When a large diversified health care company announced its intention to buy a small, but highly profitable, nursing home chain, its stock soared. This may not sound like a problem, but it can be when deals are stock financed. In this case, the buyer faced the possibility that it would have to pay more per target share to make its acquisition. In other cases, postannouncement share price volatility can work to the seller’s detriment.
Fortunately, it’s possible to prevent the market from disrupting M&A plans with a “collar.” Here’s how it works.
Renegotiate or worse
Unlike all-cash deals, where the transaction value typically remains constant, deals financed partially or entirely with stock can decline in value as the buying company’s share price fluctuates. This, in turn, complicates the deal because parties may need to renegotiate price as they approach closing.
Typically, a seller’s shares are exchanged for a fixed number of the buyer’s shares in a deal structure called a “fixed exchange ratio.” This arrangement, however, can work against the seller if the buyer’s stock declines substantially before closing. Conversely, a fixed exchange ratio can work against the buyer if its stock price increases, because it then will have a higher price-per-target share than it had originally negotiated.
Floors and caps
A collar sets floors and caps on the stock portion of an acquisition’s price, giving both parties some assurance that the deal will retain its value. The one that’s best for both buyer and seller depends on your priorities — whether you want to maintain a certain percentage ownership or secure a specified target price.
There are two major types of collars. The first is the “fixed-value collar,” where the buyer and seller agree on an acceptable price range for either party’s stock to remain within (known as the “collar width”). The exchange ratio adjusts within the set pricing parameters and won’t fall below the floor or above the cap.
The second type is the “fixed-share collar.” Here, the buyer agrees to give a specific number of its shares for each seller’s share, and the parties agree on a pricing range for those shares. The deal’s value fluctuates based on the price of the buyer’s stock. A fixed-share structure lessens the risk of buyer overpayment because the exchange ratio decreases once prices exceed the highest price in the range.
Fixed and floating
Some collars are designed to limit risk by allowing the buyer or seller to walk away if stock fluctuations make the deal undesirable. Within a collar, there are two kinds of exchange ratios:
- Fixed. The originally negotiated stock-for-stock exchange ratio doesn’t change, but either party can cancel the deal if the buyer’s share price moves above or below a specified level. Fixed-collar offers are most appropriate when sellers are willing to accept some uncertainty about the amount of the final sale proceeds.
- Floating. Here, the exchange ratio may change within a specified range up until closing, but the price remains the same. The upper boundary protects the buyer from shareholder dilution if its stock falls between the initial agreement and the close of the deal. The lower boundary protects the seller from a reduction in ownership of the combined entity.
Although they can limit risk, collars have potential drawbacks. They may make a deal more complex and increase the time that management spends negotiating terms and price parameters. On the other hand, with a collar agreement in place you’re likely to reduce time and costs at closing.
Perfect buyer and seller
Once you’ve found the perfect seller or buyer, you don’t want to allow the market’s reaction to the news to crush your deal. A collar is one price protection strategy to consider, but your advisor may be able to suggest others.