What Are the Two Reasons Firms Purchase Equity Shares?
Understand the core motivations driving companies to acquire equity in other businesses, from strategic growth to portfolio optimization.
When a firm purchases equity shares in another, it acquires an ownership stake, representing a claim on the target company’s assets and earnings. Firms engage in such purchases for diverse reasons, with their motivations broadly falling into two primary categories.
Strategic Objectives and Business Synergies
One main reason firms purchase equity shares is to achieve specific strategic business goals and create synergies. These strategic acquisitions aim to gain a competitive advantage or enhance market position. A firm might acquire shares to expand its market share, enter new geographic markets, or diversify its product and service offerings. Such purchases can also provide access to new technologies, intellectual property, or specialized talent pools that would be difficult or time-consuming to develop internally.
Strategic investments involve achieving either vertical integration, which controls parts of the supply chain, or horizontal integration, which merges with competitors to reduce market rivalry. The acquiring firm seeks significant influence or outright control over the target company’s operations. When a firm gains controlling interest (owning more than 50% of the voting stock), it consolidates the financial statements of the acquired company into its own. For significant influence (owning between 20% and 50% of the voting stock), the acquiring firm uses the equity method of accounting, where its share of the investee’s net income increases the investment account, and dividends received decrease it.
These transactions also have substantial tax implications, which influence their structure. To defer immediate taxation, many strategic acquisitions are structured as tax-free reorganizations under Internal Revenue Code Section 368. These reorganizations allow the acquiring and target companies, and their shareholders, to defer recognition of gains or losses if specific requirements are met. Key requirements include continuity of interest, where target shareholders maintain a proprietary interest in the acquiring company, and a valid business purpose beyond mere tax avoidance.
Alternatively, in some taxable acquisitions, buyers may elect to treat a stock purchase as an asset purchase for tax purposes under Section 338. A Section 338(h)(10) election allows the buyer to step up the tax basis of the acquired assets to their fair market value. This step-up can lead to increased depreciation and amortization deductions for the buyer in future periods, providing a tax benefit. Such an election requires a qualified stock purchase of at least 80% of the target’s stock within a 12-month period and is jointly made by the buyer and seller.
Financial Investment and Portfolio Diversification
A second primary reason firms purchase equity shares is purely as a financial investment. The main objective is to generate a return on investment rather than to integrate operations or achieve strategic control. These returns can materialize through capital appreciation, where the value of the shares increases over time, or through dividend income, which represents a share of the target company’s profits distributed to shareholders.
Such investments also serve to diversify the acquiring firm’s overall asset portfolio. By investing across different industries or asset classes, a firm can spread its risk, potentially mitigating the impact of adverse performance in any single investment. Unlike strategic purchases, these financial investments involve smaller, non-controlling stakes, often less than 20% ownership. In these cases, the acquiring firm has no intention of influencing or integrating the target company’s operations.
For accounting purposes, these smaller, non-controlling equity investments are accounted for using the fair value method. Under this method, the investment is recorded at cost initially and then adjusted to fair value, with unrealized gains and losses recognized in net income or other comprehensive income, depending on classification. Cash dividends received from the investee are recognized as dividend revenue by the investor.
The tax treatment of dividends received by corporations in the United States is relevant for financial investments. Under Section 243, corporations can claim a Dividends Received Deduction (DRD) on dividends from other domestic corporations. The percentage of the deduction depends on the ownership stake: 50% for ownership less than 20%, 65% for ownership between 20% and 80%, and 100% for dividends received from an affiliated group where ownership exceeds 80%. This deduction reduces the effective tax rate on dividend income, making equity investments more attractive.
When a firm sells these equity shares, any profit realized is subject to corporate capital gains tax. For corporations in the United States, capital gains are taxed at the same rate as ordinary corporate income, which is a flat 21%. Capital losses can be carried back three years and carried forward five years to offset capital gains. This tax structure influences a firm’s decisions regarding holding periods and the timing of selling its financial equity investments.