Mergers & Acquisitions

Mergers and acquisitions (M&A) are business transactions in which the ownership of companies, business organizations, or their operating units are transferred to or consolidated with another company or business organization. As an aspect of strategic management, M&A can allow enterprises to grow or downsize, and change the nature of their business or competitive position.

Technically, a merger is the legal consolidation of two business entities into one, whereas an acquisition occurs when one entity takes ownership of another entity’s share capital, equity interests or assets. A deal may be euphemistically called a “merger of equals” if both CEOs agree that joining together is in the best interest of both of their companies. From a legal and financial point of view, both mergers and acquisitions generally result in the consolidation of assets and liabilities under one entity, and the distinction between the two is not always clear.

In most countries, mergers and acquisitions must comply with antitrust or competition law. In the United States, for example, the Clayton Act outlaws any merger or acquisition that may “substantially lessen competition” or “tend to create a monopoly”, and the Hart–Scott–Rodino Act requires companies to get “pre-clearance” from either the Federal Trade Commission or the U.S. Department of Justice’s Antitrust Division for all mergers or acquisitions over a certain size.

Acquisition

An acquisition/takeover is the purchase of one business or company by another company or other business entity. Specific acquisition targets can be identified through myriad avenues, including market research, trade expos, sent up from internal business units, or supply chain analysis. Such purchase may be of 100%, or nearly 100%, of the assets or ownership equity of the acquired entity.

A consolidation/amalgamation occurs when two companies combine to form a new enterprise altogether, and neither of the previous companies remains independently owned. Acquisitions are divided into “private” and “public” acquisitions, depending on whether the acquiree or merging company (also termed a target) is or is not listed on a public stock market. Some public companies rely on acquisitions as an important value creation strategy.^[2] An additional dimension or categorization consists of whether an acquisition is friendly or hostile.

Achieving acquisition success has proven to be very difficult, while various studies have shown that 50% of acquisitions were unsuccessful.^[4] “Serial acquirers” appear to be more successful with M&A than companies who make acquisitions only occasionally (see Douma & Schreuder, 2013, chapter 13). The new forms of buy out created since the crisis are based on serial type acquisitions known as an ECO Buyout which is a co-community ownership buy out and the new generation buy outs of the MIBO (Management Involved or Management & Institution Buy Out) and MEIBO (Management & Employee Involved Buy Out).

Whether a purchase is perceived as being “friendly” or “hostile” depends significantly on how the proposed acquisition is communicated to and perceived by the target company’s board of directors, employees, and shareholders. It is normal for M&A deal communications to take place in a so-called “confidentiality bubble,” wherein the flow of information is restricted pursuant to confidentiality agreements. In the case of a friendly transaction, the companies cooperate in negotiations; in the case of a hostile deal, the board and/or management of the target is unwilling to be bought or the target’s board has no prior knowledge of the offer. Hostile acquisitions can, and often do, ultimately become “friendly” as the acquirer secures endorsement of the transaction from the board of the acquiree company. This usually requires an improvement in the terms of the offer and/or through negotiation.

“Acquisition” usually refers to a purchase of a smaller firm by a larger one. Sometimes, however, a smaller firm will acquire management control of a larger and/or longer-established company and retain the name of the latter for the post-acquisition combined entity. This is known as a reverse takeover. Another type of acquisition is the reverse merger, a form of transaction that enables a private company to be publicly listed in a relatively short time frame. A reverse merger is a type of merger where a privately held company, typically one with promising prospects and a need for financing, acquires a publicly listed shell company that has few assets and no significant business operations.

The combined evidence suggests that the shareholders of acquired firms realize significant positive “abnormal returns,” while shareholders of the acquiring company are most likely to experience a negative wealth effect^. Most studies indicate that M&A transactions have a positive net effect, with investors in both the buyer and target companies seeing positive returns. This suggests that M&A creates economic value, likely by transferring assets to more efficient management teams who can better utilize them. (See Douma & Schreuder, 2013, chapter 13).

There are also a variety of structures used in securing control over the assets of a company, which have different tax and regulatory implications:

• The buyer buys the shares, and therefore control, of the target company being purchased. Ownership control of the company in turn conveys effective control over the assets of the company, but since the company is acquired intact as a going concern, this form of transaction carries with it all of the liabilities accrued by that business over its past and all of the risks that company faces in its commercial environment and corporate environment
• The buyer buys the assets of the target company. The cash the target receives from the sell-off is paid back to its shareholders by dividend or through liquidation. This type of transaction leaves the target company as an empty shell, if the buyer buys out the entire assets. A buyer often structures the transaction as an asset purchase to “cherry-pick” the assets that it wants and leave out the assets and liabilities that it does not. This can be particularly important where foreseeable liabilities may include future, unquantified damage awards such as those that could arise from litigation over defective products, employee benefits or terminations, or environmental damage. A disadvantage of this structure is the tax that many jurisdictions, particularly outside the United States, impose on transfers of the individual assets, whereas stock transactions can frequently be structured as like-kind exchanges or other arrangements that are tax-free or tax-neutral, both to the buyer and to the seller’s shareholders.

The terms “demerger”, “spin-off” and “spin-out” are sometimes used to indicate a situation where one company splits into two, generating a second company which may or may not become separately listed on a stock exchange.

As per knowledge-based views, firms can generate greater values through the retention of knowledge-based resources which they generate and integrate. Extracting technological benefits during and after acquisition is an ever-challenging issue because of organizational differences. Based on the content analysis of seven interviews, the authors concluded the following components for their grounded model of acquisition:

• Improper documentation and changing implicit knowledge makes it difficult to share information during acquisition.
• For acquired firm symbolic and cultural independence which is the base of technology and capabilities are more important than administrative independence.
• Detailed knowledge exchange and integrations are difficult when the acquired firm is large and high performing.
• Management of executives from acquired firm is critical in terms of promotions and pay incentives to utilize their talent and value their expertise.
• Transfer of technologies and capabilities are most difficult task to manage because of complications of acquisition implementation. The risk of losing implicit knowledge is always associated with the fast pace acquisition.

An increase in acquisitions in the global business environment requires enterprises to evaluate the key stake holders of acquisitions very carefully before implementation. It is imperative for the acquirer to understand this relationship and apply it to its advantage. Employee retention is possible only when resources are exchanged and managed without affecting their independence.

Legal structures

A corporate acquisition can be structured legally as either an “asset purchase” in which the seller sells business assets and liabilities to the buyer, an “equity purchase” in which the buyer purchases equity interests in a target company from one or more selling shareholders or a “merger” in which one legal entity is combined into another entity by operation of the corporate law statute(s) of the jurisdiction of the merging entities. In a transaction structured as a merger or an equity purchase, the buyer acquires all of the assets and liabilities of the acquired entity. In a transaction structured as an asset purchase, the buyer and seller agree on which assets and liabilities the buyer will acquire from the seller.

Asset purchases are common in technology transactions where the buyer is most interested in particular intellectual property rights but does not want to acquire liabilities or other contractual relationships. An asset purchase structure may also be used when the buyer wishes to buy a particular division or unit of a company which is not a separate legal entity. Divestitures present a variety of unique challenges, such as identifying the assets and liabilities that pertain solely to the unit being sold, determaining whether the unit relies on services from other parts of the seller’s organization, transferring employees, moving permits and licenses, and safeguarding against potential competition from the seller in the same business sector after the transaction is completed.

Types of mergers

From an economic point of view, business combinations can also be classified as horizontal, vertical and conglomerate mergers (or acquisitions). A horizontal merger is between two competitors in the same industry. A vertical merger occurs when two firms combine across the value chain, such as when a firm buys a former supplier (backward integration) or a former customer (forward integration). When there is no strategic relatedness between an acquiring firm and its target, this is called a conglomerate merger (Douma & Schreuder, 2013)

The form of merger most often employed is a triangular merger, where the target company merges with a shell company wholly owned by the buyer, thus becoming a subsidiary of the buyer. In a “forward triangular merge,”, the target company merges into the subsidiary, with the subsidiary as the surviving company of the merger; a “reverse triangular merger” is similar except that the subsidiary merges into the target company, with the target company surviving the merger.

Mergers, asset purchases and equity purchases are each taxed differently, and the most beneficial structure for tax purposes is highly situation-dependent. Under the U.S. Internal Revenue Code, a forward triangular merger is taxed as if the target company sold its assets to the shell company and then liquidated, them whereas a reverse triangular merger is taxed as if the target company’s shareholders sold their stock in the target company to the buyer.

Documentation

The documentation of an M&A transaction often begins with a letter of intent. The letter of intent generally does not bind the parties to commit to a transaction, but may bind the parties to confidentiality and exclusivity obligations so that the transaction can be considered through a due diligence process involving lawyers, accountants, tax advisors, and other professionals, as well as business people from both sides.

After due diligence is complete, the parties may proceed to draw up a definitive agreement, known as a “merger agreement”, “share purchase agreement,” or “asset purchase agreement” depending on the structure of the transaction. Such contracts are typically 80 to 100 pages long and focus on five key types of terms:

• Conditions, which must be satisfied before there is an obligation to complete the transaction. Conditions typically include matters such as regulatory approvals and the lack of any material adverse change in the target’s business.
• Representations and warranties by the seller with regard to the company, which are claimed to be true at both the time of signing and the time of closing. Sellers often attempt to craft their representations and warranties with knowledge qualifiers, dictating the level of knowledge applicable and which seller parties’ knowledge is relevant. Some agreements provide that if the representations and warranties by the seller prove to be false, the buyer may claim a refund of part of the purchase price, as is common in transactions involving privately held companies (although in most acquisition agreements involving public company targets, the representations and warranties of the seller do not survive the closing). Representations regarding a target company’s net working capital are a common source of post-closing disputes.
• Covenants, which govern the conduct of the parties, both before the closing (such as covenants that restrict the operations of the business between signing and closing) and after the closing (such as covenants regarding future income tax filings and tax liability or post-closing restrictions agreed to by the buyer and seller parties).
• Termination rights, which may be triggered by a breach of contract, a failure to satisfy certain conditions or the passage of a certain period of time without consummating the transaction, and fees and damages payable in case of a termination for certain events (also known as breakup fees).
• Provisions relating to obtaining required shareholder approvals under state law and related SEC filings required under federal law, if applicable, and terms related to the mechanics of the legal transactions to be consummated at closing (such as the determination and allocation of the purchase price and post-closing adjustments (such as adjustments after the final determination of working capital at closing or earnout payments payable to the sellers), repayment of outstanding debt, and the treatment of outstanding shares, options and other equity interests).
• An indemnification provision, which provides that an indemnitor will indemnify, defend, and hold harmless the indemnitee(s) for losses incurred by the indemnitees as a result of the indemnitor’s breach of its contractual obligations in the purchase agreement

Following the closing of a deal, adjustments may be made to some of the provisions outlined in the purchase agreement, such as the purchase price. These adjustments are subject to enforceability issues in certain situations. Alternatively, certain transactions use the ‘locked box’ approach, where the purchase price is fixed at signing and based on the seller’s equity value at a pre-signing date and an interest charge.

Business valuation

Further information: Business valuation, Valuation (finance) § Business valuation, Investment banking § Corporate finance, and Corporate finance § Investment and project valuation

The assets of a business are pledged to two categories of stakeholders: equity owners and owners of the business’ outstanding debt. The core value of a business, which accrues to both categories of stakeholders, is called the Enterprise Value (EV), whereas the value which accrues just to shareholders is the Equity Value (also called market capitalization for publicly listed companies). Enterprise Value reflects a capital structure neutral valuation and is frequently a preferred way to compare value as it is not affected by a company’s, or management’s, strategic decision to fund the business either through debt, equity, or a portion of both. Five common ways to “triangulate” the enterprise value of a business are:

• asset valuation: the price paid is the value of the “easily salable parts”; the main approaches to valuing these are book value and liquidation value
• historical earnings valuation: the price is such that the payment for the business (or return targeted by the investor), would have been supported by the business’s own earnings or cash-flow averaged over the previous 3-5 years; see also Earnout
• future maintainable earnings valuation: similarly, but forward looking; see generally, Cash flow forecasting and Financial forecast, and re “maintainability”, Sustainable growth rate § From a financial perspective and Owner earnings.
• relative valuation: the price paid per dollar of earnings or revenue is based on the same multiple for comparable companies and / or recent comparable transactions
• discounted cash flow valuation (DCF): the price equates to the value of “all” future cash-flows – with synergies and tax given special attention – as discounted to today; see § Determine cash flow for each forecast period under Valuation using discounted cash flows, which compares M&A DCF models to other cases.

Professionals who value businesses generally do not use just one method, but a combination. Valuations implied using these methodologies can prove different to a company’s current trading valuation. For public companies, the market based enterprise value and equity value can be calculated by referring to the company’s share price and components on its balance sheet. The valuation methods described above represent ways to determine value of a company independently from how the market currently, or historically, has determined value based on the price of its outstanding securities.

Most often value is expressed in a Letter of Opinion of Value (LOV) when the business is being valued informally. Formal valuation reports generally get more detailed and expensive as the size of a company increases, but this is not always the case as the nature of the business and the industry it is operating in can influence the complexity of the valuation task.

Objectively evaluating the historical and prospective performance of a business is a challenge faced by many. Generally, parties rely on independent third parties to conduct due diligence studies or business assessments. To yield the most value from a business assessment, objectives should be clearly defined and the right resources should be chosen to conduct the assessment in the available timeframe.

As synergy plays a large role in the valuation of acquisitions, it is paramount to get the value of synergies right; as briefly alluded to re DCF valuations. Synergies are different from the “sales price” valuation of the firm, as they will accrue to the buyer. Hence, the analysis should be done from the acquiring firm’s point of view. Synergy-creating investments are started by the choice of the acquirer, and therefore they are not obligatory, making them essentially real options. To include this real options aspect into analysis of acquisition targets is one interesting issue that has been studied lately. See also contingent value rights.