The Definitive Guide to Mergers and Acquisitions
It's rare these days to not hear about another business merger or acquisition. That is why we have compiled the most comprehensive guide on the Internet regarding mergers and acquisitions.
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The Basics of Mergers and Acquisitions (M&A)
Mergers & Acquisitions is an exciting and dynamic space in which to be. For many business owners, selling their company, merging with another company, or purchasing a business can be quite a thrilling (and hectic) process and one in which you want a good business attorney representing you.
While the goal of any mergers and acquisitions transaction is to generate value, it can also be fraught with pitfalls. The purpose of a good business attorney is to help the business owner navigate the merger and acquisition landscape to maximize value and outcomes at the same time reducing risks and obstacles.
6 Concepts You Should Know About 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.
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 business 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 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
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.
Pros and Cons of Mergers and Acquisitions
Mergers & Acquisitions is often referred to in business conversations as a single monolithic process or deal-making play. The two terms “mergers” and “acquisitions” have become increasingly blended together and are often used in conjunction as “M&A.” In reality, mergers and acquisitions are two very different deal structures, each with their advantages and disadvantages. Either two companies merge, or one company is bought or sold by another.
Under a merger structure, two companies of relatively equal standing engage in a deal. Typically, both entities are merged into a new entity and cease to exist and a new legal entity is created, keeping one of the entity's names or having a new name. This may be known as an actual “merger of equals.”
Under an acquisition structure, two companies are also involved. However, once the deal is done, only the acquiring company remains while the acquired company is absorbed by the purchasing entity. Acquisitions are by far the most common deal structure in the world of business today.
Both mergers and acquisitions have the same end goals: to leverage synergies, combine resources, or take advantage of specific market conditions to enhance growth. In this sense, both mergers and acquisitions share some significant similarities concerning advantages and disadvantages.
We will discuss the broad implications, including the general pros and cons associated with all M&A deals. This will include mergers and acquisitions under the broad umbrella of the term “M&A.” In this way, we hope to help executives and owners better understand the world of M&A including the key similarities and crucial differences between the merger and acquisition components of general M&A.
While the goal of any M&A transaction is to generate value, it can also be fraught with pitfalls
General Pros and Cons of Mergers and Acquisitions
Why merge or acquire?
The answer to this question is growth.
Growth can be achieved through mergers and acquisitions in many ways.
Following are the benefits, or pros, of a merger or acquisition.
However, in certain circumstances, a merger and acquisition can also hinder growth, so below are also the disadvantages, or cons, of a merger or acquisition.
General Pros of Mergers and Acquisitions
General Cons of Mergers and Acquisitions
Potential Regulatory Action
High Risk in Uncertain Markets
Diseconomies of Scale
When Do General Mergers & Acquisitions Make Sense?
As an executive or owner of a company, it is essential to know, when engaging in a general merger or acquisition, what makes sense or when it would be better to participate in a business alliance or another more limited form of partnership and collaboration.
Mergers and Acquisitions make sense when:
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.
When Do General Mergers & Acquisitions NOT Make Sense?
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.
Mergers vs. Acquisitions
The benefit to growth provided by both mergers and acquisitions stems from leveraging synergies, combining resources, or taking advantage of specific market conditions that warrant a merger or an acquisition. However, each general deal structure has its unique pros and cons to take into consideration when deciding between the two.
Furthermore, both mergers and acquisitions also include their unique variations and sub-typologies. There are horizontal mergers, vertical mergers, market-extension mergers, product-extension mergers, and conglomeration to name the most common types. Under the umbrella of acquisitions, there are direct acquisitions, equity acquisitions, and direct purchase of assets.
To fully understand which deal making structure and subsequent sub-type are the most useful for your needs, it is essential to have a full understanding of the pros and cons of each. We will begin to discuss common deal sub-typologies in more depth starting in Chapter 5: 5 Types of Company Mergers. In that chapter, we will discuss the general pros and cons of a typical merger deal structure and a typical acquisition deal structure.
Why Would A Company Sell 51% and Not 100%?
Business For Sale
There are many 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 stakeholders can transform an illiquid asset, their business, into a liquid one, namely, cash. After all, a business wants to realize a return. Investors and business owners want to get their money back and make a profit. However, businesses are notoriously illiquid. You can’t pay for food, housing, or other goods and services with a business. Sure, you can barter 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 want -- or may need.
When business owners and investors sell part of a business to outside investors such as private equity groups, this is referred to as recapitalization. Companies that choose to recapitalize never sell 100% of their shares to private equity. Instead, they will often sell a much smaller percentage of their company. Frequently, companies will sell 51% of their company.
Why Sell Only 51%
The reason is simple. Many business owners are looking for an opportunity to cash out of their businesses. However, they still want to maintain some equity to realize future upside. According to the quarterly Market Pulse Report published by the International Business Brokers Association (IBBA) in partnership with M&A Source and the Pepperdine Private Capital Markets Project, recapitalization has replaced burnout as one of the top reasons that businesses valued at $5-50MM go to market.
There are obvious potential benefits for savvy business owners of both small-cap and mid-cap companies in pursuing recapitalization strategies beyond cash infusion. For example, startups looking to grow may look for venture capital to help them achieve their goals. Others find that recapitalization helps them run their business better, more efficiently, and with more resources to call upon to reach their ultimate goals.
Strategic and financial support from private equity partners helps business owners minimize their own risks and reduces the stresses of operating a business on their own. Many private equity firms are exceptionally good at running companies efficiently for growth and for a profit. By partnering with outside investors, business owners can realize an immediate partial cash buyout when they sell, and then “double dip” or “take another bite out of the apple”, so to speak, when they jointly exit with their private equity partners in 3 to 5 years. Furthermore, the financial sophistication and managerial skills private equity brings to the table can make that final pullout much more profitable.
When "Double Dipping" is Good
By recapitalizing and retaining some equity in their company, owners who choose to sell can often times realize an immediate return when they close, then another cash infusion when they sell their remaining shares a few years later. By this time, their company may be worth double what it was prior to recapitalization.
9 Reasons for A Business to Recapitalize
Receive a cash payout
Realize future upside
Partially exit an investment
Minimize the risks of owning a business
Reduce the stress of daily operations
Share financial responsibilities with private equity investors
Obtain strategic support from private equity
Get more capital in the business
Opportunity to "double dip"
Why Sell 51%? Why Not 49%?
If a company were to sell 100% of its shares and forfeit all ownership stakes, the owners would not realize any future upsides. They would not get a second opportunity to realize gains. So why sell 51% when you can sell less to achieve a cash infusion while still maintaining majority control and maintaining exposure to any potential future upside?
The reality is, a 49% stake in a company is a difficult proposition to make to outside investors and private equity groups. Many outside investors will want to bring in their leadership team, a chain of command, as well as their business processes. This is particularly prevalent in the venture capital space where many venture capitalists will not give money to startup businesses unless they agree to sell them a 51% stake. That’s because the skills required to start a business or innovate an idea are entirely different from the skills necessary to grow a sustainable and profitable company. In Silicon Valley today, many startup founders end up getting in their own way once their companies get off the ground, to the detriment of shareholders and to their personal financial goals.
Selling a 51% stake in your company to outside investors gives those investors control over strategic direction, exit timelines, salaries, management, and the timing and amount of cash distributions. While that might seem like a lot to give away, it’s important to remember that a 49% stake in something profitable, well-run, and valuable, is infinitely preferable to a 51% majority stake in a company that is worthless.
In other words, don’t let the illusion of control, or the difference of a few percentage points, cause you the business owner, to miss an opportunity to scale your business up to its real potential (and make a lot of money in the process).
It's All In The Contract
It is entirely possible for a minority owner of a company that has recently undergone recapitalization to still retain complete or partial control over their company.
It all depends on the written agreement.
An owner can reduce his stake but write in their desired level of control into the purchase agreement. There are many ways to write a purchase agreement or contract to give each party precisely what they want.
For example, deals can be structured so that the private equity investor initially takes a 51% controlling interest in a company. However, once their initial principal investment is paid off, they become a minority shareholder with a predetermined stake that is negotiated upfront. This allows the founder or business owner to retain complete control upon payment of principle. Of course, this is just one way to do things. Agreements can also be written with an option to purchase further shares or for a complete and total buyout. The point is, there are a vast variety of strategic and intelligent ways to approach a private equity deal which, depending on the company and buyer in question, may work best.