Consider the following hypothetical: You founded a company and have successfully grown the business to a point where the larger players in the industry have taken notice. Following an auction process or more discreet discussions, a public company has proposed acquiring your company in exchange for that company’s common stock. You generally prefer a stock deal over a cash transaction as it would allow you to defer a sizeable tax bill on your capital gains. However, you are concerned about the risks of taking stock versus being paid in cash.
This article explores the issues a seller should consider in evaluating a sale of his company for stock of a publicly traded company.

1. Attributes of the Buyer’s Stock. The seller should carefully review the fundamentals of the buyer’s stock. Issues to consider include: (i) How does the stock trade relative to the buyer’s peers and the market as a whole? (ii) How has the stock performed historically? (iii) What are the expectations of Wall Street research analysts and does the buyer have a track record of meeting or exceeding earnings expectations? (iv) Does the transaction fit within the buyer’s publicly announced growth strategy? (v) How significant is the transaction relative to the buyer’s market capitalization? (vi) Are there other significant events on the horizon that could influence the buyer’s stock price? (vii) How liquid is the market for the buyer’s stock? While no one issue will be controlling, the answers to all of these questions will help the seller form a view as to the relative risk of taking the buyer’s stock.

2. Time Between Signing and Closing. In most transactions, there will be some period of time between the signing of the acquisition agreement and the closing of the transaction, during which time the parties will move to satisfy various closing conditions such as antitrust clearance and obtaining necessary third–party consents to the transaction. While the time it takes to close is transaction specific, a seller should expect approximately 1 to 3 months between signing and closing.

3. Allocation of Risk (and Opportunity) Between Signing and Closing. Depending on the nature of the purchase price mechanism in the acquisition agreement, the seller may be subject to all, none or some of the risk of a decline in the buyer’s stock price between signing and closing.

(a) Fixed Shares Transaction. In a fixed shares transaction, the buyer agrees to issue to the seller a fixed number of shares. The value of the shares will fluctuate between signing and closing for reasons that may include the transaction or the buyer generally but may also be driven by extraneous market factors. In this case, the seller takes the risk of a price decline but participates in any appreciation in the share price.

(b) Fixed Value Transaction. In a fixed value transaction, the number of shares issued at the closing will float such that the actual value of the shares as of the closing remains constant. The actual number of shares, but not their aggregate value, will fluctuate between signing and closing. In this case, the seller is not subject to risk related to a share price decline and does not participate in any pre-closing appreciation in the share price.

4. Risk Sharing - Collars and Walk-Away Rights. In a fixed shares transaction, the seller will likely not want to complete the transaction if the actual value of the shares to be delivered by the buyer at closing is below some value. As such, the seller may demand some floor on the value it will receive in the deal, thus potentially requiring the buyer to issue more shares to provide that minimum value. While the buyer may agree in concept to some floor value, it may require the ability to not close the transaction, or “walk–away,” at prices below some threshold. The buyer may also seek to cap the seller’s upside at closing in exchange for providing downside protection. These negotiating positions often result in some form of collar on the value of the transaction at closing.

(a) Floor Valuation. With stock prices resulting in a transaction value below the seller’s floor value, the buyer would be required to issue additional shares in order to bring the transaction value back up to the floor value. The buyer’s stock price, however, may be impacted by the number of share being issued in the transaction and the public market’s view as to how accretive or dilutive the transaction will be to the buyer’s earnings per share. As a result, the buyer may find itself in a “vicious cycle” whereby the lower its share price, the more shares it must issue thus causing ever greater downward price pressure on its shares, thus requiring it to issue more shares and so on and so on. To avoid this problem, the buyer may negotiate for a maximum number of shares that it would have to issue in the transaction, or the ability to substitute cash for shares at certain sub–floor share prices. As part of these discussions, the parties will negotiate whether one or both parties have the ability to terminate the agreement instead of offering and/or accepting the lower valuation.

(b) Ceiling Valuation. In return for putting a floor on the value to be received by the seller at closing, the buyer may require a ceiling on the value that the seller may receive. Here, if the buyer’s shares trade above a certain price, it can cut back the number of shares issued in the transaction such that the value will not exceed a certain level. At very high buyer stock prices, the seller will be concerned that it is taking a reduced number shares of an unstable currency the value of which may deteriorate shortly after the closing. As such, the seller may want a walk-away right above some stock price.

5. Post-Closing Liquidity. When selling a business for public company stock, the seller should fully understand the limitations, if any, on its ability to freely sell that stock in the public market.

(a) Registered Deals on Form S-4. A seller can receive shares that are registered under the Securities Act of 1933 (the “Securities Act”) in a sale transaction effected through a S-4 registration statement. While a S-4 registration statement provides full liquidity (for non-affiliates) at closing, it typically delays the closing due to the requirement to have the registration statement reviewed by the SEC. Also, notwithstanding the shares being registered, affiliates of the seller (such as officers, directors and large shareholders) are subject to the volume limitation of Rule 144 (discussed below) for 1 year following the transaction.

(b) Restricted Securities and Rule 144. Absent the securities being registered under the Securities Act, shares received from a public company will be restricted securities and, as such, may not be sold unless (i) the securities are subsequently registered or (ii) the sale is exempt from the registration requirement. The primary exemption or safe harbor from the registration requirement is Rule 144 under the Securities Act. Restricted securities may be sold under Rule 144 if (i) the issuing company is current in its SEC reporting, (ii) the shares have been held for 1 year, (iii) the sale complies with the volume limitations under Rule 144(e), and (iv) the sale is effected through an ordinary broker transaction. Rule 144(e) limits sales by any one person (including certain affiliated entities), during a 90 day period, to no more than the greater of (A) 1% of the issuer’s outstanding shares and (B) the issuer’s average weekly trading volume over the 4 weeks preceding the sale. If the seller is not an affiliate of the issuer (and has not been so for 3 months) and has held the shares for 2 years, he may sell the shares without limitation under Rule 144(k).

(c) Contractual Rights and Limitations. Issuers can provide a recipient of restricted securities contractual rights to require the issuer to register the shares. There are three primary types of “registration rights”: (i) shelf registration rights, (ii) demand registration rights, and (iii) piggyback registration rights, each of which provide a recipient of restricted securities with different levels of liquidity. On the other hand, just as issuers can provide liquidity through registration rights, they can take liquidity away through lock-up arguments. Under a lock-up agreement, a shareholder agrees not to sell, sell short or otherwise hedge its position in its shares of the issuer’s stock during some period of time.

6. Concluding Thoughts. Taking stock in a corporate sale may allow for the deferral of capital gains taxes, but can result in market and company-specific risk both before and after closing. Between signing and closing, the parties may arrive at some form of risk sharing mechanism which puts a “collar” around the ultimate value of the transaction. Post–transaction liquidity can be even more important and the interests of buyers and sellers are often not aligned. Buyers want to minimize the selling pressure on their stock and may want to characterize the transaction as one in which the seller is “joining the team” – a message that may be undercut by the seller monetizing its position shortly after the transaction. Sellers, on the other hand, are converting a significant portion of their net worth from an asset they controlled into a minority position in a company the value of which could rapidly deteriorate in the public market. Potential sellers considering taking public company stock should seek assistance from legal and financial advisors with significant public company transaction experience.