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Equity or Cash? The Signal Sent by the Way You Pay

DBR | 1호 (2008년 1월)
It’s well known that the stock market reacts more favorably if a company is bought with cash than with stock. But the opposite holds true when you buy just a business unit: It’s better to pay with your equity rather than cash. Why? In simple terms, because the choice between cash and equity reveals private information that the market uses to gauge value.
In collaboration with our colleagues Stefano Lovo and Myron B. Slovin, we examined how share prices respond to announcements of intercorporate asset sales and analyzed the effects of the means of payment. We found that when the buyer paid with equity, both companies’ share prices increased; in cash deals, the seller’s value increased modestly while the buyer’s fell slightly. By contrast, numerous studies show, when entire companies are bought, the seller’s shareholders are richly rewarded in both cash and equity deals while the buyer’s shares rise modestly in cash deals but fall in equity deals.
As a general rule, buyers prefer to pay with equity when they think their shares are overvalued. And sellers prefer to receive equity when they’re confident that the asset in question will create value for the buyer, since the seller will have a stake in the buyer after the sale. Thus, a buyer’s offer to pay with equity sends a negative signal about the buyer, but a seller’s acceptance of equity signals the seller’s positive private information about the asset.
In practice, asymmetric information pervades all acquisitions and is held by both sides. Sellers have private information about the value of what they are selling, while buyers know more about what potential synergies the assets may have as part of their operations.
The difference between buying an asset and buying an entire company lies in the identity of the party whose private information governs the cash-equity choice. In a merger, a buyer must make a formal offer that requires shareholders to vote. Hence it is the buyer that decides whether to offer cash or equity, and the means of payment reveals the buyer’s private information. Buying assets does not involve shareholders; the seller conducts competitive auctions, which does induce potential buyers to reveal information through their bids. But by accepting, or even soliciting, payment in buyer equity, it is the seller that conveys any positive private information it has about the quality of the deal (and vice versa when insisting on a cash deal).
Our findings have implications for other types of corporate transactions. For example, in earn-outs and in joint ventures, which often are effectively delayed-asset sales, the seller retains an interest in the cash flow that the buyer generates after the asset is added to its existing operations. In general, when a seller retains such an equity interest, studies show, the transaction tends to generate positive share price reactions; our research explains why.