Acquisition

It is when one corporation has bought another corporation.

Author: Osman Ahmed
Osman Ahmed
Osman Ahmed
Investment Banking | Private Equity

Osman started his career as an investment banking analyst at Thomas Weisel Partners where he spent just over two years before moving into a growth equity investing role at Scale Venture Partners, focused on technology. He's currently a VP at KCK Group, the private equity arm of a middle eastern family office. Osman has a generalist industry focus on lower middle market growth equity and buyout transactions.

Osman holds a Bachelor of Science in Computer Science from the University of Southern California and a Master of Business Administration with concentrations in Finance, Entrepreneurship, and Economics from the University of Chicago Booth School of Business.

Reviewed By: Matthew Retzloff
Matthew Retzloff
Matthew Retzloff
Investment Banking | Corporate Development

Matthew started his finance career working as an investment banking analyst for Falcon Capital Partners, a healthcare IT boutique, before moving on to work for Raymond James Financial, Inc in their specialty finance coverage group in Atlanta. Matthew then started in a role in corporate development at Babcock & Wilcox before moving to a corporate development associate role with Caesars Entertainment Corporation where he currently is. Matthew provides support to Caesars' M&A processes including evaluating inbound teasers/CIMs to identify possible acquisition targets, due diligence, constructing financial models, corporate valuation, and interacting with potential acquisition targets.

Matthew has a Bachelor of Science in Accounting and Business Administration and a Bachelor of Arts in German from University of North Carolina.

Last Updated:October 6, 2023

What Is an Acquisition?

An acquisition is when one corporation has bought another corporation. Not to be confused with a merger, where both businesses combine to form a new entity. Once purchased, the smaller firm will be integrated into the more prominent firm.

Considering becoming an investment banker? When helping companies manage large financial transactions, you will likely come across a company looking to buy another, but what does that entail? 

At a minimum, the acquiring firm must control 50% or more of the target firm's voting rights or assets to control the business, yet it is not uncommon to sell the entire business in a deal. Once acquired, major business decisions at the target firm are up to the acquirer.

Typically you will hear about transactions between large public companies, such as Verizon Communications' purchasing of Verizon Wireless from Vodafone

However, these do not always happen on the public market and do not necessarily require buying shares either. Most transactions occur between small and medium-sized businesses, including incorporated and unincorporated businesses in the private market.

Key Takeaways

  1. Acquisition involves one company purchasing and integrating another, while a merger combines both businesses to form a new entity.

  2. Acquisitions offer benefits like increased revenue, diversification of segments, improved market share, synergies, cost reductions, expansion into new markets, access to technologies/IP, and potential tax advantages.

  3. Integration in acquisitions can be vertical, horizontal, or conglomerate, depending on the relationship and business segments involved.

  4. Acquisitions and takeovers differ in approach; acquisitions aim to extend market presence or diversify offerings, while takeovers are aggressive and often against the target company's will.

  5. Acquisitions can be financed through methods like stock purchase, asset purchase, debt financing, equity financing, mezzanine finance, vendor financing, or leveraged buyouts, based on the acquiring company's circumstances and goals.

Reasons of Acquisition

These can occur when a business is looking to improve its future performance by investing in another business. 

Some benefits include:

  • Increased revenue
  • Diversification of business segments
  • Improved market share
  • Synergies between businesses
  • Cost reductions
  • Expanding into new geographic markets
  • Reduce competition / greater control of product supply
  • Gain new technologies protected by IP law or too expensive for the business to develop on its own
  • Tax benefits, particularly when acquiring a business with tax loss carryforwards while you have a tax liability, although this is rarely the sole reason to buy another business

Once a firm is bought, its financials amalgamate into the new owner's. If the acknowledged firm has any sales, this will increase the total revenue of the owner. This revenue increase is typically referred to as "inorganic."

Organic growth for a business stems from its operations. Since this income was not generated internally before a deal, it is viewed as an inorganic source of revenue growth.

Diversification can exist within a similar industry as the acquiring business. However, it can spread to entirely unrelated sectors as well. The industry in which a deal is searched depends on the needs and desired outcome of the firm.

Synergies can be as simple as cost reductions, which is often the case. However, improving market share can provide opportunities to improve pricing control, or sharing technology can increase the potential output of both businesses. 

Many other synergies could cause acquiring another business, but in essence, the idea is that both firms benefit from having a relationship.

Expanding into new markets can be a difficult task for many businesses. However, using a foreign firm's assets and tacit knowledge makes it easier to enter and operate within that market because of knowledge sharing within the combined firms. 

Also, when buying an existing operation, its customer base is one of the business's assets. This makes generating customer trust and recognition an easier task.

Types and methods of firm integration

There are three main types of integration: vertical, horizontal, and conglomerate. The easiest way to think of this is through observing the supply chain of a specific industry and at what stage the acquiring company and target company are. 

  • Vertical integration of a company exists when one firm is either a supplier or a customer of the firm it is integrating into.
  • Horizontal integration typically occurs between two businesses operating at the same supply chain stage.
  • Conglomerate integration occurs to diversify the business segments of the acquirer. The target firm is not within the same supply chain or possibly even the same industry as the acquirer.

Firms also choose different integration methods, depending on what generates the best value. For example, a designer clothing brand might preserve most of the company value through subsidiary integration, and an industrial deal might benefit most from statutory integration.

  • Statutory integration: A larger corporation buys a smaller one, and once merged into the more significant business, it's no longer recognized as a separate entity by name or operation. We might consider the Verizon transaction mentioned earlier to represent this.
  • Subsidiary integration: The bought corporation continues to exist and operate under its name but is now owned and part of the portfolio of the larger corporation. For example, when Capri Holdings bought Versace.

Acquisition Vs Takeover

A takeover and an acquisition are similar in that they both entail one firm obtaining control of another. However, there is a distinction between the two. An acquisition is a transaction in which one firm buys another, usually with the goal of extending its market presence or diversifying its offers.

A takeover, on the other hand, often suggests a more aggressive strategy in which one firm buys another against its will, sometimes by a hostile offer or by purchasing a majority of its shares.

Takeovers are typically motivated by the acquirer's desire to obtain control and influence over the operations of the target firm.

These terms might sound similar, but it is essential to understand the difference.

  •  A takeover occurs when the board of directors does not agree to be purchased. Large amounts of stock must then be purchased to control the company in a takeover.
  • In an acquisition, the board of directors would agree to the takeover. This is either because both companies benefit from the transaction or it is the best decision for the shareholders

Types of Acquisition Finance

Some of the common types are:

1. Stock purchase

The corporation's shares are bought, linking ownership of assets and liabilities to the acquirer. The shareholders must agree to sell their business shares, and once they do, they will receive the funds in exchange for their shares.

2. Asset purchase

A target company can sell its assets as well. In this case, there are a few key differences:

First, the company selling assets can receive the funds directly (as opposed to the shareholders). Second, the company buying the assets can avoid taking on the liabilities of the company they receive the assets from.

There are numerous forms of acquisition finance used to fund the purchase of a company. One frequent method is debt financing, which entails securing loans or issuing bonds to fund the transaction.

This can include

  • Bank loans
  • Private placements
  • Public bond issues

Another method is equity financing, which involves the acquiring firm raising cash by selling shares or issuing additional equity.

Mezzanine finance combines components of debt and equity financing, generally in the form of subordinated loans or convertible securities.

Additionally, there may be other financing methods such as vendor financing, in which the seller provides funding to the buyer, or leveraged buyouts, in which the target company's assets are used as collateral for financing.

How are Acquisitions paid for?

There are two standard methods of payment: cash and stock. Corporations may often consider some combination of both payment methods, but it is most important to understand each individually first. 

There are many reasons why one option might be better for the firm.

Each option has unique benefits, and some payment methods are better for certain firms than others. There is also the consideration of what a company might prefer or be willing to offer a better relative deal.

What firms are looking for in their consideration is which transaction will generate the best net present value. They also want to estimate if the value of its firms and synergies of both firms is equal to or greater than the cash and/or stock paid to the other firm's shareholders.

Lastly, firms must consider the risks in payment methods, who share the risk, and the pitfalls of either a cash or stock transaction.

Cash acquisition

These are straightforward. One business offers a specified amount of cash to purchase the shares of another.

The funds can come from issuing shares, liquidating assets (including PPE, subsidiary companies, etc.), issuance of debt, and retained earnings

In this, there is a one-time cost to the corporation. This comes directly from the cash on the balance sheet, but this asset is replaced by another (the acquired firm and its assets). The benefit is that the synergies fully benefit the shareholders of the larger corporation.

On the other hand, there are the considerations of risks. The main one to consider is that the models could have overstated synergies. If this is the case, the acquirer's shareholders hold the risk entirely.

The direct cost of a cash acquisition is the total cash that one firm pays to shareholders of another. For this transaction, costs are directly linked to the more prominent firm's balance sheet.

The formula for NPV of an all-cash transaction: 

Net present value = value of target firm + present value of the synergies - cost (total cash)

Stock acquisition

It is an offer of the purchaser's stock. The stock is given to the other corporation's shareholders as a percentage or volume of the acquiring corporation's shares. This means that the target firm's shareholders will now have an equity stake in the acquirer.

Its costs belong directly to the shareholders of the acquiring firm. While they are giving up a specified amount of stock to acquire another corporation, no cash is leaving the business. Therefore, the cost can be considered the dilution of ownership in the corporation.

While there is a benefit to stock acquisitions regarding cash retention, stock acquisitions' costs contrast those of cash acquisitions. Moreover, since the shareholders of own acquiree shares of the larger corporation, they also hold rights to profits, including those from potential synergies.

In other words, if the synergies are understated, the acquiree's shareholders will yield more significant benefits than what was paid. As a result, the acquirer's shareholders will have overpaid for their own business and will not gain the full advantage of the synergies.

The actual cost is determined by the proportion of stock the acquiring firm has offered and the combined value of the two firms, including synergies. In other words, the cost is the value of the offered stock once the two firms combine.

The formula for the NPV of an all-stock transaction:

Net present value = (value of firm (A + B) + present value of synergies) * % of stock exchanged

The Role of investment banks in Acquisitions

Why do corporations reach out to investment banks during acquisitions? One crucial role is in estimating the fair value of a business. Without an M&A division, some corporations might not have the analysts and ability to create the models needed to estimate a reasonable price range.

Furthermore, in some of the most significant transactions, corporations may need help navigating the technical aspects of taking a company private. As there are many regulations and considerations to such a transaction, an investment bank can help the process run smoother.

As an example, firm A is looking to acquire another business in the SaaS space. They might reach out to Goldman Sachs or J.P. Morgan to help them find a firm to acquire. The investment bank will then find a target firm and proceed with the M&A process.

This brings us to the key role of investment banks: sourcing buyers through "teasers." These are brief descriptions of a business and are sent out to private equity funds that might be interested in buying the corporation.

In summary, investment banks help connect willing sellers with potential buyers and, through this action, improve the efficiency of selling a business. They also help other firms looking to buy a specific type of business find them and help enterprises to invest their capital more efficiently. 

How does IB determine the fair value of a business?

Establishing the value of the target firm is one of the critical jobs of an investment bank. But, you may ask, "how do they determine fair value"? 

Doing this is more of an art than a science, but there are still several standard quantitative methods.

  • Three-statement model: The three statements are linked together, and projections about future performance are made. This model is also essential as it can support the following model, the DCF.
  • DCF model discounts future cash flows to determine the business's fair value today, including an exit multiple. This model depends on your cash flow projections, which you can pull from your three-statement model.
  • Precedent transactions: Valuing a business based on historical M&A transactions.
  • Comparables: Also known as "spreading comps." The analyst will try to estimate a company's fair value based on the market pricing of similar businesses.

NOTE

There seems to be a consensus not one single method is the most appropriate for valuing a business, but all of them are put together to help form an idea of what the company is worth. To have a complete picture of what should be paid, it is important to understand the various models and processes of M&A.

Final considerations

There are many reasons to buy other businesses and a few quantitative ways to value them. But you may ask, "is that all there is to it?". The answer is no; there are many more considerations in these transactions.

Companies must consider more than just the fair value of the business. They should consider how this transaction will affect their firm and understand some qualitative aspects of the other business. The buyer needs to have some balance between qualitative and quantitative analysis.

The management quality of the target firm should be considered. The culture and values of bought firms often see much change as they become part of a larger corporation. Thus, it is important to consider how the business has been managed and who it was managed by.

What are some of the potential downsides that will arise after the transaction? First, the acquired firm's liabilities belong to the acquirer, and their degree of financial leverage will affect the larger corporations.

How does the firm affect our diversification? A firm might decide to buy out another when they aim to diversify its business segments. The firm must consider how they wish to diversify. 

Linking some concepts, does diversification generate the firm's most significant net present value? 

Does the benefit of diversifying outside of the core industry of a company outweigh the potential synergies of searching within the industry for a target and vice versa?

Researched and authored by Brandon Fausto | LinkedIn

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