What are mergers and acquisitions (M&A)?
Mergers and acquisitions (M&A) are financial agreements between corporations that merge companies or their primary commercial assets. A firm may buy and absorb another company, merge with it to form a new one, acquire some or all of its significant assets, make a tender offer for its stock, or launch a hostile takeover. All of them are mergers and acquisitions.
M&A is also used to designate the divisions of financial institutions that deal with such transactions.
Understanding Acquisitions and Mergers
Although the terms mergers and acquisitions are frequently used interchangeably, they have slightly different connotations.
Conversely, a merger refers to two enterprises of roughly the same size that join forces to continue forward as a single new entity rather than remaining separately owned and run.1 This is referred to as a merger of equals. For example, when Daimler-Benz and Chrysler combined, both companies ceased to exist, and a new corporation, DaimlerChrysler, was formed. The stocks of both firms were relinquished, and new company stock was issued in their place.2 In February 2022, the firm changed its name and ticker symbol to Mercedes-Benz Group AG (MBG) as part of a revamp.
When both CEOs agree that joining forces is in the best interests of both companies, the transaction is referred to as a merger.
Acquisitions are usually considered unfriendly or hostile takeover agreements in which target companies do not wish to be purchased. A transaction can be characterized as a merger or acquisition based on whether the acquisition is friendly or hostile and how it is disclosed. In other words, the difference is in how the deal is communicated to the target company’s board of directors, employees, and shareholders. The transaction is known as an acquisition when one company buys another and becomes the new owner.
Mergers and Acquisitions Types
The following are some examples of common mergers and acquisitions:
Mergers
The boards of directors of the two firms approve the merger and seek shareholder approval. For example, in 1998, the Digital Equipment Corporation and Compaq agreed to consolidate, with Compaq absorbing the Digital Equipment Corporation.5 In 2002, Compaq merged with Hewlett-Packard. Before the merger, Compaq’s ticker symbol was CPQ. This was joined with the ticker symbol (HWP) of Hewlett-Packard to get the present ticker symbol (HPQ).6
Acquisitions
In a straightforward purchase, the acquiring corporation receives a majority interest in the acquired firm, which retains its name and organizational structure. Manulife Financial Corporation’s 2004 acquisition of John Hancock Financial Services is an example of this deal, in which both companies kept their identities and organizational structures.7
Consolidations
Consolidation involves integrating core companies and leaving existing corporate structures to form a new company. Both companies’ stockholders must accept the consolidation before receiving common equity shares in the new company. For example, Citicorp and Travelers Insurance Group announced a merger in 1998, resulting in Citigroup.8
Tender Submissions
In a tender offer, one company offers to buy the other company’s outstanding stock for a fixed price rather than the market price. The acquiring business makes the offer directly to the other company’s shareholders, bypassing management and the board of directors.9 For example, in 2008, Johnson & Johnson made a $438 million tender offer to purchase Omrix Biopharmaceuticals.10 The company accepted the tender offer, completing the transaction by the end of December 2008.
Asset Acquisition
In an asset acquisition, one business directly acquires the assets of another. The corporation whose assets are being bought must gain shareholder approval. During a bankruptcy case, other companies bid on various assets of the bankrupt company, which is liquidated upon the ultimate transfer of assets to the acquiring firms.
Management Purchases
A management acquisition, also known as a management-led buyout (MBO), occurs when a business’s leaders buy a majority share of another company and take it private. To help fund a deal, these former executives frequently collaborate with a financier or former corporate officers. Such mergers and acquisitions are often financed disproportionately with debt, and most shareholders must approve them. For example, Dell Corporation announced in 2013 that its founder, Michael Dell, had acquired it.
The Structure of Mergers
Mergers can be organized in various ways, depending on the relationship between the two companies involved in the transaction.
- Horizontal merger: a merger between two companies in direct competition with similar product lines and markets.
- A vertical merger occurs when a client and a firm unite or when a supplier and a company merge. Consider an ice cream maker acquiring a cone provider. Congeneric mergers occur when two businesses—a TV manufacturer and a cable company—serve the same consumer base differently.
- A market-expansion merger occurs when two companies sell the same items in separate markets.
- A product-extension merger occurs when two companies sell distinct but related items in the same market.
- Conglomeration: a combination of two enterprises with no standard business lines.
Mergers can also be distinguished by using one of two financing mechanisms, each having its own set of implications for investors.
Purchase Combinations
As the name implies, this type of merger occurs when one firm buys another. The acquisition is made in cash or through debt instrument issuance. The sale is taxable, which attracts acquiring corporations that benefit from the tax breaks. Acquired assets can be written up to the actual purchase price, and the difference between the book value and the purchase price can be depreciated annually, reducing the acquiring company’s tax liability.
Mergers and Consolidation
This merger creates an entirely new firm, and both companies are purchased and amalgamated under the new corporation. The tax implications are identical to those of a merger.
How are acquisitions funded?
A corporation can buy another company using cash, shares, debt assumption, or both. In smaller transactions, it is also usual for one firm to purchase all of the assets of another company. Company X purchases all of Company Y’s assets for cash, leaving Company Y with only cash (and any debt, if any). Of course, Company Y will become a shell and eventually liquidate or enter new markets.
A reverse merger is another type of purchase arrangement that allows a private firm to become publicly traded relatively quickly. Reverse mergers occur when a private corporation with promising prospects and a strong desire for financing acquires a publicly traded shell company with no business operations and few assets. The private firm reverses its merger with the public company, and the two companies merge to form an entirely new public corporation with marketable shares.
How are mergers and acquisitions valued?
Both companies involved in an M&A transaction will value the target firm differently. The seller will undoubtedly value the company at the highest possible price, whereas the buyer will want to purchase it at the lowest feasible price. Fortunately, a company can be objectively valued by researching comparable companies in a sector and depending on the measures listed below.
P/E Ratio (Price-to-Earnings Ratio)
An acquiring business uses a price-to-earnings ratio (P/E ratio) to make an offer that is a multiple of the target company’s earnings. Examining the P/E multiples for all stocks in the same industry group will give the acquiring business a good indication of the target’s P/E multiple.
Enterprise-Value-to-Sales (EV/Sales) Ratio
The purchasing corporation uses an enterprise value-to-sales ratio (EV/sales) to make an offer as a multiple of revenues while considering competing companies’ price-to-sales (P/S) ratio.
DCF stands for discounted cash flow.
A discounted cash flow (DFC) analysis, an essential valuation tool in M&A, calculates a company’s current value based on its expected future cash flows. Forecasted free cash flows (net income + depreciation/amortization (capital expenditures) change in working capital) are discounted to present value using the company’s WACC. To be sure, DCF is challenging to master, but few tools can compete with it.
Cost of Replacement
Acquisitions are sometimes based on the cost of replacing the target company. Please assume that the worth of a corporation is simply the sum of its equipment and personnel costs. The purchasing corporation can almost command the target to sell at that price, or it will build a competitor at the same price. Attacking strong management, acquiring property, and purchasing the necessary equipment take time. This price-determining method makes little sense in a service industry when the essential assets (people and ideas) are challenging to evaluate and develop.
Questions and Answers
What Is the Difference Between Mergers and Acquisitions?
In general, an “acquisition” refers to a transaction in which one company absorbs another through a takeover. When the acquiring and target corporations join to establish a wholly new entity, the word “merger” is employed. Because each combination is a distinct situation with its features and motivations for engaging in the transaction, the use of these phrases frequently overlaps.
Why do companies continue to acquire other businesses through mergers and acquisitions?
Competition and expansion are two critical drivers of capitalism. When faced with competition, a corporation must minimize costs while also innovating. One strategy is to buy out competitors so they no longer pose a danger. Businesses can also expand by using M&A to acquire new product lines, intellectual property, human resources, and clientele. Businesses may also seek synergy. By integrating corporate activities, total performance efficiency improves, and overall costs decrease as one company utilizes the strengths of the other.
What Exactly Is a Hostile Takeover?
The most common type of acquisition is a friendly acquisition, which occurs when the target company agrees to be purchased; its board of directors and shareholders approve of the transaction, and these combinations frequently operate for the mutual advantage of the acquiring and target companies.
When the target company refuses to consent to the acquisition, it is referred to as an unfriendly acquisition. Because the target firm does not have the same agreement in hostile acquisitions, the acquiring firm must aggressively purchase large holdings in the target company to gain a controlling position, which compels the acquisition.
What impact does M&A have on shareholders?
In general, shareholders of the acquiring firm will witness a short reduction in share value in the days leading up to a merger or acquisition. At the same time, the value of the target firm’s shares often rises. This is frequently due to the acquiring firm’s requirement for funds to acquire the target firm at a premium to pre-takeover share prices.
The stock price frequently exceeds the worth of each underlying company during its pre-takeover stage once a merger or acquisition officially takes effect. The merged company’s owners often enjoy good long-term performance and dividends without unfavorable economic conditions. It should be noted that the increased number of shares released during the merger procedure may dilute voting power for both firms’ owners. This occurrence is prevalent in stock-for-stock mergers, in which the new business exchanges its shares for shares in the target company at an agreed-upon conversion rate. Owners of the acquiring firm lose a minimal amount of voting power. In contrast, owners of a smaller target company may lose significant voting power in the comparably larger pool of stakeholders.
What Is the Difference Between a Vertical Merger or Acquisition and a Horizontal Merger or Acquisition?
Horizontal and vertical integration are competitive techniques businesses use to strengthen their position among competitors. The acquisition of a related firm is an example of horizontal integration. A firm that chooses horizontal integration will buy another company that works at the same level of an industry’s value chain, such as when Marriott International, Inc. acquired Starwood Hotels & Resorts Worldwide, Inc.
Vertical integration is the acquisition of business operations within the same industrial vertical. Vertical integration means that a corporation has complete control over one or more stages of a product’s production or distribution. Apple, for example, purchased AuthenTec, which manufactures the touch ID fingerprint sensor technology used in iPhones.
Conclusion
- People often use the words “mergers” and “acquisitions” to mean the same thing, but they mean different things.
- An acquisition is when one business buys another one directly.
- Mergers happen when two businesses form a new legal body with the same corporate name.
- You can get an objective value for a business by looking at similar businesses in the same field and using metrics.
