Mergers and Acquisitions - Purchase of Stocks Vs Purchase of Assets

1. Purchase of stocks vs purchase of assets

Asset Purchase

In an asset purchase, the seller retains possession of the legal entity and the buyer purchases individual assets of the company, such as equipment, fixtures, leaseholds, licenses, goodwill, trade secrets, trade names, telephone numbers, and inventory.  

Advantages of an Asset Purchase

• A major tax advantage is that the buyer can “step up” the basis of many assets over their current tax values and obtain tax deductions for the depreciation and amortization
• Goodwill,  can be amortized on a straight-line basis over 15 years for tax purposes in an asset transaction. In a stock deal the goodwill is not amortised
• The buyer can dictate what, if any, liabilities it is going to assume in the transaction. The buyer can also dictate which assets it is not going to purchase.
• Because the exposure to unknown liabilities is limited, the buyer typically needs to conduct less due diligence.
• The buyer can select which employees they want to offer jobs

 Disadvantages of an Asset Purchase

• Contracts – especially with customers and suppliers – may need to be renegotiated.
• The tax cost to the seller is typically higher, so the seller may want a higher purchase price. Seller is faces double taxation – at corporate level and at shareholders level.
• Employment agreements with key employees may need to be rewritten.
• Certain assets are more difficult to transfer due

Stock Purchase

The Acquirer buys all the stock of the Target and takes the corporation as it finds it. All of the target corporation’s assets remain subject to all its liabilities. Most contracts, lease, and franchise rights and permits remain in place (and in effect transfer automatically).

 Advantages of a Stock Purchase

• Avoidance of taxes at corporate level for seller
• Contracts do not need to be renegociated.

Disadvantages of a Stock Purchase

• The main disadvantage is that an acquirer receives neither the “step-up” tax benefit nor the advantage of handpicking liabilities.

• Buyer is not shielded from undisclosed liabilities.
• It may be difficult to convince some stockholders to sell their shares.
• Goodwill is not tax deductible.

[pic 1]

2. method of payment

In cash transactions, acquiring shareholders take on the entire risk that the expected synergy value embedded in the acquisition premium will not materialize. In stock transactions, that risk is shared with selling shareholders, to the extent of proportion owned in new company.

Taxes

• Target shareholders: In a cash-deal target shareholders must pay taxes on their capital gains immediately. The acquisition premium for targets should be stepped up to incorporate the tax liability. (In a stock deal, the target shareholders capital gains taxes are deferred until the shares received in the deal are sold).
• Buyer shareholders: In a cash-deal the buyer can “step-up” the tax basis for its assets and thereby increase its depreciation tax shield of the target post acquisition. This creates value for the buyer shareholders.
• Academic evidence supports the notion that cash deals may be relatively costly due to the implied tax gains penalty which force higher premiums

Information asymmetry

• 1-sided information asymmetry: There is asymmetric information about the intrinsic value of the target. By offering a “contingent” payment in the form of stocks (rather than cash) bidders can reduce the likelihood of overpayment (Hansen, JB, 1987).

• 2-sided information asymmetry: The buyer as well as the seller are uncertain about the intrinsic values of each other. With 2- sided information asymmetry, the choice of payment method is determined by whether the target undervalues or overvalues the bidder stock.
• The attractiveness of contingent pricing via a stock-deal decreases when the target is considerably smaller than the bidder.

Capital structure

• Overleveraged bidders should finance acquisitions with their stock since that will reduce their leverage.
• Academic evidence: Uysal (JFE, 2011) - are less likely to pay with cash (or more likely to pay with stock) in an effort to move towards their target capital structure.

Voting control

• More the number of blockholders / concentrated owners in the target, lower the likelihood of payment with stock.

Overvaluation

• Overvaluation of buyer’s equity means higher likelihood of payment with stock.

Size of the target

• For smaller sized targets (absolute or relative to the bidder) cash is more likely to be used as it has lower transaction costs.

Stock payment is more likely under the following scenarios:

• Deals involving bidders with high “Q” (i.e, bidders with high valuation).
• Large deals / targets.
• Deals involving targets with a higher relative size.
• Acquirer is over-levered.

Cash payment is more likely under the following scenarios:

• Hostile deals.
• Deals blockholders / concentrated owners in the target.
• Acquirer has unused debt capacity.

Wealth effects of different payments methods:

Target shareholders gain significantly more from cash deals than from stock deals. One reason for the higher premium in cash offers is that target shareholders are required to pay capital gains taxes immediately, therefore they demand higher premium.

If bidders pay a higher premium for targets in cash deals, why do they still have higher announcement returns (relative to stock deals)?

• Bidders can step-up the tax basis of target’s assets to reflect the acquisition premium (i.e., reduce the tax liability of bidders) and thereby creating value.
• Cash deals often involve debt financing on the part of the acquirers. Increasing the level of debt financing increases monitoring of the acquiring firm (and potentially reduces agency costs).
• Stock deals could indicate market timing by managers who are trying to exploit overvaluation of their equity. Such deals are hence followed by negative announcement returns.
• Finally, cash deals are usually smaller, easy to integrate targets so deal synergies are potentially less risky to realize.
• Careful with inferring much from negative announcement CARs following stock deals as it reveals potential information on the valuation of the bidder itself in addition to information about deal. Selling pressure by merger arbitrageurs have also been found to contribute to negative announcement returns.

Source of financing