Implementation: Search

Through Closing
--Phases 3-10
 A man that is very good at making
excuses is probably good at nothing else.
—Ben Franklin
 Exhibit 1: Course Layout: Mergers,
Acquisitions, and Other
Restructuring Activities

Part I: M&A Part II: M&A Process Part III: M&A Part IV: Deal Part V: Alternative
Environment Valuation and Structuring and Business and
Modeling Financing Restructuring
Strategies

Ch. 1: Motivations for Ch. 4: Business and Ch. 7: Discounted Ch. 11: Payment and Ch. 15: Business
M&A Acquisition Plans Cash Flow Valuation Legal Considerations Alliances

Ch. 2: Regulatory Ch. 5: Search through Ch. 8: Relative Ch. 12: Accounting & Ch. 16: Divestitures,
Considerations Closing Activities Valuation Tax Considerations Spin-Offs, Split-Offs,
Methodologies and Equity Carve-Outs

Ch. 3: Takeover Ch. 6: M&A Ch. 9: Financial Ch. 13: Financing the Ch. 17: Bankruptcy
Tactics, Defenses, and Postclosing Integration Modeling Basics Deal and Liquidation
Corporate Governance

Ch. 10: Private Ch. 14: Applying Ch. 18: Cross-Border

Company Valuation Financial Models to Transactions
Deal Structuring
 Current Learning Objectives

• To Provide Students with an understanding of

– how to conduct an acquisition search, to
screen potential candidates, and to make
initial contact with potential targets
– the four concurrent activities within the
negotiation phase and how they interact to
determine purchase price, and
– the importance of pre-closing planning and
post-closing execution
 The Acquisition Process

• Phase 1: Business Plan (Model)

• Phase 2: Acquisition Plan
• Phase 3: Search
• Phase 4: Screen
• Phase 5: First Contact
• Phase 6: Negotiation
• Phase 7: Integration Plan
• Phase 8: Closing
• Phase 9: Integration
• Phase 10: Evaluation
 Phase 3: Initiating the Search
• Two step procedure:
– Establish primary selection criteria (e.g., industry and maximum
size of transaction)
– Develop search strategy to identify potential targets using
computerized databases; directory services; legal, banking, and
accounting firms; and the Internet.
• Brokers and finders:
– A broker has a fiduciary responsibility to either the seller or
buyer.
– A finder introduces both parties without representing either party.
– Everything is negotiable. Fee structures are normally negotiated
and may include a basic fee, a closing fee, and an
“extraordinary” fee (i.e., fees paid if closing delayed due to
obtaining antitrust approval, a hostile takeover, etc.)
– Put everything in writing
 Phase 4: The Screening Process
• As a refinement of the search process, screening
involves increasing the number of selection criteria to
reduce the list of potential candidates.
• In addition to the industry and maximum size of
transaction used in the search process, additional criteria
could include:
– Targeted market segment
– Product line
– Profitability
– Degree of leverage
– Market share
– Cultural compatibility (e.g., AOL/Time Warner)
 Phase 5: First Contact

• The appropriate approach strategy depends on

– Size of target
– Whether target is publicly or privately held
– Acquirer’s timeframe for completing transaction
• Trust and relationship building when time is not critical
• Discussing value
• Preliminary legal documents:
– Confidentiality agreements
– Term sheets (price range/formula, form of acquisition, extent of
due diligence, no-shop provision))
– Letter of intent (price range/formula, form of acquisition, form of
payment, non-competes, employee contracts, no-shop
provision)
 Phase 6: Viewing Negotiation as a Process

If No,
Walk
Away1
Perform Due Diligence
Profiling
Target First
Market & Contact
Firm Structuring the Deal
Form of Acquisition
Form of Payment Develop Decision:
If Yes, Refine Financing Proceed to
Tax Considerations
Initiate Initial Plan/ Closing or
Accounting Considerations
Negotiations Valuation Structure Walk Away
Acquisition Vehicle
Post-Closing Organization
Legal Form of Selling Entity

Negotiation Process

1
Alternatively, the potential buyer could adopt a more hostile approach such as initiating a tender offer to achieve a majority stake in the target firm.
 Phase 6: Negotiation
• Negotiating strategy
– Initially determine areas of
agreement and
disagreement
– Solve the easiest areas of
disagreement first
– Establish and maintain trust
throughout the process
• Concurrent activities:
– Refining valuation
– Deal structuring
– Conducting due diligence
(buyer, seller, and lender)
– Developing the financing
plan
Key Deal Structuring Considerations

• Form of Acquisition
• Form of Payment
• Tax Considerations
• Accounting Considerations
• Acquisition Vehicle
• Post-Closing Organization
• Legal Form of Selling Entity
 Phase 6: Buyer Due Diligence
During Negotiation
• Objectives:
– Validate preliminary valuation assumptions (e.g.,
growth, cost, productivity, etc.). Critical to the model
building/updating process
– Identify additional sources/destroyers of value (i.e.,
those providing upside potential & “fatal flaws”)
• Activities:
– Detailed legal (e.g., contracts) and financial record
reviews
– Management interviews (consistency in questions
asked)
– Site visits (e.g., inspect equipment, inventory, etc.)
– Customer and supplier interviews
 Determining the Purchase Price
for the Target Firm
• Total consideration (TC):
PVTC = C+ PVS+ PVND
Where C = cash; PVS = market value of acquirer stock; and PVND = market
value of acquirer debt issued to seller, respectively.
Composition of purchase/offer price
• Total purchase price (TPP) or enterprise value (EV):
PVTPP = PVTC+ PVAD
Where PVTPP = PV of total purchase price; PVTC = PV of total consideration;
PVAD = PV of assumed Target debt, respectively.
Purchase/offer price plus long-term assumed liabilities
• Net purchase price (NPP):
PVNPP = PVTPP+ PVOAL- PVDA
= (C+ PVS+ PVND+ PVAD) + PVOAL- PVDA
Where PVOAL = other assumed Target liabilities and PVDA = PV of discretionary
(non-critical) assets,1 respectively.
Actual cash cost of acquisition
 Due Diligence and Negotiation
Reliable Appliances, a leading manufacturer of washing machines and dryers, acquired the
stock of competitor, Quality-Built, which had been losing money during the last several years for
$100 million in cash. Reliable also assumed $20 million (present value = $18 million) of Quality-
Built’s outstanding long-term debt. To help minimize losses, Quality-Built reduced its quality-
control expenditures and began to purchase cheaper parts. Quality-Built knew that this would
hurt business in the long run, but it was more focused on improving its current financial
performance in the months prior to being sold. Reliable Appliances saw the acquisition as a way
of obtaining market share quickly at a time when Quality-Built’s market value was the lowest in
3 years.
Quality-Built had been selling its appliances with a standard industry 3-year warranty. Claims
for the types of appliances sold tended to increase gradually as the appliance aged. Quality-
Built’s warranty claims’ history was in line with the industry experience and did not appear to be
a cause for alarm. Not surprisingly, in view of Quality-Built’s cutback in quality-control practices
and downgrading of purchased parts, warranty claims began to escalate sharply within 12
months of Reliable Appliances’ acquisition of Quality-Built. Over the next several years, Reliable
Appliances paid out $15 million in warranty claims (PV = $12 million). The intangible damage
may have been much higher because Reliable Appliances’ reputation had been damaged in the
marketplace. At the end of the second year, Reliable sold certain non-strategic Quality-Built
assets for $2 million, equivalent to a PV of $1.5 million.

1. What was the total consideration, total purchase price (enterprise value), and net
purchase price ultimately paid for Quality-Built?
2. Why was it important to Quality-Built to improve its current financial performance?
3. How should Reliable Appliances have been able to anticipate this warranty problem from
its due diligence of Quality-Built?
4. How could Reliable have protected itself from the outstanding warranty claims in the
definitive agreement of purchase and sale?
5. In what sense had Reliable’s reputation been damaged?
 Discussion Questions

1. Identify several criteria that might be used to

select a manufacturing firm as a potential
acquisition target? A financial services firm? A
hi-tech firm?
2. Describe how the various activities that occur
concurrently during the negotiation process
affect the determination of the final purchase
price for the target. Be specific.
 Phase 7: Developing the Integration Plan
• Use due diligence to determine post-closing sequencing of events
necessary to realize potential savings and revenue enhancements
• Resolve contract-related transition issues in purchase agreement
– Employee payroll and benefit claims processing
– Seller reimbursement for products shipped before closing for which
payment not received
– Buyer reimbursement for vendor supplies/services received before
closing for which payment had not yet been made
• Ensure contract closing conditions include those necessary to facilitate
integration (e.g., employee contracts, agreements not to compete)
• Develop post-merger integration organization consisting of both target
and acquirer managers to
– Build a master schedule of what should be done, by whom and by
what date
– Establish work teams to determine how each function and business
unit will be combined
– Establish post-closing communication strategy for all stakeholders
 Phase 8: Closing
• Obtain all necessary consents:
– Shareholder
– Regulatory (e.g., state and federal)
– Third party (e.g., customer, lender, and vendor)
• Complete definitive agreement
– Purchase price
– Allocation of purchase price
– Assumption of liabilities
– Representations and warranties (“reps” and “warranties”)
– Covenants
– Closing conditions
– Indemnification (reimbursement for actions of the other party)
– Loan documents
– Etc.
 Phase 9: Implementing Post-Closing
Integration

• Communication plans (e.g., consistent and

continuous)
• Employee retention (e.g., retention bonuses)
• Satisfying cash flow requirements (e.g., deferred
maintenance expenditures)
• Employing best practices (e.g., competitor or
similar business)
• Cultural issues (e.g. joint work teams, co-
location of acquirer and target employees)
 Oracle Integrates Sun Microsystems
Following closing its acquisition of Sun (a leading builder of computer workstations)
in early 2010, Oracle (a leader business software firm) must rationalize and
consolidate Sun’s manufacturing operations and substantially reduce the
number of products the firm offers. Fewer products will mean less
administrative and support overhead. Furthermore, Oracle has introduced a
“build to order” mentality rather than a “build to inventory” marketing approach.
With a focus on “build to order,” hardware is manufactured only when orders
are received rather than for inventory in anticipation of future orders. By
aligning production with actual orders, Oracle expects to reduce substantially
the cost of carrying inventory; however, it does run the risk of lost sales from
customers who need their orders satisfied immediately. Oracle also intends to
pare the number of suppliers in order to realize savings from volume purchase
discounts. Historically, Oracle has been a more “bottom line” and less
bureaucratic firm than Sun.

Discussion Questions:
1. What specific challenges do you believe Oracle will face in its efforts to
integrate Sun Microsystems?
2. What do you believe Oracle should do to overcome each of these challenges?
Be specific.
 Phase 10: Conducting Post-Closing
Evaluation

• Don’t change performance benchmarks

• Ask the difficult questions

• Learn from mistakes

 Discussion Questions

1. What is the purpose of the buyer and the seller

performing due diligence? What other parties
might want to perform due diligence on the
target firm?
2. Describe the financing plan. In what sense is it
a “reality check?”
3. Of the various activities conducted during post-
closing integration, which do you believe is the
most important and why?
 Quick Quiz

All of the following are true about a confidentiality agreement

except for
a. Often applies to both the buyer and the seller
b. Stipulates the type of seller information available to the
buyer and how the information can be used
c. Limits the use of information about the seller that is
publicly available
d. Includes a termination date
e. Limits the ability of either party to disclose publicly the
nature of discussion between the buyer and seller
 Things to remember...
• The search phase involves using relatively few criteria to
identify potential targets, while screening involves narrowing the
list by employing more criteria
• How first contact is initiated depends on target size, availability
of intermediaries with contacts in target, and time criticality
• Actual purchase price determined during the negotiation phase
• Integration planning must be done before closing when buyer
has greatest leverage with the seller
• Closing involves completion of final documentation, obtaining
necessary approvals, and resolving remaining transition issues
• Post-closing integration focuses on effective communication to
all stakeholders, employee retention, and identifying and
resolving immediate cash flow needs
• Post-closing evaluation provides opportunity to learn what
worked and what didn’t