March 10, 2011

Cash Is King Even For the Guy Writing the Check

By Eric Michaels, Senior Analyst, MergerTech Advisors

We’ve all heard the expression: cash is king.  There is nothing quite as financially satisfying as being paid in full in cash at closing; however, conventional wisdom tells us that buyers generally prefer avoiding guaranteed payments and hedge risk through earnouts in an acquisition.  Nevertheless, there are times when a buyer will prefer to pay in cash, even if they don’t want to admit it.

Well-managed companies, especially those with publicly traded stock, want to see significant top and bottom line growth.  These companies have an imperative to “make the needle jump.”  Companies like Apple historically accomplish this through internal R&D (i.e. the iPhone and iPad were created internally).  Other companies acquire new product lines, services, and geographies through acquisitions that can dramatically change their business.  For example, last year HP bought Palm, a company on the verge of going out of business, for $1.2B in order to gain ownership of the WebOS platform.  Almost one year later, HP announced a new line of Palm WebOS phones, tablets, printers, and the possibility of seeing WebOS on a desktop or laptop PC.  This one acquisition dramatically changed the direction of HP, a $125B+ revenue business.  When a buyer sees an exciting opportunity with significant cross selling and R&D opportunities, they will not only pay for it in terms of higher valuation multiples, but also better terms and consideration.

More interestingly, a buyer may prefer to pay in cash for one very counter-intuitive reason: they have too much cash on the balance sheet.  Publicly traded companies are a breed of corporate entity that cannot have excess liquidity in the long term.  Since their actions are judged by the market on a daily basis, the CEO and management team are constantly motivated to maximize the company’s ROE.  If they neglect and/or fail to do so, the shareholders may replace them.  Therefore, a CEO cannot pay himself or his employees excessive bonuses nor can the CEO utilize the funds to rapidly pay off debt (as neither activity maximizes rate of return for shareholders).  This leaves the management with a few options: pay a dividend, buyback shares, invest internally, or make M&A investments.  Dividends signal to the market that significant growth opportunities for the company have dried up for the foreseeable future and must distribute the cash in order to give the investors a rate of return.  Dividends are also a tax-disadvantaged way to distribute money.  Share buybacks resolve the tax issue, but would only occur when the market is significantly undervaluing the company’s stock price.  CEOs generally prefer to grow the business as opposed to distribute cash if possible.  As the person responsible for managing the direction of their companies, a CEO will want to grow the business at a significant pace year over year, as it is the best way for him to deliver and demonstrate value.  This leaves M&A and internal projects, both essentially representing new growth prospects.  M&A offers buyers an opportunity to add new tools to their utility belts and opens doors to markets that were previously unavailable.

Many buyers are concerned about earnout structures.  Typically, sellers are given revenue, gross profit, and/or EBITDA targets to hit.  If they hit those targets, sellers receive their earnout payments.  The fear that some buyers have is that their new business partners will be incentivized to take short-term gains at the expense of the long-term picture.  High revenues can be achieved at low margins and costs could be slashed in an unsustainable manner. Additionally, earnouts often put the buyer and the seller on the opposite side of the negotiating table even after the buyer owns the company and many astute and experienced buyers realize that this does not create the culture or environment in which the people they acquired thrive. Cash consideration solves the problem cleanly and easily.

When negotiating with a buyer, it is important to understand their financial position, motivations, and concerns.  Armed with this knowledge and a professional and experienced M&A team,  sellers can achieve better terms and consideration for their company.