This is a whole series of articles on Mergers and Acquisitions, make sure to check all other articles including:
Part 1: What Are Mergers And Acquisitions
Part 2: Synergies In M&A Deals
Part 3: Outline Of Business Valuation Techniques
Part 4: Quick Overview Of M&A Process
Part 5: Selling Business To Private Equity
Part 6: Selling Business To Venture Capital
Part 7: Letter Of Intent (or “LOI”) In Mergers And Acquisitions
Part 8: Due Diligence Process
Part 9: Principles Of Negotiating In Mergers And Acquisitions
Part 10: Sale And Purchase Agreement
Part 11: M&A Deal Closing
What do we mean by the term mergers and acquisitions (or “M&A”)? The term is in common parlours and has been for 20 or 30 years, and you hear this term in the business news almost daily. But what does this term actually refer to? Essentially M&A is the combination of companies or business assets. And when you put two of these two things together, you get either a merger or an acquisition.
There are different types of transactions, and broadly speaking, you can have a merger where two equal companies come together and combine. You can get an acquisition where one company takes over takes control of another. You also can have a consolidation where a company goes out, and it starts to hoover up lots of little companies, consolidating a fragmented market so that it ends up with one major player that hopes to dominate that market.
Furthermore, you can have a tender offer where a public company or a private company tenders for the shares of a public company directly to its shareholders. Sometimes if it is hostile, bypassing the management of the target company and offering them cash or indeed their own shares in order to take control of and acquire the target company.
You can have asset purchases, and this is where the assets of a company are acquired, but the company itself is not acquired. And there is an important difference here because if you acquire the assets, then all the liabilities can be left behind in the company.
And then finally, we have management acquisitions or management buyouts, where, often backed by a financial investor, a group of senior management will go in and take control of another corporate entity.
These in nutshell are the main types of M&A deals that you find, and we will explore these in a lot more detail further on the FutureEdge CFO Academy.
What is the difference between a merger and an acquisition? It is important to understand this because these terms are often used as if they are synonymous, as if they actually mean the same thing. But strictly speaking, in deal terms, they are very different.
A merger is when two companies, often of comparable size, join forces to create a new joint business. Now, in theory, both are equal partners, and that is why these combinations are sometimes called a merger of equals. Very often you will see the main jobs of the board being split relatively equally in the combined entity. So if one company provides the chairman, the other company might provide the CEO. Sometimes there are joint CEO appointments, although these are seldom successful. So it is genuinely a combination of two companies. The companies agree to do the deal with one another.
Although the two companies are of comparable size, there will be a lot of jockeying to get the right split of the value. It is very rare that it is exactly 50:50. It might be 60:40 or 55:45, but there is normally one side that tries to get a bit of an edge over the other. And then both sets of shareholders have to give their approval to the combination of the deal. When the deal is closed, the two businesses are then merged into a new corporate entity. And this is normally done by having a new CEO at the top, which then takes leadership of both businesses, day-to-day operations, systems, processes, teams and everything that can then be combined as they see fit. A good example of this is when Daimler and Chrysler who combined and put their businesses together, that was genuinely a merger of equals.
Very often a deal is referred to as a merger rather than acquisition but in reality it is actually an acquisition. And the main reason for doing that is to make the buying company be able to present the deal to the target’s shareholders and management as a much more friendly. So the buyer actually suggests and puts forward the deal to the public as a merger, whereas in fact, the buyer is acquiring and taking over the target.
What do we mean by an acquisition? Well, an acquisition is exactly that, one company acquires another company. Very often, this is a large company buying a smaller company. And when this happens, a new company does not emerge but rather is subsumed into the buyer, and this is often referred to as a takeover. And the way this works is that the buying company acquires a majority stake, up to a hundred percent, in the target firm. The target company does not change its name or corporate structure or anything, but becomes a wholly owned subsidiary of the company that is made the acquisition.
The operations of the subsumed entity are then typically deeply integrated into those of the buyer, but in legal terms the target company has gone underneath the corporate entity and the corporate ownership of the buying company.
An acquisition can be paid for in cash or in stock, or a combination of both. Sometimes you see more elaborate arrangements, for example loan notes. But essentially the exchange is cash or some “paper” in return for the business and assets of the target company.
So that is the difference between a merger and acquisition. It is important from the outset to understand that there is a difference and what the subtleties of that difference are.
Let’s ask, why do companies merge? We understand that a merger is a mutual agreement to combine two business entities, and very often that means that there is a new corporate entity created out of that combination. But why are they doing it? What is the rationale for companies wanting to merge?
Basically, there are some core reasons why they do this. Firstly, it is the opportunity to expand into new products or new geographical markets. So by putting themselves together, one company may have a product that the other company does not have. One company may be operating in a geographical market that the other company does not operate in, which serves as a springboard for geographical expansion. It can also be an opportunity to gain market share in a market in which both companies operate, and when they combine, then their market share combined will increase which may help the combined entity grow faster, by mere benefit of it is market size.
M&As are an opportunity to eliminate duplicate costs and to take the overlap out of the business. And these are often referred to as synergies. So there are benefits to be gained just by putting two companies together and then eliminating the overlap. It is an opportunity to grow revenues and profits. The argument is that if you put these two businesses together, the rejuvenation of the businesses with the extra energy and the new ideas and the larger products and services offerings, the combined company can sell more products to the same customers and therefore grow revenues and profits. And ultimately, this is all about, of course, creating value for shareholders. And this is what it has always been about.
There are five main types of company mergers, being conglomerate, congeneric, market extension, horizontal and vertical mergers and acquisitions. Let’s review each one carefully
In conglomerate M&As there are two completely unrelated businesses that decide to combine. They are in different industries, in different geographical markets, and the aim is to get a product or a market expansion. This was a very popular strategy in the 1970s when the argument was that expert management could run any sort of business. And the more businesses you gave to very highly performing management, the more value you would create because they were better than the other managers. The argument thus in conglomerate deals is essentially about management expertise. This argument has been largely discredited in the last 20 or 30 years, but it was the rationale behind the wave of mergers and takeovers in the sixties and early seventies.
In congeneric M&As two businesses operate in the same market, and they sell complimentary products, and the purpose of the combination is to extend their product range by combining this, as well as overlapping technologies behind these products. It involves overlapping marketing, production processes, research and development, among other things. A product line from one business can be added to a second business. For example, a company selling washing machines may buy a company that sells vacuum cleaners, and then by combining the two, you can sell washing machines and vacuum cleaners to the same customer. And by doing that, you can arguably grow your sales revenues and increase your market share.
Market extension is all about two businesses, which sell the same products, but they sell them in different markets. And by combining, the two companies increase the reach of their market, very straightforward.
A horizontal deal is where businesses operating in the same market, in the same industry, selling the same products, put their operations together side by side, and through this they can lower costs and become more competitive. A lot of horizontal deals happen in the banking sector where you see large banks combining, and selling the same groups of products and services. They have an M&A department, they have a bond department, they have an equity department, they have a consumer products department, a financial products department, and they combine them purely for economies of scale and market share.
A vertical combination is where component companies provide, component parts or services within an industry, but at different levels in the supply chain. Think about, the oil industry. You may have an oil refining business, and then you may have an oil distribution business. And if you combine those two, then the combined entity offers a single offering, it does the refining and the distribution to the customers. This often provides opportunities for cost and operational synergies, and you take out the margin between the two businesses out because the top (downstream) business, the refining business, will want to sell its product and services to the distribution (upstream) business with a product attached. If you combine them that profit gets removed from the centre, and they can arguably sell their products more profitably to end consumers. So vertical combinations happen where companies provide similar products and services in the same industry, but at different levels in the supply chain.
In conclusion, these are the reasons behind company mergers. And it is essential to understand the rationale that is put forward for the deal.
Let’s take a look at why companies make acquisitions. We already understand that acquisitions happen when one company takes control of another. This is normally done by acquiring more than 50% of the shares of the target company.
We do not want to go into complex shareholding structures where you can have different classes of shares, but essentially it is the financial control of the equity of the target business that defines the takeover. And this is normally seen with large companies acquiring small companies, and this is the standard model for an acquisition.
But you can also have a situation where a smaller company buys a larger company, and this is often referred to as a reverse takeover. These most frequently happen when the small company is a public company and the large company is a private company. And this enables the larger private company to effectively go public and get its shares listed on the stock exchange without having to go through the full IPO process.
Some of the reasons why companies make acquisitions by combining the two entities is to become bigger, with the rationale being to generate economies of scale, typically through cost reductions to be made across the combined business.
Very often the costs are taken out of the acquired company while the structure of the buyer changes very little, but the deal can give the buyer increased market share. So if the acquired company has already part of the market, say 10% of the market, and the acquirer has 5% of the market, the combined entity ends up with 15% of the market. The synergy benefits come from the cost savings across the combined business that can be gained, as well as some of the growth benefits that you can get from combining products and services.
Very often in deals, these cost or growth benefits are talked up but in practice they fail to materialize. So synergies need to be looked at with care and not taken for granted. An acquisition can give, the buyer the opportunity to enter a particular market. This could be a new product, or it could be a new geographical market. For example, a US business present on the West Coast wants to expand to the East Coast, or expand from the US to Europe. And so, market entry is a very good rationale for doing a deal. It is also an opportunity to acquire a product, or technology, or intellectual property, or technical expertise. One sees this a lot in the big tech companies, such as Google, Facebook, and Microsoft who acquire small disruptive tech companies, either for their tech, for their R&D, for their intellectual property and patents, or indeed for the teams of expert engineers they have within their businesses.
And indeed on the West Coast these big tech companies very often find it easier to make an acquisition of a team of expert engineers than to try to hire a team or individuals into their team separately, such is the scarcity of good talent in that particular market.
So these are all reasons why companies make acquisitions.
What is the difference between a takeover and acquisition? Essentially they are the same thing, but a takeover does have hostile connotations to it, whereas an acquisition implies that there is an agreement by the target company to be acquired by the larger company.
Very often, one talks about hostile deals and friendly deals. What does this mean?
Well, a hostile deal is where the buyer has to persuade the shareholders of the target company to sell their stock, despite the fact that the management of the target company does not support the deal at all. And you see these particularly happening in public companies, because very often the shareholders are separate from the management. The company has gone public, it has sold a lot of shares to the public, and the management have a very small stake, and therefore the buyer can go over the head of the management company to the shareholders and ask for a deal.
However, if the management team controls 50%, then they are not under the risk or a threat or being taken over in a hostile deal because they just can say no having the controlling shareholding over their company. So the deal has to be friendly. The buyer has to persuade the management to sell their stock. This is the difference between a hostile and friendly deal.
There is a lot more management and regulation of the whole performance of the deal itself, because of the hostility. And the SEC in the US (or equivalent authority in other countries) manages this.
It is also important to understand that in acquisitions we can have accretive or dilutive effects of the acquisition? In an accretive deal the earnings per share of the buying company increase as a result of the combination, whereas in a dilutive deal the earnings per share of a buying company decrease as a result of the combination. One must bear in mind that accretion or dilution can change over time, and often if a deal is dilutive at the outset, the management will argue that it will become accretive over time as synergies are realized and extra growth and more sales are achieved.
So these are some of the reasons behind acquisitions, and I hope it gives the reader some feeling for why companies want to make acquisitions.
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