Dilutive Acquisition

It’s all about the multiples.

You work for BoringCo.com. You make stationary rollercoasters for the feint of heart, and you grow revenues at about 10% a year. Your stock trades at about 12 times earnings…and you really want to buy your would-be competitor LetsBounce.com, which makes concrete bounce houses. Unfortunately, LetsBounce has been growing revenues at about 15%, but because they make such a much-more-exciting-than-you-do product (people are really into inflicting pain on themselves these days), they trade at 30 times earnings.

They’re willing to be bought, but they’ll want 36x earnings for the privilege; that is, a 20% premium to where they trade today, and they only want stock. No cash. The primary shareholders would all suffer a huge tax bill if they took cash, so they only will take stock. Yours. So this is a conundrum: You trade at a low multiple: 12 times. Your shareholders own you because you are a "value story"…meaning that you are cheap, but you are a low-risk company.

Now, if you try to buy a growth company and pay a high multiple for it, you risk alienating your shareholder base, and that’s...bad. But if you do buy LetsBounce, the combination should be really powerful. Birthday parties everywhere would be a thrill a minute. The problem is that a 12x earnings company paying 36 times earnings to acquire a competitor is…dilutive.

That is, the combined company, if each piece were equal and they just merged as equals…would not have one half of the combined company as being valued at 12 times earnings when it was a stand-alone company, and another piece valued at 30 times as a stand alone…but combined at a price of 36 times. That’s 12 plus 36, or 48…then divided by two companies combining here, so the new company (should the stock prices all remain flat at the proposed acquisition or merger price set) would be trading at 24x earnings.

The combination of BoringCo and LetsBounce would have been dilutive to BoringCo, because its multiple of 12 would have been diluted down via the high multiple paid for LetsBounce...and the combination would have been accretive to LetsBounce, because now their stock will trade at around 24x earnings, instead of 30x earnings.

Obviously, had both companies traded at the same multiple of earnings when they combined, there would be no dilution or accretion, and the merger would simply be called “neutral.” Sort of like someone’s reaction to a rollercoaster that…neither rolls nor coasts.