In acquisition transactions, the acquiring company buys out the Target company (hereinafter referred to as Target) in cash, by giving out equity or a combination of the two. The method to fund the acquisition is contingent on both parties maximizing their returns and interests. The exact process inculcates a few steps.
The Target furnishes its capitalization table for the acquiring company. This table contains the names of all shareholders, their equity stake in Target, the initial amount invested, and the dates when each investor joined the business.
The cap table lists all the shareholders who will need to be accounted for during the acquisition. Using the cap table, the acquiring company is able to determine the estimated returns made by each shareholder in the Target, after it has assigned a valuation. This helps determine if all shareholders would accept the valuation of Target proposed by the acquiring company.
As an example:
Acquiring company A is contemplating buying out Target company T and is examining T’s cap table. T’s founder and 5 investors are the equity holders and their stake in the business has been specified.
A conducts internal financial modeling exercises to determine T’s valuation and arrives at a USD 10 million estimate. With the help of the cap table, A can calculate the equity returns that T's shareholders would make to evaluate if the returns would be attractive enough for them to consider selling their share in T to A.
Acquiring company A is contemplating buying out Target company T and is examining T’s cap table. T’s founder and 5 investors are the equity holders and their stake in the business has been specified.
A conducts internal financial modeling exercises to determine T’s valuation and arrives at a USD 10 million estimate. With the help of the cap table, A can calculate the equity returns that T's shareholders would make to evaluate if the returns would be attractive enough for them to consider selling their share in T to A.
T’s shareholders could either accept or reject this valuation based on their estimates. If they accept A’s USD 10 million estimate, then A has a few options to buy out T at this valuation.
2. A buys T by issuing its stock to T’s shareholders proportionate to T’s valuation. T is valued at USD 10 million while A is valued at USD 100 million (this is an assumption). Let us consider T’s founder. Our earlier calculation valued the Founder’s equity at USD 3 million. The Founder’s equity stake in A would be USD 3 million / USD 100 million = 3%. The calculation for other shareholders would be similar if they are also being issued stock in A.
An example of this method is Pixar’s acquisition by Disney in 2006 for USD 7.4 billion where Pixar shareholders were compensated in equity. This enabled both companies to share the profits and risks from the combined animation business. The all-equity transaction made Pixar’s management — CEO Steve Jobs and President Ed Catmull — important shareholders in Disney to maintain Pixar’s creative freedom. This way, Pixar’s management would have a say in how the entity is run within Disney.
All equity transactions may be preferred when the acquiring company’s stock is deemed undervalued. T enjoys the future upside in A’s stock price by being paid in stock. From A's perspective, having T's management after the acquisition could ensure T's strong performance with the assumption that the founders know their company best and are most motivated to see it flourish.
3. A offers part cash and part equity to T’s shareholders. A could choose to pay USD 2 million in cash and the rest in equity to T's shareholders. A would prefer this option as it could pay the rest of the amount after evaluating T's performance post-acquisition. A could add clauses in the acquisition contract suggesting that the remaining payout will be contingent on T's performance. This could include assigning a valuation to T after evaluating its performance in the initial years.
1. Buy out T in cash where each shareholder gets the cash amount proportionate to their stake in T. For example, if the Founder’s stake in T is estimated at 30%, then he/she would be compensated 30% x USD 10 million = USD 3 million in cash. Similarly for other investors based on their percentage stake in T.
If A buys T out in cash, it is assumed that A will obtain full ownership over T with minimal involvement from T’s shareholders going forward. A now holds full risk and responsibility for T’s performance going forward. The advantage of an all-cash transaction for A is that equity dilution would be avoided as it would not have to offer equity stakes to T's shareholders. On the flip side, it would lose a substantial cash buffer.
An example of this method is Amazon's acquisition of Whole Foods Market in 2017 in an all cash transaction that valued Whole Foods at USD 13.7 billion. All cash transactions may be used to convince unsure shareholders in T by paying a premium on price per share. Such transactions are usually conducted by big companies with sizeable cash buffers. In this example, Amazon issued debt to generate cash for the acquisition.
If A buys T out in cash, it is assumed that A will obtain full ownership over T with minimal involvement from T’s shareholders going forward. A now holds full risk and responsibility for T’s performance going forward. The advantage of an all-cash transaction for A is that equity dilution would be avoided as it would not have to offer equity stakes to T's shareholders. On the flip side, it would lose a substantial cash buffer.
An example of this method is Amazon's acquisition of Whole Foods Market in 2017 in an all cash transaction that valued Whole Foods at USD 13.7 billion. All cash transactions may be used to convince unsure shareholders in T by paying a premium on price per share. Such transactions are usually conducted by big companies with sizeable cash buffers. In this example, Amazon issued debt to generate cash for the acquisition.
2. A buys T by issuing its stock to T’s shareholders proportionate to T’s valuation. T is valued at USD 10 million while A is valued at USD 100 million (this is an assumption). Let us consider T’s founder. Our earlier calculation valued the Founder’s equity at USD 3 million. The Founder’s equity stake in A would be USD 3 million / USD 100 million = 3%. The calculation for other shareholders would be similar if they are also being issued stock in A.
An example of this method is Pixar’s acquisition by Disney in 2006 for USD 7.4 billion where Pixar shareholders were compensated in equity. This enabled both companies to share the profits and risks from the combined animation business. The all-equity transaction made Pixar’s management — CEO Steve Jobs and President Ed Catmull — important shareholders in Disney to maintain Pixar’s creative freedom. This way, Pixar’s management would have a say in how the entity is run within Disney.
All equity transactions may be preferred when the acquiring company’s stock is deemed undervalued. T enjoys the future upside in A’s stock price by being paid in stock. From A's perspective, having T's management after the acquisition could ensure T's strong performance with the assumption that the founders know their company best and are most motivated to see it flourish.
3. A offers part cash and part equity to T’s shareholders. A could choose to pay USD 2 million in cash and the rest in equity to T's shareholders. A would prefer this option as it could pay the rest of the amount after evaluating T's performance post-acquisition. A could add clauses in the acquisition contract suggesting that the remaining payout will be contingent on T's performance. This could include assigning a valuation to T after evaluating its performance in the initial years.
A could opt for an earnout to fund the acquisition when both parties are in disagreement over T's valuation. An earnout involves paying the target company partially upfront and partially based on specific performance metrics achieved in future.
For example - A could set revenue, EBITDA or profitability goals to be met after which T's valuation would be set at the desired amount. T's management would receive periodic earnouts when the financial metrics are achieved.
A well-known example of earnouts is Mastercard's acquisition of Finicity in 2020. Mastercard paid USD 825 million upfront and offered an additional earnout option of USD 160 million to Finicity's shareholders contingent on performance targets.
A well-known example of earnouts is Mastercard's acquisition of Finicity in 2020. Mastercard paid USD 825 million upfront and offered an additional earnout option of USD 160 million to Finicity's shareholders contingent on performance targets.
Acquisitions are funded in cash, equity, or a combination of the two where both parties weigh the pros and cons.
All cash acquisition:
Advantages for the acquiring company:
- Certainty in price being offered for the acquisition
- Equity dilution is avoided as no shares are given out
- Provides control over the Target company
- Greater flexibility over Target's strategy and post-acquisition plans without hurdle from Target's shareholders
- All-cash deals are quicker to be completed once agreed by the two parties
Disadvantages for the acquiring company
- Loss of cash buffer for other initiatives / investments
- Debt financing to raise cash could deteriorate the company's indebtedness and detrimentally impact its cost of capital and credit rating
- Acquiring company takes on all the risk associated to the future performance of the Target company
Advantages for the Target company:
- Money paid upfront
- Lower risk associated to share price volatility
- Simpler negotiation process compared to equity transactions
- May benefit from a premium price offering if acquiring company is keen on the success of the transaction
Disadvantages for the Target company:
- Lose controlling rights over own company and may result in future integration difficulties into the acquiring company without the Target's founding team
- Does not benefit from any future upside to acquirer's share price
- Immediate tax implications on the cash amount received
All equity acquisition:
Advantages for the acquiring company:
- Preserves cash
- Avoids the need to raise debt to fund the acquisition
- Acquiring company' shareholders can benefit from the continued involvement of Target's management who know their company better
- Acquiring company can share the upside and downside with Target company management
Disadvantages for the acquiring company:
- Equity dilution as shares need to be handed out to Target's management
- Research shows that at the time of the announcement, shareholders of the acquiring company fare worse in an all-equity transaction compared to an all-cash transaction. This may happen if the market believes the acquirer overpaid for the Target
Advantages for the Target company:
- Shareholders benefit from future appreciation of acquiring company stock if it deemed to be currently undervalued
- Target management benefits from synergies created between the two entities. Synergies refer to the benefits that result from combining two companies including cost savings, revenue gains, strategic synergies (e.g., by combining R&D efforts) and financial benefits (e.g., through better access to capital and improvements in credit ratings)
- Avoids immediate tax payment unlike in an all-cash transaction
Disadvantages for the Target company:
- Equity deals are difficult to iron out given considerations around Acquiring and Target companies' valuation and future management structure of the combined entity
- Target company may face a lower than justified exchange ratio between acquiring company and its stock, particularly during financial market volatility or when the estimations around synergy benefits are uncertain
