Merger & Acquisition

What is Merger and Acquisition (M&A)?
Acquisitions and mergers mostly happen when a company wants to expand in a new territory, but does not have enough expertise to do business over there, or when a company wants to expand into a new business and does not have technologies to produce that new kind of product or service. Merger and acquisition doesn’t require any sort of subsidiary or joint venture. It is a decision taken by the top management of the company meaning it is a corporate level strategy. Merger and acquisition are two different terms. However, the difference between these two terms is kind of confusing and unclear. Definitions:

Acquisition happens when a company completely takes over another company, and cements itself as the new owner. This purchase makes sure that the targeted company does not exist anymore. In merger, two companies get combine with each other and create a new entity. The two companies won’t remain separately owned and operated. There are two types of acquisitions, friendly and hostile. In friendly acquisition, the targeted firm wants to be acquired willingly by another company. Hostile acquisition is the opposite. There is no agreement from the targeted firm and acquiring firm strives to get majority of stake. An acquisition can be friendly or hostile depending on how the proposal has been communicated to the target firm and how target firm perceived the proposal. This type of information is highly classified and no third party gets to know about this. Some “improvement in the terms” can be made which can eventually turn a hostile acquisition into a friendly one. Acquisitions can also be classified as ‘public’ and ‘private’ acquisitions. This type of acquisition is based on whether the target firm is listed in stock exchange market or not. The overall acquisition process is very difficult and complicated, and according to the research, 50% acquisitions have failed.

Most of the time, a small firm gets acquired by a larger firm. However, sometimes a “reverse takeover” takes place. In this situation, a larger firm’s management gets purchased by a small firm, and acquirer uses the name of the larger firm to represent the brand new entity. In “Reverse merger”, a private company purchases a publicly listed firm so that the private company can be in the stock market even for a shorter period of time. Plenty of mergers do not work all the time. However, mergers can justify price premiums by cutting costs or boosting revenues. If someone just combine computer system, merge a few departments, force the price down by taking advantage of size and the merged giant should be profitable than its part. So, in theory, the idea seems great. However, in reality in can easily go into vain. There are different regulatory and tax implications on how a company secures its control over the asset of other company after the acquisition. For example, after the purchase, the purchaser owns the share and overall control of the acquired business. However, if that business never had any threat of liquidation, than the purchased business will carry all the liabilities from the past along with the future risks of operating.

After the buyer purchases the entire asset, the target company has to spend the cash by paying dividends to its shareholders. So, because of this purchase, the target company will end up as an “empty shell”. Buyers sometimes design the whole transaction process in a way which will get them the most useful assets that they want, and leave out the unnecessary assets and liabilities. They use this process because some liabilities can do future damage. For example, environmental damage, employee termination or liabilities that result from lawsuit over defective products. However, some jurisdictions, especially outside USA, impose a tax on the transfer of individual assets. So, this can work as a disadvantage against this transaction structure. During acquisition firms can squeeze out greater benefits if they focus on retaining “knowledge-based resources”.

However, several differences in companies exists, and it becomes very hard to extract knowledge and benefits. In the following there are five issues regarding acquisition which have been generated through research – 1. Independence regarding administration is not important for acquired firm. Rather independence regarding symbolic value and culture is more important, because it creates the base for technological capabilities. 2. False authorizing documents and change in certain knowledge can make it difficult to share information. 3. Acquired firm’s management plays an important role in terms of promotions and incentives to make their talent useful. 4. Implementation process of acquisition is so complex that it makes transferring capabilities and technologies so difficult. Fast acquisitions hampers the transfer of certain knowledge as well. 5. If the acquired firm is huge and high performing, than integration and exchange of knowledge becomes difficult.

Proper strategic management and maintenance of important resources like employees, literature and knowledge is very important for an acquisition to be successful. Maintenance of these resources are difficult as well right after the acquisition. One important thing to keep in mind is the independence of key resources along with stakeholders of acquisitions. Independence of certain resources is important to some extent for better management. Relationship with stakeholders needs to be understood and take advantage of this relationship while implementation is very important as well. Difference between acquisition and merger:

Most of the time the word merger and acquisition is used in the same sense. However, a little difference exist between the meaning of these two. When one company gets a hold on another company and due to this purchase the control of the target company goes completely to the purchaser, is called an acquisition. The target firm won’t exist as a separate entity anymore. The buyer sort of “swallows” the business and only the buyer’s stock will be traded in the market. When merger happens, two separate and independent companies will come forward, they will combine and create a new entity which will be a separate and independent venture. The previous two companies will vanish along with their separate stocks, and the stock of the newly build entity will be traded in the stock market. One good example is GlaxoSmithKline. In 1999 Glaxo Wellcome and SmithKline Beecham merged together and formed a new entity named GlaxoSmithKline. When firms of same size combines with each other and creates a new company, it is referred as “merger of equals”. Most of the time genuine merger does not takes place. Most of them are acquisitions. However, the companies claim publicly that it is a merger, because acquisition, takeover, these terms basically gives a negative vibration. So, according to the top executives, ‘merger’ is the term which will make more sense publicly. A good example would be Daimler-Benz taking over Chrysler in 1999. At that time, it was announced as a merger. However, a complete takeover deal will be considered as merger, if the top management of both companies completely agrees that it will be beneficial for both companies. In terms of unfriendly deals, it would be always acquisition. Valuating a Business:

Business evaluation includes the following steps:
1. Valuation of asset
2. Valuation of historical earnings
3. Future maintainable earning valuation
4. Comparing the price of the assets to the market value of similar assets
5. Valuation of discounted cash flow
While evaluating a business it is always not a good idea to use only one of these methods. Professionals use couple of these methods simultaneously, so they can achieve the value more accurately. An “audit”, “review engagement” and “notice to reader” are measures of accounting, which are used to get info from an income statement or a balance sheet. A proper valuation of business is immensely important. At which price the entire business will be sold totally depends on the outcomes of these valuations. There are ways to publish this valuation information. Letter fo Opinion of Value or LOV is good way to publish to value of a business. However this is not the only way to express the value of a business. The bigger the company the size detailed the size of the report. Financing for Merger and Acquisition:

Mergers and acquisitions can be financed in several ways. The financing criterions are somewhat works as a differentiator between a merger and an acquisition. Cash can be used to pay. When cash comes into play it will be considered as acquisition. The reason is during acquisition, target companies stakeholders won’t be considered in the picture. The target will be considered under the stakeholders of acquirer. Stock payment is also legal. In this case, the shareholders of acquired company gets payment in the form of acquiring company’s stock. Which Financing Method is better?

Several factors will come into play while choosing the form of payment. There are other potential purchasers who are waiting and ready to compete. So, careful steps need to be taken. Pure cash deals can remove any confusion from the real value of the bid and cash payment can compete better with competitors than securities. Risk associated with payment through stocks will be removed as well. The second factor would be taxes. Proper consultancy is required in order to evaluate this factor. The third factor is a share deal. A company’s capital structure might get affected if it is thinking about a share deal. If share deal is a must, than acquiring firm can prevent increase in capital at the general meeting of stakeholders. Cash transaction will remove the risk. So, there would be modification in buyer’s balance sheet and financial results that has been reported, will be taken into account by the decision maker. For example, when the current account of the company finances a pure cash deal, there will be a decrease in liquidity ratios. In contrast, if there is a stock deal, there will be issuance of new shares in order to finance the deal.

So, there is a chance of lower return on assets. There is a very strong link between different financing criterions and different forms of payment. If the purchaser decides to pay with stock, following financing possibilities will occur: There would be shares in the treasury and financial loose will increase. Cost of debt might get decreased. Repurchase of stocks in the market will add a brokerage fee in the transaction cost. Financial slack will be increased because of the issue of stock. Debt rating might get improved. In order to prepare a proxy statement there is a preparation fee, which will be considered as transaction cost. It will also include shareholder registration and meeting. Three financing option will rise if buyer chose cash as a form of payment: Cash on hand will absorb financial slack. Transaction costs won’t be there and debt rating might get reduced. Unused debt capacity will be increased by issue of stock. Debt rating will be improved. Cost of shareholder’s meeting and proxy statement preparation fee will be included under transaction cost. Financial elasticity is basically created by stock. For huge transactions, the payment decision are somewhat influenced by transaction cost. When purchaser sees their shares to be overvalued, they offer stocks. When they see their shares to be undervalued, they will mostly offer cash. Consultancy Regarding Mergers and Acquisitions:

In recent time, lots of merger and acquisition advisors have emerged, who only provide special consultancy on this issue. The term “transition companies” or “companies in transition” is used to refer to those companies. In United States only a broker dealer with license will be considered eligible for providing consultancy service. The advisor also needs to be subjected to SEC (FINRA) regulations. “Corporate advisory” contains more details on advisory firms regarding mergers and acquisitions. However, full service investment banks also provides consultancy regarding merger and acquisition at present. Reasons behind Merger and Acquisition:

Expecting improved financial performance is the main reason for firms performing mergers and acquisitions. Performance in the financial aspect is subjected towards some motives. These motives are listed below: Bigger market share and revenue: Through acquisition or merger a company can eat up a major and threatening competition thus becoming the market leader. And as a market leader, it would be able to set up the market price and enjoy superior revenue. Opportunity for cross selling: if a bank and a stock broker combines each other, than a possibility for cross selling will be created. The regular customer of bank will sign up with the stock broker to receive accounts on brokerage. So, stock broker is getting bank’s customers. Same way, stock broker’s customers will sign up with bank to receive bank’s services. As a result, bank acquiring stock broker’s customers. Reducing tax: If a company has a huge liability of tax, than it can acquire a loss maker company. Through the help of loss company the acquirer can easily reduce its tax liabilities. However, around the world, there are restrictions on acquiring loss making companies by large companies. So, large companies need to be careful while shop for loss maker to reduce their tax liabilities.

Collaboration: Specialization in the management can be achieved due to the collaboration that takes place during acquisition and merger. Economies of Scope: It sheds light on adeptness linked with increase or decrease in the scope of distribution and marketing of several products. Economies of Scale: When two companies get combined, there are no needs for same departments or operations. So, fixed cost can be significantly reduced by getting rid of those extra operations. As a result the overall profit margin gets increased. Vertical Integration: Vertical integration means entering into business which is a part of the same production path. An externality problem can be internalized through this initiative. Sometimes companies situated in different parts of a production path gain monopoly power and start to reduce outputs. So, two deadweight losses occur. In this case, a merger can get rid of one deadweight loss. As a result, “double marginalization” can be dealt with merger. Creating a single management for similar businesses: United growth and income fund and united money market fund a two mutual funds with similar portfolio investment. These are two similar businesses, so management decided to bring united money market fund under united growth and income fund.

Alternative Hiring process: Some companies goes beyond conventional hiring process. If a larger firm sees a private company which is in the initial phase, than that large firm can just hire the employees of that firm. As a result, the private firm won’t have too much incentive to grow anymore without any talented staffs and will dissolve automatically. Diversification: Geographical diversification is a type of diversification that makes the earnings of the company much smoother. Company’s stock price also gets smoothen because of this over a longer period of time. As a result, investors who are conservative, gains more courage while investing in the company. However, shareholders do not always get the desired value through diversification. Transferring the Resources: Sometimes during any transaction, one party have more information compared to other party, which gives the firm a competitive advantage. If there is an interaction or link between the resources of acquirer and target firm than this problem can be overcome. Scare resources can also get combined there won’t be any uneven distribution of resources among those firms. So, transfer of resources is also one the motives for mergers and acquisitions. Studies show that, along with motives regarding financial aspects, there are also several other motives which influences decisions regarding acquisitions and mergers.

Financial performance of firms, most of the time does not changes positively as a function of their acquisition activity. So, adding value to shareholders is not the only motive behind merger and acquisition. The other motives are: Building an Empire: Some managers and companies have a fascination of creating a larger, multi dimensional business which will stand as an exclusive and strong entity and every other company will look up at it. So, in need for more power companies strive towards acquisition and merger. Manager’s compensation: There are some companies, where manager’s compensations are linked with the total amount of profit made by the company as a whole. So, in order to increase the amount of profit, managers pursue an acquisition and merger strategy. The idea is that the bigger and resourceful the company will get, more profit will be generated as a result. So, acquisition would be a good option for more compensation seeking managers.

However, in order to increase company’s overall profit, sometimes profit per share gets decreased significantly. This can hurt the company in the long run. Diversification: As mentioned earlier, skeptic investors will be confident while investing because of diversification. However, diversification does not always able to provide value. However, it can predict and accurately hedge a company’s downfall in a particular industry. By diversifying their portfolios individual shareholders can also calculate the hedge at a lower cost. This cost will be lower from those linked with a merger. Manager’s Arrogance: Sometimes managers feel so confident regarding collaboration resulted from mergers and acquisition. This overconfidence can sometimes result in overpayment for target companies.

Companies according to their requirements choose between merger and acquisition, and other forms of expansion, because one size does not fit all. While one prefers merger and acquisition, other might go for separating the public ownership of a subsidiary or business segment, which will prove more beneficial for them. However, according to the theory, mergers and acquisitions create greater economies of scale and better synergies or collaboration. It also cut costs and a good way of expanding the business. Investors can at least feel relieved knowing that, greater and enhanced market power can be gained through merger and acquisition.