In all our weekly M&A reports we cite the most important figure – the consideration. We have put together a quick summary to clarify the thinking around how acquirers structure the purchase and what the ramifications are for the acquirer (buyer) and the target (seller). This is useful as general corporate finance knowledge as well as for interviews for the mergers & acquisitions group.

As a reminder, consideration is a legal concept in commercial law which represents the value offered by each party to the contract. If there is no consideration on one side of the contract, the contract is void and not enforceable.¹

For the purposes of M&A, one party of the contract is the acquirer – the consideration for them is the target. For the target, the consideration/payment to its shareholders is usually through the form of cash, stock or a combination of the two.²

In order to put up this cash or stock, the acquirer has a variety of options. From the acquirer’s perspective, any sort of stock consideration results in share dilution, so to look good on paper, the acquisition has to offer some sort of synergy or have sufficient incremental benefit to keep the deal accretive to earnings (EPS goes up) or other relevant metric (e.g. cash flow).

Sources of Cash Consideration in a Merger

• Acquirer’s own cash-on-hand at the time
• Cash that exists in the target company (technically, if the company is acquired the cash they have on hand can lower the purchase price)³
• Draws from existing credit lines/revolvers
• New bank debt in the form of term loans
• Bonds via tapping into debt capital markets for new issuance to raise proceeds (of which there may be diversity pertaining to the features of the debt – e.g. a convertible option)
• Preferred shares

Generally, using existing cash or issuing debt for the purchase is preferred as it avoids dilution for existing shareholders. Additionally, interest payments on debt are tax-deductible.

Common Stock Consideration in a Merger

• Common stock issued to the target’s shareholders – this may be a set or fixed exchange ratio (e.g 0.75 Acquirer stock shares for every 1 Target share), a floating exchange ratio (however many shares equals $3 billion), or fall into a band (to a maximum consideration of x per share and a minimum consideration of y per share)
• Common stock may be issued to the open market to fund the purchase
• Vendor Take-Back – If the acquirer is purchasing the asset of another company, the selling company may take a number of shares in consideration

Of course, there are many other forms of consideration that may be embedded in a merger agreement including options such as contingent payments if cash flows reach certain amounts in upcoming years.

Is a Cash Offer Better than a Stock Offer?

Most of the time, investors in the seller prefer cash because it is immediate and certain. Additionally, many M&A deals are viewed with scepticism due to factors that may influence acquirers to overpay and the unknown pertaining to the realisation of advertised synergies. This partially explains why the share price of the acquirer often falls post-merger announcement (as opposed to the target share price rising due to the takeover premium).

However, should the market feel that there is tangible strategic rationale or are buoyed by the growth prospects of the acquirer, shares may be viewed favorably. In these cases, the share price of both the target and the acquirer will rise post-announcement.

One other benefit of a stock purchase is the deferral of capital gains tax. A cash purchase triggers a tax-event whereas stock consideration is not a “sale” by income tax standards. The tax base remains the purchase price of the original stock and will be adjusted based on the exchange ratio.

[1] Unless a seal is produced in place of consideration

[2] And implicitly the assumption of debt, which often will require refinancing via change of control covenants – for bonds, this change of control is often 101% of face value

[3] Recall that a simplified Enterprise Value formula is EV = Equity + Debt – Cash

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