Executives can get caught up in decisions about how to finance large M&A deals to create the most value: should the company pay in cash or in shares? Such decisions come down to risk and reward—specifically, how much of each does the acquirer want to share with the target company’s shareholders.
Consider the situation for an acquirer with a $1 billion market capitalization and a target company with a $500 million market capitalization. The acquirer pays $650 million for the target, including a premium of 30 percent (exhibit).
If there is a cash deal, the target company’s shareholders get $650 million, regardless of whether the improvements are high enough to justify the premium. Meanwhile, the acquirer’s shareholders may see the value of their stake increase by $50 million or drop by the same amount. They carry the full risk.
If there is a stock deal, the target company’s shareholders take on some of the risk. Their payout from the acquisition increases as the operating improvements increase; they receive $670 million in value, as opposed to $650 million. If the deal destroys value, the target company’s shareholders now get less than before, since their portion of the combined company is worth $630 million, compared with the $500 million market value before the deal.
Two factors should influence your decision about how to finance M&A. First, consider whether the target or your company are over- or undervalued. If you’re operating within an economic bubble, you will be more inclined to pay in shares so everyone can share the burden of a market correction. Second, consider how confident you are in the deal’s ability to create value overall. The more confident you are, the more you should be inclined to pay in cash.
Vartika Gupta is a solution manager in McKinsey’s New York office, where David Kohn is an associate partner; Tim Koller is a partner in the Denver office; and Werner Rehm is a partner in the New Jersey office.
For a full discussion of market dynamics, see Valuation: Measuring and Managing the Value of Companies, seventh edition (John Wiley & Sons, 2020), by Marc Goedhart, Tim Koller, and David Wessels.