The Definitive Guide to
Mergers and Acquisitions

There are three basic merger and acquisition deal structures entrepreneurs and business owners should be aware of: (i) sales of business or assets, (ii) mergers, and (iii) stock or equity sales.

Sale of businesses or assets

The most common deal structure small business owners and start-up entrepreneurs will face are Acquisitions. While companies can be purchased outright, some acquisition deals can also be executed through asset sales.

What this means is that parts or portions of a business, such as a particular department or product, for example, are sold a-la-carte rather than the entire company. For buyers, asset acquisitions carry much less risk since liabilities and contingent expenses stay with the selling company.

For sellers, this an easy way to shed unprofitable business operations while retaining thriving ones.

Merger

Mergers are relatively uncommon in the small to mid-market business space and tend to be more common at the level of larger corporations with multiple assets.

Of course, there are many types of mergers, such as horizontal mergers, vertical mergers, congeneric mergers, and a merger of equals, to name a few, that involve businesses of all sizes and that each requires strategies and approaches. We won’t go into depth on these for the time being, but future chapters will have more information. In general, mergers tend to occur between businesses of equal to a similar size.

Stock or equity sale

Equity sales, also known as stock sales, are similar to direct sales of businesses or assets. However, instead of buying assets or liabilities, the buyer purchases a controlling interest in the entire business through the acquisition of shares. By definition, that means the buyer must own at least 51 percent of a target company’s shares, although it is possible to achieve a controlling interest in a company with less than 50 percent ownership in the company.

“M&A” simply stands for “mergers and acquisitions.” This is just business-speak for companies buying another company or, in the case of mergers, joining together to form one business entity.

While the terms “mergers” and “acquisitions” are lumped together, they refer to two very different business procedures.

In a merger, two businesses fuse or merge, to form a brand new company. This is a mutual decision. Two companies go into an alliance and a third, previously nonexistent business entity, emerges from the process.

Acquisitions are much more straightforward. In an acquisition, one company buys another company. This can occur either willingly, in the case of a business owner cashing out of his business, or unwillingly, in the case of a hostile takeover.

To begin the Mergers and Acquisitions process, you need to know which part of the market your company is in: the lower end market, middle market, or the top market. These are merely relative references to the size of a company in regards to its total revenue or asset base. As a result, there is no universally accepted valuation range for these terms. In general, however, many Merger and Acquisition experts use these rule of thumb numbers:

Each market segment has its own unique set of buyers and sellers. For example, buyers may pay a hefty premium for small market companies with the potential to grow into mid-market companies, and for mid-market companies with the potential to develop into top market companies.

Understanding relative valuations will help you determine who the players are in your market segment as well as identify potential buyers or sellers.

Companies pursue mergers and acquisitions to generate value. Utilizing an M&A approach, companies can:

• Increase market share
• Break into or buy their way into a promising market
• Promote growth
• Acquire valuable assets
• Achieve vertical integration
• Leverage “synergies” to create even more value

While each Merger & Acquisition deal is unique, there are broadly defined interdependent phases of every M&A deal that every entrepreneur or business owner, whether they are buying or selling, should strive to understand: strategy, target screening, transaction, and post-M&A integration.

• M&A Strategy – Identify value-creating merger and acquisition opportunities.
• M&A Target Screening – Identify promising merger and acquisition targets to acquire or sell to.
• M&A Transaction – Execute the merger and acquisition deal.
• Post-M&A Integration – Seamlessly integrate an acquisition. Identify issues and challenges from this deal to take into account for future transactions.

• Seller – This is the company looking to be acquired.
• Buyer – This is the company seeking acquisitions.
• Transaction lawyers – Transaction lawyers are a must for any deal. They provide transaction advice, manage negotiations, and provide legal documentation for the sale. Transaction lawyers aid in legal due diligence.
• Accountants – The role of accountants in any merger and acquisition deal are many and varied. Accountants are involved throughout the process from the initial stages of financial due-diligence to the final closing process and beyond.
• Tax Advisers – Tax advisers provide expert analysis and assessments of a deal’s tax implications and overall financial feasibility. They help achieve structuring goals of both the buyer and the seller in a merger and acquisition deal.
• Integration Consultants – Integration consultants ensure a seamless post-acquisition or post-merger transition, such as the integration of new management. They help manage changes to the business after an M&A transaction, including changes to a business’s talent and culture.
• Business brokers – Business brokers help businesses in the lower end or mid-market sell to individual owners or private equity groups.
• Investment Bankers – Like a business broker, investment bankers help a business buy, sell, or merge. However, investment bankers typically only work at the upper end of the market and deal with complex business transactions. In general, investment bankers help corporations sell to other corporations.

Ultimately, whether or not to merge with or acquire another a company will depend on if the resulting synergies, pooling of resources, and market conditions make sense to do so. In some cases, there are better alternatives to a merger or acquisition when it comes to achieving efficiencies. Many businesses, for example, will enter into a strategic business alliance rather than a merger or acquisition.

An airline, for example, needn’t engage in a merger or acquisition with a hotel chain. They would both benefit far more as a part of a business alliance in which the hotel chain accepts the frequent flier miles of the allied airline. There is no reason, or benefit, for one to buy or merge with the other.

It is crucial to distinguish reciprocal synergies from other types of synergies that can be better achieved with other forms of collaboration. Mutual synergies occur when the two companies in question both execute tasks through close knowledge sharing. To attain such close working relationships, M&A is the best solution.

When collaboration or partnering with another organization to achieve efficiencies results in extensive redundancies, mergers & acquisitions between two partner organizations may be the answer. The merging of Hewlett-Packard and Compaq, for example, was designed to net nearly 2 billion dollars in savings across the board by dramatically reducing extensive redundancies.

Hard resources are the equipment, infrastructure, and other physical forms of capital used for the production of goods and services. To achieve higher levels of efficiency, it makes sense to engage in M&A to combine resources and minimize the number of capital-intensive investments needed. An example of this would be one manufacturing factory purchasing or merging with another. It is essential to distinguish hard resources from soft resources such as workforces and institutional knowledge.

The surest way to achieve economies of scale is to pool resources through a merger and acquisition. Larger firms can often be more efficient in this way. In general, increasing output leads to decreasing costs. Many factors make the desire for economies of scale one of the primary motivators to pursue M&A.

Capital-intensive projects with high fixed costs, such as factories and manufacturing facilities, can achieve lower average costs by increasing production. Likewise, large-scale operations can reach higher levels of division of labor and specialization. Bulk buying, spreading overheads and risk, and more favorable interest rates are all reasons to pursue more top economies of scale through a merger and acquisition.

Mergers and acquisitions do not come without risks. In general, engaging in M&A means drastic changes to the leadership, staff, infrastructure, business model, and operations of one or both entities. The goal of a merger and acquisition is to create value. However, one of the high risks of engaging in mergers and acquisitions is that value may, indeed, potentially be lost. If the potential benefits of a merger and acquisition deal aren’t significant then perhaps it would be better to consider an alternative arrangement such as a business alliance.

One of the greatest threats to a mergers and acquisitions deal is uncertain market conditions. Namely, consumers or regulators may find the deal unpalatable for many reasons.

For example, a large pharmaceutical company may purchase another drug maker with a promising drug in clinical trials. However, if regulators ultimately do not allow the drug onto the market, the investment made in purchasing that company will have been a total loss. It would have been better to form an equity alliance rather than acquire the promising drug maker outright.

One of the primary motivating factors for engaging in mergers and acquisitions is to combine, configure, and leverage potential synergies between two partners. However, not all synergies benefit from M&A. Sequential and modular synergies do not reap adequate benefits from M&A and can be achieved with less risky strategic alliances.

Sequential synergies occur when one partner completes one portion of a task and passes it along to another partner. An example of this is if a larger pharmaceutical company buys the marketing and distribution rights for a smaller company’s products in return for a cut of the profit. Rather than M&A, this can be achieved more efficiently with a simple equity alliance.

Modular synergies occur when two companies manage their resources independently and pool their results. An example of this is when air carriers and hotel chains form a business alliance to share frequent traveler and loyalty points.

While higher economies of scale can result in enormous value creation, it is also possible to overextend in pursuit of economies of scale, resulting in the opposite effect: diseconomies of scale. When the business becomes overextended, or too large, as a result of M&A activity, significant problems can arise. Oversight and communication are more difficult to attain in large companies. Furthermore, employees tend to become alienated and become less productive or leave the company altogether.

Finally, diseconomies of scale can result in inefficiency and lack of control, thereby negating any efficiency gains from economies of scale. When it comes to business growth, it is vitally important to not only grow but to grow sustainably and without overextending.

Unlike hard resources, such as machines and equipment, human talent can leave a company if they are not satisfied with a business arrangement. This is a real danger for M&A where mergers and especially acquisitions can often be viewed unfavorably by the workers of one or both companies.

The exodus of high-value human capital after an M&A deal is known as post-acquisition trauma. If the goal of an agreement is acquiring valuable human capital, it is vital to ensure a smooth and seamless transition. This is incredibly difficult, fraught with peril, and tricky to pull off well with an M&A approach.

Instead, a better plan would be through a strategic alliance in which the company with the valuable human or intellectual capital is allowed to retain its autonomy, culture, and human resources.

The seller must be able to understand how the target company’s operations will synergize with theirs. All existing infrastructure at the target company should be carefully examined to determine if there are redundancies or opportunities to combine or eliminate dual functions to save costs that directly affect the bottom line.

The due diligence process should not be considered complete until the following questions are answered:

• What market/consumer base does the target company serve that the buyer doesn’t yet?
• What role does the target company play in the buyer’s existing strategy?

The due diligence process should be used to determine the most accurate value of the target company. The real value may not be realized without the right leadership, but that’s why it’s important to have a full accounting of all the assets and debts that exist right now.

The buyer should have confident answers to all of the following questions.

• What is the current cost of managing the target company’s operations?
• Are those margins increasing or decreasing?
• Are the projections for future growth well-grounded in market data?
• What debt is currently being managed by the target company?
• What patents and/or trademarks does the target company hold that is relevant to the buyer’s own operations?
• Are there trade secrets or other know-how, and how are they preserved?

Significant differences in corporate structure and management policies can make mergers very difficult if not managed properly. Switching masses of employees over to a new style of management, or culture, can cause significant disruption, but trying to maintain two contradicting structures in one company comes with its own problems.

The buyer should understand such by addressing the following questions:

• How is the workforce compensated at every level?
• How comprehensive and consistently enforced are the target company’s employee manuals?
• What are the policies regarding incentives and bonuses?

The buyer needs to ensure that its current corporate governance standards and documents do not conflict with those of the target company. These documents often determine the responsibilities of the officers of the merged company, and the rights and powers granted to stockholders.

Any buyers should make sure they understand the following:

• Who holds the securities of the target company including options, preferred stocks, and warrants?
• What voting agreements govern the stockholders?
• Are there documents that govern recapitalization or restructuring?

All successful companies must manage legal challenges. Ongoing litigation isn’t disqualifying on its own, but any buyers should understand how likely these cases are to end with judgments against the target company that may decrease its value.

Buyers should know:

• What type of litigation is currently pending?
• Has any additional litigation been threatened?
• What were the terms of past settlements?

Conglomerate mergers take place when the merging companies exist in different, unrelated industries. In this type of merger, the purchasing company is often significantly larger and more cash-rich than the merged company.

There are two subtypes of mergers within this type:

Pure Conglomerate Mergers – This type of merger occurs when the two companies exist in entirely separate markets.

Mixed Conglomerate Mergers – This type of merger occurs when the two companies intend to combine their operations to target new markets or create new products that aren’t related to the products or services of either one.

Purpose

The purpose of a conglomerate merger is often to diversify.

Companies that predict the obsolescence of their products or services may pursue pure conglomerate mergers as a way of transitioning their brand into another market while they are still profitable.

Mixed conglomerate mergers may be attractive because the purchasing company expects that the separate markets may become related at a later time due to changes in technology or consumer behavior.

Benefits

Though the risks can be significant, there are important benefits to conglomerate mergers when the merging companies have the ability to leverage them.

• Protection against changing markets: Conglomeration can give companies a safer path to transition to a new market over time. A company that is trapped in one market as sales decline may lose the cash needed to transition.
• Cross-marketing and sales: Even if the companies serve different markets, they may still serve the same demographic. Conglomeration can enable greater capture of a particular geographic area or age-group.

Horizontal mergers take place when two competing companies merge into a single new enterprise.

Purpose

The purpose of a horizontal merger is to make partners of former competitors. The newly created company claims the combined market share of both companies, along with the technologies and expertise that made them able to compete with one another.

Benefits

The benefits of horizontal mergers are easy to understand. Among the benefits:

• Increased market power: The combined market share, assets (patents), experts, and leadership can make the merged companies far more powerful and capable of growth than either would have been alone.
• Dramatic reduction in competitive costs: The two companies may have needed to aggressively invest in new technologies or keep product prices low in order to compete with one another. With competition relieved, those costs can be directed elsewhere.
• Apparent synergies: Companies that share the same market and the same understanding of the market are more likely to have synergies that can be easily leveraged for even more market power.

Market-extension mergers take place when two companies that sell the same product in different geographic markets merge.

Purpose

The purpose of market-extension mergers is to increase global market share. It is often one of the major steps to achieving international market power.

Benefits

There are many benefits to choosing market-extension mergers, especially over the alternative methods of entering new markets.

• Increased Market Share: The most basic advantage of market-extension mergers is the increased market share that comes with absorbing the merged company. In addition to the existing market share, there is now the possibility of sharing both types of products across both markets.
• Adopted Expertise: Market extension mergers are a powerful alternative to entering new markets using existing infrastructure. They allow companies to adopt the expertise that already exists in those markets instead of entering them blind to the challenges that exist there.

Product-extension mergers take place when two companies that sell similar products or that operate in the same market unite.

Purpose

The purpose of a product-extension merger is to expand products or service offerings while being able to take advantage of existing production and distribution infrastructure.

Benefits

• Improves the variety of products: Companies that enter into a product-extension merger can increase the variety of their products without any further development of their manufacturing or supply chains. They simply adopt the existing infrastructure from the merged company.
• Enables the bundling of technology: Companies can dramatically improve the quality or the competitiveness of their products and services with the raw materials, technology and supply chains that product-extension mergers provide.

Vertical mergers take place when a company joins forces with another that exists at a different place in the same supply chain. The merger may occur between companies that control the raw materials, manufacture or distribution.

Purpose

The purpose of vertical mergers is to achieve greater control of the supply chain by unifying different parts of it into the same company.

Benefits

• Cut costs: A vertical merger allows for the elimination of the seller-purchaser relationship between two companies, resulting in immediate cuts to the costs that are necessary to move a product through the supply chain.
• Improved Efficiency: Companies that unify a supply chain can exercise greater control over it, allowing for increased production, more reliable delivery of raw materials, or other advantages that allow them to claim a larger market share.

A merger or acquisition can be an excellent strategy for growth. This is especially true for larger companies that rely heavily on M&A to deliver consistent growth. According to the 2014 McKinsey report, Unlocking M&A Value at Every Step by Moni Miyashita, large companies rely on M&A to deliver as much as 50 percent of their top-line growth.

A need for speedy yet sustainable growth is what makes M&A such an attractive option for many. Whether you run a small to medium-sized company or a multinational corporation, M&A can be an excellent opportunity to grow much faster than organic growth. Of course, rapid growth often comes with increased risks if a company accidentally bites off more than it can chew.

A successful example of M&A growth is Google’s acquisition of Android in 2005. Little known at the time, today over 80 percent of all phones in the United States run on Android. At the time, Google paid a relatively paltry sum of $50 million dollars for the promising OS startup. Today Android is the dominant force in the mobile market and the primary delivery vehicle for many of Google’s web services, such as Gmail.

Android is now worth billions and has played a significant role in Google’s top-line growth over the last 15 years.

If you want to jumpstart stagnating growth or accelerate existing growth, M&A might be one way to do it.

But acquisitions of other companies is not the only way to grow.

For small companies and startups with a promising business model, innovative product, or valuable IP, being acquired can actually benefit them immensely. A small startup, for example, with an idea for a disruptive new technology might not have the R&D budget, investor relationships, or steady funding of a more established company. In this case, the small startup might seek a buyer to provide them with the resources they need to actualize their promising idea and bring it to the market before any other competitors.

The market is always changing.

No company, even a very successful one, can rest on its laurels for long without competitors, regulators, or economic shifts overtaking it. History is littered with the corpses of companies that simply weren’t agile enough or innovative enough to stay ahead of the competition.

Once high-flying companies like Kodak, Blockbuster, and Tower Records, just to name a few, all eventually failed over time because they weren’t able to anticipate changes and innovate effectively. Innovation can be scary for companies that are used to doing business in a certain way.

Innovation is costly. It requires investments in research and development and making risky ventures into unknown territories. Furthermore, innovation takes time. For companies facing a very real competitive threat or potential business opportunity, there might not be the luxury of building an innovation pipeline from scratch.

Fortunately, M&A offers companies a way to acquire the innovation they need to reposition their core business to better meet the challenges of tomorrow. Take Altria, for example. Altria owns and manages a large portfolio of domestic tobacco brands. I’m sure you realize tobacco use in the United States has been in decline for many years and the forecast is a further decline for the foreseeable future. With no new ideas in the wings to address the structural threat, Altria had no choice but to explore M&A options including a failed attempt at a merger with Phillip Morris. Ultimately, Altria purchased a 35 percent stake in Juul, the market leader in e-cigarette “vaping” devices in order to reposition themselves in the market and hedge against declining conventional tobacco sales.  And, most recently, Juul has been one of the leading innovators in e-cigarettes.

M&A allows companies to rapidly change their business model and reposition themselves. Merging with or acquiring a company with experience in a certain market also gives the buyer the opportunity to avoid costly missteps and growing pains associated with a lack of expertise.

M&A can also help a company obtain the assets they need to be successful, whether it be talent, equipment, infrastructure, or market access.

Acquiring a company with a strong brand reputation or topflight talent will bring that brand recognition and talent into your company. M&A allows a business to add crucial capabilities or services and can help companies mitigate certain gaps in expertise and skillset or inherent competitive weaknesses.

M&A is particularly hot in the tech and pharmaceutical sectors currently. That’s because acquiring companies that have valuable intellectual property (IP) directly has become an important strategy for securing lucrative IP. In most cases, M&A activity is directly targeting the acquisition of intellectual property, which is often a company’s most valuable asset.

Sometimes two companies of roughly equal size and market share might decide it’s time to team up in the form of a merger. This can be a true merger of equals or a simple acquisition that is billed as a merger.

In both cases, the merger or acquisition can be driven by a desire from both parties to create a single stronger, more versatile, and more competitive new entity.

In theory, a good merger allows both merging companies to combine their own complementary strengths and mitigate their respective individual weaknesses. A small software company that is great at producing code, but bad at distributing their code might want to team up with another small software company that lacks coding talent but controls important distribution channels. The resulting third entity will be much better positioned to make an impact in the marketplace.

While M&A plays can often be risky, M&A can also be used defensively as a way to hedge against market uncertainties and threats.

Defensive M&A doesn’t always have to track with growth. While it is most common for M&A to be used as a way to increase market share, grow revenue, or acquire valuable assets such as intellectual property — defensive M&A can be pursued for a variety of other strategic reasons.

The defensive motivations for pursuing a merger or acquisition include avoiding a hostile takeover, denying rivals valuable assets, and hedging against market downturns.

A company that wishes to avoid a hostile takeover might purchase other smaller companies to make themselves, in turn, larger and more challenging to buy. They might even finance their acquisitions with debt to make themselves unattractive to potential buyers.

Businesses will also often defensively acquire other companies purely to deprive a market rival of any potential value. Occidental Petroleum’s acquisition of Anadarko, for example, could be read as a defensive acquisition to deny Chevron valuable assets in the Texas Permian Basin.

Defensive acquisitions can also be made as a way of hedging against an expected market downturn or forecasted challenges. Altria’s stake in Juul is an excellent example of a company hedging against the steady decline of its core market segment by investing in a sector with higher growth potential.

Finally, there is an excellent defensive reason a company might actively seek a buyer. Companies that have run out of capital or who are at risk of going bankrupt might find a buyer to bail them out and provide them with the funding they need to survive.

The need to acquire other companies, outside talent, and valuable assets are quite understandable. Sometimes, the best way to get what you need is to hit the open market rather than relying on organic growth.

But why would a company want to be acquired?

Why would a company seek a buyer for itself?

There are a variety of reasons a business may wish to list itself for sale. One of the primary reasons companies opt to sell is so that the owners or investors can cash out. Being acquired allows stakeholders to transform an ill-liquid asset, their business, into a liquid one, namely, cash. After all, the goal of starting a business or investing in a business is to realize a return. Investors and owners want to get their money back and then some. However, companies are notoriously ill-liquid. You can’t pay for food, housing, or other goods and services with a business. Sure, you can swap the goods and services your business offers in return for the products and services you want, but this is not a very efficient way to go about getting what you need and want.

M&A allows business owners and investors the opportunity to cash out and enjoy the fruits of their labor.

A merger with another company may allow leadership to acquire valuable new assets that give them the power, expertise, additional products, or infrastructure they need to increase market share or break into entirely new markets.

Equity that is sold isn’t always used by the selling company to expand operations. Sometimes it may be used to relieve debts or to allow the owner to start investing in other outside projects—even if they do not intend to leave the existing company.

When companies are owned by a single person, or when the leadership is provided by one figure, in particular, an acquisition may be sought so that the leader can leave the company for personal reasons. This is often the motivation when medical conditions or family matters advance too quickly for a new leader to be groomed.

Companies may be acquired so that their existing assets or specialties can be used to fill gaps in the larger company’s infrastructure. For example, if a large manufacturing company needs a significant amount of storage, it may be able to save money by acquiring a company that owns or manages storage along its supply chain.

This is just one example of “vertical integration.” Uniting the different stages of production doesn’t just save money. The combination of data that both companies possess allows for logistical insights that wouldn’t be possible if both companies were working together.

Sometimes, an acquisition is how a larger company acknowledges the tenacity of a smaller competitor. When outmaneuvering a newer, more agile company isn’t cost-effective, a more practical option is to engage them with an offer.

These acquisitions can be amazingly beneficial for both sides. The leadership of the smaller company can get a massive influx of new investment, and the ability to exercise their vision in a large arena. The larger, cash-rich company often gets to enjoy an infusion of youthful energy and ideas.

The partnership that is created is well-suited to take on greater challenges than ever before.

An acquisition can be a means of unlocking the true abilities of a company. Sometimes, a company is perfectly positioned, but still unable to achieve its potential for many reasons. It may be held back by dysfunctional leadership (such as feuding family members), limited information or a lack of will to take the next steps toward market control.

The resources provided by the acquiring company can provide all of that and more—new leadership, previously unavailable data, and a more ambitious outlook.