Mergers & Acquisitions: Why & How

 

Merger. A merger, theoretically, is when two companies agree that they want to go forward as a single company, rather than being separate entities. That's in theory. Usually, a merger is a polite way of saying that one company has bought another and that one of the terms of the deal was to let the CEO (Chief Executive Officer) or Chairman of the company that was bought say that it is a merger of equals. That's rarely the case in reality. On this page we provide descriptions, how to videos, and following that you can download specific deal templates such as term sheets, letters of interest, asset purchase agreements, share purchase agreements, and more.

 

What drives a merger is the competitive landscape. When times are very bad, strong companies will seek out weak and strong companies to find out if the combination of the two of them will create a more competitive, cost efficient company than either one currently is. The strong companies combine to gain a greater market share or to achieve greater efficiency. The same is true for weaker companies who know they can't survive as independents. They will often contact each other to see if a merger can be effected and retain some of the business the companies have developed as well as some of the employees.

 

Note that a merger is not necessarily between equals. If one company is much larger or smaller than the other, that can still be a merger. The idea of the merger is that the CEOs agree that continuing in business alone isn't the best thing for both companies.

 

By merging with each other, the companies will benefit from:

  • Elimination of certain personnel that will save money for the new entity. Think of all the administrative staff that would be duplicated from the accounting department to the buying staff to the marketing group. And that might include one of the CEOs because oftentimes after a merger, one of the CEOs takes the money and runs. It's a rare CEO that stays around when the new CEO office is filled by someone else.
  • Better cost efficiencies. Whether it's buying paper clips or new automobiles for the sales department, when a larger entity is placing the order, there are cost savings. When a merger is completed, the new, bigger corporation has more purchasing power.
  • Higher profile in the industry. The combined entity gives the company higher visibility because it's now reporting higher revenues and has larger distribution. Sometimes that image will create sales opportunities that weren't there for the two, smaller companies.

 

There are basically three kinds of mergers:  

  • pooling of interests
  • a consolidation
  • or a purchase.

The pooling of interest merger puts the two companies' assets together and combines all the accounts. The consolidation is when a new entity is formed and both the companies are bought and combined under the new entity. The purchase is when one company buys another. In the strictest sense, only when one of the companies survives as a legal entity is there a merger.

Here are some of the tax consequences of the mergers.  

 

Pooling of Interest: stock is exchanged between two companies and one entity survives. This is a tax free merger, and if you own the company that is being merged, you will receive stock in the surviving company. That stock will have the same basis as your original purchase price, and you have no tax consequence. You simply put the new stock in your portfolio in exchange for the old stock.

 

Purchase: When one company buys another using cash or a debt instrument, the stock of the acquired company is sold for the agreed upon amount and triggers a taxable event. The reason companies will sometimes use this method is that there is a tax benefit to the acquiring company. They can write-up the assets they acquire to the actual value paid for the company, and the difference between the book value and that purchase value for the assets can be charged off as depreciation over several years, thereby lowering the taxes payable by the surviving entity.

 

Consolidation: This would be treated the same as the Purchase merger.

There are also several types of economic mergers:

 

Horizontal Merger: When two companies that are in direct competition in the same product lines and markets combine.

 

Vertical Merger: When a customer and company or when a supplier and company merge. Think of a cone supplier to an ice cream maker.

 

Market Extension Merger: When two companies combine that sell the same products in different markets.

Product Extension Merger: When two companies are selling different but related products in the same market.

 

Conglomerate Merger: When two companies have none of the above attributes get together.

The hope of every merger is that there will be a synergy making the whole of the two companies greater than the sum of the two. Sometimes it works; sometimes it doesn't.

 

An Acquisition of one company by another is a little different from a merger but not much. All of the above reasons for combining two companies apply, but instead of swapping stock or consolidating under a new corporate entity, one company simply buys another. Sometimes it's done in a friendly way. Sometimes it's done in a way best described as hostile. Another name for the unfriendly acquisition is a Takeover.

 

In an acquisition, a company can buy another company with cash, with stock, or a combination of the two. The difference between the merger purchase and an acquisition depends on whether the purchase is friendly and announced as a merger or announced as an acquisition or the purchase is unfriendly. When it's unfriendly, it's always an acquisition.

When Company A buys Company B with cash, the shareholders of Company B have a taxable event because they exchange their shares for cash. If Company A issues stock to purchase Company B, then there is an exchange of shares and there is no taxable consequence for the shareholders.

 

When there's a merger or acquisition, many elements come into play. How will the transaction be paid for? How is the acquired company evaluated? Who has to approve it, if it needs approval? In this second of the four part series on M&A, we'll look at these issues.

 

Any time there is a merger or acquisition, the acquiring company has to pay the target company with money or stock, or both, for the business. If there is debt in the target company, that also has to be considered because the acquiring company has to pay the interest on the debt as well as pay it off when it comes due. If the acquiring company pays cash for the target company, it immediately triggers a taxable event for the shareholders of the target company. In other words, the shareholders of the target company get cash for their stock, and that's equal to a sale. Therefore, taxes are due.

 

If the acquiring company uses stock instead of cash, the transaction is not a taxable event for the shareholders of the target company. There is just a swap of paper: the stock of the acquiring company is used as the currency, and those shares are traded for the shares of the target company. The cost basis for the new shares is the same as the cost basis for the old shares for investors in the acquired company. Only when the shareholder sells the new shares will there be a taxable event. That's why many mergers and acquisitions are done with stock; there are no taxes due for the shareholders of the acquired company at the time of the acquisition.

 

The new shares from the acquiring company's stock are issued to the target company's stockholders. They are given directly to shareholders who own the stock certificates or to the brokers who show holders of the target company, and the broker removes the acquired company's shares and replaces them with the new, acquired company's shares. Often times, there will be odd amounts of shares because the target company will pay a price that doesn't allow for round numbers of stock.

 

For example, if the target company offers 1.2 shares of its stock to buy another company, then for every 100 shares of stock investors hold in the target company, they will receive 120 shares of the new, acquiring company's stock. And when the formula requires 1.42 or some other uneven amount of stock, investors end up with a rather odd looking number of shares. Fortunately, there is no penalty anymore for selling odd lots (transactions with less than 100 shares of stock) for the vast majority of stocks. So when investors do sell their stock, there isn't any problem, no matter how many shares are involved.

 

Of course, when stock is used to buy a company, investors will show a new stock in their portfolio, the acquirer's. Sometimes, there is a new entity created and new shares are issued for both the target company and the acquiring company, using a new name. One recent switch on all this was when NationsBank bought Bank of America. In that case, NationsBank gave up its name and ticker symbol number and took on Bank of America's. When a new entity from a merger or acquisition is created with a new symbol, it also means a new CUSIP number is created as well. Individual investors need to keep track of news on their stocks to make sure they know how a merger or acquisition might change everything about them from names to symbols to CUSIP numbers.

 

One of the difficult questions acquiring companies ask is: How much is a company worth? The answer is: Usually less than the seller thinks and more than the buyer wants to pay. However, there are various ways of evaluating companies. The most common method is to look at comparable companies in an industry. While each company has some unique attributes, most of them do have comparable competition that can be used as benchmarks for value. Some of the most common measures used to evaluate a target company are:

  • P/E ratios (price to earnings) The acquirer makes an offer as a multiple of the earnings the target company is producing. Looking at the P/E for all the stocks within the same industry group will give a good guidance for what that P/E should be.
  • PSRs (price to sales ratios) The acquiring company pays a multiple of the revenues, again, being aware of the PSR that other companies in the industry have.
  • Asset evaluation. If a company doesn't earn money, it doesn't mean it's worthless. Many deals are done based on the replacement value of the assets a target company owns, such as gold deposits, real estate holdings, etc.
  • Market Cap. Take the number of shares of each comparable company for the target company and multiply each one by its stock price. This is known as Market Capitalization. The seller will be looking for the highest market cap and the buyer will be looking for the lowest. They usually meet somewhere in between.
  • Replacement Cost. Some acquisitions or mergers are based on what it would cost to replace the target company. In other words, if it's a capital intensive company with large machinery, a price can be determined by finding the cost of all the equipment and staffing a company. Then the acquiring company can literally tell the target: sell at this price or we'll build a competitor for the same amount of money. Of course, it takes a long time to assemble good management, acquire property and the right equipment. This method of establishing a price wouldn't work with a service company where most of the assets are the people who provide the service.

 

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Merger Agreement & Joint Venture Agreement Templates

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Asset Purchase & Sale Agreement- DEF01

Stock Purchase & Sale Agreement: Common Stock, Shorter Version- DEF02

Stock Purchase & Sale Agreement: Common Stock, Longer Version- DEF11

Stock Purchase & Sale Agreement: Preferred Stock, Longer Version- DEF12

Distribution Agreement - DEF03

Exclusive License Agreement - DEF04

Joint Venture Agreement - DEF05

Marketing & Sales Only Joint Venture Agreement - DEF06

License Technology In Exchange For Stock Agreement - DEF13

Partnership Agreement - DEF07

Promissory Note - DEF08

Non-Disclosure Agreement : DEF09

Shareholder Agreement - DEF10

 

 

 

Term Sheet/Letter of Intent Template

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Asset Purchase - M&A01

Asset Purchase - M&A02

Stock For Cash & Stock Purchase - M&A03

Stock For Cash Purchase - M&A04

Stock for Stock Purchase - M&A05

Earnout Purchase - M&A06

Joint Venture - M&A07

Product Distribution - M&A08

Product License - M&A09

Technology Development - M&A10

Series A Preferred - M&A11

Series B Preferred - M&A12

 

 


 

 

 

 

All mergers or acquisitions have to be approved by regulatory bodies. For example, if ABC wanted to buy CBS (or the other way around), the Federal Communications Commission would have to approve that deal because the combination of the two giants would probably create a monopoly or at least it would seem that way to the regulatory body or the media competitors. In every transaction, the Federal Trade Commission and the Department of Justice do reviews, just to be sure competition in an industry group has not been lessened when two companies become one. There are other levels of approval usually needed as well, depending on the industry group, the size, etc. If a regulatory body objects to a merger or acquisition or if there is some litigation stemming from the transaction, the acquiring company in an acquisition or the lead company in the merger has the right to appeal the ruling in court. But often that is too time consuming and costly to warrant the effort. Still, large companies with the resources will often fight the government. Smaller companies usually don't have the option.

 

When a U.S. company looks to acquire a company in Europe, the European Unity Council has to approve that purchase. Similarly in any foreign country, a U.S. firm has to get the approval from the appropriate authorities. Domestically, the buyer's intentions on employment practices is subject to scrutiny by federal and state labor and employment agencies. Issues include: racial and age discrimination, immigration law compliance, sexual harassment, drug testing, and wage and hour laws, as well as its compliance with the Family and Medical Leave Act, the American with Disabilities Act and the Worker Adjustment and Retraining Notification Act which governs plant closings and retraining requirements. The buyer also has to carefully check the retirement program of the seller, to be sure it's in compliance with the Employee Retirement Income Security Act.

 

As for a timetable of events, once there has been an agreement between the two parties, and all approvals have been granted (including the shareholders' blessing), the merger or acquisition proceeds with all due haste. Both companies want to get started as a new entity to achieve certain goals. Usually, they are:

  • Higher profitability through economies of scale. That means fewer people in the administration, sales, management, etc. to run the company. It also means better purchasing power to buy equipment or office supplies since the new entity will have a larger order with the ability to negotiate lower prices.
  • New regional coverage. Often companies buy a competitor to reach new markets.
  • Better national coverage. Efficiencies in advertising, in particular, help the new entity as the same ad reaches more potential clients if the new company has a broader reach.
  • Acquire new technology. One driving force these days is the need to stay on top of the latest technology and applying it to a business. By acquiring smaller companies with specialized niches (Cisco just bought Cerent for exactly this reason), the acquiring company can keep a competitive advantage.

Tender Offer: A tender offer is made by an acquiring company in order to purchase the shares of a target company. Payment may be made in either cash or stock. Sometimes the tender offer is made in a friendly manner, with the blessing of the target company. Most of the time, a tender offer is a hostile way for an acquiring company to buy control of a firm by circumventing the management and going directly to the shareholders.

 

The tender offer is a set price that a company is willing to pay for shares of another company. You'll see them announced in The Wall Street Journal, in the third section of the paper. It takes up about 1/3 of the page. The ad will state the price of the tender offer and the deadline for accepting it. By putting a defined time limit on the offer, it forces the shareholders to make a decision quickly. Usually the price offered is above the current price at which the stock is trading. And most of the time a tender offer is successful.

 

But the target company isn't helpless in this matter. Once the acquiring company starts to purchase shares in the open market (that's how tenders start: the acquiring company begins carefully and discreetly buying shares in the target company, building a position), it has a limit of 5% of the total outstanding shares it can buy before filing with the SEC (Securities and Exchange Commission). In the filing, the company must declare how many shares it owns and whether it intends to keep the shares as an investment or is looking to buy the company.

 

When the target company sees this filing, it can do several things:

  • Adopt a poison pill provision in its by-laws. This is usually done before a company is a target, but it's still a maneuver that can be used when the target realizes it is a target. It basically develops a plan to make the acquiring company pay more for the target company or changes the voting structure of the common stock. The target may issue a new series of preferred shares that must be redeemed at a premium price after a takeover has occurred. Or another tactic is to issue more common stock at a bargain price for all existing shareholders except the acquiring company. Usually these programs make the purchase more expensive and also create dilution which discourages the hostile takeover.
  • Attempt an agreement. Most of the time, it's the management of the target company that has the most to lose, mainly their jobs, in a tender offer. By going directly to the acquirer, sometimes the two firms can work out a peaceful agreement.
  • Find a White Knight. That's a company that fits better with the current management. The white knight rides into the fray, usually offering the same or more for the shares than the hostile bidder, but has the blessing of the current management.

There are two types of tender offers: Take-Overs and Take-Unders. Take-overs occur when the tender offer for the shares in the target company is higher than the current price of the stock. A Take-under is when the tender offer is less than the current price of the stock. While Take-overs are the norm for acquisitions since most shareholders have to be induced with higher prices to sell their shares, the Take-under does occur, especially in a strong market.

 

The Take-under happens when a target company has its stock price run-up in anticipation of a tender offer or with the expectation of more than one bidder for the company. Investors may be too aggressive in their pricing and push a stock's price well ahead of its value to any buyer. When the tender price is announced, and it's less than the current price, the stock will sometimes stay above the tender price because investors believe another, higher price will materialize. Sometimes it does.

 

Other times, there's only one bidder, and if enough shareholders don't tender their shares, the acquisition doesn't happen. When that occurs, the price of the stock drops dramatically. Or the buyer may get a majority of the shares at the lower price because enough holders believe the price is more than fair given the true value of the company.

 

The Holding Company: This is a company that owns enough voting stock in another company to influence its board of directors and therefore to control its policies and management. Holding companies, in and of themselves, do not manufacture anything nor do they offer a service. Their sole purpose is to invest in or create subsidiaries that they can control. The holding company doesn't have to own the majority of the shares of its subsidiaries or be engaged in similar activities. But, to receive the tax benefit of consolidation which allows tax-free dividends to the holding company, or permits sharing of losses with the operating unit, the holding company must own 80% or more of the subsidiary's voting stock.

 

Probably the best known and most diverse holding company was Gulf+Western Industries. It owned companies as diverse as motion pictures to food makers. The holding company usually is more focused, and the structure allows for vertically integrating a certain industry, such as financial services. In that industry, the holding company can own a life insurance company, a bank, a brokerage firm, a mortgage banking company, or any other financial related service and can ideally achieve cross selling from one company to another to create a symbiosis among all its companies.

 

The holding company structure allows for a strong vertical integration of companies, if that's management's purpose. But it also gives great flexibility for investing in diverse industries, creating a portfolio of companies that may be well balanced so that when one industry group is less profitable, another group is benefiting from the same economic circumstance.

 

Leveraged Buyout (LBO): Whenever you see the word leverage, think of debt. That's because leverage requires the use of borrowed money. An LBO occurs when a company borrows money (usually in the form of bonds) to buy a target company. This was very prevalent in the late 80s when Drexel Burnham became the issuer of many of the bonds used to buy companies.

 

Sometimes the leverage became too much and some of the LBOs failed. Today the LBO is rare because valuations of stocks are very high. For LBOs to work, the acquiring company will often look to the cash flow of the target company or its assets to pay off the debt incurred to buy the target company. That's why you'll often see, after a successful LBO, the target company sell some of its divisions. It's to pay off some or all of the debt used in the LBO.

 

Many times an LBO is used to take a public company private. The management of the company will use the assets of the company as collateral for borrowing the funds needed to buy the stock back. Managers do that when they feel the market doesn't value their stock anywhere near its true value. By going private, the company can then sell themselves for their true value, or it can wait to go public again when the market places the company at a higher level. Often the LBO by management is a defensive mechanism. It prevents the company from being bought by another company at a low price.

 

Another LBO tactic is for individuals to place their own assets up as collateral and borrow the needed money from banks to buy the stock of a target company. In this deal, the new owners are looking for the cash-flow from the target to pay the interest payments and ultimately the principle of the bonds. In almost all cases, the LBO deals pay a premium to the shareholders to entice them to sell their stock.

 

Joint Ventures: These are usually referred to as JVs. A JV is when to companies agree to contribute to one project. Oftentimes one will have the cash to fund a project and the other will have the expertise. Think of a new bio tech company that has discovered a possible new drug but doesn't have the funding to take it from the research stage to Phase III of FDA trials. In that case, the biotech company will often seek a JV partner from one of the major pharmaceutical companies. In return for the needed money, the biotech gives the large drug company certain rights to the drug.

 

Most of the time there are "milestone" payments in a JV. These are established points in the process of developing a product, that, when reached, more money is added to the project. In the case of a new drug, it might be FDA approval to proceed with Phase I of trials. When each milestone is reached, more money is contributed to the JV. Many times there is also a requirement of an equity investment in the "non-money" partner. That gives the smaller company much needed funds to continue working on other projects and gives an incentive to the larger company to make sure the smaller one continues in business and prospers.

 

The JV differs from a merger or acquisition in that both companies remain independent. There is no other affiliation between the parties (except when there is an equity investment of one in the other but that investment is usually a small percentage of the company). If the JV doesn't work out, both companies go their separate ways. If it's successful, there is always a business plan as how the two companies proceed. In the case of the hypothetical drug companies, a successful new drug is usually marketed by the money partner and the developer of the drug continues to produce it.

 

The most fitting way to end is with the way many mergers and acquisitions do: with a spinoff or a divestiture of one or more companies once the merger or acquisition has been completed. It's not intuitive that two companies would come together and then let go of one or more of the subsidiaries that made up one or both entities. Here's why it happens.

 

Divestitures involve the outright sale of a subsidiary of a company. This is usually done because the sub doesn't fit into the core strategy the new combined entity is pursuing. For example, (this is not going to happen, it's only an example), if Coca-Cola decided to buy Ball Corporation for its canning and bottling production, there would be at least one subsidiary of Ball Corp. that would be sold. It's the one that's making aerospace and communications hardware for government agencies and corporate users. That's just not one of Coke's strengths.

 

A divestiture does two things for the new entity: it eliminates a non-essential subsidiary and raises cash. That cash is often times used to pay some or all of the debt the acquiring company raised to buy the target company. In the late 80's and early 90's, many of the corporate raiders raised debt to buy a company, then after acquiring a target would divest many of the subs to raise cash to service the debt or to pay part or all of it off. Sometimes that worked very well when the sum of the parts was worth more than the whole. When the whole was worth more than the sum of the parts, the debt didn't get paid off because the divestitures weren't as highly valued as the raiders had originally calculated.

 

A spin-off occurs when a subsidiary becomes an independent entity, divorced from the parent entirely. Most often, that means shares in the new entity (the spin-off sub) are distributed to the parent corporation's shareholders on a pro rata basis. Pro rata is Latin for "according to the rate". So the shareholders of the parent are given shares in the new spin-off based on their percentage ownership of the parent. If a shareholder had 5% of the parent, that owner would receive 5% of the shares of the spin-off entity.

 

The spin-off also occurs when two entities merge, or there is an acquisition and the management of one of the subsidiaries wants to make the subsidiary an independent unit. The management will then do a Leveraged Buy Out which amounts to borrowing the money needed to buy the subsidiary from the parent. Management will often use the assets of the subsidiary as the collateral for the debt needed to buy the sub from the parent. In these spin-offs, cash is paid to the corporate parent, and the shareholders of the parent do not receive any stock in the new entity. That's because it is a direct sale and the proceeds go to the parent, thereby compensating the shareholders of the parent. Of course, the shareholders don't usually receive a pro-rata cash distribution, but they could. Most of the time the new funds are put to work in the parent corporation by buying back debt or shares or re-investing in new equipment for the on-going business.

 

Another type of spin-off is accomplished when an ESOP buys a subsidiary of a company. The ESOP is an Employee Stock Ownership Plan. When a spin-off is announced, sometimes the employees who work for the subsidiary will use all the funds from their ESOP to purchase the unit. If there aren't enough funds in the ESOP, additional money is raised through debt. Again, the parent sells the sub and gets the cash so the shareholders get the benefit of the sale. The employees of the sub get to keep their jobs and have the added responsibility of making the new, independent sub a profitable business.

 

Again, the driving forces behind divestitures and spin-offs are elimination of non-core businesses and/or to raise cash. In the period of 1991 to 1995, there were $100 billion of spin-offs, and from 1995 to 1997, there were $121 billion according to Securities Data Corp. Some of the larger spin-offs were AT&T spinning off Lucent Technologies and Sprint's spin-off of Sprint Cellular. While some of these newly independent subs survive and thrive (like Lucent), others find the going a little rougher without the umbrella of a large parent to help cushion any mistakes that are made. For investors, each one has to be carefully scrutinized to determine if it will be better on its own rather than part of the parent.

 

This series has covered most of the aspects of Mergers and Acquisitions, but there is one detail deliberately left out: the tax implications. Most investors will not have any tax problems if they own stock in a company that is merged or bought. That's because most of the mergers or acquisitions where stock is used as the currency are designed to be a tax-free exchange of stock.

 

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