Paying With Corporate “Mini-Currencies”
Once upon a time, a publicly-traded technology company (or a pharmaceutical — essentially, a special case of technology company) with $1 billion in sales and, say, $200 million in net income, might have earmarked $20 to $30 million annually for research and development (“R&D”).
Today, it makes more financial sense for such a company to outsource its R&D to a start-up, which the established company then buys with its own (highly) appreciated stock.
Not only does the company fatten its bottom line that way (“$1 million saved is $1 million earned??”), but, through the magic of stock market alchemy, it has much more valuable currency — its own stock — to go on a spending spree.
Market Multiple Alchemy
A concrete example illustrates why.
Per above, assume the company formerly spent $25 million annually on expensive R&D.
Now, further assume that the company meets Wall Street’s definition of a fast-grower, and is awarded a suitably lofty multiple of earnings, like 50 times.
That means each million of earnings translates into $50 million of market capitalization.
Stock Market Darling
If the established company buys a start-up with its own appreciated stock, the only cost is negligible equity dilution — 
negligible because the acquiring company is such a market darling, and therefore need only carve off a thin slice of itself to afford the start-up.
So, even if the public company bought the start-up for a rich $500 million in stock, if its own market cap is an equally inflated $20 billion (Uber’s is now $40 billion(!), and it hasn’t even had an IPO yet), that’s only 2.5% dilution.
Overpaying for Acquisitions? Maybe Not
What did that $500 million price tag really cost the company?
The true accounting cost (vs. cash outlay) to the acquirer to buy a start-up for $500 million in stock was only $10 million.
That’s less than half what it would have cost the acquiring company to do the same R&D internally.
In fact, given that the acquiring company co-opted what might eventually have become a competitor, you could effectively call it killing two birds with one stone (sorry — I’ll now return to the original metaphor).
Creating Gold — or Lead?
If it all sounds a little too good to be true, that’s because it usually is.
Consider Broadcast.com founder (and very timely seller) Mark Cuban, who received and promptly sold $3 billion in Yahoo! stock for his company.
If Cuban instead held onto his Yahoo! stock for just six months, he likely wouldn’t own an NBA team today: Yahoo’s stock promptly collapsed.
The other cautionary tale is the now infamous AOL – Time Warner hookup around the same time.
Mesmerized by AOL’s loft market valuation (and “new era” cred), Time Warner unwisely agreed to a merger of equals when the vastly smaller (but fast-growing) AOL was deemed to be worth the same as Time Warner.
Shareholders of the newly-combined company promptly discovered otherwise.
