Use of the Buyer’s Stock as Deal Consideration

In many acquisitions, the seller prefers to receive cash in return for the sale of his or her business. This preference stems from the fact that the value of cash is generally accepted and not disputed. After all, “cash is king.” But what happens when, as part of the deal consideration, the buyer offers the acquiring company’s own stock to the seller? While much of the focus in an M&A transaction is on the value of the seller’s business, this issue hinges on the value of the buyer’s business.

As you might expect, estimating the value of the buyer’s stock can be difficult, especially in comparison to the alternative of using cash as consideration for the deal. Stocks are riskier financial instruments than cash, and therefore the value of the buyer’s stock carries far more volatility with it. When the seller is offered stock as consideration in a deal, he or she should consider the marketability characteristics of the stock along with the stock’s valuation fundamentals.

The concept of marketability is critical in ascribing value in these deals. For example, if the buyer’s stock is privately-held, the seller will not be able to quickly liquidate the stock and “unlock” his value. Therefore, when valuing a closely-held interest, valuators apply a lack of marketability discount (oftentimes up to 35% of the company’s equity value) to capture the impact of this lack of marketability on value. This discount takes into account the fact that a minority owner in a privately held company cannot readily turn his or her ownership interest into cash (unlike an investment in a publicly traded company). If this discount is not considered when assigning value to a minority ownership interest in the acquirer’s shares, it can result in the seller receiving less value than he or she would have had all of the proceeds been paid in cash.

On the other hand, if the buyer is a publicly traded company, similar issues can arise. It is common for the buyer in these cases to place restrictions on the sale of stock after the deal closes. For example, restrictions may not permit the sale of shares for periods ranging from a few months to a few years, which make the shares less valuable than they would be if they were freely tradable at the closing of the deal. Once again, the inability for the holder of the stock to sell his shares and monetize his or her interest reduces the value of the stock-based consideration received. In reality, the restricted shares that the seller received are worth less than the published stock price of the acquiring company. Imagine receiving shares of a publicly traded company worth $5 million on the date of issuance and watching them decline to $1 million prior to the restricted sale period elapsing. As a result, it is appropriate to consider a discount for lack of marketability for restricted shares in publicly traded companies. Doing so properly captures the risk associated with potential changes in the price of the acquiring company’s shares before the restricted sale period has ended.

In addition to the marketability concepts discussed above, the seller must take care in understanding the value of the underlying stock. Here are a few questions the seller should consider when determining the value the stock to be received:

• For publicly traded stock, does the current stock price “overvalue” or “undervalue” the stock based on the company’s fundamentals (e.g., earnings results) and comparable companies in its industry?
• What are the earnings expectations of the acquiring company?
• Is the acquiring company healthy from a balance sheet perspective and how will the acquisition of the seller’s company impact the health of the new company post-acquisition?
• How will the acquisition of the seller’s company impact future earnings expectations?
• How will the acquisition of the seller’s company impact the new company’s risk profile after the acquisition is completed?
• In the case of a publicly traded buyer, how will the announcement of the acquisition impact the stock price? Will the stock price get a boost?

As a practical matter, the use of stock as consideration is a mechanism to shift some of the risk of the deal to the seller (much like contingent consideration, such as an earnout). Just because we live in a “buyer beware” world, the seller must also beware and perform due diligence to protect his or her sale price in deals where consideration is made up of something other than cash.

For more information on the various approaches to valuation or our Valuation and Litigation Advisory Services.