M&A Considerations and Implications

During the 19th century, the history of mergers and acquisitions began in the United States. In 1708, the East India Company merged with an erstwhile competitor and the Hudson’s Bay Company, which merged with the rival North West Company in 1821.

However, the discipline of mergers and acquisitions is becoming important in modern business.

Since 1994, very large-scale mergers and acquisitions have changed some industries, including finance, oil, pharmaceuticals, telecommunications, I.T., and chemicals.

For instance, the U.K. business's 2000 purchase of the German business Mannesmann was valued at $183 billion. The fourth largest company in the world and the by far largest company listed on the London Stock Exchange were created due to this deal.

On the other hand, mergers and acquisitions can also occur in much smaller transactions. For example, mergers between public sector organizations, such as universities and hospital trusts, are becoming more common in many countries.

This high interest in mergers and acquisitions appears to continue, if not increase.

As technology advances and deregulation and globalization take hold, old trade barriers and national influence become less of an impediment to international trade.

As a result, mergers and acquisitions are likely to become an even more important consideration in future strategic planning and strategy implementation in this context.

What are Mergers & Acquisitions?

Mergers and Acquisitions are the joinings of two or more businesses to form a new corporation or company. However, the primary distinction between a merger and an acquisition is how the two companies are combined.

A merger is joining two independent companies to form a combined entity. Whereas acquisition is the purchase of one company by another, it can be hostile.

Before the merger, there is usually a negotiation process between the two companies.

For example, assume that Companies A and B are already established financial institutions. Company A is a high-street bank with a sizable commercial clientele.

Company B is a building society or similar organization specializing in domestic home loans. Both companies may believe that a merger would be helpful because it would provide the combined company with commercial and domestic customer bases.

On the other hand, the negotiation process does not always take place during an acquisition.

Acquisitions can be hostile or friendly:

1. A friendly acquisition occurs when the target is willing to be acquired. The target may see the acquisition as an opportunity to expand into new markets and utilize the acquirer's resources.

This is especially true for small, successful businesses that want to grow and expand but are hampered by a lack of capital.

2. The acquisition could also be hostile. In this case, the acquisition is opposed by the target. Hostile acquisitions are also known as hostile takeovers.

Types of Mergers & Acquisitions

The types of mergers & acquisitions may depend on how and where the organization wants to expand.

The expansion can be to acquire the operations in the supply chain or acquire a firm that operates within the same value chain, or go totally out of the way and expand in industries that have no relation to what the organization does.

There are three basic types of mergers:

1. Vertical integration (includes both forward and backward integrations)

A merger of two businesses producing various products or services for a single finished good. When two or more businesses that operate at different levels of an industry's supply chain merge their operations, it is known as a vertical merger.

This is because increasing synergies created by merging businesses would be more efficiently operating as one is typically the rationale behind a merger.

2. Horizontal integration

A horizontal merger is a business consolidation between companies competing in the same market and frequently offering the same product or service. In other words, two similar businesses merge to form one. For example, a merger between Nike and Adidas.

Since there is typically more competition in industries with fewer firms and more potential for synergies and market share gains for merging firms, horizontal mergers are frequently seen in these industries. In other words, two similar businesses merge to form one

3. Conglomeration 

It is the combination of businesses engaged in completely unrelated industries. Conglomerate mergers can be either pure or mixed.

While mixed conglomerate mergers involve companies looking for products or market extensions, pure conglomerate mergers involve companies with no common interests.

Forms of considerations in Merger & Acquisition (cash vs. shares)

Consideration is the payment of the bidding company for the target company. In general, it is the way that mergers and acquisitions are financed, and the companies' relative sizes set them apart.

In addition, different payment methods have different effects on the financial situation, capital structure, and controlling the structure of the remaining acquiring companies.

There are numerous ways to finance an M&A transaction:

Cash Payment (Cash on hand or borrowed cash)

The cash financing method is utilized in mergers and acquisitions when the target company is not publicly traded. Acquirers frequently use cash offers if their company is undervalued. Otherwise, they opt for other forms of financing.

The cash payment method is

• The most popular payment method with M&A’s.
• Simple purchasing action
• Simple and transparent

Pros and cons of using the cash payment method: According to experts, the Tang dynasty in China between 618 and 907 A.D. was when paper money first appeared. Because it was so much lighter than modern coins and was simple to transport, it quickly gained popularity.

But as we can see, the coin never vanished and is still present alongside the banknote. There are several advantages and disadvantages to using the cash payment method.

Pros:

1. Less risk

The cash payment method provides a guaranteed purchase price with no fluctuation in cash value. This method is associated with less risk.

2. No dilution of ownership. 

Its shareholders will become part owners of your acquired company if you exchange your company's stock for that of another to finance the acquisition.

They will be eligible for a portion of your company's future profits. In contrast to stock acquisitions, cash acquisitions allow you to keep your company's current ownership structure.

Cons:

1. Loss of liquid assets 

In times of need, you will deplete your company's cash reserves, which are its most liquid asset. While an acquired company's fixed assets are expected to provide long-term growth, it will be difficult to convert to cash in the short run.

If you run into cash flow issues and need to sell the acquired company quickly, you will certainly receive less than you paid for it.

2. Debt problems

Suppose you finance a cash purchase with Bank Loans. Increasing your company's debt will increase your annual interest payments, potentially causing cash flow issues.

While you can suspend dividend payments to shareholders if your company requires cash, you must make interest payments every year to avoid default.

Taking on more debt to acquire a company may make your company appear riskier to lenders, and rating agencies may reduce your debt rating.

Security Payments

It refers to a method of payment in which the acquiring company issues new securities to buy the valuable assets or stock of the target companies. It consists of the following forms:

a) Stock payment

This type of payment is the most common form of acquisition. The purchasing companies issue new stock by purchasing the target companies' stocks or assets.

Under this payment, the most widely used form is the stock exchange; the purchasing company pays the target company directly with its stock to purchase the target company's stock or assets.

1. Stock swap
   Known as Share exchange or stock-for-stock. Occurs during an acquisition, where the company performing the takeover offers its shares at a predetermined rate. Part of the transaction is done through a stock swap. However, trading one equity-based asset for another gives the buyer the option to pay in stock rather than cash.
2. Swap ratio
   The exchange rate between the shares of the companies involved in a merger and acquisition.
   • For example, if the acquiring company offers four shares for every share of the target company, the swap ratio = 4:1.
   • There is no precise formula for calculating the swap ratio. Instead, companies analyze their financial situations through various calculations:
     1. Book value
     2. Dividend paid
     3. Profits after tax
     4. Earnings per share

b) Bonds payment

The purchasing companies issue new corporate bonds by purchasing the target companies' stocks or assets.

• Relatively higher negotiability 
• Higher credit rating.

Pros and cons of using a secure payment method: A few advantages and disadvantages are associated with the Security payment method. Although this payment method is not widely known as the cash payment method, it can be associated with pros and cons.

• Pros: It's straightforward and inexpensive. You won't have to deal with expensive valuations.
• Cons: Securities laws can make situations involving a large number of shareholders more complicated. 

Leveraged Buyout (LBO)

It is a combination of equity and debt. It is the purchase of another company by one corporation with a significant amount of borrowed money covering the purchase price. Along with the acquiring firm's assets, the target company's assets are sometimes used as collateral for loans.

It can have many different forms, such as

a. Management buyout (MBO)

A financial transaction in which someone from corporate management or the team buys the business from the owner(s).

b. Management buy-in (MBI)

Occurs when an outside management team buys a company and replaces the existing management team MBIs involve companies that are either poorly managed or undervalued.

c. Secondary buyout (SBO)

A financial transaction in which a portfolio company—an entity in which a corporation has an investment—is sold.

d. A Tertiary buyout

Executed when a company acquired through a secondary buyout is sold to another financial sponsor.

Pros and cons of using Leveraged Buyout: LBOs benefit the buyer because they allow them to spend less of their funds, earn a larger return on investment, and assist in turning around failing businesses.

Due to the ability to use the seller's assets rather than their own to cover the financing cost, they experience a higher return on equity than in other buyout scenarios.

There are several pros and cons associated with the LBO payment method.

Pros:

1. If the acquisition fails after the purchase and you cannot repay the debt, your business and personal finances are safe. You are not obligated to pay the money.
2. LBO may provide tax benefits to your company since the purchase is debt-driven.
3. A high rate of return is expected on the investment in the company.

In terms of cons:

1. If the target company has enough cash flow to pay its debts, it will have far less money to spend.
2. The company may have to cut R&D expenses, pushing it back from the forefront of the market.
3. The leveraged company may downsize, increasing the rate of unemployment.

What determines the payment method of M&As?

The payment method differs depending upon management ownership, acquirers’ shares performance, and the relative size of the assets in consideration of the target firm. Additional consideration should be of the cash flow and taxes involved.

Several factors help identify the payment method of M&A:

1. Relative size

It is defined as the ratio of the total assets of the target to that of the acquirer. The value of the total assets is calculated at the fiscal year-end. Moreover, the greater the relative size, the more likely that share exchange will be used in M&As.

2. Free cash flow and the tax consideration 

There are two ways firms distribute cash to their shareholders:

1. Cash Dividends
2. Repurchasing shares from the stock market

   As this ratio increases, the level of free cash flow increases.

3. Management Ownership

The percentage of equity the firm's management holds is referred to as managerial ownership. The percentage of shares (equity) held by the bidder's (target's) management is positively (negatively) related to the cash offer.

4. Performance of the acquirer’s shares 

It represents the pre-acquisition performance of acquirers and targets. Bad-performing firms show an acquisition target (liable to be attacked), while well-performing firms tend to return to the acquirer.

Proxies to measure a firm’s performance:

1. Dividend yields
2. Market value to book value
3. Return on equity (ROE)

The share exchange method is more likely to be used if the acquirer's shares perform well on the stock market.

Researched and authored by Sedra Hariri / LinkedIn

Reviewed and edited by Parul Gupta | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Cash Flow Drivers
• Comparable Company Analysis
• Store of Value
• Sweat Equity
• Tangible Net Worth (TNW)