The Basics of a Buyout

While the buyout mania of the past few years definitely lost steam this summer as easy financing options disappeared, we still get questions from readers about what they should do if one of their stocks receives an acquisition offer. Such offers force holders of target firms, many of whom expected to hold those stocks for several years, to make immediately decisions about what to do with those holdings. That can be a tough. One of our readers recently wrote: "I would like to know what generally happens when a company is bought out or merged. Do the shareholders always receive stock in the acquiring firm, or cash; and what is the best way to evaluate my options?" While each buyout offer is unique and needs to be considered on its own merits, we can offer some general answers to that inquiry.

To begin with, buyouts can come in cash, stock, or any combination thereof. The form of currency is important primarily because the target firm's stock will react very differently post-offer based on that factor. When it comes to evaluating a possible deal, we compare the offer price with what we think the target firm is worth. If the offer price is significantly higher than the target firm's intrinsic value, that should be a no-brainer in terms of how target-firm shareholders should feel about the deal (good!). When the deal merely reflects the firm's fair value or even represents a lower valuation, things get a bit trickier.

Let's highlight a no-brainer cash deal and a more complicated stock-based deal to get a better idea of how acquisitions can play out for target firm shareholders.

For cash-based deals, the target firm's stock price generally moves toward the offer price, discounted at a normalized cost of equity from when the deal is expected to close. If we think the deal is likely to close, we typically change our fair value estimate to reflect the cash offer on the table, which can differ substantially from our stand-alone fair value estimate. For example,  Kyphon , a maker of spinal implant devices, recently received a $71 per share buyout offer from  Medtronic (MDT), a deal that is expected to close in early 2008. We think Kyphon brokered a great deal for shareholders. We raised our fair value estimate to $67 per share to reflect the cash offer on the table, which is the $71 per share offer discounted at a plain-vanilla 10.5% rate through early 2008. Since a higher offer is unlikely, we'd expect Kyphon shares to trade between our fair value estimate and $71 per share until the deal closes. If this transaction doesn't close as expected, we'd revert back to our stand-alone fair value estimate for Kyphon, which was $45 per share at the time of the deal's announcement, adjusted for cash flows generated in the interim.

If, by contrast, the acquirer offers stock in a buyout, the acquiring firm's value will determine the target firm's valuation. Typically, stock-based transactions are structured as a tax-free transfer of shares based on a transaction ratio that defines how many shares of the acquiring company are traded for each target company share. To further evaluate a stock-based offer, we first need to determine the acquiring firm's value (after accounting for the effects of the potential acquisition, including cost structure implications). Then we need to calculate the target firm's fair value estimate based on the acquiring firm's new fair value estimate and the transaction ratio. Our recommendation will then depend on where the target firm's shares trade in relation to that new fair value estimate.

For example,  FoxHollow Technologies  recently agreed to be acquired by  ev3  in a primarily stock-based deal. In this case, an attractively valued firm by our estimation (ev3)  agreed to purchase an even more attractively valued firm (FoxHollow). After we combined the firms' potential cash flows and accounted for the number of shares ev3 would likely have to issue to purchase FoxHollow, ev3 shares were still trading below our fair value estimate (and they still are). Using the acquiring firm's valuation and the stated transaction ratio, FoxHollow's shares are trading at lower levels than our fair value estimate for the firm.

FoxHollow shareholders have been given the option of accepting stock-plus-cash, stock-only, and cash-only offers. Because the firm's true value is not being reflected in its stock price at this time, we think FoxHollow shareholders should consider opting for the stock-only option at deal close. That way, they can retain as much upside potential as possible in the combined entity, rather than settling for a guaranteed, but too low, cash offer. The combination stock and cash offer price remains very similar to the stock-only price, but FoxHollow shareholders would have to forgo some upside potential and pay taxes on the cash portion of that transaction, which makes it less attractive than the stock-only offer, in our view.

In general, the process of evaluating the attractiveness of a buyout offer remains very similar to evaluating the attractiveness of a stock's valuation. First, determine how much the target firm is worth. In cash deals, we use the target firm's stand-alone value. In stock deals, we consider how the combined entity would be valued and adjust the target firm's fair value based on the transaction ratio. In both cases, comparing the firm's intrinsic value with the offer price should determine the deal's attractiveness and course of action for investors.