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).
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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 priceearnings 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.
Another ratio used is the enterprise value to sales ratio (EV/Sales Ratio). Enterprise value is calculated by taking the company’s outstanding stock, adding its debt, and deducting its cash or cash-equivalent assets. This value is then divided by the company’s sales (not earnings) to arrive at an EV/Sales Ratio. The concept here is to treat both stock and debt as values that need to be paid back with sales. If the ratio is low, the value of the company is high. If the company has a lot of cash, the ratio may be negative, indicating that the target can be bought using its own cash.
The most common method of valuation used in M&A is discounted cash flow (DCF) analysis. The method is described in detail in this volume (see Discounted Cash Flow). It involves projecting the financial performance of the company over some period, typically ten years, and then calculating net cash flow for every year. The analyst then discounts (reduces) future earnings using the purchaser’s actual rate of return on capital. The logic here is that capital invested now would earn the buyer interest in future years. That same interest is deducted from the projected cash flows. The sum of discounted cash flows is then viewed as the acquisition target’s current value. The analyst usually assumes that the company will be sold in the 11th year for a conservative multiple of earnings; this residual is also discounted and added. The drawback of DCF is its complexity—above all the need to project all of the complex financial flows into the future. Its benefits are greater detail which typically requires a very full understanding of the candidate.
In virtually all valuations of companies, the prospective buyer also factors in so-called synergies which will help it increases in market share and sales, lower costs, and increased profitability. Projected synergy gains are then used as part of the valuation. Following many acquisitions, large layoffs are announced because the merger of functions eliminates duplications. Such layoffs are an example of a “synergy”; often the announcement lifts the stock.
Success And Failure
Are mergers and acquisitions a success or a failure? The answer is that results are mixed. Many smaller companies are successfully sold to larger operation and, transformed (often beyond recognition), continue to operate and grow. Larger deals are evidently less successful.
Investopedia.com, in its article regarding M&A states: “Historical trends show that roughly two thirds of big mergers will disappoint on their own terms, which means that they will lose value on the stock market. The motivations that drive mergers can be flawed and efficiencies from economies of scale may prove elusive. In many cases the problems associated with trying to make merged companies work are all too concrete.”
Results for stockholders depend on which side of the deal they are on. There is substantial empirical evidence that the shareholders in acquired firms benefit substantially. Gains for this group typically amount to 20 percent in mergers and 30 percent in tender offers above the market prices prevailing a month prior to the merger announcement. Most small company owners realize substantial gains when selling successful, privately-held corporations to a public buyer. The gains of stockholders of acquiring firms are difficult to measure, but the best evidence suggests that shareholders in bidding firms gain little. Losses in value subsequent to merger announcements are not unusual. In post-acquisition periods, managements are often distracted with cost cutting and integration processes and spend less time on the business, sometimes with unfavorable results. This seems to suggest that overvaluation by bidding firms is common.
Managers may also have incentives to increase firm size at the potential expense of shareholder wealth. If so, merger activity may very often happen for structural, “legacy,” and other reasons as already indicated above.