Once the target firm has been identified and valued, the acquisition moves forward into the structuring phase. There are three interrelated steps in this phase. The first is the decision on how much to pay for the target firm, synergy and control built into the valuation. The second is the determination of how to pay for the deal, i.e., whether to use stock, cash or some combination of the two, and whether to borrow any of the funds needed. The final step is the choice of the accounting treatment of the deal because it can affect both taxes paid by stockholders in the target firm and how the purchase is accounted for in the acquiring firm’s income statement and balance sheets.
Deciding on an Acquisition Price
The value determined in consideration of synergy and control represents a ceiling on the price that the acquirer can pay on the acquisition rather than a floor. If the acquirer pays the full value, there is no surplus value to claim for the acquirer’s stockholders and the target firm’s stockholders get the entire value of the synergy and control premiums. This division of value is unfair, if the acquiring firm plays an indispensable role in creating the synergy and control premiums.
Consequently, the acquiring firm should try to keep as much of the premium as it can for its stockholders. Several factors, however, will act as constraints. They include:
- The market price of the target firm, if it is publicly traded, prior to the acquisition: Since acquisitions have to base on the current market price, the greater the current market value of equity, the lower the potential for gain to the acquiring firm’s stockholders. For instance, if the market price of a poorly managed firm already reflects a high probability that the management of the firm will be changed, there is likely to be little or no value gained from control.
- The relative scarcity of the specialized resources that the target and the acquiring firm bring to the merger: Since the bidding firm and the target firm are both contributors to the creation of synergy, the sharing of the benefits of synergy among the two parties will depend in large part on whether the bidding firm’s contribution to the creation of the synergy is unique or easily replaced. If it can be easily replaced, the bulk of the synergy benefits will accrue to the target firm. If it is unique, the benefits will be shared much more equitably. Thus, when a firm with cash slack acquires a firm with many high-return projects, value is created. If there are a large number of firms with cash slack and relatively few firms with high-return projects, the bulk of the value of the synergy will accrue to the latter.
- The presence of other bidders for the target firm: When there is more than one bidder for a firm, the odds are likely to favor the target firm’s stockholders. The benefits of synergy accrue primarily to the target firms when multiple bidders are involved in the takeover. They estimated the market-adjusted stock returns around the announcement of the takeover for the successful bidder to be 2% in single bidder takeovers and -1.33% in contested takeovers.
Payment for the Target Firm
Once a firm has decided to pay a given price for a target firm, it has to follow up by deciding how it is going to pay for this acquisition. In particular, a decision has to be made about the following aspects of the deal.
- Debt versus Equity: A firm can raise the funds for an acquisition from either debt or equity. The mix will generally depend upon both the excess debt capacities of the acquiring and the target firm. Thus, the acquisition of a target firm that is significantly under levered may be carried out with a larger proportion of debt than the acquisition of one that is already at its optimal debt ratio. This, of course, is reflected in the value of the firm through the cost of capital. It is also possible that the acquiring firm has excess debt capacity and that it uses its ability to borrow money to carry out the acquisition. Although the mechanics of raising the money may look the same in this case, it is important that the value of the target firm not reflect this additional debt. The additional debt has nothing to do with the target firm and building it into the value will only result in the acquiring firm paying a premium for a value enhancement that rightfully belongs to its own stockholders.
- Cash versus Stock: There are three ways in which a firm can use equity in a transaction. The first is to use cash balances that have been built up over time to finance the acquisition. The second is to issue stock to the public, raise cash and use the cash to pay for the acquisition. The third is to offer stock as payment for the target firm, where the payment is structured in terms of a stock swap – shares in the acquiring firm in exchange for shares in the target firm. The question of which of these approaches is best utilized by a firm cannot be answered without looking at the following factors.
- The availability of cash on hand: Clearly, the option of using cash on hand is available only to those firms that have accumulated substantial amounts of cash.
- The perceived value of the stock: When stock is issued to the public to raise new funds or when it is offered as payment on acquisitions, the acquiring firm’s managers are making a judgment about what the perceived value of the stock is. In other words, managers who believe that their stock is trading at a price significantly below value should not use stock as currency on acquisitions, since what they gain on the acquisitions can be more than what they lost in the stock issue. On the other hand, firms that believe their stocks are overvalued are much more likely to use stock as currency in transactions. The stockholders in the target firm are also aware of this and may demand a larger premium when the payment is made entirely in the form of the acquiring firm’s stock.
- Tax factors: when an acquisition is a stock swap, the stockholders in the target firm may be able to defer capital gains taxes on the exchanged shares. Since this benefit can be significant in an acquisition, the potential tax gains from a stock swap may be large enough to offset any perceived disadvantages. The final aspect of a stock swap is the setting of the terms of the stock swap, i.e., the number of shares of the acquired firm that will be offered per share of the acquiring firm.
While this amount is generally based upon the market price at the time of the acquisition, the ratio that results may be skewed by the relative mispricing of the two firm’s securities, with the more overpriced firm gaining at the expense of the more under priced (or at least, less overpriced) firm. A fairer ratio would be based upon the relative values of the two firm’s shares.
There is one final decision that, in our view, seems to play a disproportionate role in the way in which acquisitions are structured and in setting their terms, and that is the accounting treatment. In this section, we describe the accounting choices and examine why firms choose one over the other.
Purchase versus Pooling
There are two basic choices in accounting for a merger or acquisition. In purchase accounting, the entire value of the acquisition is reflected on the acquiring firm’s balance sheet and the difference between the acquisition price and the restated value of the assets of the target firm is shown as goodwill for the acquiring firm. The goodwill is then written off (amortized) over a period of 40 years, reducing reported earnings in each year.
The amortization is not tax deductible and thus does not affect cash flows. If an acquisition qualifies for pooling, the book values of the target and acquiring firms are aggregated. The premium paid over market value is not shown on the acquiring firm’s balance sheet.
For an acquisition to qualify for pooling, the merging firms have to meet the following conditions.
- Each of the combining firms has to be independent; pooling is not allowed when one of the firms is a subsidiary or division of another firm in the two years prior to the merger.
- Only voting common stock can be issued to cover the transaction; the issue of preferred stock or multiple classes of common stock is not allowed.
- Stock buybacks or any other distributions that change the capital structure prior to the merger are prohibited.
- No transactions that benefit only a group of stockholders are allowed.
- The combined firm cannot sell a significant portion of the existing businesses of the combined companies, other than duplicate facilities or excess capacity.
The question whether an acquisition will qualify for pooling seems to weigh heavily on the managers of acquiring firms. Some firms will not make acquisitions if they do not qualify for pooling, or they will pay premiums to ensure that they do qualify.
Furthermore, as the conditions for pooling make clear, firms are constrained in what they can do after the merger. Firms seem to be willing to accept these constraints, such as restricting stock buybacks and major asset divestitures, just to qualify for pooling.
In the last few years, another accounting choice has entered the mix, especially for acquisitions in the technology sector. Here, firms that qualify can follow up an acquisition by writing off all or a significant proportion of the premium paid on the acquisition as in process R&D. The net effect is that the firm takes a one-time charge at the time of the acquisition that does not affect operating earnings12, and it eliminates or drastically reduces the goodwill that needs to be amortized in subsequent periods. The one-time expense is not tax deductible and has no cash flow consequences. In acquisitions such as Lotus by IBM and MCI by Worldcom, the in-process R&D charge allowed the acquiring firms to write off a significant portion of the acquisition price at the time of the deal.
The potential to reduce the dreaded goodwill amortization with a one-time charge is appealing for many firms and studies find that firms try to take maximum advantage of this option. The firms that qualify for this provision tend to pay significantly larger premiums on acquisitions than firms that do not.
In early 1999, as both the accounting standards board and the SEC sought to crack down on the misuse of in-process R&D, the top executives at high technology firms fought back, claiming that many acquisitions that were viable now would not be in the absence of this provision. It is revealing of managers’ obsession with reported earnings that a provision that has no effects on cash flows, discount rates and value is making such a difference in whether acquisitions get done.