When a Purchase Involves Both Cash and Stock

Buyer and Seller Beware

When a privately-held acquirer uses its stock to partly purchase a company, it is imperative that both the acquirer and the target in a transaction have support for, and a level of comfort with, the value assigned to the acquirer’s shares if they are being issued as part of the deal. It is especially important for the seller to conduct its own due diligence to better assess its risk exposure and understand the fair value of intangible assets. This article discusses procedures that sellers and buyers should consider before finalizing the terms.

We are all familiar with the phrase “cash is king.” Why is it, though, that cash is crowned king and not real estate, bonds or LeBron James? It all boils down to the fact that everyone can agree on the value of a $1 bill without dispute—$1 is worth $1. Someone cannot reasonably argue that a dollar bill is worth $1.10 or 0.90 cents.

As a result, investors typically prefer to receive cash when selling an ownership interest in a business. It is not uncommon, however, for an acquirer to pay part of the purchase price of an acquisition with its own stock (or for the seller to make a rollover equity investment).

In the case of a privately held acquirer, the value of its stock is somewhat subjective and there can be reasonable arguments for what one person perceives as value of $1 per share being worth 0.70 cents or $1.40. You get the idea. As a result, it is imperative that both the acquirer and the target in a transaction have support for, and a level of comfort with, the value assigned to the acquirer’s shares if they are being issued as part of the deal.

There is risk on both sides of a transaction when a privately held company is issuing shares as a component of deal consideration. The buyer has an incentive to overvalue its stock and issue fewer shares to the seller, which results in the seller not receiving sufficient compensation for his/her company. The seller, on the other hand, has an incentive to undervalue the acquirer’s stock to receive more shares and greater ownership percentage, which results in the buyer overpaying. As you can see, there are competing interests that can heighten the incentives for, and the likelihood of, overpayment or underpayment.

These risks are minimized when rollover equity is being issued to the seller and other investors are purchasing shares in the buyer at the same price at that time. However, if rollover equity is being issued and there are no other investors purchasing shares at the same time, or if there is no rollover equity component but shares of the buyer are being issued as purchase consideration to the seller, the assigned value of the shares may not necessarily be reflective of the value received in return.

Another factor that may need to be considered is that shares in a privately held company that do not represent a controlling ownership interest are often subject to a meaningful lack of marketability discount, which may be greater than 30% of the acquiring company’s undiscounted value. This discount considers the fact that a minority owner in a privately held company cannot readily turn his or her ownership interest into cash (unlike an investment in a publicly traded company). If this discount is not considered when assigning value to the acquirer’s shares, it can result in the seller receiving less value than he or she would have had all of the proceeds been paid in cash.

The impact of discounts for lack of marketability are not confined solely to publicly traded companies. This issue can impact the shares of publicly traded companies issued in connection with acquisitions as well. For example, there are instances in which the sellers in a transaction receive restricted stock of the publicly traded acquirer. These restrictions do not permit the sale of the shares for periods ranging from a few months to a few years, which makes the shares less valuable than they would be if they were freely tradable from day one. Therefore, simply relying on the quoted price of the shares to be received is likely to overvalue the consideration being received.

Imagine receiving shares of a publicly traded company worth $5 million on the date of issuance and watching them decline to $1 million prior to the restricted sale period elapsing. The inability to sell the shares would have a material impact on their value. As a result, it may be necessary to consider a discount for lack of marketability for restricted shares in publicly traded companies, as well, to capture the risk associated with potential changes in the price of the acquiring company’s shares before the restricted sale period has ended. Not doing so could result in the seller receiving far less in value than it may appear as of the closing date.

In practice, valuation experts are most likely to run into this share-based consideration issue in one of two scenarios: 1) assisting a client in the sale or purchase of a Company; or 2) developing a purchase price allocation to value the intangible assets acquired in a transaction in accordance with GAAP. 

In the former scenario, which often occurs when valuation experts are assisting a buyer or seller with determining an appropriate transaction price, it is important to make your client aware of the possibility that the stock consideration being offered/received may not have a value equal to the suggested amount and that it may be necessary to dive deeper into the numbers to develop a more supportable (and accurate) value. This is particularly important for the seller who, after going through the rigors of the buyer’s due diligence, needs to determine the extent to which he/she wants to perform due diligence in regard to the buyer since the seller is effectively making an investment in the buyer (just like the buyer is making an investment in the seller).

In the latter case, which involves valuing intangible assets for GAAP purposes that will be subject to auditor review, it is strongly advised to have a discussion with the company’s auditors on the front end to determine whether they will require a separate valuation (or reasonableness check) to be performed to support the fair value of the stock consideration issued. Determination of the total purchase price, regardless of its form (cash up front, deferred payments, buyer equity, contingent consideration/earnouts, etc.), is one of the most important steps of any purchase price allocation. You do not want to get to what you think is the end of the engagement only to have the audit firm tell you that they need a fair value analysis performed for the stock consideration, which significantly changes the scope of the project for the valuation expert and pushes back the delivery deadline due to the additional work that needs to be performed.

While acquirers go to great lengths to reduce their risks when purchasing a company, it is still very much a “buyer beware” world—hence the amount of time spent on due diligence before a transaction closes. When shares of the acquiring company are being issued as a portion of the deal consideration in an acquisition; however, the seller also must beware and consider performing due diligence of its own on the buyer. In these cases, it is essential that both the buyer and seller accurately value the acquirer’s shares, or one party may be left with something worth far less than what it thought it bargained for.

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Sean Saari, CPA, ABV, CVA, MBA, is a partner at Marcum LLP in the firm’s Valuation, Forensic and Litigation Services group. He assists a diverse client base in valuations for litigated matters, domestic disputes, shareholder disputes, estate and gift tax planning, financial reporting, and strategic planning.

Mr. Saari can be contacted at (440) 459-5865 or by e-mail to sean.saari@marcumllp.com.