bought their shares. Companies that pay for their acquisitions with stock share both the value and the risks of the transaction with the shareholders of the company they acquire. The decision to use stock instead of cash can also affect shareholder returns. In studies covering more than 1, major deals, researchers have consistently found that, during the time of announcement, shareholders of acquiring companies fare worse in stock transactions than they do in cash transactions. Despite their obvious importance, these issues are often given short shrift in corporate board-rooms and the pages of the financial press. Both during and journalists tend to focus mostly on the prices paid for acquisitions. Price is certainly an important issue confronting both during of shareholders. But when companies are considering making—or accepting—an offer for an exchange of shares, the valuation of the company in play becomes just one of several factors that managers and investors need to consider. In this article, we provide a framework to guide the boards of both the acquiring and the selling companies through their decision-making process, and we offer two simple tools to help managers quantify the risks involved to their shareholders in offering or accepting stock. The main distinction between cash and stock transactions is this: In cash transactions, acquiring shareholders take on the entire risk that the expected synergy value embedded in the acquisition premium will not materialize. In stock transactions, that risk is shared with selling shareholders. More precisely, in stock transactions, the synergy risk is shared in proportion to the percentage of the combined company the acquiring and selling shareholders each will own. Suppose that Buyer Inc. The market capitalization of Buyer Inc. The managers of Buyer Inc. They announce an offer to buy all the shares of Seller Inc. The value placed on Seller Inc. The expected net gain to the acquirer from an acquisition—we call it the shareholder value added SVA —is the difference between the estimated value of the synergies obtained through the acquisition and the acquisition premium. So if Buyer Inc. But if Buyer Inc. The new offer places the same value on Seller Inc. They will own only The rest goes to Seller Inc. The only way that Buyer Inc. In other words, the new shares would reflect the value that Buyer Inc. But while that kind of deal sounds fair in principle, in practice Seller Inc. In light of the disappointing track record of acquirers, this is a difficult sell at best. One thing about mergers and acquisitions has not changed since the s. In most cases, that drop is just a precursor of worse to come. And the larger the premium, the worse the share-price performance. But why is the market so skeptical? Why do acquiring companies have such a difficult time creating value for their shareholders? First of all, many acquisitions fail simply because they set too high a performance bar. Even without the acquisition premium, performance improvements have already been built into the prices of both the acquirer and the seller. The rest is based entirely on expected improvements to current performance. In other cases, acquisitions turn sour because the benefits they bring are easily replicated by competitors. Competitors will not stand idly by while an acquirer attempts to generate synergies at their expense. Arguably, acquisitions that do not confer a sustainable competitive advantage should not command any premium at all. Acquisitions also create an opportunity for competitors to poach talent while organizational uncertainty is high. Take Deutsche Bank, for example. After it acquired Bankers Trust, Deutsche Bank had to pay huge sums to retain top-performing people in both organizations. A third cause of problems is the fact that acquisitions—although a quick route to growth—require full payment up front. By contrast, investments in research and development, capacity expansion, or marketing campaigns can be made in stages over time. Thus in acquisitions, the financial clock starts ticking on the entire investment right from the beginning. Not unreasonably, investors want to see compelling evidence that timely performance gains will materialize. Thus the price paid may have little to do with achievable value. Finally, if a merger does go wrong, it is difficult and extremely expensive to unwind. Managers whose credibility is at stake in an acquisition may compound the value destroyed by throwing good money after bad in the hope that more time and money will prove them right. The problem, of course, is that the options of the acquired company also have to share the risks. In an all-cash deal, Buyer Inc. But in a share deal, their loss is only In many takeover situations, of course, the acquirer will be so much larger than the target that the selling shareholders will end up acquisition only a negligible proportion of the combined company. It is one of the highest profile takeover stories of the s, and it vividly illustrates the perils of being paid in paper. The Popularity of Paper Source: But there was a catch: Shareholders who had chosen to be paid entirely in stock fared even worse: Boards and shareholders must do more than simply choose between cash and stock when making—or accepting—an offer. There are two ways to structure an offer for an exchange of shares, and the choice of one approach or the other has a significant impact on the allocation of risk between the two sets of shareholders. Companies can either issue stock fixed number of shares or they can issue a fixed value of shares. But the acquisition was not without its risks. First, the Green Tree deal was more than eight times larger than the largest deal Conseco had ever completed and almost 20 times the average size of its past 20 deals. So investors started to sell Conseco shares. The other way to structure a stock deal is for the acquirer to issue a fixed value of shares. In these deals, the number of shares issued is not fixed until the closing date and depends on the prevailing price. As a result, the proportional ownership of the ongoing company is left in doubt until closing. At that share price, in a fixed-value deal, Buyer Inc. But that leaves Buyer Inc. As the illustration suggests, in a fixed-value deal, the acquiring company bears all the price risk on its shares between announcement and closing. If the stock price falls, the acquirer must issue additional shares to pay sellers their contracted fixed-dollar value. The way an acquisition is paid for determines how the risk is distributed between the buyer and the seller. An acquirer that pays entirely in cash, for example, assumes all the risk that the price of its shares will drop between the announcement of the deal and its closing. The acquirer also assumes all the operating risk after the deal closes. By contrast, an acquirer that pays the seller a fixed number of its own shares limits its risk from a drop in share price to the percentage it will own of the new, merged company. The acquirer that pays a fixed value of shares assumes the entire preclosing market risk but limits its operating risk to the percentage of its postclosing ownership in the new company. By the same token, the owners of the acquired company are better protected in a fixed-value deal. They are not exposed to any loss in value until after the deal has closed. In our example, Seller Inc. The loss in the share price is made up by granting the selling shareholders extra shares. And if, after closing, the market reassesses the acquisition and Buyer Inc. However, if Buyer Inc. Given the dramatic effects on value that the method of payment can have, boards of both acquiring and selling companies have a fiduciary responsibility to incorporate those effects into their decision-making processes. Acquiring companies must be able to explain to their stockholders why they have to share the synergy gains of the transaction with the stockholders of the acquired company. All this makes the job of the board members more complex. The management and the board of an acquisition company should address three economic questions before deciding on a method of payment. Second, what is the risk that the expected synergies needed to pay for the acquisition premium will not materialize? The answers to these questions will help guide companies in making the decision between a cash and a stock offer. The answer to that question should guide the decision between a fixed-value and a fixed-share offer. If the acquirer believes that the market is undervaluing its shares, then it should not issue new shares to finance a transaction because to do so would penalize current shareholders. If the acquirer believes the market is undervaluing its shares, it should not issue new shares to finance an acquisition. That can cause a company to pay more than it intends and in some cases to pay more than the acquisition is worth. Suppose that our hypothetical acquirer, Buyer Inc. Its managers should value the 40 million shares it plans to issue to Seller Inc. Then if Buyer Inc. Which signal is the market more likely to follow? But if managers believe the risk of not achieving the required level of synergy is substantial, they can be expected to try to hedge their bets by offering stock. Once again, though, the market is well able to draw its own conclusions. Indeed, empirical research consistently finds that the market reacts significantly more favorably to announcements of cash deals than to announcements of stock deals. Stock offers, then, send two powerful signals to the market: In principle, therefore, a company that is confident about integrating an acquisition successfully, and that believes its own shares to be undervalued, should always proceed with a cash offer. Quite often, for example, a company does not have sufficient cash resources—or debt capacity—to make a cash offer. In that case, the decision is much less clear-cut, and the board must judge whether the additional costs associated with issuing undervalued shares still justify the acquisition. A board that has determined to proceed with a share offer still has to decide how to structure it. Research has shown that the market responds more favorably when acquirers demonstrate their confidence in the value of their own shares through their willingness to bear more preclosing market risk. That leads to the logical guideline that the greater the potential impact of preclosing market risk, the more important it is for the acquirer to signal its confidence by assuming some of that risk. Therefore, the fixed-share approach should be adopted only if the preclosing market risk is relatively low. Common economic forces govern the share prices of both companies, and thus the negotiated exchange ratio is more likely to remain equitable to acquirers and sellers at closing. But there are ways for an acquiring company to structure a fixed-share offer without sending signals to the market that its stock is overvalued. Acquirers that offer such a floor typically also insist on a ceiling on the total value of shares distributed to sellers. That might have helped Bell Atlantic in its bid for TCI in —which would have been the largest deal in history at the time. An even more confident signal is given by a fixed-value offer in which sellers are assured of a stipulated market value while acquirers bear the entire cost of any decline in their share price before closing. As with fixed-share offers, floors and ceilings can be attached to fixed-value offers—in the form of the number of shares to be issued. It just has to compare the value of the company as an independent business against the price offered. The only risks are that it could hold out for a higher price or that management could create better value if the company remained independent. The latter case certainly can be hard to justify. If the bid were rejected, Seller Inc. So uncertain a return must compete against a bird in the hand. In essence, shareholders of the acquired company will be partners in the postmerger enterprise and will therefore have as much interest in realizing the synergies as the shareholders of the acquiring company. If the expected synergies do not materialize or if other disappointing information develops after closing, selling shareholders may well lose a options portion of the premium received on their shares. Essentially, then, the board must act in the role of a buyer as well as a seller and must go through the same decision process that the acquiring company follows. At the end of the day, however, no matter how a stock offer is made, selling shareholders should never assume that the announced value is the value they will realize before or after closing. Selling early may limit exposure, but that strategy carries costs because the shares of target companies almost invariably trade below the offer price during the preclosing period. Of course, shareholders who wait until after the closing date to sell their shares of the merged company have no way of knowing what those shares will be worth at that time. The questions we have discussed here—How much is the acquirer worth? How likely is it that the expected synergies will be realized? But those concerns should not play a key role in the acquisition decision. The actual impact of tax and accounting treatments on value and its distribution is not as great as it may seem. The way an acquisition is paid for affects the tax bills of the shareholders involved. On the face of it, a cash purchase of shares stock the most tax-favorable way for the acquirer to make an acquisition because it offers the opportunity to revalue assets and thereby increase the depreciation expense for tax purposes. Conversely, shareholders in the selling company will face a tax bill for capital gains if they accept cash. After all, if the selling shareholders suffer losses on their shares, or if their shares are in tax-exempt pension funds, they may favor cash rather than stock. But if sellers are to realize the deferred tax benefit, they must be long-term shareholders and consequently must assume their full share of the postclosing synergy risk. Stock managers claim that stock deals are better for earnings than cash deals. But this focus on reported earnings flies in the face during economic sense and is purely a consequence of accounting convention. In the United States, cash deals must be accounted for through the purchase-accounting method. This approach, which is widespread in the developed world, records the assets and liabilities of the acquired company at their fair market value and classifies the difference between the acquisition price and that fair value as goodwill. The goodwill must then be amortized, which causes a reduction in reported earnings after the merger is completed. This approach requires companies simply to combine their book values, creating no goodwill to be amortized. Therefore, better earnings results are reported. Although it can dramatically affect the reported earnings of the acquiring company, it does not affect operating cash flows. Goodwill amortization is a options item and should not affect value. Managers are well aware of this, but many of them contend that investors are myopically addicted to short-term earnings and cannot see through the cosmetic differences between the two accounting methods. Acquisition evidence does not support that claim, however. Studies consistently show that the market does not reward companies for using pooling-of-interests accounting. Nor do goodwill charges from purchase accounting adversely affect stock prices. In fact, the market reacts more favorably to purchase transactions than to pooling transactions. The message for management is clear: We present two simple tools for measuring synergy risk, one for the acquirer and the other for the seller. A useful tool for assessing the relative magnitude of options risk for the acquirer is a straightforward calculation we call shareholder value at risk. SVAR is simply the premium paid for the acquisition divided by the market value of the acquiring company before the announcement is made. The index can also be calculated as the premium percentage multiplied by the market value of the seller relative to the market value of the buyer. The greater the premium percentage paid to sellers and the greater their market value relative to the acquiring company, the higher the SVAR. In those cases, SVAR underestimates risk. In a cash deal, its SVAR would therefore be 1. But if Seller Inc. To calculate Buyer Inc. The question for sellers is, What percentage of the premium is at risk in a stock offer? The answer is the percentage of ownership the seller will have in the combined company. In our hypothetical deal, therefore, the premium at risk for Seller Options. Once again, the premium-at-risk calculation is actually a rather conservative measure of risk, as it assumes that the value of the independent businesses is safe and only the premium is at risk. SVAR and Premium at Risk for Major Stock Deals Announced in Data for calculations courtesy of Securities Data Company. The cash SVAR percentage is calculated as the premium percentage multiplied by the relative size of the seller to the acquirer. Since no synergy expectations are built into the price of those shares now, Seller Inc. In other words, Seller Inc. But in a fixed-share transaction, Seller Inc. Although we have taken a cautionary tone in this article, we are not advocating that companies should always avoid using stock to pay for acquisitions. We have largely focused on deals that have taken place in established industries such as hotels and insurance. Stock issues are a stock way for young companies with limited access to other forms of financing, particularly in new industries, to pay for acquisitions. In those cases, a high stock valuation can be a major advantage. Even managers of Internet companies like Amazon or Yahoo! But it is a vulnerable one, and even the managers of Internet acquisition such as America Online, Amazon. Worse, it can trigger a spiral of decline because companies whose share prices perform badly find it hard to attract and retain good people. Internet and other high-technology companies are especially vulnerable to this situation because they need to be able to offer expectations of large stock-option gains to recruit acquisition best from a scarce pool of talent. The choice between cash and stock should never be made without full and careful consideration of the potential consequences. Kellogg Graduate School of Management and author of Saving Capitalism from Short-Termism: How to Build Long-Term Value and Take Back Our Financial Future. Stern School of Business. He is the author of The Synergy Trap: How Companies Lose the Acquisition Game Free Press, Your Shopping Cart is empty. Alfred Rappaport Mark L. November—December Issue Explore the Archive. A really confident acquirer would be expected to pay for the acquisition with cash. A version of this article appeared in the November—December issue of Harvard Business Review. About Us Careers Privacy Policy Copyright Information Trademark Policy Harvard Business Publishing:. Harvard Business Publishing is an affiliate of Harvard Business School.

Why Do Stock Prices Often Drop After Mergers and Acquisition

Why Do Stock Prices Often Drop After Mergers and Acquisition stock options during acquisition

3 thoughts on “Stock options during acquisition”

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