A company that is in the market to make an acquisition typically has several financing options. Among the choices, a deal can be paid for using all cash or the publicly traded stock of the acquiring company. Deals can also be funded with a combination of cash and stock. An acquiring company's management team may choose the desired financing method based on the amount of cash on hand coupled with the risk tolerance of the corporation.
When a company wants to merge with another company, it is common for existing shareholders to receive a premium to convert the shares to a merged entity. Even the merger of equals, companies initiating mergers that offer cash or stock to the shareholders of the acquired company.
Read More: What Happens to Stock Prices When Companies Merge?
Cash Deal Mergers
In a cash merger, the acquirer uses cash to buy a target company. The price tag may still be expressed on a per-share basis even if it is financed with cash. Instead of exchanging shares of stock, however, the buyer uses cash that is available on a balance sheet or turns to the debt capital markets for loans.
In a straight cash merger, the firm makes a tender offer at a price that is acceptable to the shareholders of the target company, shareholders must approve a deal. For example, a company offering to pay $30 cash for a share in the target corporation stock currently sells at $22.
Debt increases the risk associated with the transaction because those financial obligations must be repaid. The risk becomes heightened if the target company also has debt because it is not unusual for a buyer to inherit the liabilities of the newly acquired business.
Stock Deal Mergers
A publicly traded company may decide to make an acquisition using its own equity. The precise terms of stock deals vary but can be performed on a one-to-one basis. With this ratio, the buying company exchanges one of its own shares of stock for each one of the target company's shares.
The two stocks continue to trade until the merger is finally approved by regulators and shareholders. At this time, the target company's stock ceases to trade. Investors in the target company may exchange each share for one share of the surviving company's stock.
A key term regarding stock mergers is the conversion ratio. The ratio converts the target company shares into the shares in the combined firm. For example, if you owned 1,000 shares in the target company that received the stock merger offer with a conversion ratio 1.545, you receive 1,545 shares in the merged company.
Tax Factor in Mergers
Investors in a target company face greater tax liabilities in a deal that is financed using cash versus stock. Sometimes, a stock deal can also leave investors with a higher tax obligation.
If a deal is financed using both cash and stock and less than 80 percent of the deal is done using equity shares, investors in the target company may be taxed. Investors are taxed for the difference between the market value of the stock at the time the shares were purchased and the merger price per share.
Shareholders Influence in Mergers
In order for any deal to be approved it needs to win the support of shareholders, regardless of whether it is paid for using cash or stock. If a bid for a target company becomes competitive, an acquirer may be motivated to enhance the deal with a greater cash component or raising the price per share to appease shareholders.
In 2021, the planned merger of Zoom and Five9 failed to materialize after Five9’s shareholders rejected the merger with Zoom at a special meeting. Five9 will continue to operate as a standalone publicly traded company. The deal entailed a cash merger proposal from Zoom company.
Geri Terzo is a business writer with more than 15 years of experience on Wall Street. Throughout her career, she has contributed to the two major cable business networks in segment production and chief-booking capacities and has reported for several major trade publications including "IDD Magazine," "Infrastructure Investor" and MandateWire of the "Financial Times." She works as a journalist who has contributed to The Motley Fool and InvestorPlace. Terzo is a graduate of Campbell University, where she earned a Bachelor of Arts in mass communication.