Deal valuation and financing - Cash versus share offers and ...

Learning Outcomes

After reading this article, you will be able to compare the use of cash offers, share-for-share exchanges, and earn-out structures in the context of mergers and acquisitions. You will understand how different forms of consideration impact the valuation of deals, the financial position of both acquirer and target, and the treatment of key risks for all parties involved.

ACCA Advanced Financial Management (AFM) Syllabus

For ACCA Advanced Financial Management (AFM), you are required to understand the practical and financial implications of alternative deal structures when evaluating mergers and acquisitions. Your revision should focus on:

• Methods of consideration for acquisitions: cash offers, share exchanges, and mixed offers
• The use and purpose of earn-out arrangements in acquisitions
• Evaluation of deal value under different offer structures
• Impacts on key financial metrics (EPS, gearing) and on the interests of both acquirer and target shareholders
• Risks to stakeholders and practical considerations surrounding each payment method

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which of the following is a main advantage to target shareholders when accepting a share-for-share offer over a cash offer?
   1. Greater certainty of value
   2. Immediate liquidity
   3. Ongoing participation in the combined business
   4. Lower taxation on proceeds

2. What is the primary purpose of an earn-out arrangement in an acquisition context?

3. True or false? A cash-financed acquisition always reduces the acquirer’s gearing.

4. Briefly explain how a cash offer and a share exchange can impact the earnings per share (EPS) of the acquiring company after a takeover.

Introduction

When a company acquires another, a critical consideration is how the acquisition will be financed and how the deal will be structured. The main forms of payment are cash, shares in the acquiring company, or a combination. In some cases, an earn-out is used to bridge valuation uncertainty, especially where future performance is hard to predict. Each option has different consequences for deal value, risk allocation, and the financial structure of both the acquirer and the target.

This article explains the differences between cash offers, share-for-share exchanges, mixed offers, and earn-outs, focusing on their implications for value, risk, and stakeholder interests in the context of M&A transactions.

FORMS OF ACQUISITION CONSIDERATION

There are three principal methods of consideration in corporate acquisitions: cash offers, share exchanges, and mixed or hybrid offers. Selecting the most suitable form depends on the strategic goals of each party and the resources available.

Cash Offers

In a cash offer, the acquiring company pays a fixed sum of money for each target share. This method is simple and gives certainty to target shareholders, but may require the acquirer to raise significant funds, either from existing resources, new debt, or a rights issue.

Key Term: cash offer
An acquisition payment method where the acquirer offers target shareholders a specified cash amount per share.

Share-for-Share Exchange

In a share-for-share (or stock-for-stock) exchange, the acquirer offers its own shares to the target's shareholders in exchange for their shares in the target. This allows target shareholders to participate in the future performance of the combined entity and may be more attractive for large deals or if the acquirer wants to conserve cash.

Key Term: share-for-share exchange
A transaction where target shareholders receive new shares in the acquirer in exchange for their own shares, rather than cash.

Mixed Offers

A mixed offer combines cash and shares as payment. This structure is often used to provide flexibility and balance immediate value with future participation for target shareholders.

Earn-Outs

Where deal value is uncertain—such as when a large portion of the target’s future profits is unpredictable—an earn-out arrangement may be negotiated. This defers part of the purchase price, linking it to the future financial performance of the target. It helps close gaps between buyer and seller expectations by sharing post-acquisition success or risk.

Key Term: earn-out
A deal structure where a portion of the payment to target shareholders is contingent on the target achieving specified future performance targets.

EVALUATING THE IMPACT OF PAYMENT METHODS ON DEAL VALUE

The form of payment affects not only the price and perceived value but also risk allocation, taxation, and key financial metrics for both companies.

Effect on Acquirer

A cash offer requires access to liquid funds, and if financed with debt, often increases the acquirer's gearing and financial risk. Increased debt may affect key ratios and credit ratings. A share exchange preserves cash but dilutes existing shareholder control and may impact earnings per share (EPS).

Key Term: gearing
The proportion of a company’s capital financed through debt compared to equity; high gearing means more debt relative to equity.

A mixed offer spreads risks and may be negotiated to align stakeholder interests.

Effect on Target Shareholders

A cash offer gives immediate certainty and liquidity, but may trigger immediate tax liabilities. Share offers provide participation in the combined entity’s upside but expose the target's shareholders to future risks and market movements in the acquirer’s shares. Earn-outs transfer some risk to target shareholders, rewarding continued performance but delaying certainty.

Effect on Earnings Per Share (EPS) and Other Metrics

Share exchanges usually result in more shares issued, potentially diluting EPS unless synergies raise profit sufficiently. Cash offers decrease available cash (or require new borrowings) but may leave EPS unchanged for the acquirer, assuming no additional shares are issued.

COMPARISON OF CASH, SHARE, AND EARN-OUT CONSIDERATIONS

Worked Example 1.1

A large listed company wants to acquire TechCo, a fast-growing unlisted firm with unpredictable earnings. The acquirer offers $25m in cash or, alternatively, $15m in cash plus a deferred earn-out of up to $15m based on TechCo meeting post-acquisition profit targets. Explain the implications for both sides.

Answer:
The full cash offer gives TechCo’s owners certainty and immediate payment, but the acquirer takes on all future performance risk. The cash-plus-earn-out structure reduces the guaranteed upfront payment, while allowing TechCo’s owners potential additional payment if the company performs as forecast. This shares the risk—if profits are lower than expected, the acquirer pays less overall.

Worked Example 1.2

Omega Co makes a share-for-share offer to acquire Delta Ltd. Omega Co’s shares trade at $8, while Delta’s are at $4. Omega proposes exchanging 1 Omega share for every 2 Delta shares. After the deal, what is the effective price per Delta share, and what are the likely concerns for shareholders?

Answer:
The effective price per Delta share is $4 ($8 / 2), matching the market price. Delta’s shareholders may be concerned if Omega’s share price drops after the deal, or if their post-transaction holding in the new company is small. They also face exposure to Omega’s future performance.

EARN-OUTS: RISK ALLOCATION AND KEY ISSUES

Earn-outs are suitable where future earnings are volatile, or vendor knowledge is critical post-sale. They can help complete deals where price negotiations are deadlocked. However, they raise practical issues:

• Disputes over accounting methods can affect earn-out calculations.
• Vendors may have limited ability to influence results once control passes to the acquirer.
• Contingent payments complicate deal evaluation, and may be contested if targets are missed due to acquirer actions.
• Taxation of contingent payments varies by jurisdiction and should be assessed in advance.

STAKEHOLDER CONSIDERATIONS

The form of payment impacts shareholders, creditors, employees, and management in both companies. Key points:

• Cash consideration may disrupt the acquirer’s capital structure and risk profile.
• Share exchanges can dilute control and returns for existing shareholders if not carefully managed or if anticipated synergies are not realised.
• Earn-outs may affect the willingness of founders or management to remain engaged post-acquisition, as a portion of their reward is deferred and performance-linked.

Exam Warning

Failing to consider the impact of deal structure on post-acquisition financial metrics, such as earnings per share or gearing, is a common error. Share issues dilute EPS unless growth in profits outpaces new shares issued. Always evaluate likely post-deal ratios and shareholder interests.

Summary

Selecting the right combination of consideration and financing is critical in deal valuation and acquisition success. Cash, shares, and earn-out arrangements each present benefits and drawbacks for value, risk, and stakeholder interests. Robust analysis must look beyond headline price to future value creation, risk allocation, and practical execution.

Key Point Checklist

This article has covered the following key knowledge points:

• Understand cash offers, share-for-share exchanges, mixed offers, and earn-outs in M&A deals
• Evaluate the impact of payment method on deal valuation, EPS, and gearing
• Compare advantages and disadvantages of each approach for acquirers and target shareholders
• Recognise stakeholder impacts and the potential for disputes in earn-out structures
• Identify key risks and strategic considerations linked to deal structure

Key Terms and Concepts

• cash offer
• share-for-share exchange
• earn-out
• gearing