Merger and Acquisitions: Basics

Why M&A:
One plus one makes three: this equation is the special alchemy of a merger or an
acquisition. The key principle behind buying a company is to create shareholder
value over and above that of the sum of the two companies. Two companies
together are more valuable than two separate companies - at least, that's the
reasoning behind M&A.
Acquisition:
When one company takes over another and clearly established itself as the new owner, the
purchase is called an acquisition. From a legal point of view, the target company ceases to
exist, the buyer "swallows" the business and the buyer's stock continues to be traded
Merger

A merger happens when two firms, often of about the same size, agree to go forward
as a single new company rather than remain separately owned and operated. This
kind of action is more precisely referred to as a "merger of equals." Both companies'
stocks are surrendered, and new company stock is issued in its place.
Mostly mergers and acquisitions ( M & A ) as a business transaction where one company
acquires another company. The acquiring company will remain in business and the acquired
company (which we will sometimes call the Target Company) will be integrated into the
acquiring company and thus, the acquired company ceases to exist after the merger.

Mergers can be categorized as follows:

1. Horizontal:
Two firms are merged across similar products or services. Horizontal mergers are often used
as a way for a company to increase its market share by merging with a competing company.
For example, the merger between Exxon and Mobil will allow both companies a larger share
of the oil and gas market.
Chapter
2.Vertical:
Two firms are merged along the value-chain, such as a manufacturer merging with a
supplier. Vertical mergers are often used as a way to gain a competitive advantage within the
marketplace. For example, Merck, a large manufacturer of pharmaceuticals, merged with
Medco, a large distributor of pharmaceuticals, in order to gain an advantage in distributing its
products.

3. Conglomerate:
Two firms in completely different industries merge, such as a gas pipeline company merging
with a high technology company. Conglomerates are usually used as a way to smooth out
wide fluctuations in earnings and provide more consistency in long-term growth. Typically,
companies in mature industries with poor prospects for growth will seek to diversify their
businesses through mergers and acquisitions. For example, General Electric (GE) has
diversified its businesses through mergers and acquisitions, allowing GE to get into new
areas like financial services and television broadcasting.
Reasons for M & A

The joining or merging of the two companies creates additional value which we call
"synergy". The primary reason for any company to do merger and acquisition is to create
synergy after joining two firms.

Synergy value can take three forms:

1. Revenues: By combining the two companies, we will realize higher revenues then if the
two companies operate separately.

2. Expenses: By combining the two companies, we will realize lower expenses then if the
two companies operate separately.

3. Cost of Capital: By combining the two companies, we will experience a lower overall cost
of capital.

For the most part, the biggest source of synergy value is lower expenses. Many mergers are
driven by the need to cut costs. Cost savings often come from the elimination of redundant
services, such as Human Resources, Accounting, Information Technology, etc.
However,
the best mergers seem to have strategic reasons for the business combination. These
strategic reasons include:

 Positioning - Taking advantage of future opportunities that can be exploited when

the two companies are combined. For example, a telecommunications company
might improve its position for the future if it were to own a broad band service
company. Companies need to position themselves to take advantage of emerging
trends in the marketplace.

 Gap Filling - One company may have a major weakness (such as poor distribution)
whereas the other company has some significant strength. By combining the two
companies, each company fills-in strategic gaps that are essential for long-term
survival.

 Organizational Competencies - Acquiring human resources and intellectual capital

can help improve innovative thinking and development within the company.

 Broader Market Access - Acquiring a foreign company can give a company quick
access to emerging global markets.
Mergers can also be driven by basic business reasons, such as:

 Bargain Purchase - It may be cheaper to acquire another company then to invest

internally. For example, suppose a company is considering expansion of fabrication
facilities. Another company has very similar facilities that are idle. It may be cheaper
to just acquire the company with the unused facilities then to go out and build new
facilities on your own.

 Diversification - It may be necessary to smooth-out earnings and achieve more

consistent long-term growth and profitability. This is particularly true for companies in
very mature industries where future growth is unlikely. It should be noted that
traditional financial management does not always support diversification through
mergers and acquisitions. It is widely held that investors are in the best position to
diversify, not the management of companies since managing a steel company is not
the same as running a software company.

 Short Term Growth - Management may be under pressure to turnaround sluggish

growth and profitability. Consequently, a merger and acquisition is made to boost
poor performance.

 Undervalued Target - The Target Company may be undervalued and thus, it

represents a good investment. Some mergers are executed for "financial" reasons
and not strategic reasons. For example, Kohlberg Kravis & Roberts acquires poor
performing companies and replaces the management team in hopes of increasing
depressed values.

 Staff reductions - As every employee knows, mergers tend to mean job

losses. Consider all the money saved from reducing the number of staff
members from accounting, marketing and other departments. Job cuts will
also include the former CEO, who typically leaves with a compensation
package.

 Economies of scale - Yes, size matters. Whether it's purchasing stationery

or a new corporate IT system, a bigger company placing the orders can
save more on costs. Mergers also translate into improved purchasing
power to buy equipment or office supplies - when placing larger orders,
companies have a greater ability to negotiate prices with their suppliers.

 Acquiring new technology - To stay competitive, companies need to stay

on top of technological developments and their business applications. By
buying a smaller company with unique technologies, a large company
can maintain or develop a competitive edge

The Merger & Acquisition Process can be broken down

into five phases:
Phase 1 - Pre-Acquisition Review:
The first step is to assess your own situation and determine if a merger and acquisition
Strategy should be implemented. If a company expects difficulty in the future when it comes
to maintaining core competencies, market share, return on capital, or other key performance
drivers, then a merger and acquisition (M & A) program may be necessary.
It is also useful to ascertain if the company is undervalued. If a company fails to protect its
valuation, it may find itself the target of a merger. Therefore, the pre-acquisition phase will
often include a valuation of the company - Are we undervalued? Would an M & A Program
improve our valuations?
The primary focus within the Pre Acquisition Review is to determine if growth targets (such
as 10% market growth over the next 3 years) can be achieved internally. If not, an M & A
team should be formed to establish a set of criteria whereby the company can grow through
acquisition. A complete rough plan should be developed on how growth will occur through
M & A, including responsibilities within the company, how information will be gathered, etc.

Phase 2 - Search & Screen Targets:

The second phase within the M & A Process is to search for possible takeover candidates.
Target companies must fulfill a set of criteria so that the Target Company is a good strategic
fit with the acquiring company. For example, the target's drivers of performance should
compliment the acquiring company. Compatibility and fit should be assessed across a range
of criteria - relative size, type of business, capital structure, organizational strengths, core
competencies, market channels, etc.
It is worth noting that the search and screening process is performed in-house by the
Acquiring Company. Reliance on outside investment firms is kept to a minimum since the
preliminary stages of M & A must be highly guarded and independent.

Phase 3 - Investigate & Value the Target:

The third phase of M & A is to perform a more detail analysis of the target company. You
want to confirm that the Target Company is truly a good fit with the acquiring company. This
will require a more thorough review of operations, strategies, financials, and other aspects of
the Target Company. This detail review is called "due diligence." Specifically, Phase I Due
Diligence is initiated once a target company has been selected. The main objective is to
identify various synergy values that can be realized through an M & A of the Target
Company. Investment Bankers now enter into the M & A process to assist with this
evaluation.
A key part of due diligence is the valuation of the target company. In the preliminary phases
of M & A, we will calculate a total value for the combined company. We have already
calculated a value for our company (acquiring company). We now want to calculate a value
for the target as well as all other costs associated with the M & A.

The calculation can be summarized as follows:

Value of Our Company (Acquiring Company) $ 560

Value of Target Company 176
Value of Synergies per Phase I Due Diligence 38
Less M & A Costs (Legal, Investment Bank, etc.) (9)
Total Value of Combined Company $ 765

Phase 4 - Acquire through Negotiation:

Now that we have selected our target company, it's time to start the process of negotiating a
M & A. We need to develop a negotiation plan based on several key questions:

 How much resistance will we encounter from the Target Company?

 What are the benefits of the M & A for the Target Company?
 What will be our bidding strategy?
 How much do we offer in the first round of bidding?

The most common approach to acquiring another company is for both companies to reach
agreement concerning the M & A; i.e. a negotiated merger will take place. This negotiated
arrangement is sometimes called a "bear hug." The negotiated merger or bear hug is the
preferred approach to a M & A since having both sides agree to the deal will go a long way to
making the M & A work.
In cases where resistance is expected from the target, the acquiring firm will acquire a partial
interest in the target; sometimes referred to as a "toehold position." This toehold position
puts pressure on the target to negotiate without sending the target into panic mode.

In cases where the target is expected to strongly fight a takeover attempt, the acquiring
company will make a tender offer directly to the shareholders of the target, bypassing
the target's management. Tender offers are characterized by the following:

 The price offered is above the target's prevailing market price.

 The offer applies to a substantial, if not all, outstanding shares of stock.
 The offer is open for a limited period of time.
 The offer is made to the public shareholders of the target.

A few important points worth noting:

 Generally, tender offers are more expensive than negotiated M & A's due to the
resistance of target management and the fact that the target is now "in play" and may
attract other bidders.
 Partial offers as well as toehold positions are not as effective as a 100% acquisition
of "any and all" outstanding shares. When an acquiring firm makes a 100% offer for
the outstanding stock of the target, it is very difficult to turn this type of offer down.
Another important element when two companies merge is Phase II Due Diligence. As
Phase- I Due Diligence started when we selected our target company. Once we start the
negotiation process with the target company, a much more intense level of due diligence
(Phase II) will begin. Both companies, assuming we have a negotiated merger, will launch a
very detail review to determine if the proposed merger will work. This requires a very detail
review of the target company - financials, operations, corporate culture, strategic
issues, etc.
Phase 5 - Post Merger Integration:
If all goes well, the two companies will announce an agreement to merge the two
companies. The deal is finalized in a formal merger and acquisition agreement. This leads
us to the fifth and final phase within the M & A Process, the integration of the two companies.
Every company is different - differences in culture, differences in information systems,
differences in strategies, etc. As a result, the Post Merger Integration Phase is the most
difficult phase within the M & A Process. Now all of a sudden we have to bring these two
companies together and make the whole thing work. This requires extensive planning and
design throughout the entire organization.
The integration process can take place at three levels:

1. Full: All functional areas (operations, marketing, finance, human resources, etc.) will be
merged into one new company. The new company will use the "best practices" between
the two companies.

2. Moderate: Certain key functions or processes (such as production) will be merged

together. Strategic decisions will be centralized within one company, but day to day
operating decisions will remain autonomous.

3. Minimal: Only selected personnel will be merged together in order to reduce

redundancies. Both strategic and operating decisions will remain decentralized and
autonomous.

If post-merger integration is successful, then we should generate synergy values. However,

before we embark on a formal merger and acquisition program, perhaps we need to
understand the realities of mergers and acquisitions.
A Reality Check
As mergers and acquisitions are extremely difficult. Expected synergy values may not be
realized and therefore, the merger is considered a failure. Some of the reasons behind
failed mergers are:

 Poor strategic fit - The two companies have strategies and objectives that are too
different and they conflict with one another.
 Cultural and Social Differences - It has been said that most problems can be
traced to "people problems." If the two companies have wide differences in cultures,
then synergy values can be very elusive.
 Incomplete and Inadequate Due Diligence - Due diligence is the "watchdog" within
the M & A Process. If you fail to let the watchdog do his job, you are in for some
serious problems within the M & A Process.
 Poorly Managed Integration - The integration of two companies requires a very
high level of quality management. In the words of one CEO, "give me some people
who know the drill." Integration is often poorly managed with little planning and
design. As a result, implementation fails.
 Paying too Much - In today's merger frenzy world, it is not unusual for the acquiring
company to pay a premium for the Target Company. Premiums are paid based on
 expectations of synergies. However, if synergies are not realized, then the premium
paid to acquire the target is never recouped.
 Overly Optimistic - If the acquiring company is too optimistic in its projections about
the Target Company, then bad decisions will be made within the M & A Process. An
overly optimistic forecast or conclusion about a critical issue can lead to a failed
merger.

Some of the hard fact about M&A:

 Synergies projected for M & A's are not achieved in 70% of cases.
 Just 23% of all M & A's will earn their cost of capital.
 In the first six months of a merger, productivity may fall by as much as 50%.
 The average financial performance of a newly merged company is graded as C - by
the respective Managers.
 In acquired companies, 47% of the executives will leave the first year and 75% will
leave within the first three years of the merger.

Hostile takeovers and defences - Defence

Strategies

Hostile Takeover:
The term “Hostile Takeover” is defined as when a company puts a bid on a target firm, which
is being opposed by the management of the targeted company which furthermore advises its
shareholders not to sell to the acquiring firm. Also, if a bid is placed for the shares of the
target company without informing its board and is directly aimed to the shareholders, the
term hostile takeover is also applied. The bid or offer could be suggested towards the
shareholders with or without the consent or negotiations from the management of the
targeted firm.
Furthermore, there is a thin line between what is characterized as a hostile bid or a normal
bid, since it sometimes occurs that a friendly or normal bid if you, develops into a hostile bid.
However, hostile bids and offers are generally directly aimed at the shareholders of the
targeted company in hope of gaining control over the company without the consent from the
board of directors of the targeted firm.
The motives behind a hostile takeover in theory, is usually the same as with other
acquisitions, except one additional reason or motive for a hostile bid. It is said that the most
effective way of replacing an ineffective board of directors or management of a targeted firm,
is through a hostile takeover. When a company operates ineffectively even though it has
great growth potential or the value of the stock price doesn’t properly illustrate the real value
of the company, the firm is undervalued. The acquiring company then wishes and aims to
replace the old management, in order for the company to achieve its full revenue and growth
potential, thus increasing its stock value. For this reason, companies with a management
that doesn’t seek the best interests for its shareholders are often potential objects for future
acquirements.
A hostile takeover could therefore sometimes also be seen as an effective market
transaction, which simply replaces a bad management, in order to gain increased company
value for the acquiring company as well as for the shareholders of the targeted firm.
The acquirers usually employ the following hostile takeover techniques:
 Toehold acquisition – a purchase of the target’s shares on an open market. They
allow the acquirer to become a shareholder of the target and provide an opportunity
to sue the target later on if the takeover attempt turns out unsuccessful.
 Tender offer – an acquirer’s offer to the target’s shareholders to buy their shares at a
premium over the market price. A partial, two-tier, front-end loaded tender offer
usually involves a back-end merger. The takeover literature generally treats tender
offer as a hostile takeover technique. It should not be treated as hostile, however, if it
favors the interests of the majority of shareholders. Such a majority should be
adequate to approve the relevant merger or acquisition. To claim that any tender offer
is hostile would make virtually any merger or acquisition hostile.
 Proxy fight – a solicitation of the shareholders’ proxies to vote for insurgent
directors. Proxy fights can run along with “board packing,” where the number of
board members increases and the acquirer intends to fill this increase with his slate
of directors.

Antitakeover Defences
In response to these hostile takeover techniques, targets usually devise the following
defences:
1. Stock repurchase
Stock repurchase (aka self-tender offer) is a purchase by the target of its own-issued shares
from its shareholders. This is an effective defence that successfully passed such prominent
antitakeover defence cases as Unitrin and Unocal v. Mesa Petroleum Co.
2. Poison pill
Poison pill (aka shareholder rights plan) is a distribution to the target’s shareholders of the
rights to purchase shares of the target or the merging acquirer at a substantially reduced
price. What triggers an execution of these rights is an acquisition by an acquirer of certain
percentage of the target’s shareholding. If exercised, these rights can considerably dilute the
acquirer’s shareholding in the target and thus can deter a takeover. The poison pill is one of
the most powerful defences against hostile takeovers. The pills can be flip-in, flip-over, dead
hand, and slow/no hand.

Flip-in poison pill can be “chewable,” which means that the shareholders may force a pill
redemption by a vote within a certain timeframe if the tender offer is an all-cash offer for all
of the target’s shares. The poison pill can also provide for a window of redemption. That is a
period within which the management can redeem the pill. This window hence determines the
moment when the management’s right to redeem terminates.
“Dead hand” pill creates continuing directors. These are current target’s directors who are
the only ones that can redeem the pill once an acquirer threatens to acquire the target. While
the earlier court decisions restricted use of dead hand and no hand pills, the more recent
decisions uphold such pills.
“No hand” (aka “slow hand”) pill prohibits redemption of the pill within a certain period of
time, for example six months.
3. Staggered board
Staggered board is a board in which only a certain number of directors, usually one third, is
re-elected annually. It is a powerful antitakeover defence, which might be stronger than is
commonly recognized. For the reason of being too strong and reducing returns to the
target’s shareholders, the latter happened to resist this type of defence.
4. Shark repellents
Shark repellents are certain provisions in the target’s charter or bylaws deterring an
acquirer’s desirability of a hostile takeover. This defence typically involves a supermajority
vote requirement regarding a merger of the target with its majority shareholder. This defence
also includes other takeover deterrent provisions in the target’s certificate of incorporation or
bylaws.
5. Golden parachutes
Golden parachutes are additional compensations to the target’s top management in the case
of termination of its employment following a successful hostile acquisition. Since these
compensations decrease the target’s assets, this defence reduces the amount the acquirer
is willing to pay for the target’s shares. This defence may thus harm shareholders. It,
however, effectively deters hostile takeovers.
6. Greenmail
Greenmail is a buyout by the target of its own shares from the hostile acquirer with a
premium over the market price, which results in the acquirer’s agreement not to pursue
obtaining control of the target in the near future. The taxation of greenmail used to present a
considerable obstacle for this defence. Plus, the statute may require a shareholder approval
of repurchase of a certain number of shares at a premium.
7. Standstill agreement
Standstill agreement is an undertaking by the acquirer not to acquire any more shares of the
target within certain period of time. A standstill agreement is an additional defence that
usually accompanies the greenmail described above.
8. Leveraged recapitalization
Leveraged recapitalization (aka corporate restructuring) is a series of transactions designed
to affect the equity and debt structure of a corporation. Recapitalization usually involves such
transactions as (i) sale of assets, (ii) issuance of debt, and (iii) distribution of dividends.

9. Leveraged buyout
Leveraged buyout is a purchase of the target by the management with the use of debt
financing. This defence burdens the target with the debt. In such a case, the management
becomes a bidder and competes with a hostile acquirer for control over the target.
10. Crown jewels
Crown jewels are options under which a favored party can buy a key part of the target at a
price that may be less than its market value.
11. Scorched earth
Scorched earth is a self-tender offer by the target that burdens the target with debt.
12. Lockups
Lockups are defensive mechanisms in friendly mergers and acquisitions designed to deter
hostile bids. The lockups include (i) no-shop covenant, (ii) termination/bust-up fee, (iii) option
to buy a subsidiary, (iv) expense reimbursement etc.
13. Pacman
Pacman is a target’s tender offer for the acquirer’s shares.
14. White knight
White knight is a strategic merger that does not involve a change of control and relieves the
target’s management of the responsibility to seek the best price available. An example is the
case of Paramount Communications, Inc. v. Time Inc.
15. White squire
White squire is giving by the target to a friendly party of a certain ownership in the target.
This defence is effective against acquisition by the hostile party of a complete control over
the target by “freezing out” of minority shareholders.
16. Change of control provisions
Change of control provisions is target’s contractual arrangements with third parties that
burden the target in the case of a change in its control.
17. “Just say no”
On top of all, the “just say no” approach is a board’s development and implementation of a
long-term corporate strategy which enables the board simply to reject a proposal of any
potential acquirer who would fail to prove that his acquisition strategy matches that of the
target.

Leveraged buyout:
A leveraged buyout (LBO) is an acquisition of a company or a segment of a company funded
mostly with debt. A financial buyer (e.g. private equity fund) invests a small amount of equity
(relative to the total purchase price) and uses leverage (debt or other non-equity sources of
financing) to fund the remainder of the consideration paid to the seller. The LBO analysis
generally provides a "floor" valuation for the company, and is useful in determining what a
financial sponsor can afford to pay for the target and still realize an adequate return on its
investment.

Simple Leveraged buyout structure:

How is the purchase financed?
Most small and midsize company leveraged buyouts usually require two types of financing.
The buyer needs funds to acquire the company. They also need some financing to operate
and expand the business.
On the other hand, smaller transactions, or those involving companies that are not well
known, tend to use alternative financing options. These options include:

1. Seller financing: Many small to midsize leveraged buyout transactions have a seller-
financing component. Basically, the seller takes a note from the buyer that is amortized over
a period of time. Seller financing is an advantage to the buyer, since sellers tend to be more
willing than banks to provide financing. This type of financing is common in smaller
transactions and in management buyouts (a form of leveraged buyout).
2. Assumption of debt: In many cases, as part of the payment, the acquiring company can
assume some – or all – of the target company’s debt.
3. Bank loans: Bank financing is also commonly used in small and midsize leveraged
buyouts. Usually, the buyer takes a loan and uses it to cover part of the purchase price.
Keep in mind that banks seldom provide 100% of the funds needed to purchase the
company. They often require that the buyer use its own capital as well. Learn about business
acquisition loans.
4. Asset based funding: This funding is used to secure loans against certain assets, such
as real estate and machinery. This option is more common in transactions that include real
estate or that have machinery that is in good condition and paid off.

Advantages of an LBO
The main advantage of a leveraged buyout to the company that is buying the business is the
return on equity. Using a capital structure that has a substantial amount of debt allows them
to increase returns by leveraging the seller’s assets. There can also be some tax benefits
due to higher debt interest payments.
Leveraged buyouts also allow for the sale of companies that are in distress or going through
a turnaround. They provide a viable exit to the seller while also allowing the business to
continue operating while the problems are fixed.

Disadvantages of an LBO
From a buyer’s perspective, LBOs have some risks. The main disadvantage is that, once the
deal is completed, the target business is very leveraged. This scenario allows for little
margin of error. A problem with liquidity, such as the loss of a few key customers, could put
the business in serious distress.