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Mergers and Acquisitions (M&A)

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 Mergers and Acquisitions (M&A): The Basics

S. M. Ikhtiar Alam, Ph.D.

Professor, Institute of Business Administration, Jahangirnagar University, Bangladesh.

Mergers and acquisitions (M&A) are a general term that describes the
consolidation of companies or assets through various types of financial
transactions, including mergers, acquisitions, consolidations, tender
offers, purchase of assets, and management acquisitions.

Basic Points to Remember:

1. The terms "mergers" and "acquisitions" are often used

interchangeably, but they differ in meaning.
2. In an acquisition, one company purchases another outright.
3. A merger is the combination of two firms, which subsequently
form a new legal entity under the banner of one corporate name.
4. A company can be objectively valued by studying comparable
companies in an industry and using metrics.
5. The exchange ratio calculates how many shares an acquiring
company needs to issue for each share an investor owns in a
target company to provide the same relative value to the
investor.
6. The target company purchase price often includes a price
premium paid by the acquirer due to buying 100% control of the
target company.
 2

7. The intrinsic value of the shares and the underlying value of the
company are considered when coming up with an exchange
ratio.

8. There are two types of exchange ratios: a fixed exchange ratio

and a floating exchange ratio (discussed later).

Understanding Mergers and Acquisitions

What's an Acquisition? The terms mergers and acquisitions are often used
interchangeably, however, they have slightly different meanings.

When one company takes over another and establishes itself as the new
owner, the purchase is called an acquisition.

On the other hand, a merger describes two firms, of approximately the

same size, that join forces to move forward as a single new entity, rather
than remain separately owned and operated. This action is known as
a merger of equals. Case in point: Both Daimler-Benz and Chrysler ceased
to exist when the two firms merged, and a new company, DaimlerChrysler,
was created. Both companies' stocks were surrendered, and new company
stock was issued in its place.

A purchase deal will also be called a merger when both CEOs agree that
joining together is in the best interest of both of their companies.

Unfriendly or hostile takeover deals, in which target companies do not

wish to be purchased, are always regarded as acquisitions. A deal can be
classified as a merger or an acquisition based on whether the acquisition
is friendly or hostile and how it is announced. In other words, the
 3

difference lies in how the deal is communicated to the target

company's board of directors, employees, and shareholders.

M&A deals generate sizable profits for the investment banking industry,
but not all mergers or acquisition deals close.

Types of Mergers and Acquisitions

The following are some common transactions that fall under the M&A
umbrella:

Mergers

In a merger, the boards of directors for two companies approve the

combination and seek shareholders' approval. For example, in 1998, a
merger deal occurred between the Digital Equipment Corporation and
Compaq, whereby Compaq absorbed the Digital Equipment Corporation.
Compaq later merged with Hewlett-Packard in 2002. Compaq's pre-
merger ticker symbol was CPQ. This was combined with Hewlett-
Packard's ticker symbol (HWP) to create the current ticker symbol (HPQ).

Acquisitions
In a simple acquisition, the acquiring company obtains the majority stake
in the acquired firm, which does not change its name or alter its
organizational structure. An example of this type of transaction is
Manulife Financial Corporation's 2004 acquisition of John Hancock
Financial Services, wherein both companies preserved their names and
organizational structures.

Consolidations
 4

Consolidation creates a new company by combining core businesses and

abandoning the old corporate structures. Stockholders of both
companies must approve the consolidation, and subsequent to the
approval, receive common equity shares in the new firm. For example, in
1998, Citicorp and Travelers Insurance Group announced a consolidation,
which resulted in Citigroup.

Tender Offers

In a tender offer, one company offers to purchase the outstanding stock

of the other firm at a specific price rather than the market price. The
acquiring company communicates the offer directly to the other
company's shareholders, bypassing the management and board of
directors. For example, in 2008, Johnson & Johnson made a tender offer
to acquire Omrix Biopharmaceuticals for $438 million. Though the
acquiring company may continue to exist—especially if there are certain
dissenting shareholders—most tender offers result in mergers.

Acquisition of Assets

In an acquisition of assets, one company directly acquires the assets of

another company. The company whose assets are being acquired must
obtain approval from its shareholders. The purchase of assets is typical
during bankruptcy proceedings, wherein other companies bid for various
assets of the bankrupt company, which is liquidated upon the final
transfer of assets to the acquiring firms.
 5

Management Acquisitions

In a management acquisition, also known as a management-led buyout

(MBO), a company's executives purchase a controlling stake in another
company, taking it private. These former executives often partner with a
financier or former corporate officers in an effort to help fund a
transaction. Such M&A transactions are typically financed
disproportionately with debt, and the majority of shareholders must
approve it. For example, in 2013, Dell Corporation announced that it was
acquired by its founder, Michael Dell.

How Mergers Are Structured

Mergers can be structured in a number of different ways, based on the

relationship between the two companies involved in the deal:

• Horizontal merger: Two companies that are in direct competition

and share the same product lines and markets.
• Vertical merger: A customer and company or a supplier and
company. Think of an ice cream maker merging with a cone
supplier.
• Congeneric mergers: Two businesses that serve the same consumer
base in different ways, such as a TV manufacturer and a cable
company.
• Market-extension merger: Two companies that sell the same
products in different markets.
 6

• Product-extension merger: Two companies selling different but

related products in the same market.
• Conglomeration: Two companies that have no common business
areas.

Mergers may also be distinguished by following two financing methods,

each with its own ramifications for investors.

Purchase Mergers

As the name suggests, this kind of merger occurs when one company
purchases another company. The purchase is made with cash or through
the issue of some kind of debt instrument. The sale is taxable, which
attracts the acquiring companies, who enjoy the tax benefits. Acquired
assets can be written up to the actual purchase price, and the difference
between the book value and the purchase price of the assets
can depreciate annually, reducing taxes payable by the acquiring
company.

Consolidation Mergers

With this merger, a brand-new company is formed, and both companies

are bought and combined under the new entity. The tax terms are the
same as those of a purchase merger.

How Acquisitions Are Financed

A company can buy another company with cash, stock, assumption of

debt, or a combination of some or all of the three. In smaller deals, it is
 7

also common for one company to acquire all of another company's assets.
Company X buys all of Company Y's assets for cash, which means that
Company Y will have only cash (and debt, if any). Of course, Company Y
becomes merely a shell and will eventually liquidate or enter other areas
of business.

Another acquisition deal known as a reverse merger enables a private

company to become publicly listed in a relatively short time period.
Reverse mergers occur when a private company that has strong prospects
and is eager to acquire financing buys a publicly listed shell company with
no legitimate business operations and limited assets. The private
company reverse merges into the public company, and together they
become an entirely new public corporation with tradable shares.

How Mergers and Acquisitions Are Valued

Both companies involved on either side of an M&A deal will value the
target company differently. The seller will obviously value the company
at the highest price possible, while the buyer will attempt to buy it for the
lowest price possible. Fortunately, a company can be objectively valued
by studying comparable companies in an industry, and by relying on the
following metrics:

Price-to-Earnings Ratio (P/E Ratio)

With the use of a price-to-earnings ratio (P/E ratio), an acquiring

company makes an offer that is a multiple of the earnings of the target
company. Examining the P/E for all the stocks within the same industry
 8

group will give the acquiring company good guidance for what the
target's P/E multiple should be.

Enterprise-Value-to-Sales Ratio (EV/Sales)

With an enterprise-value-to-sales ratio (EV/sales), the acquiring company

makes an offer as a multiple of the revenues while being aware of
the price-to-sales (P/S) ratio of other companies in the industry.

Discounted Cash Flow (DCF)

A key valuation tool in M&A, a discounted cash flow (DCF) analysis

determines a company's current value, according to its estimated future
cash flows. Forecasted free cash flows (net income +
depreciation/amortization – capital expenditures – change in working
capital) are discounted to a present value using the company's weighted
average cost of capital (WACC). Admittedly, DCF is tricky to get right, but
few tools can rival this valuation method.

Replacement Cost

In a few cases, acquisitions are based on the cost of replacing the target
company. For simplicity's sake, suppose the value of a company is simply
the sum of all its equipment and staffing costs. The acquiring company
can literally order the target to sell at that price, or it will create a
competitor for the same cost. Naturally, it takes a long time to assemble
good management, acquire property, and purchase the right equipment.
This method of establishing a price certainly wouldn't make much sense
in a service industry wherein the key assets (people and ideas) are hard to
value and develop.
 9

How Do Mergers Differ from Acquisitions?

In general, "acquisition" describes a transaction, wherein one firm absorbs

another firm via a takeover. The term "merger" is used when the
purchasing and target companies mutually combine to form a completely
new entity. Because each combination is a unique case with its own
peculiarities and reasons for undertaking the transaction, use of these
terms tends to overlap.

Why Do Companies Keep Acquiring Other Companies

Through M&A?

Two of the key drivers of capitalism are competition and growth. When a
company faces competition, it must both cut costs and innovate at the
same time. One solution is to acquire competitors so that they are no
longer a threat. Companies also complete M&A to grow by acquiring new
product lines, intellectual property, human capital, and customer bases.
Companies may also look for synergies. By combining business activities,
overall performance efficiency tends to increase, and across-the-board
costs tend to drop as each company leverages off the other company's
strengths.

What Is a Hostile Takeover?

Friendly acquisitions are most common and occur when the target firm
agrees to be acquired; its board of directors and shareholders approve of
the acquisition, and these combinations often work for the mutual benefit
of the acquiring and target companies. Unfriendly acquisitions,
commonly known as hostile takeovers, occur when the target company
does not consent to the acquisition. Hostile acquisitions don't have the
 10

same agreement from the target firm, and so the acquiring firm must
actively purchase large stakes of the target company to gain a controlling
interest, which forces the acquisition.

How Does M&A Activity Affect Shareholders?

In the days leading up to a merger or acquisition, shareholders of the
acquiring firm will see a temporary drop in share value. At the same time,
shares in the target firm typically experience a rise in value. This is often
since the acquiring firm will need to spend capital to acquire the target
firm at a premium to the pre-takeover share prices. After a merger or
acquisition officially takes effect, the stock price usually exceeds the value
of each underlying company during its pre-takeover stage. In the absence
of unfavorable economic conditions, shareholders of the merged
company usually experience favorable long-term performance and
dividends.

Note that the shareholders of both companies may experience

a dilution of voting power due to the increased number of shares released
during the merger process. This phenomenon is prominent in stock-
for-stock mergers, when the new company offers its shares in
exchange for shares in the target company, at an agreed-
upon conversion rate. Shareholders of the acquiring company
experience a marginal loss of voting power, while shareholders of a
smaller target company may see a significant erosion of their voting
powers in the relatively larger pool of stakeholders.

What Is the Difference Between a Vertical and Horizontal

Merger or Acquisition?
 11

Horizontal integration and vertical integration are

competitive strategies that companies use to consolidate their position
among competitors. Horizontal integration is the acquisition of a related
business. A company that opts for horizontal integration will take over
another company that operates at the same level of the value chain in an
industry—for instance when Marriott International, Inc. acquired
Starwood Hotels & Resorts Worldwide, Inc.

Vertical integration refers to the process of acquiring business operations

within the same production vertical. A company that opts for vertical
integration takes complete control over one or more stages in the
production or distribution of a product. Apple, for example, acquired
AuthenTec, which makes the touch ID fingerprint sensor technology that
goes into its iPhones.

What Is the Exchange Ratio?

The exchange ratio is the relative number of new shares that will be given
to existing shareholders of a company that has been acquired or that has
merged with another. After the old company shares have been delivered,
the exchange ratio is used to give shareholders the same relative value in
new shares of the merged entity.

Calculating the Exchange Ratio

The exchange ratio only exists in deals that are paid for in stock or a mix
of stock and cash as opposed to just cash. The calculation for the
exchange ratio is:
 12

𝐎𝐟𝐟𝐞𝐫 𝐏𝐫𝐢𝐜𝐞 𝐟𝐨𝐫 𝐓𝐚𝐫𝐠𝐞𝐭’𝐬 𝐒𝐡𝐚𝐫𝐞𝐬

𝐄𝐱𝐜𝐡𝐚𝐧𝐠𝐞 𝐑𝐚𝐭𝐢𝐨 =
𝐀𝐜𝐪𝐮𝐢𝐫𝐞𝐫 ′ 𝐬 𝐒𝐡𝐚𝐫𝐞 𝐏𝐫𝐢𝐜𝐞

The target share price is the price offered for the target shares. Because
both share prices can change from the time the initial numbers are
drafted to when the deal closes, the exchange ratio is usually structured
as a fixed exchange ratio or a floating exchange ratio.

A fixed exchange ratio is fixed until the deal closes. The number of issued
shares is known but the value of the deal is unknown. The acquiring
company prefers this method as the number of shares is known therefore
the percentage of control is known.

A floating exchange ratio is where the ratio floats so that the target
company receives a fixed value no matter the changes in price shares. In
a floating exchange ratio, the shares are unknown but the value of the
deal is known. The target company, or seller, prefers this method as they
know the exact value they will be receiving.

Example of the Exchange Ratio

Imagine that the buyer of a company offers the seller two shares of the
buyer's company in exchange for one share of the seller's company. Prior
to the announcement of the deal, the buyer's or acquirer's shares may be
trading at $10, while the seller's or target's shares trade at $15. Due to the
2 to 1 exchange ratio, the buyer is effectively offering $20 for a seller share
that is trading at $15.
 13

Fixed exchange ratios are usually limited by caps and floors to reflect
extreme changes in stock prices. Caps and floors prevent the seller from
receiving significantly less consideration than anticipated, and they
likewise prevent the buyer from giving up significantly more
consideration than anticipated.

Post announcement of a deal, there is usually a gap in valuation between

the seller's and buyer's shares to reflect the time value of money and risks.
Some of these risks include the deal being blocked by the government,
shareholder disapproval, or extreme changes in markets or economies.

Taking advantage of the gap, believing that the deal will go through, is
referred to as merger arbitrage and is practiced by hedge funds and other
investors. Leveraging the example above, assume that the buyer's shares
stay at $10 and the seller's shares jump to $18. There will be a $2 gap that
investors can secure by buying one seller share for $18 and shorting two
buyer shares for $20.

If the deal closes, investors will receive two buyer shares in exchange for
one seller share, closing out the short position and leaving investors with
$20 in cash. Minus the initial outlay of $18, investors will net $2.

In mergers and acquisitions (M&A), the exchange ratio measures the

number of shares the acquiring company has to issue for each individual
share of the target firm. For M&A deals that include shares as part of the
consideration (compensation) for the deal, the share exchange ratio is an
important metric. Deals can be all cash, all shares, or a mix of the two.
 14

Exchange Ratio example

Assume Firm A is the acquirer and Firm B is the target firm. Firm B has
10,000 outstanding shares and is trading at a current price of $17.30 and
Firm A is willing to pay a 25% takeover premium. This means the Offer
Price for Firm B is $21.63. Firm A is currently trading at $11.75 per share.

To calculate the exchange ratio, we take the offer price of $21.63 and
divide it by Firm A’s share price of $11.75.

The result is 1.84. This means Firm A must issue 1.84 of its own shares for
every 1 share of the Target it plans to acquire.

Importance of the Exchange Ratio

In the event of an all-cash merger transaction, the exchange ratio is not a

useful metric. In fact, in this situation, it would be fine to exclude the ratio
from the analysis. Often, M&A valuation models will note the ratio as
“0.000” or blank, when it comes to an all-cash transaction. Alternatively,
the model may display a theoretical exchange ratio, if the same value of
 15

the cash transaction were, instead, to be carried out by a stock

transaction.

However, in the event of a 100% stock deal, the exchange ratio becomes
a powerful metric. It becomes virtually essential and allows the analyst to
view the relative value of the offer between the two firms.

In the event of a split deal, where a portion of the transaction involves

cash and a portion involves a stock deal, the percentage of stock involved
in the transaction must be considered. Excluding any cash effects, what is
the actual exchange ratio based on the stock? Additionally, M&A models
may want to also show what this transaction would look like if there was
a 100% stock deal.

Complications

Accounting for exchange ratios becomes more difficult when analyzing

the firm’s values. This is because it involves the transfer of some value of
the acquirer firm into the target firm’s owners. When an acquiring firm
offers cash to the target firm, the effect is simple. The target firm is
absorbed by the acquirer in exchange for cash.

However, when an acquirer offers stock in its own firm for the target firm,
the valuation becomes more complex. This is because some of the value
of the acquiring firm is diluted and given to the target firm. After the
transaction, some of the value of the merged firm and its synergies will
be owned by the target firm. Thus, this must be considered when
calculating the proper exchange ratio to use in an M&A transaction.
 16

Applications in Financial Modeling

In financial modeling for M&A transactions, it’s important to consider all

sources in the full impact of the transaction. The main impact comes from
calculating the accretion/dilution of the Earnings per Share (EPS) of the
combined company.

Mergers and Acquisitions (M&A) Transactions – Types

1. Horizontal

A horizontal merger happens between two companies that operate in

similar industries that may or may not be direct competitors.

2. Vertical

A vertical merger takes place between a company and its supplier or a

customer along its supply chain. The company aims to move up or down
along its supply chain, thus consolidating its position in the industry.

3. Conglomerate

This type of transaction is usually done for diversification reasons and is

between companies in unrelated industries.

Mergers and Acquisitions (M&A) – Forms of Integration

1. Statutory

Statutory mergers usually occur when the acquirer is much larger than
the target and acquires the target’s assets and liabilities. After the deal,
the target company ceases to exist as a separate entity.
 17

2. Subsidiary

In a subsidiary merger, the target becomes a subsidiary of the acquirer

but continues to maintain its business.

3. Consolidation

In a consolidation, both companies in the transaction cease to exist after

the deal, and a completely new entity is formed.

Reasons for Mergers and Acquisitions (M&A) Activity

Mergers and acquisitions (M&A) can take place for various reasons, such
as:

1. Unlocking synergies

The common rationale for mergers and acquisitions (M&A) is to create

synergies in which the combined company is worth more than the two
companies individually. Synergies can be due to cost reduction or higher
revenues.

Cost synergies are created due to economies of scale, while revenue

synergies are typically created by cross-selling, increasing market share,
or higher prices. Of the two, cost synergies can be easily quantified and
calculated.

2. Higher growth

Inorganic growth through mergers and acquisitions (M&A) is usually a

faster way for a company to achieve higher revenues as compared to
 18

growing organically. A company can gain by acquiring or merging with a

company with the latest capabilities without having to take the risk of
developing the same internally.

3. Stronger market power

In a horizontal merger, the resulting entity will attain a higher market

share and will gain the power to influence prices. Vertical mergers also
lead to higher market power, as the company will be more in control of
its supply chain, thus avoiding external shocks in supply.

4. Diversification

Companies that operate in cyclical industries feel the need to diversify

their cash flows to avoid significant losses during a slowdown in their
industry. Acquiring a target in a non-cyclical industry enables a company
to diversify and reduce its market risk.

5. Tax benefits

Tax benefits are investigated where one company realizes significant

taxable income while another incurs tax loss carryforwards. Acquiring the
company with the tax losses enables the acquirer to use the tax losses to
lower its tax liability. However, mergers are not usually done just to avoid
taxes.

Forms of Acquisition

There are two basic forms of mergers and acquisitions (M&A):

 19

1. Stock purchase

In a stock purchase, the acquirer pays the target firm’s shareholders cash
and/or shares in exchange for shares of the target company. Here, the
target’s shareholders receive compensation and not the target. There are
certain aspects to be considered in a stock purchase:

• The acquirer absorbs all the assets and liabilities of the target – even
those that are not on the balance sheet.
• To receive the compensation by the acquirer, the target’s
shareholders must approve the transaction through a majority vote,
which can be a long process.
• Shareholders bear the tax liability as they receive the compensation
directly.

2. Asset purchase

In an asset purchase, the acquirer purchases the target’s assets and pays
the target directly. There are certain aspects to be considered in an asset
purchase, such as:

• Since the acquirer purchases only the assets, it will avoid assuming

any of the target’s liabilities.

• As the payment is made directly to the target, generally, no

shareholder approval is required unless the assets are significant

(e.g., greater than 50% of the company).

 20

• The compensation received is taxed at the corporate level as capital

gains by the target.

3. Method of payment

There are two methods of payment – stock and cash. However, in many

instances, M&A transactions use a combination of the two, which is called

a mixed offering.

4. Stock

In a stock offering, the acquirer issues new shares that are paid to the

target’s shareholders. The number of shares received is based on an

exchange ratio, which is finalized in advance due to stock price

fluctuations.

5. Cash

In a cash offer, the acquirer simply pays cash in return for the target’s

shares.

Mergers and Acquisitions (M&A) – Valuation

In an M&A transaction, the valuation process is conducted by the

acquirer, as well as the target. The acquirer will want to purchase the

target at the lowest price, while the target will want the highest price.
 21

Thus, valuation is an important part of mergers and acquisitions (M&A),

as it guides the buyer and seller to reach the final transaction price. Below
are three major valuation methods that are used to value the target:

• Discounted cash flow (DCF) method: The target’s value is calculated

based on its future cash flows.
• Comparable company analysis: Relative valuation metrics for public
companies are used to determine the value of the target.
• Comparable transaction analysis: Valuation metrics for past
comparable transactions in the industry are used to determine the
value of the target.

M&A Process

Overview of the M&A Process

The mergers and acquisitions (M&A) process has many steps and can
often take anywhere from 6 months to several years to complete. In this
guide, we’ll outline the acquisition process from start to finish, describe
the various types of acquisitions (strategic vs. financial buys), discuss the
importance of synergies (hard and soft synergies), and identify
transaction costs.

Mergers & Acquisitions can take place:

• by purchasing assets

• by purchasing common shares

• by exchange of shares for assets

 22

• by exchanging shares for shares

Types of Mergers and Acquisitions:

Merger or amalgamation may take two forms: merger through

absorption or merger through consolidation. Mergers can also be
classified into three types from an economic perspective depending on
the business combinations, whether in the same industry or not, into
horizontal (two firms are in the same industry), vertical (at different
production stages or value chain) and conglomerate (unrelated
industries). From a legal perspective, there are different types of mergers
like short form merger, statutory merger, subsidiary merger, and merger
of equals.

Reasons for Mergers and Acquisitions:

• Financial synergy for lower cost of capital

• Improving company’s performance and accelerate growth

• Economies of scale

• Diversification for higher growth products or markets

• To increase market share and positioning giving broader market access

• Strategic realignment and technological change

• Tax considerations

• Undervalued target

• Diversification of risk
 23

Principle behind any M&A is 2+2=5

There is always synergy value created by the joining or merger of two

companies. The synergy value can be seen either through the Revenues
(higher revenues), Expenses (lowering of expenses) or the cost of capital
(lowering of overall cost of capital).

Three important considerations should be considered:

• The company must be willing to take the risk and vigilantly make
investments to benefit fully from the merger as the competitors and the
industry take heed quickly

• To reduce and diversify risk, multiple bets must be made, in order to

narrow down to the one that will prove fruitful

• The management of the acquiring firm must learn to be resilient, patient

and be able to adopt to the change owing to ever-changing business
dynamics in the industry

Stages involved in any M&A:

Phase 1: Pre-acquisition review: this would include self-assessment of the

acquiring company with regards to the need for M&A, ascertain the
valuation (undervalued is the key) and chalk out the growth plan through
the target.

Phase 2: Search and screen targets: This would include searching for the
possible apt takeover candidates. This process is mainly to scan for a good
strategic fit for the acquiring company.
 24

Phase 3: Investigate and valuation of the target: Once the appropriate

company is shortlisted through primary screening, detailed analysis of the
target company has to be done. This is also referred to as due diligence.

Phase 4: Acquire the target through negotiations: Once the target

company is selected, the next step is to start negotiations to come to
consensus for a negotiated merger or a bear hug. This brings both the
companies to agree mutually to the deal for the long-term working of the
M&A.

Phase 5: Post merger integration: If all the above steps fall in place, there
is a formal announcement of the agreement of merger by both the
participating companies.

Reasons for the failure of M&A – Analyzed during the stages of M&A:

Poor strategic fit: Wide difference in objectives and strategies of the

company

Poorly managed Integration: Integration is often poorly managed without

planning and design. This leads to failure of implementation

Incomplete due diligence: Inadequate due diligence can lead to failure of

M&A as it is the crux of the entire strategy

Overly optimistic: Too optimistic projections about the target company

leads to bad decisions and failure of the M&A
 25

10-Step M&A Process

If you work in either investment banking or corporate development,

you’ll need to develop an M&A deal process to follow. Investment
bankers advise their clients (the CEO, CFO, and corporate development
professionals) on the various M&A steps in this process.

A typical 10-step M&A deal process includes:

1. Develop an acquisition strategy – Developing a good acquisition

strategy revolves around the acquirer having a clear idea of what
they expect to gain from making the acquisition – what their
business purpose is for acquiring the target company (e.g., expand
product lines or gain access to new markets)
2. Set the M&A search criteria – Determining the key criteria for
identifying potential target companies (e.g., profit margins,
geographic location, or customer base)
3. Search for potential acquisition targets – The acquirer uses their
identified search criteria to look for and then evaluate potential
target companies
4. Begin acquisition planning – The acquirer contacts one or more
companies that meet its search criteria and appear to offer good
value; the purpose of initial conversations is to get more
information and to see how amenable to a merger or acquisition
the target company is
 26

5. Perform valuation analysis – Assuming initial contact and

conversations go well, the acquirer asks the target company to
provide substantial information (current financials, etc.) that will
enable the acquirer to further evaluate the target, both as a business
on its own and as a suitable acquisition target
6. Negotiations – After producing several valuation models of the
target company, the acquirer should have sufficient information to
enable it to construct a reasonable offer; Once the initial offer has
been presented, the two companies can negotiate terms in more
detail
7. M&A due diligence – Due diligence is an exhaustive process that
begins when the offer has been accepted; due diligence aims to
confirm or correct the acquirer’s assessment of the value of the
target company by conducting a detailed examination and analysis
of every aspect of the target company’s operations – its financial
metrics, assets and liabilities, customers, human resources, etc.
8. Purchase and sale contract – Assuming due diligence is completed
with no major problems or concerns arising, the next step forward
is executing a final contract for sale; the parties make a final decision
on the type of purchase agreement, whether it is to be an asset
purchase or share purchase
9. Financing strategy for the acquisition – The acquirer will, of course,
have explored financing options for the deal earlier, but the details
of financing typically come together after the purchase and sale
agreement has been signed
 27

10. Closing and integration of the acquisition – The acquisition deal

closes, and management teams of the target and acquirer work
together on the process of merging the two firms

Structuring an M&A Deal

One of the most complicated steps in the M&A process is properly

structuring the deal. There are many factors to be considered, such as
antitrust laws, securities regulations, corporate law, rival bidders, tax
implications, accounting issues, market conditions, forms of financing,
and specific negotiation points in the M&A deal itself. Important
documents when structuring deals are the Term Sheet (used for raising
money) and a Letter of Intent (LOI) which lays out the basic terms of the
proposed deal.
 28

Rival bidders in M&A

Most acquisitions are competitive or potentially competitive. Companies

normally must pay a “premium” to acquire the target company, and this
means having to offer more than rival bidders. To justify paying more
than rival bidders, the acquiring company needs to be able to do more
with the acquisition than the other bidders in the M&A process can (i.e.,
 29

generate more synergies or have a greater strategic rationale for the

transaction).

Strategic vs Financial Buyers in M&A

In M&A deals, there are typically two types of acquirers: strategic and
financial. Strategic acquirers are other companies, often direct
competitors or companies operating in adjacent industries, such that the
target company would fit in nicely with the acquirer’s core business.
Financial buyers are institutional buyers, such as private equity firms, that
are looking to own, but not directly operate the acquisition target.
Financial buyers will often use leverage to finance the acquisition,
performing a leveraged buyout (LBO).

7 Different types of mergers with examples

The following are the types of mergers

1. Horizontal mergers: It refers to two firms operating in same

industry or producing ideal products combining. For e.g., in the
banking industry in India, acquisition of Times Bank by HDFC Bank,
Bank of Madura by ICICI Bank, Nedungadi Bank by Punjab National
Bank etc. in consumer electronics, acquisition of Electrolux’s Indian
operations by Videocon International Ltd., in BPO sector, acquisition
of Daksh by IBM, Spectra mind by Wipro etc. The main objectives of
horizontal mergers are to benefit from economies of scale, reduce
competition, achieve monopoly status, and control the market.
 30

2. Vertical merger: A vertical merger can happen in two ways. One is when
a firm acquires another firm which produces raw materials used by it. For
e.g., a car tire manufacturer acquires a rubber manufacturer, a car
manufacturer acquires a steel company, a textile company acquires a
cotton yarn manufacturer etc.
Another form of vertical merger happens when a firm acquires another
firm which would help it get closer to the customer. For e.g., a consumer
durable manufacturer acquiring a consumer durable dealer, an FMCG
company acquiring m advertising company or a retailing outlet etc.

3. Conglomerate merger: It refers to the combination of two firms

operating in industries unrelated to each other. In this case, the business
of the target company is entirely different from those of the acquiring
company. For e.g., a watch manufacturer acquiring a cement
manufacturer, a steel manufacturer acquiring a software company etc.
The main objective of a conglomerate merger is to achieve i big size.

4. Concentric merger: It refers to combination of two or more firms which

are related to each other in terms of customer groups, functions or
technology. For e.g., combination of a computer system manufacturer
with a UPS manufacturer.

5. Forward merger: In a forward merger, the target merges into the buyer.
For e.g., when ICICI Bank acquired Bank of Madura, Bank of Madura which
was the target, merged with the acquirer, ICICI Bank.
 31

6. Reverse merger: In this case, the buyer merges into the target and the
shareholders of the buyer get stock in the target. This is treated as a stock
acquisition by the buyer.

7. Subsidiary merger: A subsidiary merger is said to occur when the buyer

sets up an acquisition subsidiary which merges into the target.

What is merger premium? Takeover premium is the difference between

the market price (or estimated value) of a company and the actual price
paid to acquire it, expressed as a percentage. The premium represents the
additional value of owning 100% of a company in a merger or acquisition.

What is merger premium?

Takeover premium is the difference between the market price (or
estimated value) of a company and the actual price paid to acquire it,
expressed as a percentage. The premium represents the additional value
of owning 100% of a company in a merger or acquisition. Learn
how mergers and acquisitions and deals are completed

Then, what is a typical control premium?

Our analysis indicates when buyers already hold between 10% and 50% of
the target's equity, the average control premium is around 40% and the
median between 30% and 35%. In contrast, when the acquirer has a lesser
or no shareholding, the average premium is around 30% and the
median premium in the range of 20% to 25%.
 32

One may also ask, why do most acquisitions result in paying a premium
over the market price? Most companies pay acquisition premiums for
two reasons: (1) to ensure that the deal gets closed and (2) because they
feel that the synergies generated by the combined entities will be greater
than the total price paid for the target.

Considering this, how do you calculate premium payments?

Method 1 – Using Share Price Takeover premium can be calculated from

share price value. Let's assume company A wants to acquire company B.
The value of Company's B share is $20 per share and company A offers
$25 per share. This means company A is offering ($25- $20)/ $20= 25%
takeover premium.

Why does the price of the target rise by less than the premium?

The target company's stock usually rises because the acquiring company
has to pay a premium for the acquisition. As a result, shareholders might
vote to sell the target company for a lower price than the current market.

What is control premium in business combination?

The control premium is the excess paid by a buyer over the market price
of a target company in order to gain control. This premium can be
substantial when a target company owns crucial intellectual property, real
estate, or other assets that an acquirer wishes to own.

Why is there a control premium?

 33

In most cases, a control premium is necessary when the target's cash flows
and profits are not being maximized. The amount that a potential new
owner is willing to pay as a control premium depends on the incremental
value that can be generated in the target company.

Understanding the control value

The value of control is a quantitative measure of the value of controlling

the outcome of an uncertain variable. Decision analysis provides a means
for calculating the value of both perfect and imperfect control. The former
value, informally known as the value of wizardry, is an upper bound for
the latter.

What is a minority discount valuation?

A minority discount is the reduction applied to the valuation of a minority

equity position in a company due to the absence of control. This absence
of control reduces the value of the minority equity position against the
total enterprise value of the company.

How do you calculate minority interest discount?

Calculating the minority interest share in the subsidiary Next, multiply

that book value by the percentage owned by the parent company. For
example, if a public company owns 10% of another company worth $1
billion. Then the minority interest owned is $100 million.

What is a control premium and how does it affect financial

statements?
 34

What is a control premium and how does it affect financial statements? A

control premium is the portion of an acquisition price (above currently
traded market value) paid by a parent company to induce shareholders
to sell enough shares to gain control.

How do you calculate discount for lack of marketability?

The price of that put is the discount for lack of marketability. Chaffe relied
on the Black Scholes Option Pricing Model for a put option to determine
the cost or price of the put option, and defined the DLOM as the cost of
the put option divided by the market price.

What is Acquisition Premium?

Acquisition premium is the difference between the price paid for a target
company in a merger or acquisition and the target’s assessed market
value. It represents the excess amount over the fair value of all identifiable
assets paid by an acquiring company. The acquisition premium is also
known as goodwill and is maintained on the acquirer’s balance sheet as
an intangible asset, post-transaction.
 35

The actual premium paid can depend on many factors, including the
following:

• Target company’s stock price fluctuations

• Competition within the industry
• Presence of other bidders
• Motivations of the acquirer and the target company

How to Calculate Acquisition Premium?

In order to arrive at the acquisition premium, the acquiring company must

estimate the real value of the target company. It can be done
using enterprise value or equity valuation.

A simpler way to calculate the acquisition premium for a deal is taking

the difference between the price paid per share for the target company
and the target’s current stock price, and then dividing by the target’s
current stock price to get a percentage amount.

Where:

• DP = Deal Price per share of the target company

• SP = Current Price per share of the target company
•
 36

Reasons for Acquisition Premium

Intuitively, it may not make sense that an acquiring company is paying a

price that is higher than what the target company is worth.

It should be noted that the current price of the target company represents
what it is worth through the lens of the market. However, an acquiring
company may value the target company greater than the market does,
often because of the strategic value that it may bring.

Some reasons that an acquiring company may pay a premium are as

follows:

1. Synergy

The most common motivation for a merger or acquisition is the creation

of synergies, where the combined companies are more valuable than the
sum of its parts. Synergies generally come in two forms, hard synergies,
and soft synergies.

Hard synergies refer to cost savings from economies of scale, while soft
synergies refer to revenue increases from expanded market share, cross-
selling, and increased pricing power.

2. Growth

The management of companies is usually under pressure to grow

revenues continuously. Although it can be done organically, it may be
faster to grow externally through mergers and acquisitions activity.
 37

3. Stronger market power

Combined companies may have fewer competitors when an industry is

more concentrated. It gives the combined company a greater ability to
influence market prices. Also, a combined company can control more
aspects of the supply chain, reducing reliance on other stakeholders.

4. Unlocking hidden value

A target company, on its own, may be uncompetitive due to various

reasons, such as poor management, lack of resources, or poor
organizational structure. An acquiring company may have the belief that
it can unlock hidden value through the reorganization of the target.

5. Diversification

Diversification can be considered from the viewpoint of a company as a

portfolio of investments in other companies. Therefore, the variability of
cash flows from the company can be reduced if the company is diversified
to other industries.

6. Unique capabilities/resources

An acquirer may grow through M&A activity to pursue competitive

advantages or obtain resources that it currently lacks, but that a target
company may have. They can be specific competencies or resources, such
as an advanced research and development (R&D) team, a strong sales
team, or other unique talents.

7. Management’s personal motives

 38

Through agency problems, management may be personally motivated to

maximize the size of their company for greater power or more prestige.

8. Tax considerations

In some cases, it may be beneficial for a profitable acquirer to acquire or

merge with a target company with large tax losses, where the acquirer
can immediately lower its tax liability.

9. Cross-border incentives

A merger or an acquisition can be used as a strategic tool to extend the

market reach internationally to different countries and markets. Less
regulation and more uniform accounting standards will make such a
reason more common for M&A deals in the future.

If the perceived value of any of the reasons above is greater than the
market value of a target company, then an acquirer can be motivated to
engage in an M&A transaction to acquire the target.

What is Goodwill?

As mentioned earlier, the acquisition premium is recorded on the

acquirer’s balance sheet as goodwill. The account includes intangibles,
such as the value of the target’s brand name, stakeholder relations,
reputation, and patents. Goodwill can be impaired or reduced when the
market value of the intangible assets falls below the acquisition cost.
Impairments result in a decrease in the goodwill account.
 39

An acquirer can also theoretically purchase a target company for less than
its market value, resulting in an acquisition discount and a negative
goodwill balance.

In mergers and acquisitions, the company that is getting acquired is

called the target company, and the company that acquires it is called the
acquirer. Takeover premium is the difference between the prices paid for
the target company minus the pre-merger value of the target company.
In other words, it is the price paid for each of the target firm’s shares by
the acquiring firm.

Takeover premium= PT – VT

where:

• PT = price paid for the target company

• VT = pre-merger value of the target company
 40

The acquirer is willing to pay the acquisition premium as it expects the

synergies (expected increase in revenue, cost savings) that will be
generated by the acquisitions. The synergies generated in M&A will be
the gain of the acquirer.

The gain of the Acquirer = Synergies generated- Premium = S- (PT- VT)

• Where S = Synergies generated by the merger

So, the post-merger value of the merged company (VC) is

VC= VC* + VT +S-C

where:

• C = cash paid to the shareholders.

• VC*= pre-merger value of the acquirer.

Why does the Acquirer Pay the Extra Acquisition Premium?

Acquirer pay extra Premium because of the following reasons:

• To minimize competitions and win over the deal.

• The synergies created will be greater than the premium paid for the target

company. By synergy, we mean that when the two companies, when

combined, will produce greater revenue than they could do individually.

 41

In 2016, we witnessed the merger of the world’s leading professional

cloud and the world’s leading professional network. Microsoft paid $196

per LinkedIn share, a 50% acquisition premium as they believed it would

Microsoft’s revenue as well as its competitive position. It was the biggest

acquisition of Microsoft.

The relationship between Takeover Premium and

Synergies

Higher synergies in M&A results in higher premiums. Before we go to the

Premium calculation, we need to understand the synergies created from

the merger.

• Cost Savings – The categories of cost savings vary from company to

company. The most common categories include the cost of sales, cost of

production, administrative cost, other overhead costs, etc. Cost savings

also depends on how much people are acceptable to change. If the senior

management is not ready to make some tough decisions, then cost-

cutting may take longer. Cost Savings occurs at a maximum when both

the company belongs to the same industry. For example, in 2005, when

Procter & Gamble acquired Gillette, the management took a bold decision
 42

to replace underperforming P&G workers with Gillette’s talent. It yielded

good results, and P&G upper management supported this initiative.

• Increase in Revenue– Most of the time, it is possible to have an increase

in revenue when both of the companies are combined. But there are a lot

of external factors like the reaction in a market to their merger or the

competitor’s pricing (the competitors may reduce the pricing). For

example, Tata Tea, a 114 $ company, took a bold move by acquiring Tetley

for 450 $ million, which has defined the growth for Tata Sons. Procter &

Gamble achieved revenue increase within one year after its merger with

Gillette.

• Process Enhancement: Mergers also help in the improvement of

processes. Gillette and P&G had a lot of process improvement in place,

which helped them achieve an increase in revenue. Disney and Pixar

merger made them collaborate more easily and helped them achieve

success together.

Takeover Premium Calculation

Method 1 – Using Share Price

 43

Takeover premiums can be calculated from share price value. Let’s

assume company A wants to acquire company B. The value of the

Company’s B share is $20 per share, and company A offers $25 per share.

This means company A is offering ($25- $20)/ $20= 25% premium.

Method 2 – Using Enterprise Value

We can also calculate the takeover premium by calculating the enterprise

value of the company. The enterprise value reflects both equity and debt

of the company. By taking the EV/EBITDA value and multiplying it by

EBITDA, we can calculate the enterprise value of the firm EV. For example,

if the Enterprise value of company B is $12.5 million. Suppose company A

is offering a 15 % premium. Then we get 12.5*1.15= 14.375 million. That

means premium of (14.37 million ౼ 12.50 million) = $1.87 million

Suppose the acquirer offers a higher EV/EBITDA ratio than the average

EV/EBITDA multiple. It can be concluded that the acquirer is overpaying

for the deal.

Other methods, like the Black- Scholes option pricing model, can also be

used for calculation. Investment banks hired by the target company will
 44

also look into the historical data of the premium paid on similar deals to

provide a proper justification to the shareholder of its company.

Factors Affecting the Value of Takeover Premium

Takeover premium was found to be higher during the period of investor’s

pessimism, market undervaluation, and was found to be lower during

market overvaluation, a period of investor’s optimism. The other factors

that affect acquisition premium include the motivation of the bidders,

number of bidders, competition in the industry, and also on the type of

industry.

What is the Correct Price to be Paid as Acquisition

Premium?

It is difficult to understand whether the acquisition premium that is paid

is overvalued or not. As in several cases, a high premium ended in better

results than what a lower premium did. But this case is always not true.

Like when Quakers Oats acquired Snapple, it had paid $1.7 billion. The

company did not perform well as Quaker Oats sold Snapple to Triarc

Companies for less than 20% of what it had paid earlier. Therefore proper

analysis should be done before going for a deal and not get instigated

because the other competitors in the market are offering a greater price.
 45

Where do we Record Turnover Premium in Books of

Account for the Acquirer?

Turnover Premium is recorded as the goodwill on the balance sheet. If the

acquirer buys it at a discount, then it is recorded as negative goodwill. By

discount, we mean less than the market price of the target company. If

the acquirer benefits from the technology, good brand presence, patents

of the target company, then it is considered in goodwill. Economic

deterioration, negative cash flows, etc. account for a reduction of

goodwill in a balance sheet.

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