Mergers and Acquisitions

Related Terms: Discounted Cash Flow; Leveraged Buyout

Mergers and acquisitions (M&As) is a phrase used to describe a host of financial activities in which companies are bought and sold. In an acquisition one party buys another by acquiring all of its assets. The acquired entity ceases to exist as a corporate body, but the buyer sometimes retains the name of the acquired company, indeed may use it as its own name. In a merger a new entity is created from the assets of two companies; new stock is issued. Mergers are more common when the parties have similar size and power. Sometimes acquisitions are labeled "mergers" because "being acquired" carries a negative connotation (like "being eaten"); a merger suggests mutuality. M&A activity involves both privately held and publicly traded companies; acquisitions may be friendly (both entities are willing) or may be hostile (the buyer is opposed by the management of the acquisition target).

WHY M&A?

M&A activity is invariably explained as creating greater stockholder value. Stockholder interests are, indeed, central, because these transactions must have the approval of a majority of stockholders, and stockholders are unlikely to vote their shares in favor of a sale, purchase, or merger unless they believe that they will benefit. The real motivation behind M&A activity, however, is almost always a mixture in which financial, structural, institutional, and even personal aims are present. Companies make acquisitions to grow more rapidly, to gain control over their raw materials, to obtain new technology, to pump up their stock, to take advantage of weaknesses in others, to diversify, etc.

A major element of M&A activity in hostile acquisitions is resistance to being acquired. It is motivated by the management's fear of losing control, distrust of the buyer's motivation, disagreement with the buyer's methods and strategy, etc. Frequently management resists an acquisition although their stockholders would clearly benefit; thus they try to persuade the stockholders that "in the long run" the stockholders will suffer. Resisting managements are frequently correct—but often lose because stockholders look at the bird in the hand.

Motivations for selling a company are equally complex. Retiring founders of small businesses sell companies to realize the business's cash value after a life-time of work. Companies projecting failure sell before the failure is actually knocking on the door. Companies reach the limit of their resources, financial or technical, and see great benefit in joining a larger company able to fund growth and to enhance their own art by major engineering inputs. In the first two cases the motives are liquidity and fear of bankruptcy respectively. The third case is mixed, with structural, institutional, and opportunistic motives leading to a sale. In periods of M&A frenzy (common in expansionary periods) a company may also face an offer it just can't refuse.

TYPES OF ACQUISITIONS

Acquisitions are classified by their structural effects, the attitudes of the parties, and by the mechanisms of the transaction. The classifications are not mutually exclusive, just different ways of looking at M&A.

Acquisitions can be horizontal, vertical, or conglomerative. The first case involves a company that simply expands by purchasing another company in its own field: two real-estate firms merging or one buying the other. The second case, the vertical, involves a company buying another which heretofore supplied it: a construction company buying a lumber yard or a brick yard. In a conglomerative acquisition the buyer's business has nothing to do with that of the purchased company's: a steel mill buying a chain of clothing stores. The building of vast conglomerates by acquisition is a cyclic corporate fad, viewed as a way of diversifying, justified by the notion that management is fundamentally a financial enterprise.

Acquisitions are classified as "friendly" or "hostile" depending on the attitudes of the managements on either side. In a friendly merger or acquisition both parties are willing participants and negotiate in that spirit. Hostile acquisitions tend to be launched by dissident stockholder groups (or raiders who first buy in to have a share); the targeted company may have a large amount of cash, may be paying thin dividends, may (in the opinion of the hostile bidder) be favoring growth over stockholder return, etc. In friendly acquisitions management teams cooperate in communicating with stockholders; in hostile takeovers, the acquiring group solicits the votes of the target's stockholders in order to obtain enough votes to prevail.

Classification by mechanism involves how the buyer pays for the seller. Payment may take the form of cash, stock, or a combination. Cash-for-stock is the simplest method but more costly for the stockholder: the transaction is taxable, the stockholder having to pay capital gains taxes. The stock-for-stock method is the most popular because it is tax free; the seller's stockholders receive stock in the buyer's company; if the action is a merger, stock in the new entity is issued in payment instead. If the deal is a combination, the cash portion of the deal is taxable.

VALUING THE CANDIDATE

What is a company worth? The balance sheet provides a partial answer. The company's assets less its liabilities produce the company's net worth. Very few companies, however, are willing to sell for net worth. It represents a static value, a snapshot in time. A company is a dynamic entity expected to produce earnings in the future.

A common measure used for valuation is the price-earnings ratio (P/E Ratio) in which the price of a share of stock is divided by the company's after-tax earning per share. A $100 share earning $10 per share a year, is said to have a 10:1 ratio. The market, in other words, is willing to pay $10 for every $1 of earnings. A company with an annual after-tax earnings of $500,000 and a P/E Ratio of 7 would thus be valued at $3.5 million.

 1 | 2  NEXT