What are Mergers & Acquisitions (M&A)?
Mergers and acquisitions (M&A) refer to transactions between two
companies combining in some form. Although mergers and acquisitions
(M&A) are used interchangeably, they come with different legal meanings.
In a merger, two companies of similar size combine to form a new single
entity.
On the other hand, an acquisition is when a larger company acquires a
smaller company, thereby absorbing the business of the smaller company.
M&A deals can be friendly or hostile, depending on the approval of the
target company’s board.
Key Highlights
Mergers and acquisitions (M&A) refer to transactions involving two
companies that combine in some form.
M&A transactions can be divided by type (horizontal,
vertical, conglomerate) or by form (statutory, subsidiary,
consolidation).
Valuation is a significant part of M&A and is a major point of
discussion between the acquirer and the target.
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.
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
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 looked into 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):
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 from 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).
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.
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.
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