Basic, lesson 1 of 3
Why companies buy, and how they pay
An acquisition is a bet that two businesses are worth more together. How the buyer pays, in cash, stock, or new debt, changes who carries the risk and what the deal does to earnings.
7 min, 2 checks
1The reasons, honestly
Buyers usually give some mix of these reasons: grow faster than they can on their own, enter a new market or product, gain scale to cut costs, buy a technology or team, or remove a competitor. Underneath all of them is one test: the buyer should be able to make more from the target's business than the price it pays.
That test is hard to pass. The buyer usually pays a premium over the target's share price, often 20% to 40% for a public company, so the combined company has to create at least that much extra value just to break even.
- Strategic buyers are operating companies. They can pay more because they expect synergies.
- Financial buyers are private equity funds. They buy to own and sell, and price off returns rather than synergies. The LBO track covers them.
2Three ways to pay
| Currency | What it costs the buyer | Who carries the risk |
|---|---|---|
| Cash on hand | The interest the cash would have earned, after tax | The buyer; target holders walk away with cash |
| New debt | Interest on the new borrowing, after tax, plus higher leverage | The buyer and its lenders |
| Stock | A share of all future earnings, given to the target's holders | Shared; target holders become owners of the combined company |
Cash on hand is usually the cheapest money, because cash in the bank earns very little. Debt costs more but is still cheap after tax for a healthy company. Stock is usually the most expensive in earnings terms, because new shareholders get a cut of every future dollar of profit.
Check 1
For a buyer with plenty of cash earning a low interest rate, which currency is usually cheapest?
3Why anyone pays in stock
If stock is expensive, why use it? Three reasons come up. The buyer may not have the cash or the debt capacity for a large deal. The buyer's shares may be richly valued, so each share buys more. And paying in stock shares the risk: if the combination disappoints, the target's former holders take part of the loss.
Sellers have their own view. Cash is certain. Stock lets them participate in the upside and, in many structures, defer tax until they sell the new shares.
Check 2
Which is a good reason for an acquirer to pay in stock?
Terms in this lesson: Synergies, Leveraged buyout.
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