Understanding mergers and acquisitions
To better understand the M&A notion and how it can boost your business, let’s go through the key points of mergers and acquisitions.
Definition of mergers and acquisitions
Mergers and acquisitions is the general term that refers to the consolidation of two or more companies.
Mergers and acquisitions are often used synonymously, however, these are two different deals.
A merger describes the process of two privately held companies or public companies uniting into one completely new entity to face strong prospects in the industry or conquer new markets. These two companies are of similar size and have similar growth goals. A new legal entity gets unique branding, and a new stock price is formed.
When it comes to the acquisitions process, one company takes over another, becomes its only owner, and obtains a controlling interest. The acquiring company is usually a larger organization that obtains a smaller one — the target company.
Friendly and hostile acquisitions
A friendly acquisition happens when an acquiring firm and an acquired firm negotiate M&A prospects in order to gain new financing options for the business.
On the contrary, hostile takeovers take place without the approval of the target company’s board. In this case, a target company does not want to be purchased. Such a deal usually happens when an acquiring firm makes an M&A offer to the target company’s shareholders, but the board of directors doesn’t approve it.
Such a negotiation takes place in a so-called “confidentiality bubble” where the parties involved follow confidentiality agreements.
Key takeaway: The main difference between a friendly and hostile M&A deal is the way it’s negotiated with the target company’s board of directors, shareholders, and management.
Types of mergers and acquisitions
- Mergers. During the merger deal, the board of directors of the target companies approves the deal. They also require regulatory approval from the stakeholders to form a combined company and establish a completely new entity.
- Acquisitions. The acquisition deal is always about one company acquiring a selling company, its intellectual property, or the biggest share of its stakes. In this case, the name of the target firm and legal issues are not changed.
- Consolidation. Consolidation deals refer to the process when two companies form a completely new entity, integrating core businesses and leaving the old structures behind. Consolidation requires shareholders of both companies to approve the deal. After this, they get a common equity share in the newly established firm.
- Asset purchase. During the asset purchase, an acquiring company purchases the assets of the target company. The selling company must get stakeholders’ approval to enter the deal. This type of acquisition is common for the target companies that face bankruptcy. In this case, public and private companies bid for asset purchase of the bankrupt company, and after the final transaction, the target company is liquidated.
- Management acquisitions. This type of mergers and acquisitions deal takes place when a company’s management team executives purchase a stake in their own company or another target firm, thus making it private.
- Tender offers. During the tender offer, one company offers to purchase an exceptional stock of another company at a purchase price that differs from the market price. To enter the deal, an acquiring company has to negotiate the offer with the stakeholders of the target company. The board of directors and the management team of the selling company are bypassed.
- Reverse mergers. This kind of mergers and acquisitions deal takes place when a private company purchases a public firm with limited assets and no legitimate business operations — a so-called publicly listed shell company. This is helpful when an acquiring company faces strong prospects and wants to go public in a short time period. As a result of reverse mergers, a new public company with tradable shares appears.
Mergers and acquisitions sides
- Sell-side. It’s a selling company or any other entity that seeks funding options for its business to face new prospects in the industry or conquer new markets.
- Buy-side. It’s an acquiring firm, usually a larger company, that aims to acquire the selling company, its intellectual property, or the share of stakes at the most profitable purchase price.
Structure of mergers and acquisitions
The structure of mergers and acquisitions can be different depending on the relationship between two companies that are involved in the deal:
- Horizontal. A horizontal merger takes place when two companies operate in the same markets and have similar business goals. A horizontal merger usually means that a selling company merges with a rival. The best example is the integration of Facebook, Instagram, and Messenger.
- Vertical. A vertical merger happens when a particular company merges with its customer or supplier. It’s a common type of merger for technology companies. Apple is considered a perfect example of vertical integration since they not only produce software products but also hardware and components used in their electronic devices.
- Conglomeration. This type of merger happens when two companies from totally different markets unite. It’s often done to increase the market share, improve cross-border selling, and take advantage of synergies. Conglomeration mergers also take place for diversification reasons. The brightest example is the eBay and PayPal merge that happened in 2002.
- Congeneric mergers. Such a mergers and acquisitions deal is about the integration of two companies that operate in different business industries but serve the same consumer base. For example, a TV manufacturer acquires a cable company.
- Product-extension merger. This type of merger is about synergies between two companies that sell different but related products and operate in the same industry. The best illustration of the product-extension merger is when two food suppliers unite.
- Market-extension merger. Such a merger takes place when two public companies or private companies that produce the same products but in different markets integrate. Such type of deal focuses on the expansion of the market. A good example is the acquisition of Eagle Bancshares Inc by RBC Centura.
Reasons for mergers and acquisitions activity
Below are the common reasons why private and public companies consider M&A deals:
- Unlocking synergies. The majority of M&A transactions happen when two companies unite to raise their economic value on the market. This way, the newly created combined company has a higher stock price than the two companies individually.
- Diversification. Two companies that operate in cyclical markets need to diversify their cash flows to avoid serious losses in case of a financial crisis in the industry.
- Stronger market power. This is the logical outcome companies expect when entering a horizontal type of mergers and acquisitions. However, the companies get the same result in a vertical merge. Acquiring the market power, a selling or acquiring company unlocks new financial opportunities.
- Higher growth. Mergers and acquisitions deal is a chance for a company to grow inorganically and faster. By merging with another company, it boosts its market share.
- Tax benefits. M&A deals for a tax benefits reason take place when one company suffers from a significant tax loss, and another experiences a notable taxable income. By acquiring the company with tax losses, an acquirer can use those losses to lower its tax liability. In other words, such a deal helps to arrange legal issues.
Valuation methods during mergers and acquisitions
The valuation process is an integral part of any merger or acquisition deal. It’s conducted by acquiring and selling sides.
An acquiring company wants to close the deal at the lowest price, while the best interest of the sell-side is to close the deal at the highest price.
To outline the final deal value, both parties usually use the following methods:
- Discounted cash flow (DCF) method. Discounted cash flow method determines the company’s working capital and the estimated future cash flows. Based on that information, the final deal value is calculated.
- Comparable transaction analysis. All the past comparable transactions in the industry are analyzed to determine the target deal value.
- Comparable company analysis. This method presupposes a relative valuation of comparable public companies to determine the deal price.
Mergers and acquisitions documentation
The due diligence process can’t start without a letter of intent. This doesn’t oblige parties to commit to the transaction yet, but it obliges to certain confidentiality liability.
After this, the due diligence process begins with attorneys, accountants, tax consultants, and other professionals involved.
When the due diligence is complete, participants of the mergers and acquisitions deal prepare a conclusive agreement. The type of agreement depends on the transaction structure.
Such a contract always focuses on the following terms:
- Conditions. These should be satisfied before the obligation to complete the transaction. Conditions often include regulatory approvals.
- Representations and warranties. These are provided by a selling company to prove its credibility and usually include knowledge qualifiers.
- Covenants. These regulate the conduct of the parties involved in the M&A before the deal and after its closure. Covenants typically include future income tax filings, tax liability, or post-closing restrictions that are agreed by the parties.
- Termination rights. These cover the conditions under which the deal may be terminated and fees that parties are obliged to pay in case of contract termination.
Mergers and acquisitions deals are a common decision for companies who seek growth and new financial opportunities. It allows for exploring new industries and gaining a bigger market share.
M&A deals can be of various types and have different structures based on the goals parties involved pursue. The guide above covers all the key aspects of an M&A deal.