The legendary merger mania of the 1980s pales beside the M&A activity of this decade. In 1998 alone, 12,356 deals involving U.S. targets were announced for a total value of $1.63 trillion. Compare that with the 4,066 deals worth $378.9 billion announced in 1988, at the height of the 1980s merger movement. But the numbers should be no surprise. After all, acquisitions remain the quickest route companies have to new markets and to new capabilities. As markets globalize, and the pace at which technologies change continues to accelerate, more and more companies are finding mergers and acquisitions to be a compelling strategy for growth.

What is striking about acquisitions in the 1990s, however, is the way they’re being paid for. In 1988, nearly 60% of the value of large deals—those over $100 million—was paid for entirely in cash. Less than 2% was paid for in stock. But just ten years later, the profile is almost reversed: 50% of the value of all large deals in 1998 was paid for entirely in stock, and only 17% was paid for entirely in cash.

This shift has profound ramifications for the shareholders of both acquiring and acquired companies. In a cash deal, the roles of the two parties are clear-cut, and the exchange of money for shares completes a simple transfer of ownership. But in an exchange of shares, it becomes far less clear who is the buyer and who is the seller. In some cases, the shareholders of the acquired company can end up owning most of the company that bought their shares. Companies that pay for their acquisitions with stock share both the value and the risks of the transaction with the shareholders of the company they acquire. The decision to use stock instead of cash can also affect shareholder returns. In studies covering more than 1,200 major deals, researchers have consistently found that, at the time of announcement, shareholders of acquiring companies fare worse in stock transactions than they do in cash transactions. What’s more, the findings show that early performance differences between cash and stock transactions become greater—much greater—over time.

In a cash deal, the roles of the two parties are clear-cut, but in a stock deal, it’s less clear who is the buyer and who is the seller.

Despite their obvious importance, these issues are often given short shrift in corporate board-rooms and the pages of the financial press. Both managers and journalists tend to focus mostly on the prices paid for acquisitions. It’s not that focusing on price is wrong. Price is certainly an important issue confronting both sets of shareholders. But when companies are considering making—or accepting—an offer for an exchange of shares, the valuation of the company in play becomes just one of several factors that managers and investors need to consider. In this article, we provide a framework to guide the boards of both the acquiring and the selling companies through their decision-making process, and we offer two simple tools to help managers quantify the risks involved to their shareholders in offering or accepting stock. But first let’s look at the basic differences between stock deals and cash deals.

Cash Versus Stock Trade-Offs

The main distinction between cash and stock transactions is this: 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. More precisely, in stock transactions, the synergy risk is shared in proportion to the percentage of the combined company the acquiring and selling shareholders each will own.

To see how that works, let’s look at a hypothetical example. Suppose that Buyer Inc. wants to acquire its competitor, Seller Inc. The market capitalization of Buyer Inc. is $5 billion, made up of 50 million shares priced at $100 per share. Seller Inc.’s market capitalization stands at $2.8 billion—40 million shares each worth $70. The managers of Buyer Inc. estimate that by merging the two companies, they can create an additional synergy value of $1.7 billion. They announce an offer to buy all the shares of Seller Inc. at $100 per share. The value placed on Seller Inc. is therefore $4 billion, representing a premium of $1.2 billion over the company’s preannouncement market value of $2.8 billion.

The expected net gain to the acquirer from an acquisition—we call it the shareholder value added (SVA)—is the difference between the estimated value of the synergies obtained through the acquisition and the acquisition premium. So if Buyer Inc. chooses to pay cash for the deal, then the SVA for its shareholders is simply the expected synergy of $1.7 billion minus the $1.2 billion premium, or $500 million.

But if Buyer Inc. decides to finance the acquisition by issuing new shares, the SVA for its existing stockholders will drop. Let’s suppose that Buyer Inc. offers one of its shares for each of Seller Inc.’s shares. The new offer places the same value on Seller Inc. as did the cash offer. But upon the deal’s completion, the acquiring shareholders will find that their ownership in Buyer Inc. has been reduced. They will own only 55.5% of a new total of 90 million shares outstanding after the acquisition. So their share of the acquisition’s expected SVA is only 55.5% of $500 million, or $277.5 million. The rest goes to Seller Inc.’s shareholders, who are now shareholders in an enlarged Buyer Inc.

The only way that Buyer Inc.’s original shareholders can obtain the same SVA from a stock deal as from a cash deal would be by offering Seller Inc. fewer new shares, justifying this by pointing out that each share would be worth more if the expected synergies were included. In other words, the new shares would reflect the value that Buyer Inc.’s managers believe the combined company will be worth rather than the $100-per-share preannouncement market value. But while that kind of deal sounds fair in principle, in practice Seller Inc.’s stockholders would be unlikely to accept fewer shares unless they were convinced that the valuation of the merged company will turn out to be even greater than Buyer Inc.’s managers estimate. In light of the disappointing track record of acquirers, this is a difficult sell at best.

Why the Market Is Skeptical About Acquisitions

One thing about mergers and acquisitions has not changed since the 1980s. In about two-thirds of all acquisitions, the acquirer’s stock price falls immediately after the deal is announced. In most cases, that drop is just a precursor of worse to come. The market’s routinely negative response to M&A announcements reflects investors’ skepticism about the likelihood that the acquirer will be able both to maintain the original values of the businesses in question and to achieve the synergies required to justify the premium. And the larger the premium, the worse the share-price performance. But why is the market so skeptical? Why do acquiring companies have such a difficult time creating value for their shareholders?

First of all, many acquisitions fail simply because they set too high a performance bar. Even without the acquisition premium, performance improvements have already been built into the prices of both the acquirer and the seller. Research has shown that the current level of operating performance accounts for only between 20% to 40% of a company’s stock price. The rest is based entirely on expected improvements to current performance. The 30% to 40% premium typically paid for an acquisition therefore just adds to what is already a significant expectation for improvement. What’s more, if important resources are diverted from some businesses during the integration process, performance gains from synergy can easily be canceled out by declines in the units providing the resources.

In other cases, acquisitions turn sour because the benefits they bring are easily replicated by competitors. Competitors will not stand idly by while an acquirer attempts to generate synergies at their expense. Arguably, acquisitions that do not confer a sustainable competitive advantage should not command any premium at all. Indeed, acquisitions may actually increase a company’s vulnerability to competitive attack because the demands of integration can divert attention away from competitors. Acquisitions also create an opportunity for competitors to poach talent while organizational uncertainty is high. Take Deutsche Bank, for example. After it acquired Bankers Trust, Deutsche Bank had to pay huge sums to retain top-performing people in both organizations.

A third cause of problems is the fact that acquisitions—although a quick route to growth—require full payment up front. By contrast, investments in research and development, capacity expansion, or marketing campaigns can be made in stages over time. Thus in acquisitions, the financial clock starts ticking on the entire investment right from the beginning. Not unreasonably, investors want to see compelling evidence that timely performance gains will materialize. If they don’t, they will mark the company’s shares down before any integration takes place.

Fourth, all too often the purchase price of an acquisition is driven by the pricing of other “comparable” acquisitions rather than by a rigorous assessment of where, when, and how management can drive real performance gains. Thus the price paid may have little to do with achievable value. Finally, if a merger does go wrong, it is difficult and extremely expensive to unwind. Managers whose credibility is at stake in an acquisition may compound the value destroyed by throwing good money after bad in the hope that more time and money will prove them right.

On the face of it, then, stock deals offer the acquired company’s shareholders the chance to profit from the potential synergy gains that the acquiring shareholders expect to make above and beyond the premium. That’s certainly what the acquirers will tell them. The problem, of course, is that the stockholders of the acquired company also have to share the risks. Let’s suppose that Buyer Inc. completes the purchase of Seller Inc. with an exchange of shares and then none of the expected synergies materialize. In an all-cash deal, Buyer Inc.’s shareholders would shoulder the entire loss of the $1.2 billion premium paid for Seller Inc. But in a share deal, their loss is only 55.5% of the premium. The remaining 44.5% of the loss—$534 million—is borne by Seller Inc.’s shareholders.

In many takeover situations, of course, the acquirer will be so much larger than the target that the selling shareholders will end up owning only a negligible proportion of the combined company. But as the evidence suggests, stock financing is proving particularly popular in large deals (see the exhibit “The Popularity of Paper”). In those cases, the potential risks for the acquired shareholders are large, as ITT’s stockholders found out after their company was taken over by Starwood Lodging. It is one of the highest profile takeover stories of the 1990s, and it vividly illustrates the perils of being paid in paper.

The Popularity of Paper Source: Securities Data Company

The story started in January 1997 with an offer by Hilton Hotels of $55 per share for ITT, a 28% premium over ITT’s preoffer share price. Under the terms of the offer, ITT’s shareholders would receive $27.50 in cash and the balance in Hilton stock. In the face of stiff resistance from ITT, Hilton raised its bid in August to $70 per share. At that point, a new bidder, Starwood Lodging, a real estate investment trust with extensive hotel holdings, entered the fray with a bid of $82 per share. Starwood proposed paying $15 in cash and $67 in its own shares.

In response, Hilton announced a bid of $80 per share in this form—ITT shareholders would receive $80 per share in cash for 55% of their shares and two shares of Hilton stock for each of the remaining 45% of their shares. If the stock did not reach at least $40 per share one year after the merger, Hilton would make up the shortfall to a maximum of $12 per share. In essence, then, Hilton was offering the equivalent of an all-cash bid that would be worth at least $80 per share if Hilton’s shares traded at $28 or higher one year after the merger. Hilton’s management believed it would clinch the deal with this lower bid by offering more cash and protecting the future value of its shares.

Starwood countered by raising its offer to $85 per share. This time, it gave ITT’s shareholders the option to take payment entirely in stock or entirely in cash. But there was a catch: if more than 60% of the stockholders chose the cash option, then the cash payout to those shareholders would be capped at just $25.50, and the balance would be paid in Starwood stock. Despite this catch, ITT’s board voted to recommend the Starwood offer over the less risky Hilton offer, and it was then approved by shareholders. Ironically, while ITT’s board chose the offer with the larger stock component, the stockholders actually had a strong preference for cash. When the votes were counted, almost 75% of ITT’s shareholders had selected Starwood’s cash option—a percentage far greater than publicly predicted by Starwood’s management and which, of course, triggered the $25.50 cap.

As a consequence of accepting Starwood’s offer, ITT’s shareholders ended up owning 67% of the combined company’s shares. That was because even before the bid was announced (with its very substantial premium), ITT’s market value was almost twice as large as Starwood’s. ITT’s shareholders were left very exposed, and they suffered for it. Although Starwood’s share price held steady at around $55 during the takeover, the price plunged after completion. A year later, it stood at $32 per share. At that price, the value of Starwood’s offer had shrunk from $85 to $64 for those ITT shareholders who had elected cash. Shareholders who had chosen to be paid entirely in stock fared even worse: their package of Starwood shares was worth only $49. ITT’s shareholders had paid a steep price for choosing the nominally higher but riskier Starwood offer.

Fixed Shares or Fixed Value?

Boards and shareholders must do more than simply choose between cash and stock when making—or accepting—an offer. There are two ways to structure an offer for an exchange of shares, and the choice of one approach or the other has a significant impact on the allocation of risk between the two sets of shareholders. Companies can either issue a fixed number of shares or they can issue a fixed value of shares.

Fixed Shares.

In these offers, the number of shares to be issued is certain, but the value of the deal may fluctuate between the announcement of the offer and the closing date, depending on the acquirer’s share price. Both acquiring and selling shareholders are affected by those changes, but changes in the acquirer’s price will not affect the proportional ownership of the two sets of shareholders in the combined company. Therefore, the interests of the two sets of shareholders in the deal’s shareholder value added do not change, even though the actual SVA may turn out to be different than expected.

In a fixed-share deal, shareholders in the acquired company are particularly vulnerable to a fall in the price of the acquiring company’s stock because they have to bear a portion of the price risk from the time the deal is announced. That was precisely what happened to shareholders of Green Tree Financial when in 1998 it accepted a $7.2 billion offer by the insurance company Conseco. Under the terms of the deal, each of Green Tree’s common shares was converted into 0.9165 of a share of Conseco common stock. On April 6, a day before the deal was announced, Conseco was trading at $57.75 per share. At that price, Green Tree’s shareholders would receive just under $53 worth of Conseco stock for each of their Green Tree shares. That represented a huge 83% premium over Green Tree’s preannouncement share price of $29.

Conseco’s rationale for the deal was that it needed to serve more of the needs of middle-income consumers. The vision articulated when the deal was announced was that Conseco would sell its insurance and annuity products along with Green Tree’s consumer loans, thereby strengthening both businesses. But the acquisition was not without its risks. First, the Green Tree deal was more than eight times larger than the largest deal Conseco had ever completed and almost 20 times the average size of its past 20 deals. Second, Green Tree was in the business of lending money to buyers of mobile homes, a business very different from Conseco’s, and the deal would require a costly postmerger integration effort.

The market was skeptical of the cross-selling synergies and of Conseco’s ability to compete in a new business. Conseco’s growth had been built on a series of highly successful acquisitions in its core businesses of life and health insurance, and the market took Conseco’s diversification as a signal that acquisition opportunities in those businesses were getting scarce. So investors started to sell Conseco shares. By the time the deal closed at the end of June 1998, Conseco’s share price had fallen from $57.75 to $48. That fall immediately hit Green Tree’s shareholders as well as Conseco’s. Instead of the expected $53, Green Tree’s shareholders received $44 for each of their shares—the premium had fallen from 83% to 52%.

Green Tree’s shareholders who held on to their Conseco stock after closing lost even more. By April 1999, one year after announcement, Conseco’s share price had fallen to $30. At that price, Green Tree’s shareholders lost not only the entire premium but also an additional $1.50 per share from the preannouncement value.

Fixed Value.

The other way to structure a stock deal is for the acquirer to issue a fixed value of shares. In these deals, the number of shares issued is not fixed until the closing date and depends on the prevailing price. As a result, the proportional ownership of the ongoing company is left in doubt until closing. To see how fixed-value deals work, let’s go back to Buyer Inc. and Seller Inc. Suppose that Buyer Inc.’s offer is to be paid in stock but that at the closing date its share price has fallen by exactly the premium it is paying for Seller Inc.—from $100 per share to $76 per share. At that share price, in a fixed-value deal, Buyer Inc. has to issue 52.6 million shares to give Seller Inc.’s shareholders their promised $4 billion worth. But that leaves Buyer Inc.’s original shareholders with just 48.7% of the combined company instead of the 55.5% they would have had in a fixed-share deal.

As the illustration suggests, in a fixed-value deal, the acquiring company bears all the price risk on its shares between announcement and closing. If the stock price falls, the acquirer must issue additional shares to pay sellers their contracted fixed-dollar value. So the acquiring company’s shareholders have to accept a lower stake in the combined company, and their share of the expected SVA falls correspondingly. Yet in our experience, companies rarely incorporate this potentially significant risk into their SVA calculations despite the fact that the acquirer’s stock price decreases in a substantial majority of cases. (See the table “How Risk Is Distributed Between Acquirer and Seller.”)

How Risk Is Distributed Between Acquirer and Seller

The way an acquisition is paid for determines how the risk is distributed between the buyer and the seller. An acquirer that pays entirely in cash, for example, assumes all the risk that the price of its shares will drop between the announcement of the deal and its closing. The acquirer also assumes all the operating risk after the deal closes. By contrast, an acquirer that pays the seller a fixed number of its own shares limits its risk from a drop in share price to the percentage it will own of the new, merged company. The acquirer that pays a fixed value of shares assumes the entire preclosing market risk but limits its operating risk to the percentage of its postclosing ownership in the new company.

By the same token, the owners of the acquired company are better protected in a fixed-value deal. They are not exposed to any loss in value until after the deal has closed. In our example, Seller Inc.’s shareholders will not have to bear any synergy risk at all because the shares they receive now incorporate no synergy expectations in their price. The loss in the share price is made up by granting the selling shareholders extra shares. And if, after closing, the market reassesses the acquisition and Buyer Inc.’s stock price does rise, Seller Inc.’s shareholders will enjoy higher returns because of the increased percentage they own in the combined company. However, if Buyer Inc.’s stock price continues to deteriorate after the closing date, Seller Inc.’s shareholders will bear a greater percentage of those losses.

How Can Companies Choose?

Given the dramatic effects on value that the method of payment can have, boards of both acquiring and selling companies have a fiduciary responsibility to incorporate those effects into their decision-making processes. Acquiring companies must be able to explain to their stockholders why they have to share the synergy gains of the transaction with the stockholders of the acquired company. For their part, the acquired company’s shareholders, who are being offered stock in the combined company, must be made to understand the risks of what is, in reality, a new investment. All this makes the job of the board members more complex. We’ll look first at the issues faced by the board of an acquiring company.

Questions for the Acquirer.

The management and the board of an acquiring company should address three economic questions before deciding on a method of payment. First, are the acquiring company’s shares undervalued, fairly valued, or over-valued? Second, what is the risk that the expected synergies needed to pay for the acquisition premium will not materialize? The answers to these questions will help guide companies in making the decision between a cash and a stock offer. Finally, how likely is it that the value of the acquiring company’s shares will drop before closing? The answer to that question should guide the decision between a fixed-value and a fixed-share offer. Let’s look at each question in turn:

Valuation of Acquirer’s Shares

If the acquirer believes that the market is undervaluing its shares, then it should not issue new shares to finance a transaction because to do so would penalize current shareholders. Research consistently shows that the market takes the issuance of stock by a company as a sign that the company’s managers—who are in a better position to know about its long-term prospects—believe the stock to be overvalued. Thus, when management chooses to use stock to finance an acquisition, there’s plenty of reason to expect that company’s stock to fall.

If the acquirer believes the market is undervaluing its shares, it should not issue new shares to finance an acquisition.

What’s more, companies that use stock to pay for an acquisition often base the price of the new shares on the current, undervalued market price rather than on the higher value they believe their shares to be worth. That can cause a company to pay more than it intends and in some cases to pay more than the acquisition is worth. Suppose that our hypothetical acquirer, Buyer Inc., believed that its shares are worth $125 rather than $100. Its managers should value the 40 million shares it plans to issue to Seller Inc.’s shareholders at $5 billion, not $4 billion. Then if Buyer Inc. thinks Seller Inc. is worth only $4 billion, it ought to offer the shareholders no more than 32 million shares.

Of course, in the real world, it’s not easy to convince a disbelieving seller to accept fewer but “more valuable” shares—as we have already pointed out. So if an acquiring company’s managers believe that the market significantly undervalues their shares, their logical course is to proceed with a cash offer. Yet we consistently find that the same CEOs who publicly declare their company’s share price to be too low will cheerfully issue large amounts of stock at that “too low” price to pay for their acquisitions. Which signal is the market more likely to follow?

Synergy Risks

The decision to use stock or cash also sends signals about the acquirer’s estimation of the risks of failing to achieve the expected synergies from the deal. A really confident acquirer would be expected to pay for the acquisition with cash so that its shareholders would not have to give any of the anticipated merger gains to the acquired company’s shareholders. But if managers believe the risk of not achieving the required level of synergy is substantial, they can be expected to try to hedge their bets by offering stock. By diluting their company’s ownership interest, they will also limit participation in any losses incurred either before or after the deal goes through. Once again, though, the market is well able to draw its own conclusions. Indeed, empirical research consistently finds that the market reacts significantly more favorably to announcements of cash deals than to announcements of stock deals.

A really confident acquirer would be expected to pay for the acquisition with cash.

Stock offers, then, send two powerful signals to the market: that the acquirer’s shares are overvalued and that its management lacks confidence in the acquisition. In principle, therefore, a company that is confident about integrating an acquisition successfully, and that believes its own shares to be undervalued, should always proceed with a cash offer. A cash offer neatly resolves the valuation problem for acquirers that believe they are undervalued as well as for sellers uncertain of the acquiring company’s true value. But it’s not always so straightforward. Quite often, for example, a company does not have sufficient cash resources—or debt capacity—to make a cash offer. In that case, the decision is much less clear-cut, and the board must judge whether the additional costs associated with issuing undervalued shares still justify the acquisition.

Preclosing Market Risk

A board that has determined to proceed with a share offer still has to decide how to structure it. That decision depends on an assessment of the risk that the price of the acquiring company’s shares will drop between the announcement of the deal and its closing.

Research has shown that the market responds more favorably when acquirers demonstrate their confidence in the value of their own shares through their willingness to bear more preclosing market risk. In a 1997 article in the Journal of Finance, for example, Joel Houston and Michael Ryngaert found in a large sample of banking mergers that the more sensitive the seller’s compensation is to changes in the acquirer’s stock price, the less favorable is the market’s response to the acquisition announcement. That leads to the logical guideline that the greater the potential impact of preclosing market risk, the more important it is for the acquirer to signal its confidence by assuming some of that risk.

A fixed-share offer is not a confident signal since the seller’s compensation drops if the value of the acquirer’s shares falls. Therefore, the fixed-share approach should be adopted only if the preclosing market risk is relatively low. That’s more likely (although not necessarily) the case when the acquiring and selling companies are in the same or closely related industries. Common economic forces govern the share prices of both companies, and thus the negotiated exchange ratio is more likely to remain equitable to acquirers and sellers at closing.

But there are ways for an acquiring company to structure a fixed-share offer without sending signals to the market that its stock is overvalued. The acquirer, for example, can protect the seller against a fall in the acquirer’s share price below a specified floor level by guaranteeing a minimum price. (Acquirers that offer such a floor typically also insist on a ceiling on the total value of shares distributed to sellers.) Establishing a floor not only reduces preclosing market risk for sellers but also diminishes the probability that the seller’s board will back out of the deal or that its shareholders will not approve the transaction. That might have helped Bell Atlantic in its bid for TCI in 1994—which would have been the largest deal in history at the time. Bell Atlantic’s stock fell sharply in the weeks following the announcement, and the deal—which included no market-risk protection—unraveled as a result.

An even more confident signal is given by a fixed-value offer in which sellers are assured of a stipulated market value while acquirers bear the entire cost of any decline in their share price before closing. If the market believes in the merits of the offer, then the acquirer’s price may even rise, enabling it to issue fewer shares to the seller’s stockholders. The acquirer’s shareholders, in that event, would retain a greater proportion of the deal’s SVA. As with fixed-share offers, floors and ceilings can be attached to fixed-value offers—in the form of the number of shares to be issued. A ceiling ensures that the interests of the acquirer’s shareholders are not severely diluted if the share price falls before the deal closes. A floor guarantees the selling shareholders a minimum number of shares and a minimum level of participation in the expected SVA should the acquirer’s stock price rise appreciably.

Questions for the Seller.

In the case of a cash offer, the selling company’s board faces a fairly straightforward task. It just has to compare the value of the company as an independent business against the price offered. The only risks are that it could hold out for a higher price or that management could create better value if the company remained independent. The latter case certainly can be hard to justify. Let’s suppose that the shareholders of our hypothetical acquisition, Seller Inc., are offered $100 per share, representing a 43% premium over the current $70 price. Let’s also suppose that they can get a 10% return by putting that cash in investments with a similar level of risk. After five years, the $100 would compound to $161. If the bid were rejected, Seller Inc. would have to earn an annual return of 18% on its currently valued $70 shares to do as well. So uncertain a return must compete against a bird in the hand.

More than likely, though, the selling company’s board will be offered stock or some combination of cash and stock and so will also have to value the shares of the combined company being offered to its shareholders. In essence, shareholders of the acquired company will be partners in the postmerger enterprise and will therefore have as much interest in realizing the synergies as the shareholders of the acquiring company. If the expected synergies do not materialize or if other disappointing information develops after closing, selling shareholders may well lose a significant portion of the premium received on their shares. So if a selling company’s board accepts an exchange-of-shares offer, it is not only endorsing the offer as a fair price for its own shares, it is also endorsing the idea that the combined company is an attractive investment. Essentially, then, the board must act in the role of a buyer as well as a seller and must go through the same decision process that the acquiring company follows.

At the end of the day, however, no matter how a stock offer is made, selling shareholders should never assume that the announced value is the value they will realize before or after closing. Selling early may limit exposure, but that strategy carries costs because the shares of target companies almost invariably trade below the offer price during the preclosing period. Of course, shareholders who wait until after the closing date to sell their shares of the merged company have no way of knowing what those shares will be worth at that time.

The questions we have discussed here—How much is the acquirer worth? How likely is it that the expected synergies will be realized?, and How great is the preclosing market risk?—address the economic issues associated with the decisions to offer or accept a particular method of paying for a merger or acquisition. There are other, less important, issues of tax treatment and accounting that the advisers of both boards will seek to bring to their attention (see the sidebars “Tax Consequences of Acquisitions” and “Accounting: Seeing Through the Smoke Screen”). But those concerns should not play a key role in the acquisition decision. The actual impact of tax and accounting treatments on value and its distribution is not as great as it may seem.

Tax Consequences of Acquisitions

The way an acquisition is paid for affects the tax bills of the shareholders involved. On the face of it, a cash purchase of shares is the most tax-favorable way for the acquirer to make an acquisition because it offers the opportunity to revalue assets and thereby increase the depreciation expense for tax purposes. Conversely, shareholders in the selling company will face a tax bill for capital gains if they accept cash. They are therefore likely to bargain up the price to compensate for that cost, which may well offset the acquirer’s tax benefits. But it’s difficult to generalize. After all, if the selling shareholders suffer losses on their shares, or if their shares are in tax-exempt pension funds, they may favor cash rather than stock.

By contrast, the tax treatments for stock-financed acquisitions appear to favor the selling shareholders because they allow them to receive the acquirer’s stock tax-free. In other words, selling shareholders can defer taxes until they sell the acquirer’s stock. But if sellers are to realize the deferred tax benefit, they must be long-term shareholders and consequently must assume their full share of the postclosing synergy risk.

Accounting: Seeing Through the Smoke Screen

Some managers claim that stock deals are better for earnings than cash deals. But this focus on reported earnings flies in the face of economic sense and is purely a consequence of accounting convention.

In the United States, cash deals must be accounted for through the purchase-accounting method. This approach, which is widespread in the developed world, records the assets and liabilities of the acquired company at their fair market value and classifies the difference between the acquisition price and that fair value as goodwill. The goodwill must then be amortized, which causes a reduction in reported earnings after the merger is completed.

In contrast, acquisitions that are at least 90% paid for in shares, and meet a number of other requirements, can be accounted for under the pooling-of-interests method. This approach requires companies simply to combine their book values, creating no goodwill to be amortized. Therefore, better earnings results are reported. Perhaps not surprisingly, a recent proposal by the Financial Accounting Standards Board to eliminate pooling has caused deep consternation in corporate boardrooms concerned about earnings and among investment bankers who fear a serious downturn in M&A activity.

In principle, though, the accounting treatment should make no difference to an acquisition’s value. Although it can dramatically affect the reported earnings of the acquiring company, it does not affect operating cash flows. Goodwill amortization is a noncash item and should not affect value. Managers are well aware of this, but many of them contend that investors are myopically addicted to short-term earnings and cannot see through the cosmetic differences between the two accounting methods.

Research evidence does not support that claim, however. Studies consistently show that the market does not reward companies for using pooling-of-interests accounting. Nor do goodwill charges from purchase accounting adversely affect stock prices. In fact, the market reacts more favorably to purchase transactions than to pooling transactions. The message for management is clear: value acquisitions on the basis of their economic substance—their future cash flows—not on the basis of short-term earnings generated by accounting conventions.

Shareholder Value at Risk (SVAR)

Before committing themselves to a major deal, both parties will, of course, need to assess the effect on each company’s shareholder value should the synergy expectations embedded in the premium fail to materialize. In other words, what percentage of the company’s market value are you betting on the success or failure of the acquisition? We present two simple tools for measuring synergy risk, one for the acquirer and the other for the seller.

A useful tool for assessing the relative magnitude of synergy risk for the acquirer is a straightforward calculation we call shareholder value at risk. SVAR is simply the premium paid for the acquisition divided by the market value of the acquiring company before the announcement is made. The index can also be calculated as the premium percentage multiplied by the market value of the seller relative to the market value of the buyer. (See the table “What Is an Acquirer’s Risk in an All-Cash Deal?”) We think of it as a “bet your company” index, which shows how much of your company’s value is at risk if no postacquisition synergies are realized. The greater the premium percentage paid to sellers and the greater their market value relative to the acquiring company, the higher the SVAR. Of course, as we’ve seen, it’s possible for acquirers to lose even more than their premium. In those cases, SVAR underestimates risk.

What Is an Acquirer’s Risk in an All-Cash Deal? An acquirer’s shareholder value at risk (SVAR) varies both with the relative size of the acquisition and the premium paid.

Let’s see what the SVAR numbers are for our hypothetical deal. Buyer Inc. was proposing to pay a premium of $1.2 billion, and its own market value was $5 billion. In a cash deal, its SVAR would therefore be 1.2 divided by 5, or 24%. But if Seller Inc.’s shareholders are offered stock, Buyer Inc.’s SVAR decreases because some of the risk is transferred to the selling shareholders. To calculate Buyer Inc.’s SVAR for a stock deal, you must multiply the all-cash SVAR of 24% by the percentage that Buyer Inc. will own in the combined company, or 55.5%. Buyer Inc.’s SVAR for a stock deal is therefore just 13.3%.

A variation of SVAR—premium at risk—can help shareholders of a selling company assess their risks if the synergies don’t materialize. The question for sellers is, What percentage of the premium is at risk in a stock offer? The answer is the percentage of ownership the seller will have in the combined company. In our hypothetical deal, therefore, the premium at risk for Seller Inc.’s shareholders is 44.5%. Once again, the premium-at-risk calculation is actually a rather conservative measure of risk, as it assumes that the value of the independent businesses is safe and only the premium is at risk. But as Conseco’s acquisition of Green Tree Financial demonstrates, unsuccessful deals can cost both parties more than just the premium. (See the table “SVAR and Premium at Risk for Major Stock Deals Announced in 1998.”)

SVAR and Premium at Risk for Major Stock Deals Announced in 1998 Data for calculations courtesy of Securities Data Company. The cash SVAR percentage is calculated as the premium percentage multiplied by the relative size of the seller to the acquirer. The stock SVAR percentage is calculated as the cash SVAR percentage multiplied by the acquirer’s proportional ownership.

From the perspective of the selling company’s shareholders, the premium-at-risk calculation highlights the attractiveness of a fixed-value offer relative to a fixed-share offer. Let’s go back to our two companies. If Buyer Inc.’s stock price falls during the preclosing period by the entire premium paid, then Seller Inc.’s shareholders receive additional shares. Since no synergy expectations are built into the price of those shares now, Seller Inc.’s premium at risk has been completely absorbed by Buyer Inc. In other words, Seller Inc.’s shareholders receive not only more shares but also less risky shares. But in a fixed-share transaction, Seller Inc.’s stockholders have to bear their full share of the value lost through the fall in Buyer Inc.’s price right from the announcement date.

Although we have taken a cautionary tone in this article, we are not advocating that companies should always avoid using stock to pay for acquisitions. We have largely focused on deals that have taken place in established industries such as hotels and insurance. Stock issues are a natural way for young companies with limited access to other forms of financing, particularly in new industries, to pay for acquisitions. In those cases, a high stock valuation can be a major advantage.

Even managers of Internet companies like Amazon or Yahoo! should not be beguiled into thinking that issuing stock is risk-free.

But it is a vulnerable one, and even the managers of Internet companies such as America Online, Amazon.com, and Yahoo! should not be beguiled into thinking that issuing stock is risk-free. Once the market has given a thumbs-down to one deal by marking down the acquirer’s share price, it is likely to be more guarded about future deals. A poor stock-price performance can also undermine the motivation of employees and slow a company’s momentum, making the difficult task of integrating acquisitions even harder. Worse, it can trigger a spiral of decline because companies whose share prices perform badly find it hard to attract and retain good people. Internet and other high-technology companies are especially vulnerable to this situation because they need to be able to offer expectations of large stock-option gains to recruit the best from a scarce pool of talent. The choice between cash and stock should never be made without full and careful consideration of the potential consequences. The all-too-frequent disappointing returns from stock transactions underscore how important it is for the boards of both parties to understand the ramifications and be vigilant on behalf of their shareholders’ interests. A version of this article appeared in the November–December 1999 issue of Harvard Business Review.