Before we get to Warren Buffett’s big mistake, we’ll explore a pivotal choice companies must make, and explain how even the Oracle of Omaha screwed up by choosing incorrectly.
Most companies start out small. They have an idea for a product or service, and they focus on bringing that product or service to market. The best ones start turning a profit, and then it is time for leadership to make some choices.
Will those profits be reinvested in the company to grow and expand into new markets and other product lines, or are profits distributed among owners for personal use?
Some companies go with the latter option – they are satisfied with staying small and limiting product lines. But most prefer to build the business. Their objective is to bring in more revenue in hopes of increasing profits. However, the length of time required to expand organically isn’t especially attractive.
The alternative is to explore opportunities for mergers and acquisitions. A common goal of M&A activity is to gain instant access to new expertise and capabilities, rather than putting time into developing them internally.
Another goal is to expand into new markets or distribution channels all at once, instead of dedicating the resources required to move into those markets and displace established competitors.
Of course, buying or merging with another company is an expensive proposition. How are mergers and acquisitions funded?
Cash vs Stock Acquisition: Which Is Best?
In a majority of cases, companies fund mergers and acquisitions with cash, stock, or a combination of both cash and stock. There are pros and cons to each of these strategies, and the option that is best for one transaction might not be the right move in another situation.
When domestic acquisitions are completed with cash, the process tends to move quickly as compared to stock transactions. However, the opposite is true when foreign currencies are involved. Exchange rate fluctuations can wreak havoc on closing international cash deals in a timely manner.
Cash offers usually include a premium for the shareholders of the company being acquired under the assumption that the combined company will be more profitable. That is great for encouraging shareholder enthusiasm for the transaction, but there is a caveat. When shareholders sell their stock to the acquiring company, it is a taxable transaction – and large profits on the sale of these shares means large tax bills when returns are filed.
Most companies don’t have enough cash on hand to fund large acquisitions – and if they do, it’s not wise to deplete cash reserves to critical levels. The solution is to raise money through traditional methods such as selling bonds or taking loans. While effective, bonds and loans come with interest expense.
Funding mergers and acquisitions with stock is a bit more complicated – values are assigned to each company’s shares, and shareholders are awarded an equivalent amount of the combined company’s shares when the deal closes. From a tax perspective, that’s good news for shareholders – they remain in control of when capital gains taxes come due.
The idea is that the stock will become more valuable when the companies come together. It’s also worth noting that when the deal is completed with stocks, both sides take on the potential risks and rewards of the merger. That’s helpful for ensuring that the leadership and staff of the acquired company continue to work towards the combined company’s success after the merger is complete.
The most important advantage of funding mergers and acquisitions with equity is that cash reserves remain intact, and there is no need to manage the complexities of selling bonds or securing loans. Unfortunately, acquisitions made with equity aren’t completely risk-free. There are two significant disadvantages to all-stock transactions.
First, issuing new shares to fund an acquisition dilutes the value of existing shares. More shares means a higher price-to-earnings ratio, which can discourage new investors and prompt current shareholders to sell.
The second is a bit harder to quantify because it takes years to reveal itself. Unlike cash transactions that come with a defined price tag, stock transactions start off with a defined price tag, but the value of that stock changes over time. If the stock issued to make the purchase doubles in value, there is an argument that the total cost of the acquisition is ultimately twice as high as the original agreement. Warren Buffett found this out the hard way.
Warren Buffett’s $69 Billion Mistake
Warren Buffett has been trading in the stock market for more than 80 years, and his experience protects him from the kinds of mistakes that average investors make. He never buys overvalued companies, and he can’t be tempted by media hype.
Buffett carefully researches every purchase, and he only buys established businesses with sustainable competitive edges. His discipline has made his holding company, Berkshire Hathaway, one of the most successful organizations in the world. Along the way, he built a massive personal fortune. Warren Buffett’s net worth stands at nearly $13 billion.
Today, Berkshire Hathaway acquires companies with cash, but that wasn’t always the case. In 1998, Berkshire Hathaway bought General Reinsurance (Gen Re) with Berkshire Hathaway stock in an effort to grow the insurance division.
Buffett’s decision to buy Gen Re was a good one – the company has performed well and Buffett considers it one of Berkshire Hathaway’s most prized assets. However, now that 25 years have passed since the transaction, Buffett can see that his decision to fund the acquisition with stock was an expensive mistake.
Berkshire Hathaway issued 272,200 new shares to gather the funds necessary to buy Gen Re – an outstanding share count increase of 22 percent.
At the time, Berkshire Hathaway stock traded at $58,400, making the cost of the Gen Re acquisition $15.9 billion, which was a fair price. But here’s the problem: Those 272,000 shares are now worth more than $69 billion. The true cost to shareholders ended up being far more than intended, which is something Buffett despises.
At Buffett’s direction, Berkshire Hathaway now pays cash for its acquisitions. That ensures the true cost of the deal is established at the time of the transaction, and there is no risk of watering down the value of existing shares.
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