WFG - Capital Advisors

Business Finance
By Karen M. Kroll
September, 2005

Cash, stock or a combo? The choices sound simple, but making the right decision isn't always so easy.

Having successfully completed eight deals over the past four years, Jeff Ginsberg knows all the ins and outs of structuring merger-and-acquisition (M&A) transactions. The chairman of Eureka Networks, a New York City-based communication services provider, has steered his organization through some complex deals, the first four of which were acquisitions that the company snapped up in exchange for stock at a time when it needed to conserve its cash resources. Back in 2001, "all our capital was used to fund operations and keep the businesses going," recalls Ginsberg. In addition, the company's profit levels were below what potential lenders would have wanted to see before helping to finance the transactions.

Since then, Eureka Networks has consolidated its new businesses and eliminated many redundant operations. The success of those first deals freed up funds for more M&A projects. At press time, the company was finalizing its merger with Melville, N.Y.-based InfoHighway Communications Corp. in an all-cash transaction.

Ginsberg's company is not alone in aggressively seeking expansion opportunities. The M&A market is growing, and it will remain strong through 2005, according to a March survey by audit, tax and advisory firm KPMG LLP in New York City. Nearly 90 percent of the 110 finance executives who participated said their company expects to complete at least one merger or acquisition this year. That's up from the 70 percent who gave that response in a comparable KPMG survey in 2004.

A little more than half of the respondents in the 2005 study indicated that the improving economy was a key driver of this trend. "Many executives are finding that they must make acquisitions in order to grow," says Rick Dowd, managing director and head of the strategic advisory group with Wachovia Securities in Charlotte, N.C. "They've done all they can internally, and they have to acquire to grow, complement product opportunities and achieve more scale."

The increasing number of companies shopping for acquisitions has helped drive up valuations of target businesses, Dowd adds. In M&A deals worth more than $500 million in 2004, the average purchase price was 7.5 times the acquired company's EBITDA. That's the highest multiple in that category since 1999.

For any organization undertaking an M&A transaction, two questions are central. First, what type of currency -- cash, stock or some combination of these -- should it use to pay for the deal?

Second, what exactly does the company want to buy? Should it purchase the target company's assets? Or would it be better off buying its stock -- but thereby assuming any liabilities that may escape detection in the due diligence process?

Choosing the Currency

The currency decision can be complex. Cash is "a more certain currency," notes Jeff Clarke, COO with IT software provider Computer Associates International Inc. in Islandia, N.Y. Its value doesn't fluctuate the way stock's does, so the seller knows exactly how much it will get at closing. When a seller is fielding several stock offers, buyers that offer cash can often tilt the deal their way. Clarke's company has plunked down about $1 billion in cash to finance four acquisitions over the past 12 months, he reports.

Plus, "interest rates are low, and money is cheap and plentiful," points out Charles (Kip) Clarke (no relation to Jeff Clarke), managing director and co-head of the mergers and acquisition group at KeyBanc Capital Markets in Cleveland. At press time, the federal funds rate stood at 3.5 percent.

However, tying up a chunk of cash in an M&A project means that the money is not available for operations, capital investments or dividends. In addition, drawing down large amounts of cash can adversely impact a company's credit rating, especially if the move requires a significant increase in debt. That's why many buyers choose stock to cover all or part of the purchase price.

When Avnet Inc., a $10 billion global technology distributor, purchased semiconductor distributor Memec in July, its executive team decided not to use cash to cover the entire $700 million price tag, concerned that such a large outlay might threaten the company's credit ratings (currently Ba2 with Moody's and BBB- by Standard & Poor's). Instead, Avnet structured a 65/35 split of stock and cash, reports Ray Sadowski, CFO with the Phoenix, Ariz.-based company. "The sellers got an attractive deal and the opportunity to make more money by their investment in Avnet," he reports.

Choosing stock as the currency can help a purchaser boost its offer. When Applied Digital Solutions Inc., a Delray Beach, Fla.-based provider of security and identification products and services, acquired eXI Wireless Inc. in an all-stock transaction in April, it was able to pay more in shares than it could have paid in cash, says Jay McKeage, vice president of business development.

In addition, some stock deals may have favorable tax implications. In many cases, if the buyer uses its shares to finance at least half of a stock-for-stock transaction, the seller won't owe taxes on those assets until it sells them, according to Bill Wofford, partner with law firm Hutchison + Mason PLLC in Raleigh, N.C.

Of course, stock deals have their drawbacks, too. For starters, these transactions may dilute shareholders' stake in the purchasing company. Say your company's stock is trading at a price-earnings (P/E) ratio of 10, and you're planning to merge in a 50/50 transaction with a business whose stock is trading at a P/E of 20. And let's say that both organizations earn $1 per share. "Because you trade at half the P/E, you need two of your shares to equal the value of one of the target's," says Charles Clarke. "There are now three shares outstanding for every $2 in earnings."

What's more, stock can be an expensive currency in the long run. "You're giving away the upside of the company," says Jeri Harman, managing director with Allied Capital, a Washington, D.C.-based business development company that specializes in debt and equity financing. Holders of equity typically demand higher returns than debt holders do.

Buyers are often reluctant to part with stock if they feel it's undervalued. In part, that's why Computer Associates International used cash for its recent acquisitions, according to Jeff Clarke. "Prospects are better than the share price is showing," he says. Given that the company's operations generate about $1.5 billion in cash flow each year, using cash was a viable option.

What To Buy: Stock or Assets?

Whatever currency they decide to use, most acquiring companies prefer to buy a target's assets rather than its shares. That way, they have a better idea of what they're getting for their money.

With a stock purchase, the seller takes ownership of the entire enterprise -- and that includes any liabilities that may surface after the deal is done. And some liabilities -- for example, violations of environmental regulations and employment practices that might lead to discrimination suits -- can be difficult to detect. "Stock deals aren't ones that we do lightly," says Ginsberg. Thorough due diligence is always critical, but that's particularly true when it comes to stock purchases, he observes.

One way the buying company can mitigate such risks is by forming an acquisition subsidiary, says Dennis J. White, a Boston-based partner with law firm McDermott Will & Emery LLP. This move generally insulates the parent company from liabilities that may arise after the purchase is completed. "It's not a guarantee, but it makes it more difficult for a plaintiff to pursue the parent corporation for the actions of the subsidiary," White notes.

Asset purchases may offer buyers tax advantages. Section 338 (h) (10) of the Internal Revenue Code allows buyers of depreciable assets to take the depreciation expense and so reduce their taxes, says Michael Kaplan, senior associate with Littlejohn & Co., an investment firm based in Greenwich, Conn. For example, say a corporation spends $100 million to purchase assets with 10 years of remaining life. Each year for the next 10, its taxable income can be reduced by $10 million.

If the company had purchased the target through a stock deal, it would have had to use the tax basis (the amount at which the assets are recorded on the seller's books for tax purposes) to calculate the depreciation expense. Typically, this is a much smaller figure than the assets' purchase price.

However, asset sales can result in adverse tax consequences for sellers organized as C corporations, notes Rob Lieblein, president of WFG Capital Advisors in Harrisburg, Pa., an investment banking firm that focuses on financial services. C corporations pay tax on the amount by which the sale price of the assets exceeds the tax basis. And shareholders pay capital gains tax on the money from the sale when it's distributed. Combined, these taxes can hit 50 percent, notes Lieblein.

What's more, asset sales can be a document-intensive process, particularly for the seller, says Kaplan. Each asset must be identified and cataloged, and contracts or leases previously negotiated by the seller may need to be revisited. Some vendors that lease assets to customers -- some enterprise software providers, for example -- require customers to notify them when the asset changes hands. These providers may seek to renegotiate the contract with the acquiring company to obtain a higher fee.

"In general, buyers want to buy assets and sellers want to sell stock," concludes Lieblein. Stock purchases typically result in lower prices because buyers assume additional liabilities and these transactions don't provide the tax benefits that asset deals often deliver. The differential can range from 15 percent to 30 percent.

Earn-outs

If a buyer and seller can't agree on the terms of a deal, an earn-out is one way to bridge the gap. The buyer agrees to pay a specified amount for the purchased company up front and an additional sum later based on the acquired operation's performance in the interim. For instance, the buyer may agree to pay $10 million at the time of the sale and $1 million more after 12 months if the acquisition's revenues rise 10 percent in that period.

When Digital Angel Corp., a subsidiary of Applied Digital Solutions, bought Denmark-based DSD Holdings A/S, it structured the deal in two payments, McKeage reports. About 30 percent of the purchase price changed hands at closing; the remaining 70 percent will follow in a balloon payment in 2007. The final purchase price will depend on the acquisition's performance between now and 2007.

The earn-out approach fits Digital Angel's growth strategy well. DSD Holdings makes devices that enable farmers to track livestock through the delivery chain. It subsidiary, Daploma International A/S, is well-connected in Eastern Europe, where several countries, including Bulgaria and Romania, are expected to join the European Union in 2007, says McKeage. At that point those countries will have to conform to the European Union's livestock tracking standards, which should boost sales of Daploma's products.

While earn-outs can help buyers and sellers find middle ground, "they're notoriously subject to dispute," says Hutchison + Mason's Wofford. For example, if the acquisition's sales fail to meet the earn-out criteria, the seller may claim that the shortfall is due to the buyer's poor management of the asset.

"The buyer has to be of the mentality that they want to pay the earn-out," adds Doug Gonsalves, managing director with SVB Alliant, a Palo Alto, Calif.-based investment banking firm. "You don't want to use the earn-out as a way to pay less for the company." Organizations tempted to go that route should understand that the move can backfire by undermining morale among the acquired company's employees, who may not appreciate learning that their new management has lowered its estimate of the value of their contribution.

In the end, the objective for any M&A venture is to structure the right deal, at the right price, with the right target. "If it's a good acquisition, you won't care in the end if you paid a few extra million," observes Gonsalves. "If it's a bad acquisition, you won't care if you saved a few million."

Reverse Mergers

You might think that if any group of private-company executives could be expected to choose an initial public offering (IPO) to take their organization public, it would be those at the helm of the New York Stock Exchange. Not so.

Instead, the NYSE and a small but growing number of companies are going public through what's known as a reverse merger. Fifty-five reverse mergers were completed from January 1 through June 28 of this year, compared with 89 in all of 2004, says Steven Dresner, publisher with Jericho, N.Y.-based Deal Flow Media Inc., which publishes The Reverse Merger Report.

In a reverse merger, a private company is acquired by a dormant public company, usually a shell corporation with no assets or liabilities of its own. The shell issues such a large number of shares to the private company that the private company's investors end up owning most of the shell's stock. This transfers ownership of the shell to the private company, effectively transforming the private entity into a publicly traded operation. The post-merger organization usually changes the shell's name to reflect the new business.

A reverse merger typically runs about half the cost of an IPO and requires only about 20 percent of the time commitment, according to Dave Brigante, president of the Halter Financial Group, a Plano, Texas-based firm that advises companies seeking to access the U.S. capital markets. Halter Financial specializes in reverse mergers.

Was the Deal Worth It?

To determine whether an acquisition is a success, executives at Computer Associates International Inc. use a measure they call cash flow yield, says Jeff Clarke, COO with the Islandia, N.Y.-based IT software provider. This is the annual cash flow expected or generated by the deal divided by the purchase price. For instance, Clarke's company spent some $340 million to acquire network management vendor Concord Communications in June. The acquisition is expected to generate cash flow of approximately $40 million a year, so the cash flow yield is about 12 percent.

That's higher than Computer Associates International's overall average cash flow yield, which Clarke puts at about 8 percent. This figure is calculated by dividing the company's annual cash flow, $1.3 billion, by its market capitalization of $16.5 billion.

The acquisition "brought up the aggregate and average cash flow," adds Clarke. "It was a good use of cash."

How Finance Can Guide M&A

In many companies, it's the business development team that scouts for merger-and-acquisition (M&A) opportunities. Once a potential target is identified, however, the treasurer and finance team belong at the table to help negotiate the terms of the deal. "The purpose [for including] the chief financial officer or treasurer is to bring accountability to the process," says Dave Petroni, CFO and vice president of business development with Valchemy, a provider of merger-and-acquisition software based in San Mateo, Calif. These executives can help ensure full disclosure on the part of the seller, and they can verify that the terms of the transaction accurately reflect the value and risks that are changing hands.

The accounting team typically takes the lead in the due diligence process, but the treasurer or CFO should be involved here, too. As the process moves along, its findings may prompt a change in either the purchase price or the deal's structure, says Peter L. Coffey, attorney with Michael Best & Friedrich in Milwaukee.

For instance, say a company is working toward purchasing a manufacturer, and the due diligence process reveals that one of the target's largest customers is in financial trouble and is reducing its order volume. The potential hit to the target's income statement should be factored into the purchase price. "Most businesses are sold on trend lines and the expectation of future profits," says Coffey.

Along with the internal finance team, qualified external advisers -- including lawyers and investment bankers -- are a critical resource, say experienced M&A players. "They can give voice to the perspective of both sides," notes Bill Brown, CFO of Authoria Inc., a provider of human resources solutions in Waltham, Mass. Brown currently is completing Authoria's acquisition of Hire.com, a deal that will come to tens of millions of dollars. Outside advisers can also provide insight into the deal valuation ranges that competing acquirers are likely to consider, says Rick Dowd, managing director and head of the strategic advisory group for Wachovia Securities.

That said, some organizations prefer to go it alone, particularly on smaller deals. Applied Digital Solutions Inc., a Delray Beach, Fla.-based provider of security and identification products and services, recently acquired three companies -- eXI Wireless Inc., Instantel Inc. and DSD Holdings A/S -- without engaging investment bankers. "Our internal team has a lot of experience in legal, accounting and financing deals," says Jay McKeage, vice president of business development. "It's probably 65 years between four people."

McKeage recommends that companies should engage investment bankers for purchases that exceed about half their market capitalization or annual revenue. These providers have an established infrastructure for managing the purchase process and channeling information flow to all parties in a way that ensures that none of the participants gets an inside track.

Equally important, "as you reach a certain point, you want to give business to investment bankers," McKeage asserts. "Wall Street is a quid-pro-quo ecosystem." If you include these providers in your M&A project, they may approach you with attractive deals in the future.