M&A Issues: Consideration
We are getting to the end of the series on M&A. Two more M&A Issues to talk about and then I am done. The final two are consideration and price. Today I'll talk about consideration and next week I'll talk about price.
Consideration is the way in which you and your shareholders will get paid. The most common way to get paid is cash. The other common way to get paid is in the buyer's stock. You may also get paid by accepting a note (an IOU) from the buyer. And of course, many transactions include more than one form of consideration. A combination of cash and stock is very common.
Cash is the best way to get paid in most cases. You know exactly what you are getting when you get paid in cash. If the purchase price is a signficant amount of money to you and your shareholders, I would almost always prefer cash. If you've created a lot of wealth with your company, why risk that wealth on someone else's company?
Stock is the best way to get paid if you are selling your company relatively cheap but you are a big believer in the upside of the buyer's stock. A good example of this are sales of young companies to fast growing privately held businesses. When Ev Williams sold Blogger to Google, the Blogger shareholders got privately held Google stock which appreciated a lot when it eventually went public. When Summize sold its twitter search service to Twitter, the Summize shareholders got Twitter stock (and some cash) and that Twitter stock has appreciated significantly since. In these kinds of transcations the Blogger and Summize shareholders would not have made much of a return if they had taken cash. By taking stock, they turned their company sales into fantastic transactions.
There are situations where the buyer will require the seller to take stock. It might be because the buyer doesn't have sufficient cash to make the purchase. Or it might be because the buyer wants the seller to be aligned with the buyer and incented to stick around.
If you are accepting stock as consideration, you need to be careful to evaluate the short, medium, and long term potential of the buyer's stock. Back during the first Internet bubble, we sold one of our portfolio companies for stock in another company. We did diligence on the buyer's company and knew that it was weak and in trouble. But so was our portfolio company. Three months later, the buyer went under and we lost our entire investment. We probably would have ended up in the same place if we didn't sell. But I tell this story so that you all understand that taking private stock can be risky. It is not an exit unless the stock is public and liquid and you can sell immediately and turn it into cash.
Selling for public stock is a lot different than selling for private stock. Public stock is a lot closer to cash, particularly if there are no restrictions on the seller's stock. If you get public stock with no restrictions, you can sell immediately and turn it into cash. Or you can hedge your stock with puts and calls and take a lot of the risk out of the position. Or you can put in place a regular selling program. If you are selling your company for public stock, pay a lot of attention to the restrictions the seller wants to put on your stock. And resist them as much as you can.
Taking a note from the seller is not very attractive. A note has very little upside (compared to stock) and it is not immediate cash. With a note you are still taking risk that the purchaser could falter and not be able to pay the note. It is true that a note will not fluctuate with company performance like stock. If the purchaser remains in business and solvent, the note will be paid at face value with interest. We've received notes as consideration in a few situations over the years but it is very rare in the venture capital and startup business. As a matter of practice, I like to avoid them.
In summary, you can get paid in multiple ways in an M&A transaction. Cash is usually best and is also the most common. Stock is attractive if you believe there is a lot of upside in the purchaser's stock or if it is public and immediately liquid. A note is the least attractive form of consideration and also is rare in the venture capital and startup sector.
Comments (Archived):
Interesting, thanks. How often do you think sellers have a choice of which form of consideration they get? Is this mostly driven (dictated) by the buyer?
The sellers are always have a choice – don’t accept the offer if you don’t like the consideration.
Well, sure.
I’m not sure which is more helpful, username or comment.
it is most often dictated by the buyer but as JLM suggests, you can always negotiate
In life, you don’t get what you deserve, you get what you…………………………………………………………………………………..negotiate!
Truer in business than life because life doesn’t pay back in dollars…usually nor consistently.This is a tweetable gem however:”In business you don’t get what you deserve, you get what you negotiate.”Attributable to you JLM?
Were your YHOO shares locked up when you sold geocities (or even more so Yoyodyne)? YHOO probably did at least a 5X in those 12 months. Those restrictions can work both ways.
geocities no because it was a public company and you can’t lock up public shareholdersbut on yoyodyne (seth godin’s company) yeswe made out like bandits on that lockup. i think 3x in 6 months
Hmmm, why do you say you cannot lock up public shareholders?It is very normal to have “legend” stock and unregistered stock and other restrictions. I have routinely done this but usually for capital transactions.
Geocities was public target/public buyer. Sale transaction was registered on an S-4 with the SEC so registered, freely tradeable stock was issued and the only restricted stock would have been stock issued to Rule 145 affiliates.
yup
Listen very, very, very carefully — VALUE SAVINGS CLAUSE.This tool will provide some considerable downside protection when crafting a deal with a seller who is offering, in part, stock.This is not some pie in the sky business school baloney, I have done it though folks fought me and it was not easy. Well, actually, it was easy because I was not wiling to compromise.A value savings clause typically stipulates that on an annual basis, the value of stock offered is valued and if the value comes up short, then the seller gets more stock.This is a balance drawn between the typical “lock up” and restrictions that a seller wants on their stock — they will not be enthusiastic about a buyer being able to just sell their stock the day after the closing — and the underlying risk of the securities delivered.Also, think about dividend paying stock. Done this also. It is a good thing.If you get stuck on a valuation issue on the overall transaction, a deal saver can be some warrants to acquire the buyer’s stock even when the warrants are modestly out of the money. This is not a different form of compensation than what Fred has outlined, it is a variation on the theme of taking stock.Last comment, think about a convertible promissory note that converts into a fixed number of shares thereby providing upside if the stock trends upward.
i’ve also used a put to give the seller protection on a stock deal
In effect, a value savings mechanism created and customized by the seller but this requires the buyer to have a stock with enough depth to have an efficient option market.That cat can get skinned a lot of different ways. But it needs to be skinned.
“It is not an exit unless the stock is public and liquid and you can sell immediately and turn it into cash.”Well said, many people that get caught up “the art of the deal” forget this.
“If you are selling your company for public stock, pay a lot of attention to the restrictions the seller wants to put on your stock.”Learned this one the hard way. Received restricted shares in a public company and as I was waiting for Rule 144 to apply the stock dropped 70% overnight.
Cash deal is taxable at closing. 100% stock deal is generally tax free at closing, tax only when the stock is subsequently sold. Mix of cash and stock in varying permutations allows tax on the cash, deferring tax on the stock, within certain boundaries–say not less than 45% of deal value in stock depending on your tax lawyers.
Sorry Antonio, put the response one comment down.I have felt the 144 downside as well and it is an awful feeling.
While not that common in tech deals, the question of *what* the buyer is buying is also a very important consideration. Are they buying the IP? The stock of the company? A specific subset of assets? These have significant tax implications and other implications, and you need to have good counsel to help guide you through the different scenarios. In a previous successful exit at my first company, Lighthammer, we had to navigate/negotiate a mix of an asset purchase + stock purchase, complicated by a split sale to the German organization and the US organization. Needless to say, our lawyer was our best friend during that process (I highly recommend Morgan Lewis by the way).
why would a public company want to put restrictions on their stock if they are just using the stock as consideration? Or do the restrictions usually come because of regulatory issues?
they don’t like the selling pressure
If a portion of the consideration is private-company stock, not only must the seller do extensive due diligence on the buyer, but also it must require a full set of buyer representations and warranties and indemnities in the acquisition agreement in order to protect itself post-closing. As a result, the deal will be much more complicated and time-consuming than an all-cash deal and the transaction fees (for lawyers and accountants) will be much higher. In addition, it is critical that the seller negotiate the right to pay any buyer claims post-closing with buyer stock (in lieu of cash) until exhausted; otherwise, the seller could end-up with nothing but worthless paper. Cash is indeed king.Scott (@ScottEdWalker)
Great explanation. Fred, I think you should be teaching a course at #HBS =D
i am 😉
testing 1-2 1-2
Did you have a comment here disappear too?
I was an investor in a company that had 2 acquisition offers. One was from a “hot” private company and all stock, the other from a well respected public company and all cash. Based on private company’s recent valuation from top-tier VC, offers had near identical paper value. Some investors were pushing for private company sale. Founder seemed somewhat swayed by them, saying the stock could go way up in value. I said to founder: If you sold your company for cash, would you invest ALL your cash in that private company, because effectively that’s what you are doing. (He was a first time founder and so had no savings.)Investors have a portfolio and welcome volatity. Entrepreneurs generally have all of their net worth in their own company. One of the most striking cases I’ve seen where investor and founder incentives diverge.
VC is a service business. we serve entrepreneurs and need to work for them. those investors didn’t understand that.
Respect.
Thank you, as an entrepreneur I love this.
Thank you for just being a mensch in that story….
** Investors have a portfolio and welcome volatility. Entrepreneurs generally have all of their net worth in their own company. One of the most striking cases I’ve seen where investor and founder incentives diverge.**I couldn’t agree more. Sometimes you feel that your hand is forced. Having Friends & Family investors adds to that complexity for the entrepreneur.
The interesting thing is that whether a founder (and/or their investors) should take cash or stock when selling a company is a highly personal question.For many, taking cash and investing it in a diversified way is the only way they can sleep at night (and for VCs, taking cash is often the right choice because of the LPs they represent).On the other hand, for a “take no prisoners” kind of founder, taking the stock is the precise event that might facilitate achieving their financial goals. (Imagine getting access to Twitter stock back in 2009 and having to pick between it and cash.)At my new startup, Riskalyze, we’ve got some incredible technology that we’re building a product around to revolutionize how we make risk/reward decisions.Startup acquisitions is most definitely not our target market, but the technology can extract an individual’s “Risk Fingerprint” and then apply that data quantitatively to any set of risk/reward decisions with monetary value at stake.It’s going to be fascinating to see how this applies to private stock with limited valuation data, even though 100% of our product’s focus will be on publicly traded asset classes.(And by the way, if anyone wants to get a backstage pass for our beta in May, you can grab one at http://www.riskalyze.com.)
taking cash and stock is great hedge
It’s true and our algorithm could determine the mix of cash and stock that perfectly fit the combination of your financial goals and risk fingerprint.
Thanks for the article, Fred.I think basically you can summarize the M&A consideration decision in the following way.Your payment preference in the M&A process which depends on (I assume you are the seller):- your liquidity/cash preference- your expectation of the equity growth of the other companyThe payment preference of the buyer:- their expectation of the equity growth of their other company – their cash availabilityCheers,Martin from Finance Club
Great post Fred. Interesting that you did not address the differences in taxability between cash deals (taxed now) and stock deals (generally taxed later). Years ago everyone wanted stock because they were convinced stocks only went up and deferring the tax event until later was always preferable, plus there were the benefits of pooling of interest accounting that no longer exist. Now people realize stocks go down, liquidity can be hard to come by and cash is cash so people like cash more.Tax wise I think notes and interest actually can have the worst of all tax treatment or at least the most confusing by the time the accountants work their magic.
that was purposefuli think doing things for tax reasons is a bad idea
I figured it was purposeful. It is one of many reasons why I enjoy your columns so much. “I think doing things for tax reasons is a bad idea.” is a quote that should be given to every lawyer, banker and accountant dealing in M&A. The sheer amount of time spent on tax structuring without pausing to ask if a deal is a good one amazes me. I’m sure we’ve all seen lots of stupid things done for tax reasons only.
I definitely agree with this concept – business decisions should not be driven by tax reasons. However, one has to be careful though not to take illiquid consideration that creates a taxable event – this can easily happen in accepting private company or restricted public company stock as consideration – big step up in value and no cash to pay the tax is potentially a very bad position to be in.
yes! very true
” We probably would have ended up in the same place if we didn’t sell.” Sorry, but this statement was hilarious. 🙂
With respect to liquidation preference and an all-stock deal (listed buyer & unlisted buyer different naturally), how would the liquidation preference get treated?If the preferred converts to common at some ratio, then it becomes simple. But if there’s a multiple on investment valuation, how would it work?
preferred gets its money first and common gets what is left if the value ofthe deal is not sufficient for the preferred to convert to common
Thanks Fred.But how would this work for an all-stock deal? Would the value of the stock be taken in case of a listed buyer? Would that mean the number of buyer’s shares per preferred stock and common would be different?What if the buyer is unlisted?Third, have you seen any case where there’s a carveout & different sale considerations?
you take the number of shares the buyer is offering, multiply it by thevalue they ascribe to their stock, and you get the value of the deal to theseller. then you run the liquidation waterfall for the seller to determinewhat the preferred and common get
I’m surprised how little the converse of this theory is applied in the public markets — of all the technical indicators, ratios, insider trades, etc. — whether an acquiring public company uses stock or cash in an acquisition is a strong indication of whether they believe in the value of their own stock. (This assumes they have the cash as an alternative, or are not concerned as AT&T may have been with the deal composition for T-Mobile USA, about a debt downgrade.) It certainly would have been a leading indicator 10+ years ago!The permutation that I do think drives the market is stock might be perceived as more appealing than cash if in fact it is _illiquid_ and desirable — Facebook etc. now perhaps. Is this route chosen by founders who have exhausted their entrepreneurial energy but want the distinctive upside of other private company stock? The cold tangibility of cash might have some psychological downside with no dreamy, exclusive upside any longer to be had.
An additional form of consideration not discussed is Seller Financing. It is rarely used, and probably never used on an exit for a VC backed company. However, it is a mechanism that can be used to start a company that a VC would back. This mechanism is often used for spin-outs and can be a great way for a big company to create value when their culture would crush that innovation.
As you’re ramping down M&A… are you taking nominations for the next in the series?As Startup Marketing was a recent hot button… could you/would you please consider the various stages of Startup Marketing the next of the bunch? Early stage, mid life, maintenance…And, have you talked with Gary V about his Vook experience? The MBA Mondays would make one kick ass Vook series. Really admire how he executed his.
i’m not that into Vook
Wow !! really nice blog. It will be very useful for me. So, thanks for sharing this post.
You have expounded some excellent issues involved in M&A. Thanx alot for this info ill definitely share it with my fellows.
tese
This is not a different type of compensation than what Fred has outlined, it is a variation on the theme of taking stock.holiday homes ireland
Darned good question Charlie; also would be very interested in the answer to it. Most likely, this probably does not have a simple or one-size-fits-all response or needs a CPA to answer it.
Cash deal is taxable at closing. 100% stock deal is generally tax free at closing, tax only when the stock is subsequently sold. Mix of cash and stock in varying permutations allows tax on the cash, deferring tax on the stock, within certain boundaries–say not less than 45% of deal value in stock depending on your tax lawyers.
Of course; thank you Dave. Sometimes the obvious is just too obvious to be noticed! lol