Mergers and

Acquisitions
Chapter 19

Mergers and Acquisitions

Corporations strive to increase their
earnings per share over time.
Methods
Organic approaches:
Increase sales of existing divisions while
maintaining level operating margins
Increase operating margins with constant sales

Mergers and Acquisitions:

Seek to merge or acquire another corporation,
with resulting corporations size and earnings
enhanced by combination

A Brief History of Mergers and

Acquisitions
M&A transactions date back to 19th
century
Horizontal acquisitions: acquiring
competitors in the same industry and
then systematically reducing costs of
acquired company by integrating its
operations into acquirer's company
Vertical acquisitions: acquiring
companies in own supply chain
Enormous trusts, or business holding
companies

A Brief History of Mergers and

Acquisitions
In the 1920s, 1960s, and 1980s,
M&A activity reached historic highs
and corresponded to positive
performance of the stock market.
1920s: combinations of firms within industries
1960s: conglomerate approach (e.g. LTV, ITT)
1980s: use of large amounts of debt as the
means to finance acquisitions of companies
with cheaply priced assets through leveraged
buyouts

A Brief History of Mergers and

Acquisitions
In the 2000s, Wall Street declined due to
lower asset values and increased
government regulation; strategic horizontal
mergers are becoming more common.
Strong banks are absorbing weak ones before/after
FDIC seizes them.
Chemical, pharmaceutical and commodities firms are
merging in order to increase global reach and reduce
cost per unit of production.
Leveraged buyout firms (now private equity firms)
have decreased their activity due to losses from
2007/2008 vintage investments and reduction in debt
availability.
Completed deals have lower levels of debt and
therefore, either a lower price or more equity.

How Companies Can Work

Together
Article 2 of the Uniform Commercial
Code (UCC): set of contractual rules for
sale of goods between companies
Vendor-customer relationships are
governed by purchase orders (POs):
short form of contract, containing
standard provisions and blank spaces for
price, quantity, and shipment date of
goods involved

How Companies Can Work

Together
Strategic alliance (or teaming
agreement): parties work together on a
single project for a finite period of time
Do not exchange equity
Do not create permanent entity to mark
relationship
Written memorandum of
understanding (MOU): memorializes
strategic alliance and sets forth how parties
plan to work together

How Companies Can Work

Together
Joint venture: parties work together for
lengthy or indeterminate period of time
Form new, third entity
Divide ownership and control of new entity,
determine who will contribute what resources
Advantage: two entities can remain focused on
their core businesses while letting joint venture
pursue the new opportunity
Downside: governance issues and economic
fairness issues create friction and eventual
disbandment

How Companies Can Work

Together
Acquisition: acquired company
becomes subsidiary of purchasing
company
Most permanent
Eliminates governance and economic
fairness issues
Forms of acquisitions
Merger
Stock acquisition
Asset acquisition

How Companies Can Work

Together
Merger: two companies legally become
one
All assets and liabilities being merged out of
existence become assets and liabilities of
surviving company

Stock acquisition: acquired company

becomes subsidiary of acquiring company
Asset acquisition: assets but not
liabilities become assets of acquiring firm

How and Why to do an

Acquisition
If acquisition will create positive
present value when weighing
outflow (acquisition price) versus
future inflow (cash flow of acquired
company plus any synergies), then
transaction makes financial sense.
Difficulty: determine what exactly are the
outflows, inflows, and synergies (both
revenue/cost synergies)

How and Why to do an

Acquisition
Common synergies
Cost Savings:
One has lower existing costs due to efficiency,
scale, etc.
One has better cost management
Combined company has greater economies of scale
One has better credit rating/balance sheet and
therefore cheaper financing costs
Transactions costs eliminated in vertical merger
Reduction in employee costs (layoffs)
Reduction in taxes if acquirer has NOLs and is not
limited by Section 382 of IRC

How and Why to do an

Acquisition
Common synergies (continued)
Revenue enhancements:
Use of each others distributors and
other channels
Bundling opportunities from combined
product offering makes company more
attractive
Combined company can raise prices
(greater market power)

How and Why to do an

Acquisition
Companies will hire a group of
advisors to assist in evaluating
and consummating transaction
investment bank, law firm with
expertise in mergers and
acquisitions, accounting firm,
valuation firm

How and Why to do an

Acquisition
Investment bank
Primary financial advisor
Puts together financial model to analyze cash
flows of combined company on pro forma basis
Evaluates comparable transaction in order to
render advice on price
Offers advice on tax and accounting structure
for transaction
Helps raise capital needed to complete
transaction

How and Why to do an

Acquisition
Law firm
Responsible for drafting and negotiation of
transaction documents
Reviews appropriate tax, employment,
environmental, corporate governance,
securities, real property, and other applicable
international, federal, state and local laws
Advise Board of Directors on fulfilling its
fiduciary duties of care and loyalty to
shareholders

How and Why to do an

Acquisition
Accounting firm
Advise company on proper tax and
accounting treatment of transaction
Assist in valuing certain specific assets
Comfort letter on certain accounting
issues
Consent letter needed if publicly
registered securities offering is made in
connection with transaction

The Politics and Economics of

Acquisitions
Key political elements of a
transaction
1. Which entity will survive or be parent
company
2. What will new companys board of
directors look like
3. Who will manage company day-to-day

The Politics and Economics of an

Acquisition
Smaller company will typically
become subsidiary of larger company
Smaller company may have token
representation on Board of Directors of
parent
Management of smaller company will
typically either remain at subsidiary or
exit

The Politics and Economics of an

Acquisition Merger of Equals
Board positions often allocated 50/50
Office of the Chairman or Office of
CEO: formed to share management
authority
Murky lines of authority or shared
power can lead to difficulty and
conflict

The Politics and Economics of an

Acquisition
Buyer will offer price based on whether
transaction will be accretive: increases
earnings per share of acquiring company
Seller will seek premium over its
existing stock price (if public) or price in
line with public traded comparables or
recent public disclosed M&A transaction
multiples based on price to earnings,
price to EBITDA or price to sales (if
private)

LBOs, Hostile Takeovers and

Reverse M&A
Leveraged Buy Outs (LBOs): purchases of
stock of company where a significant
percentage of purchase price is paid for
with proceeds of debt
Became prominent in 1970s and 1980s with
rise of LBO shop
Debt financing to fund:
High yield (junk) bonds
Hostile takeovers: acquisition in which targets
board of directors does not consent to transaction
Tender offer: Potential buyer or raider makes cash offer
directly to shareholders, thereby bypassing board of
directors

LBOs, Hostile Takeovers and

Reverse M&A
Three major events altered landscape to
reduce incidence of hostile takeovers:
1. Creation of poison pills: companies issued
convertible preferred stock to exiting shareholders
with provisions which made a potential tender
offer prohibitively expensive
2. State of Delaware passed new provision of
Delaware General Corporate Law, Section
203: requires hostile buyer to acquire at least
85% of target company in order to consummate
hostile takeover
3. U.S. Congress passed revision of tax code:
limited tax deductibility of certain high yield debt
(HYDO rules), thus reducing attractiveness of junk
bonds as means of financing acquisitions

LBOs, Hostile Takeovers and

Reverse M&A
Reverse M&A (add value through
divestiture)
Four forms of reverse M&A:
1.Simple sale of division or
subsidiary: asset sale, stock sale, or
merger

LBOs, Hostile Takeovers and

Reverse M&A
2. Spin-off: corporation issues dividend of
shares of subsidiary to be spun-off
corporations shareholders
Shareholders of parent participate in spin-off on
pro rata based on their ownership percentage in
parent
Prior to spin-off, parent may extract cash
from subsidiary
19.9% IPO: subsidiary is taken public and all or large
portion of proceeds are then allocated to parent
Transfer certain debts to subsidiary so that parent ends
up with less leveraged balance sheet post spin-off
Parent has subsidiary dividend to parent a portion of
subsidiarys cash

LBOs, Hostile Takeovers and

Reverse M&A
3. Split-off: shareholder in parent
corporation elects to take shares in
subsidiary being split-off, but ends up
with fewer shares of parent corporation
4. Split-up: shareholder elects to take
shares in one part of split company or
other
Less common than spin-offs and split-offs
because most shareholders like having parts
of both parent and entity divested