Selling Your Company: Stock or Cash?

IMG_0585When I was in venture capital and sold one of my investee companies, I preferred stock over cash.  Silly me.  To a VC it might make sense, but not to the owners.

If I got stock, I could keep on rolling the dice.  In venture capital, when you reach the cash endpoint, you distribute the proceeds to your investors, and you have a terminal value.  That means that for your $1 invested five years ago, it is now worth $3 today, and has no future value

However, if the VC sells for stock, in a tax-free transaction, he’s still rolling the dice.  The one dollar he invested five years ago is worth $3 in stock today, and he hopes $10 in cash by the time he distributes the stock to his limited investors.

As a refresher, three steps must be met for a sale of your company to be a tax -free transaction:

  • At least 50 percent of the consideration is the stock of the acquirer;
  • The acquirer must continue your company’s historical business;
  • The acquirer must have a business reason to buy your company.

Avoiding taxes is a good thing, but is it in your best interest?  If the stock is liquid, with no sale restrictions, it is as good as cash.  If you can sell today, you probably should.  However, if you’re locked up for extended periods of time in an illiquid stock, think again.  Promise me, that if you take stock, you’ll diversify your holdings quickly so that you are down to 20 percent rather than 100 percent in stock.

A stock transaction merits a twenty percent discount to a cash transaction for a simple reason:  you’ve taken on significant risk by agreeing to stock.  The stock market could go down by 20 percent tomorrow, and your company sale proceeds would as well.  You would still be at 100 percent if you had cash.

I’m always astonished by how surprised people are when told that one should always prefer cash over stock.  Such is the allure o f avoiding taxes.  Remember, you sell your company only once.  This is your end point. You have no control from this point forward.

When I think of stock versus cash, I think of Dragon Systems, one sad story.  The husband and wife founder team, Jim and Janet Baker, sold the Company to Lernout & Hauspie for $580 million in 2000.  Lernout and Hauspie soon collapsed in an accounting fraud;  the Bakers had been able to sell only a few million dollars of the stock they had received.  Ultimately, Lernout & Hauspie declared bankruptcy, and its stock was worthless; the creditors received all proceeds from the sale of assets.  The company’s assets re-emerged as Nuance Systems, which today is a thriving company.

It’s a case that I have always considered to be tragic and has bothered me greatly.  I had greatly respected the persistence of the Bakers in building such a solid company over the years.  I had once taken a voice recognition company public, which was later found to have cooked their books.  The remains of that company was acquired by Lernout & Hauspie in1997.  I always wondered if there was a trail from that company to the fraud at Lernout & Hauspie.

One other point that people don’t often know is that large companies prefer to pay in cash.  Going through the bother of issuing stock for a relatively small transaction is distasteful and a bother to a significant corporation.

So follow my advice.  You never know what is around the bend.  Be conservative, protect yourself, and take cash.