MERGERS AND ACQUISITIONS
What is Mergers & Acquisitions (M&A)?
Both Mergers and acquisitions are prominent aspects of corporate strategy, corporate finance and management. Mergers and acquisitions (M&A) refer to transactions between two companies combining in some form. Although mergers and acquisitions (M&A) are used interchangeably, they come with different legal meanings. M&A deals can be friendly or hostile, depending on the approval of the target company’s board.
In a merger, two companies of similar size combine to form a new single entity.
On the other hand, an acquisition is when a larger company acquires a smaller company, thereby absorbing the business of the smaller company.
Motives for mergers and acquisitions
- Higher growth
The promise of higher growth is, to some extent, present in almost every single M&A transaction. In theory, acquiring or merging with another company should enable a company to achieve revenues and income much faster than it would be able to achieve organically.
Synergies describe the extra value that is generated when two companies combine, or simply put “one plus one equals three.”
This occurs when a resource such as capital or intellectual property is shared between the two firms in the new entity, allowing two companies to benefit from the resource instead of one.
- Horizontal integration for Stronger market power
This type of acquisition or merger involves two companies that operate at similar levels of the supply chain coming together to generate extra value.
For example, the merger of two supermarket chains would allow both companies to enjoy greater distribution and stronger buying power.
- Vertical integration for Stronger market power
This involves the acquisition of companies at different levels in the supply chain to that of the buying company.
For example, a supermarket chain could buy a manufacturing plant to start making its own-brand products, or a courier service to begin a grocery delivery service.
In the sense that no two companies are identical, all M&A represents diversification to a certain extent.
However, when the term is used, it tends to mean that a company is moving into different areas of operation. For example, GE moving from electronics into banking is the textbook example of diversification.
- Tax benefits
Although this is often cited as one of the benefits of undertaking M&A – the idea that companies can benefit from the tax jurisdiction of other companies by acquiring them and then establishing headquarters in that territory – new moves by governments across the world seem to have effectively cut out this loophole for companies to exploit.
Forms of Mergers
Statutory mergers usually occur when the acquirer is much larger than the target and acquires the target’s assets and liabilities. After the deal, the target company ceases to exist as a separate entity.
In a subsidiary merger, the target becomes a subsidiary of the acquirer but continues to maintain its business.
In a consolidation, both companies in the transaction cease to exist after the deal, and a completely new entity is formed.
Forms of Acquisition
- Stock purchase
In a stock purchase, the acquirer pays the target firm’s shareholders cash and/or shares in exchange for shares of the target company. Here, the target’s shareholders receive compensation and not the target. There are certain aspects to be considered in a stock purchase:
- The acquirer absorbs all the assets and liabilities of the target – even those that are not on the balance sheet.
- To receive the compensation by the acquirer, the target’s shareholders must approve the transaction through a majority vote, which can be a long process.
- Shareholders bear the tax liability as they receive the compensation directly.
- Asset purchase
In an asset purchase, the acquirer purchases the target’s assets and pays the target directly. There are certain aspects to be considered in an asset purchase, such as:
- Since the acquirer purchases only the assets, it will avoid assuming any of the target’s liabilities.
- As the payment is made directly to the target, generally, no shareholder approval is required unless the assets are significant (e.g., greater than 50% of the company).
- The compensation received is taxed at the corporate level as capital gains by the target.
- Method of payment
There are two methods of payment – stock and cash. However, in many instances, M&A transactions use a combination of the two, which is called a mixed offering.
In a stock offering, the acquirer issues new shares that are paid to the target’s shareholders. The number of shares received is based on an exchange ratio, which is finalized in advance due to stock price fluctuations.
In a cash offer, the acquirer simply pays cash in return for the target’s shares.
Steps in M&A Process
- Company and buyer analysis –
During this process it is important to consider potential synergies, restructuring needs, risks involved, Capital structure etc.
- Analysis of pricing mechanism-
The various issues that need to be considered here are Cash or equity, various Pricing mechanisms, Terms and Conditions etc.
- Share data analysis-
At this stage it is important to determine if the company is listed or not listed, who were the minority shareholder, determine the status of share certificate.
- Management presentation and meeting-
Here the buyer and the sellers, all meet the management.
- Letter of intent-
The issues to consider at this stage are the letter of intent, confidentiality agreement.
- Process of due diligence-
This includes review of public registers, Annual reports and financial statements.
Issues that are important here are Preparation of applications and filings.
The share transfer certificate plays an important role here.
Here the Submission of applications and filings to Competition Authority and to Financial Supervisory Authority has to be done for approval.
Closing memorandum, purchase price payments are the important steps at this stage of the process.
Importance of Valuation in M&A
Investors of a company which has the intention to take over another one must determine if the purchase will be beneficial to them. Hence, they must ask themselves the question that – “How much the company being acquired is really worth?”
The answer to this is valuation of the company. There are many ways of company Valuation. The most common method is to look for comparable peer companies in an industry. But the deal makers employ a variety of other methods and tools for assessment.
Let’s understand a few of them:
- Comparative Ratios –
The following are two examples of the many comparative metrics on which acquiring companies may base their offers:
- Price-Earnings Ratio (P/E Ratio) –
An acquiring company makes an offer which is a multiple of the earnings of the target company. Analysing the P/E for all the stocks of the same industry group gives the acquiring company a good picture of what the target’s P/E multiple should be.
- Enterprise-Value-to-Sales Ratio (EV/Sales) –
Here the acquiring company makes an offer as a multiple of the sales.
- Replacement Cost –
Sometimes acquisitions cost is the cost of replacing the target company. For example, the value of a company is the sum of all its equipment and staffing costs. Then acquiring company can direct the target company to sell at that price.
- Discounted Cash Flow (DCF) –
Discounted cash flows help in determining company’s current value according to its estimated future cash flows. Predicted free cash flows are discounted to a present value using the company’s weighted average costs of capital (WACC).
Free cash flows are calculated by the following formula-
Operating profit + depreciation + amortization of goodwill – capital expenditures – cash taxes – change in working capital.
Advantages of M&A deal
- M&A is a proven means for growth, allowing the newly formed business entity to boost market share, increase their geographical footprint, overtake or buy out competitors, and acquire new talent, technologies and assets.
- Two heads are better than one, so they say – a relevant sentiment for mergers and acquisitions where two companies can realize valuable synergies and generate much more value together rather than operating individually.
- Joining together can allow two companies to cut a number of costs associated with duplicate roles, systems and licenses.
Disadvantages of M&A deal
- M&A deals can be incredibly time consuming. The M&A process is intensive and can take months or even years to finalize. Due diligence is time-consuming manual work that can take key players away from their day jobs, causing a dip in productivity and taking a toll on the companies involved.
- There is a lot of risk involved in an M&A deal. Proper due diligence must be done to ensure that the acquiring company has a full understanding of the target company, which is why it’s standard practice for companies to seek external services to evaluate the risk of a deal.