Methods of Payment and Financing Strategies in Mergers and Acquisitions Study Guide

Overview of Payment Methods in Acquisitions

• The selection of a payment method is a critical decision in M&A that influences deal structure, the probability of shareholder acceptance, and post-acquisition performance outcomes.

• Methods range from pure cash and stock exchanges to complex deferred or contingent structures.

• Key selection drivers include the acquirer's financial health, specific nature of the target assets, tax implications, and target shareholder sentiment.

Primary Methods of Payment

• Cash Payment: The bidder provides immediate liquidity to target shareholders in exchange for their shares.

• Share Exchange/Stock-for-Stock Exchange: The acquirer issues a specific number of its own shares for each share held in the target company.

• Stock and Cash (Mixed): The acquirer pays a portion of the total purchase price in cash and the remainder in their own equity.

• Cash Under-written Share Offer: In this arrangement, the target receives the bidder's shares but subsequently sells them to an underwriter (typically an investment bank) to receive cash instead of holding equity.

Alternative and Specialized Payment Structures

• Convertible Loan or Preferred Shares: Involves loan stock or preferred shares that can be converted into ordinary shares at a predetermined rate during a specific period. This provides upfront negotiation flexibility.

• Debt Payment: The acquiring firm takes on specific new debt obligations specifically to fund the acquisition costs.

• Deferred Payment: A portion of the deal consideration is withheld and paid after a certain period, often contingent on the target meeting performance benchmarks.

• Asset-Based Payment: The acquirer purchases specific assets of the target company rather than buying the entire corporate entity.

• Earnout: An additional payment amount based on the target firm's future performance.   - Limits upfront cash requirements for the bidder.   - Highly effective when target management remains involved and motivated.   - Key negotiation components include thresholds, reporting rights, defining "commercially reasonable efforts," and dispute resolution mechanisms.   - Usage increased post-pandemic; the $SRS Acquiom 2024 M\&A Deal Terms Study$ found that $33\%$ of US private target deals in $2023$ included earnout provisions.

• Debt Assumption: The acquirer assumes responsibility for the target's outstanding bonds or loans. This may offer lower financing costs than new debt and mitigates immediate credit profile impact.

• Leveraged Buyout (LBO): Acquisitions funded by significant borrowed money, using target assets as collateral.   - Usually structured with a ratio of approximately $90\%$ debt to $10\%$ equity.   - Goals include purchasing large companies with minimal capital, acquiring competitors, or privatizing public companies to improve performance.   - Spreads risk across a larger group of investors.

Historical Trends in Global Payment Methods

UK Dominant Methods (1900–2025)

• 1900–1950s (Cash): Driven by limited equity market access and a conservative financial culture.

• 1960s–1970s (Mixed): Era of conglomerate growth supported by tax incentives for stock deals.

• 1980s (Cash): Marked by the rise of LBOs, private equity expansion, and financial deregulation.

• 1990s–2000s (Stock and Mixed): Influenced by the technology boom and M&A globalization.

• 2008–2015 (Cash): Resulted from post-financial crisis conservatism and low interest rates.

• 2016–2025 (Cash and Mixed): Influenced by Brexit uncertainty and escalating private equity activity.

US Dominant Methods (1960s–2020s)

• 1960s–1970s (Stock): Primarily driven by tax advantages.

• 1980s (Cash): Defined by the rise of the LBO.

• 1990s (Stock): Propelled by the tech boom.

• 2000s–2010s (Mixed): Preference for cash grew post-2008 crisis due to conservatism and low interest rates.

• 2020s (Stock and Mixed): Response to rising interest rates.

Bidder Financial Strategy and Impact

• Gearing Ratios: Bidders must maintain reasonable ratios. High gearing makes issuing loan stock less attractive than share exchanges.

• Credit Ratings: A primary goal is to prevent credit rating downgrades. High leverage leading to financial distress can increase the cost of future debt.

• Market Timing: Bidders exploit favorable market conditions to determine when to use equity as currency.

• Cash Flow Coverage: Projected cash flows or earnings must be sufficient to cover debt interest, particularly in bank-loan-funded cash offers.

• Debt-to-Equity Limits: Firms reaching their maximum ratio may face financial distress or credit downgrades.

Analysis of Cash Payments

Advantages

• Certainty of Closing: Most reliable form of payment as it does not depend on future stock performance.

• Target Value Assurance: Provides immediate known value to target shareholders, avoiding the "lemon problem" (accepting overvalued equity).

• Tax Efficiency: Acquirers may deduct cash payments as business expenses in specific jurisdictions.

• Flexibility: Cheapest option if using cash on hand (no transaction costs). Otherwise, can fund via bank credit or seasoned equity offerings (SEO)/rights issues.

• Market Signaling: Signals bidder confidence in the deal and the target's intrinsic value.

Disadvantages

• Financial Burden: Can strain liquidity and increase debt levels.

• Long-term Effects: Potential negative impact on the bidder's stock value and credit rating.

• Immediate Tax Liability: Target shareholders are usually taxed immediately upon receipt of cash.

Leveraged Cash Financing

• Mechanism: The acquirer borrows funds via loans or bonds to finance the purchase.

• Preservation of Equity: Avoids ownership dilution for existing shareholders.

• Tax Benefits: Interest on the debt is often tax-deductible.

• Disadvantages: High interest burdens can erode profitability, and target firms may resist if they doubt the bidder's ability to service the debt.

Cash Deal Examples

• Microsoft & LinkedIn (June 2016): All-cash transaction at $\$196$ per share, valued at $\$26.2\,\text{billion}$.

• Microsoft & Activision Blizzard (January 2022): All-cash transaction at approximately $\$95$ per share, valued at $\$68.7\,\text{billion}$.

• Oracle & Cerner (June 2022): All-cash transaction at $\$95$ per share, valued at $\$28.3\,\text{billion}$.

• UnitedHealth & LHC Group (December 2022): All-cash transaction at $\$170$ per share, valued at $\$6\,\text{billion}$.

• Thomas Brava & Coupa Software (December 2022): All-cash transaction at $\$81$ per share ($77\%$ premium), valued at $\$8\,\text{billion}$.

• Advent & Maxar (December 2022): All-cash transaction at $\$53$ per share ($129\%$ premium), valued at $\$6.4\,\text{billion}$.

• Paramount & Warner Bros (December 2025): Bid of $\$30$ per share ($139\%$ premium), all-cash, valued at $\$108.4\,\text{billion}$.

• Netflix & Warner Bros (January 2026): Revised bid of $\$27.75$ per share, all-cash, valued at $\$82.7\,\text{billion}$.

Analysis of Share Exchange (Stock-for-Stock)

Advantages

• Tax Deferral: Target shareholders defer capital gains taxes until the new stock is sold.

• Alignment of Interests: Target shareholders become owners of the combined entity.

• Cash Preservation: Maintains the acquirer's balance sheet for future investments.

• Talent Retention: Equity provides incentives for key target personnel to stay post-acquisition.

• Market Capitalization: Issuing shares can increase market cap and potentially boost the stock price.

Disadvantages

• Dilution: Existing shareholders face ownership dilution and potentially reduced Earnings Per Share (EPS).

• Valuation Uncertainty: The value of the payment fluctuates with the bidder's stock price.

All-Stock Deal Examples

• Prologis & Duke Realty (June 2022): All-stock transaction valued at $\$26\,\text{billion}$.

• Healthpeak Properties & Physicians Realty Trust (February 2023): Combination valued at $\$21\,\text{billion}$.

• Exxon Mobil & Denbury (July 2023): Valuation of $\$4.9\,\text{billion}$ ($\$89.45$ per share equivalent).

• Exxon Mobil & Pioneer (October 2023): Valued at $\$59.5\,\text{billion}$.

• Chevron Corp & Hess Corp (October 2023): Valued at $\$53\,\text{billion}$.

• Capital One Financial & Discover Financial Services (February 2024): Valued at $\$35.3\,\text{billion}$. Discover shareholders receive $1.0192$ Capital One shares per Discover share ($26\%$ premium).

Earnings Dilution and Accretion Mathematics

• Earnings Dilution: Occurs when post-acquisition combined EPS is lower than pre-acquisition EPS.   - Causes: High purchase premiums, high integration costs, and additional financing costs (debt interest or new dividends).

• Dilution Example Calculation:   - Bidder (B): $Net\,Income = \$2\,\text{m}, Shares = 20\,\text{m}, EPS = \$0.10, Price = \$2, MV = \$40\,\text{m}, PE = 20$   - Target (T): $Net\,Income = \$2\,\text{m}, Shares = 20\,\text{m}, EPS = \$0.10, Price = \$1, MV = \$20\,\text{m}, PE = 10$   - Bidder offers $1.5$ shares for each Target share ($30\,\text{m}$ new shares).   - Combined Shares: $20\,\text{m} + 30\,\text{m} = 50\,\text{m}$.   - Combined Net Income: $\$2\,\text{m} + \$2\,\text{m} = \$4\,\text{m}$.   - Combined EPS: $\frac{\$4\,\text{m}}{50\,\text{m}} = \$0.08$.   - Dilution Effect: $EPS$ drops from $\$0.10$ to $\$0.08$ ($20\%$ dilution).

• Avoiding Dilution:   - Improve the target's post-acquisition earnings growth.   - Reduce the premium paid or the Exchange Ratio (ER).   - Base the ER on the target's actual performance.

• Earnings Accretion: Target EPS is higher than pre-acquisition EPS.   - Causes: Cost savings/revenue synergies, strategic resource fit, or lower cost of capital financing.

Valuation Risks and Payment Currency Dynamics

• Bidder's Perspective:   - Scenario A (Target overvaluation): If the target's value is lower than expected, a cash payment means the bidder bears the entire loss. A stock offer shares the loss with the target shareholders.   - Scenario B (Synergy gains): In a successful deal, a stock exchange requires the bidder to share profits with the target. If the bidder expects significant gains, they prefer cash to retain all benefits.   - Adverse Selection: Concern about "buying lemons" leads bidders to favor stock for risk-sharing.

• Target's Perspective:   - Target risks accepting overvalued bidder equity or poor acquisition management.   - Targets prefer cash to avoid downside risk but forgo upside potential.   - Adverse Selection: Mitigated by the bidder offering cash or a higher Exchange Ratio (ER).

Analysis of Mixed (Stock and Cash) Payments

Advantages

• Tax Efficiency: Allows deferral on stock while permitting the bidder to deduct cash interest/expenses.

• Alignment and Stake: Target shareholders gain an ongoing stake in the acquiror while getting immediate liquidity.

• Risk Mitigation: Provides potential upside growth for target holders plus the safety of cash.

Mixed Deal Examples

• Kraft & Cadbury (January 2010): Valued at $\$19.6\,\text{billion}$. $840$ pence/share total: $500$ pence in cash, remainder in Kraft shares.

• Facebook & WhatsApp (February 2014): Valued at $\$19\,\text{billion}$. Consisted of $\$4\,\text{billion}$ cash, $\$12\,\text{billion}$ Facebook Class A shares, and $\$3\,\text{billion}$ in restricted stock units (RSUs).

• AT&T & Time Warner (October 2016): Valued over $\$85\,\text{billion}$. $\$107.50$ per share: $50\%$ cash ($\$53.75$) and $50\%$ AT&T stock.

• Broadcom & VMware (May 2022): Valued at $\$61\,\text{billion}$. Shareholders could choose $\$142.50$ cash or $0.252$ Broadcom shares, subject to $50/50$ proration.

• Netflix & Warner Bros (December 2025): Initially planned at $\$72\,\text{billion}$ with $\$23.25$ cash and $\$4.50$ stock; changed to all-cash in January $2026$.

Risk Management in Equity Offers: Derivatives and Protections

• Warrants: Derivative security giving holders the right to buy stock at a specific price within a timeframe.

• Fixed Stock Exchange Ratio: The value of the offer to the target falls if the bidder's stock price drops.

• Fixed Value Offer (Floating Rate Offer): The ER adjusts if the bidder's share price shifts outside agreed ranges, protecting the target but creating dilution uncertainty for the bidder.

• Floor: If the bidder's price falls below a threshold, the ER must adjust upward.

• Cap: An absolute limit on how many additional shares a bidder will issue as the price falls.

• Collar: Applies both a floor and a cap to the fixed rate price.

• Walk-Away Options: Permits termination if the price falls too low (target walks) or rises too high (bidder walks).

• Contingent Value Rights (CVRs):   - Commitment to pay additional cash or securities if specified share price levels or clinical/commercial milestones are met.   - Example: Johnson & Johnson & Abiomed (December 2022). $\$16.6\,\text{billion}$ enterprise value. $\$380$ upfront cash + non-tradeable CVR entitling holders to an additional $\$35$ per share based on milestones.

Debt Financing: Specialized Instruments and Seniority

• Secured Bank Debt (Senior Debt): Characterized as cheap and flexible but requiring collateral.

• Mezzanine Debt: A hybrid of debt and equity. It is subordinated to senior debt but has priority over common equity.   - Returns often range from $15\%$ to $20\%$.   - Maturity typically lasts $8$ to $10$ years.   - Common in mature businesses rather than startups.

• High-Yield Corporate Bonds: Used for large amounts (typically >\$100\,\text{m}) with $7\text{--}30$ year maturities.

• Bridge Loans: Short-term loans bridging the gap to long-term financing needs.

• Convertible Bonds: Bonds that can convert into common stock at a set price. They are cheaper than straight debt and allow participation in stock appreciation.

Taxation Aspects of Acquisition Financing

• Transfer Tax: Transferring shares is often taxed at lower rates than transferring assets.   - Example: In the Netherlands, share transfers have $0\%$ tax, while assets are taxed at $6\%$.

• Interest Deductibility: Debt interest is generally tax-deductible, reducing overall tax exposure.   - "Push Down" Debt: Strategies to move debt from the country of the acquisition vehicle to the target's country to maximize tax benefits.   - Tax Rates: UK Corporation Tax is $25\%$, while the US is $21\%$.

• Anti-Avoidance Rules: Laws may treat excess debt as equity (making interest non-deductible) if debt-to-equity ratios are too high.   - Example: Spain caps net interest expense at $30\%$ of EBITDA.

• Tax Shield Math:   - Firm U (Unlevered): EBIT = $\$1,000$, Tax ($35\%$) = $\$350$, Net Income = $\$650$.   - Firm L (Levered): EBIT = $\$1,000$, Interest = $\$80$, Pretax = $\$920$, Tax ($35\%$) = $\$322$, Net Income = $\$598$.   - Total income to investors in Firm L: $\$80 + \$598 = \$678$.   - Interest Tax Shield: $0.35 \times \$80 = \$28$.

• Tax Losses: In the UK, using a target's accumulated losses is strictly regulated. In the US, they can be utilized if target shareholders represent a substantial part of the combined entity.

Empirical Evidence and Scholarly Studies

• Bhardwaj and Shivdasani (2003): Bank financing of acquisitions has a favorable impact on market reaction due to bank monitoring; higher lending correlates with higher bidder returns. Debt-funded cash offers are perceived more positively than equity-funded ones.

• Ghosh and Ruland (1998): Stock offers are more likely when past returns are high; high liquidity decreases the chance of stock payments. Target managers with high ownership prefer stock.

• Malmendier and Tate (2008): Found that overconfident managers are significantly more likely to pay in cash.

• Salami and Sudarsanam (2000): Cash offers are favored for small targets when the bidder has high free cash flow; high stock returns enhance stock payments.

• Faccio and Masulis (2005): Studied European M&As ($1997\text{--}2000$). Positive impact on cash deals from bidder collateral and access to bank borrowing; leverage had a negative impact on cash use. Bidders avoid stock to prevent creating new block holders.

• Travlos (1987): US stock deals generated significant losses ($-2.09\%$) for bidding firms, while cash deals saw small positive returns ($0.31\%$). Explanation: Information asymmetry leads managers to use stock when it is overvalued.