Among the reasons why companies with less than about $2 billion in market capitalization go public is to gain acquisition currency in the form of a security to offer to a target company. Nonetheless, issuers pursuing an acquisition often find themselves in situations where some or all of the consideration to be paid must be in cold hard cash. Perhaps the target’s management wants immediate liquidity. Or certain shareholders of the target may believe the acquirer is harboring too much excess cash that’s earning no return.

Fred D. Johnson

Fred D. Johnson

When an acquirer’s M&A pipeline produces an opportunity that makes strategic and financial sense, it wants to be in a position to pounce. But too many companies make the mistake of not planning the financing of an acquisition until a Letter of Intent (LOI) is in place. Their rationale is understandable, but misguided and impractical.

Clearly, most management teams and boards are sensitive to the financial drag on returns that results from holding substantial excess cash on the balance sheet for an extended period of time. Headlines are replete with examples of even blue-chip companies under fire from the growing legions of activist investors over exactly such a situation. Witness Carl Icahn and others grappling with Apple, Jana Partners’ missives with Safeway and ValueAct’s pursuit of Microsoft’s cash, to name a few. Given that dynamic, who would rightly question a management team for trying to time a capital raise and an acquisition concurrently?

Well, their investment banker, for one. The flaws in this strategy relate to (1) disclosure requirements, (2) investor access to both detailed information about the target and its management and (3) SEC financial-statement requirements.

Take the example of a company that has presciently and prudently filed a shelf registration statement on Form S-3 for such a purpose. The acquirer then signs an LOI with a target whose size makes it a material acquisition (not a significant threshold to cross, mind you, as “material” may be as little as 10% and almost certainly no more than 20% of the issuer’s pre-merger market cap). The acquirer calls its investment banker at that point to discuss either issuing the previously registered shares directly to the target (which prefers registered shares to restricted stock) or selling into the market for the needed cash component. With an effective shelf and a terrific use of proceeds, a quick successful offering should be no problem — or so the thinking goes.

At that point the investment banker winces. He realizes that not only must he deliver bad news to his client but, with all due sympathy, he also sees his prospective fee in jeopardy. He explains that disclosure rules require that the prospectus supplement to be delivered at the close of the financing needs to include detailed information on the target, if the acquisition is material. He also explains that the information must be 100% accurate. The investors in the deal, he continues, will likely want access to management of the target and some level of diligence. That usually is not something the acquirer discussed with the target’s management.

Then the subjects of audits and the SEC come up. Those are typically not favorite areas of discussion among merger partners racing to the altar, but they become particularly onerous here. In order to use the registration statement, the financial statements included and incorporated by reference in the S-3 shelf must have timely audited information on the target. With a material acquisition, that includes pro-forma audited financials. The target may or may not have audited financials, and combining its books with those of the issuer for the pro-forma is not something that can be done in a week or two. Moreover, there is no certainty that significant issues, such as revenue-recognition differences among a host of others, will not arise.

Mired in these challenges but hungry to consummate the deal, the issuer may then get creative. It might propose to the banker that if it can’t close the acquisition with a concurrent issuance of registered shares, it can do it with a contingent issuance of shares. Management believes the target would still accept the offer, provided that the company stipulates raising some minimum amount of capital within a specified period (during which the adequate disclosure and pro-forma audited financials are made public). Even the banker (though not likely a very astute one) may comply by agreeing to underwrite the offering (and save his precious fee). Sounds good, right?

Well, both the issuer and banker should recall one of the reasons for filing the shelf registration statement in the first place: the ability to raise capital quickly and perhaps confidentially. The banker likely advised the shelf registration, reasoning that with an effective shelf, the issuer had the opportunity to do a quietly marketed deal (a “Registered Direct” offering) at any point. A targeted, discreet offering brings the benefit of protecting the share price. Both the issuer and banker know too well that a public announcement of an imminent capital raise almost always causes a significant drop in price. Investors may simply not like dilution at these levels, or may be selling/shorting with the expectation of then buying discounted deal stock when the issuance prices.

So now you see the problem with the contingent capital raising strategy: The issuer has telegraphed a dire need for capital within a known time frame. The strategy is all but certain to beget a stock price that may be so low as to make the formerly attractive and accretive deal now too expensive to make any sense at all.

There are solutions (including perhaps getting a new banker). Issuers can raise the capital prospectively. If the issuer has a history of sound and accretive deals, investors should be more patient while management hunts for a deal that merits tapping into its cash war chest. Alternatively, given today’s historically low interest rates and plentiful debt capital, an issuer can obtain private debt capital with fewer complexities than a public-equity offering and a lower cost of capital. The debt can potentially be paid off with a subsequent equity offering at a higher stock price that would result from the successful acquisition and the combined company’s concomitant proven track record over a couple of quarters.

Management teams often describe their strategy of filing a shelf registration statement as a “rainy day” mechanism to be used only if and when needed. That is sound thinking. Just be sure that when you look to use your shelf for an acquisition, it is simply sprinkling and not pouring. The best advice here is to dig your well before you are thirsty.

Fred D. Johnson is managing director of investment banking at Barrington Research Associates in Chicago. He has spent almost 20 years raising capital for small-cap companies.  His career stops before Barrington Research have included William Blair, A.G. Edwards (Wachovia), Arthur Andersen, PaineWebber and Dun & Bradstreet.

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