In M&A, an acquirer must pay an acquisition premium to target shareholders. However, much to academic puzzlement, this universal reality rubs against theory. Two fundamental ideas in modern financial economics are the efficient capital market hypothesis (ECMH) and the capital asset pricing model (CAPM). Together, they tell us: (1) an efficient market incorporates into the stock price all public information and thus all factors of value except private information, (2) the intrinsic value of a firm is the discounted, per CAPM, future free cash flow, (3) thus, stock price and intrinsic value should be tethered, albeit stock price can be “noisy.” Accepting these truths in the main, what accounts for the universal fact that an acquirer always pays a premium when the stock price is said to be “right”? The academic and practical answer is found in the theory of the firm and Coase’s error. The theoretical answer has a practical implication on Delaware merger rules.

Wrong or Incomplete Theories of the Premium

Because the premium is confounding, a slew of explanations has been propounded, e.g.: negative sloping demand curve, private information, shareholder rent or “free-riding,” agency cost, hubris, and irrational expectation. These explanations can certainly explain spot transactions (i.e., why certain deals were actually done, e.g., private information), but they are not a theory of the premium. They don’t and can’t explain a universal premium.

Two prominent explanations should be rejected. First, M&A practice tells us that the “control premium” reverses the “minority discount” embedded in all shares held by diffuse, unaffiliated shareholders. This explanation can’t be right. CAPM has no variable for “control,” and ECMH tells us that the stock price is “right.” Control premium and minority discount are empty but harmless placards. They recite the correlative observation that a premium is paid forcontrol but otherwise have no explanatory power on the cause (to wit, a dollar is the same regardless of whose hand generated it).

Second, M&A practice tells us that the acquisition is justified by “synergies.” Of course, this reason is foundational for M&A rationality. But it can’t explain the premium. Why should the acquirer transfer the benefit of expected synergy gains to target shareholders as they exit the firm? It shouldn’t, unless we believe in a theory of target shareholder rent or “free-riding” which would raise a profound issue of rule efficiency. All synergy gains—every last penny—should inure to acquirer shareholders since this result should be the reason for the deal and is the product of the acquirer’s effort and risk-taking. This idea is consistent with appraisal law (DGCL Section 262(h)).

Theory of the Firm and Coase’s Error

The acquisition premium must account for a theory of the firm since an acquirer is buying a firm. According to Coase’s seminal article, The Nature of the Firm, a firm exists because, as compared with substitute market transactions, a firm minimizes the transaction cost of dealings (“cost of ‘organising’ production”) among factors of production: viz., it would be far more costly to conduct Exxon’s business through a “series of contracts among the factors” (e.g., managers, geologists, drillers, shippers, refiners, etc.) as opposed to “one” contract that is the firm “Exxon.” An obvious point, but one that should be stated explicitly, is that transaction cost—being a “cost”—is a bad thing. It represents a loss of resources, a deadweight loss.

Coase made a category error in theorizing the firm. We start with the axiomatic principle in economics that all transactions have a double entry. The Coasean double entry through the transaction cost prism, for which he won the Nobel Prize, is this: credit assets (decline in resources of some kind), and debit expense (increase in loss of those resources), which together say that the firm incurred a transaction “cost” and thus incurred a diminution of resources. This is Coase’s error.

When venturers spend (vis-à-vis expense) resources to create and maintain a firm, that expenditure is not a deadweight loss. Sure, the firm will lose that resource, such as effort or cash: But what is on the other side of the equation? What did that expenditure buy? It bought a durable organization and structure. Neither atoms in the physical world nor factors of production in the business world self-organize; it takes energy or resources. The benefit gained from the expenditure is an organization among factors of production where that structure had not existed before. A thing that is expected to give a future benefit is the textbook definition of an asset. Accordingly, the conceptualization of the double entry must be: credit assets (loss of resources), and debit assets (gain of firm’s durable organization and structure, a thing I call “entityness”). There is no loss, only an asset substitution.

An intuitive way to think about the double entry is a sale of a Kia in a dealership. A customer buys a Kia, and it “costs” her $40,000. Did she incur a “loss”? Of course not. Her cash asset declines by $40,000 (credit cash), and the other side of this entry is the acquisition of a Kia (debit car). Her asset mix changed, but she suffered no economic loss. The dealership’s dual entry is the mirror inverse: debit cash $40,000 (increase in cash), and credit Kia (decrease in car). Neither side incurred an economic “loss” at the point of the transaction. They engaged in an equivalent asset swap.

Coase made a category error when he attributed “transaction cost” in the firm-creation process. His transaction-cost prism assumed that the resources spent were an economic deadweight loss. Clearly, the transaction cost created something of value that must be accounted for. In reality, that expenditure transforms into the firm’s entityness, a durable state of organization and structure. Acquirers must always pay for this entityness, and empirically we see this payment in the form of an acquisition premium.

Arbitrage and Acquirer’s Payment for Entityness

We can demonstrate Coase’s error through another foundational principle of modern financial economics. The law of one price states that equivalent cash flows or assets must be priced the same, lest there be arbitrage. Arbitrage polices asset prices in the market.

In M&A, an acquirer has two fundamental choices: Build the asset in the market for factors of production or Buyit in the M&A market. Assume that two ventures: Firm (Inchoate) and Firm (Operating) are exactly identical, except that Inchoate is an unordered collection of assets housed in the legal boundary of the firm (say a startup), and Operating is an operating firm whose same collection of assets is structured and organized such that it is already generating cash flow. If acquisition funds didn’t matter (money is free), which firm would acquirer prefer? Operating would be preferable because (Inchoate < Operating) even though the “ordinary” assets (e.g., people, cash, PP&E, etc.) are exactly the same. What accounts for this value delta? It is the firm’s organization and structure.

The key point is that an acquirer cannot arbitrage away the necessity of having to invest in entityness by electing to make an acquisition in the M&A market as opposed to the market for factors of productions. If this investment is “free,” acquirers will always elect the “buy” option, and thus arbitrage away the need for an investment in entityness. As economists like to say, there is no free lunch. The law of one price says that this sort of obvious, massive arbitrage opportunity cannot occur in a rational market, certainly not for decades on end like the modern M&A market. The acquisition premium represents the value of the investment that must be made in either the market for factors of production (“build”) or the market for M&A (“buy”).

Entityness and “Fair Value”

My analysis shows that the M&A market and practitioners over the modern era have been systemically rational. Academic ideas that question this systemic rationality (as opposed to spot irrationality) based on “mispricing” or “inefficiency” or “hubris” or “shareholder rent or free-riding” are wrong.

The theory of entityness and Coase’s error well explain a variety of corporate merger rules, and in fact the corporate merger doctrine generally. It also has one immediate implication for the practice of M&A. Delaware cases have cooled to the use of the discounted cash flow (DCF) analysis in appraisal and have expressed a preference (but not a legal presumption) for a reliable, untainted deal price (e.g., Dell and DFC Global). This preference has much merit.

In terms of price discovery, Delaware recognized that a reliable deal price (a reliance on the market) compared with an adversarial setting (a reliance on the courtroom) is a better indicator of firm value. Indeed, Delaware could have created a rebuttable presumption that a reliable deal price is the “fair value,” thus minimizing instances of complex litigation and encouraging a deal process to procure a reliable price. A presumption would still be consistent with the statutory term “take into account all relevant factors” since the deal price and its reliability incorporates these factors through an efficient market and the presumption is still rebuttable.

Concluding Thoughts

Coase was right that the firm is much more efficient (more than he believed), and this efficiency, plus the legal–political endowments in corporate law, is the reason why firms exist. Coase did not account for the fact that the firm preserves more assets than substitute market transactions. The acquisition premium reveals Coase’s error and the essential nature of the firm. Ultimately, the M&A market and the universal acquisition premium are rational.

Robert J. Rhee is John H. and Mary Lou Dasburg Professor of Law at the University of Florida Levin College of Law. In his prior career, he was an M&A investment banker at UBS Warburg and several other investment banking firms. This post is based on his article, “On Entityness and Takeovers: Acquisition Valuation, Theory of the Firm and Coase’s Error,” published in the Vanderbilt Law Review and available here.