Paper or Plastic? It Really Matters When Your Are Buying a Company

I was thinking about the Skype acquisition by eBay the other day—some $2 to $4 billion dollars, depending on earn-outs—and how shocking that sum sounds, especially for a company with very small revenues.  But management and investors both make a big mistake when they equate paying cash for a company to buying it with stock.  The two are radically different transactions, and to say that they converge on a common price is to misunderstand the nature and function of currency.

Paying cash for a company makes sense for accretive acquisitions which will improve the acquiring company's financials in the coming year, top and bottom line.  After all, cash is money that you could have given back to investors, and so when you don’t, it is right that you put it to work in ways that will generate immediate returns for them at your existing P/E ratio.

Paying equity for a company is an entirely different matter.  It makes sense when you are making strategic acquisitions that are dilutive in the short term but which you expect will fundamentally change your competitive advantage profile, and thus your earnings potential, in the long term.  In effect, you are not acquiring a going concern but instead mixing two gene pools to create a next generation of capability.  You are going to create a new P/E ratio.

Equity is not actually currency, it is ownership rights, and although markets are willing to trade one for the other, they should not confuse the two.  eBay gave up around 4% of its ownership rights to gain Skype.  That is a good deal if Skype can change eBay’s future earnings potential by more than 4%, a bad deal if it cannot  The cash value of the transaction is a distraction in this calculation.

Too many boards and CEOs are unwilling to pay up for major acquisitions because they see them only as adding in cash flows and not as marriages with the potential to create wholly new offspring.  As a result they do not improve their competitive advantage sufficiently to deal with the next round of natural selection in their marketplace.  Their stocks languish and eventually decline because, like marriage-averse bachelors, they are never able to take the plunge.

Comments

[Mark Rosneck]

Warren Buffett made a similar comment in his latest annual report: "In this quest [of making acquisitions], 2005 was encouraging. We agreed to five purchases: two that were completed last year, one that closed after yearend and two others that we expect to close soon. None of the deals involve the issuance of Berkshire shares. That’s a crucial, but often ignored, point: When a management proudly
acquires another company for stock, the shareholders of the acquirer are concurrently selling part of their interest in everything they own. I’ve made this kind of deal a few times myself – and, on balance, my actions have cost you money."

http://www.berkshirehathaway.com/2005arn/2005ar.pdf
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[Geoff Moore]

This is actually a crucial issue for all volume operations companies that want to use customer intimacy as a differentiator. You have to be able to do this at scale and with a high turnover work force. This means you need to have systems that successfully select for and/or train for the behavior you are seeking. So, yes, at the end of the day, it is the human being that delivers the experience, but systems are key to making this happen consistently enough to create and maintain a brand image. Think of McDonald's for their consistent following of standard operational procedures as another kind of example.

[Tom Foremski]

Geoffrey, that's a very good distinction between cash and stock deals.

In too many minds they are considered almost interchangeable, but you've spelled out how these types of deals differ, and the impact on shareholders.