Mergers and Acquisitions

INTRODUCTION: 

           Acquisitions, mergers and amalgamations have become strategic devices in the hands of more and more firms not only to stay in competition but also to extend their dominance. There are primarily two ways of achieving growth, organic and inorganic for a business organization. A firm focusing on organic growth essentially aims at achieving business growth through enhanced customer base as well as higher sales, both physical and financial, together with growth in revenue. Essentially, organic growth entails business growth aided and induced by a gradually and progressive increasing deployment of the four inputs viz., men, money, materials and machines. An inorganic growth opportunity provides the organization with an avenue for attaining accelerated – in a way instantaneous – growth enabling it to skip a few steps on the growth ladder. Mergers and Acquisitions (M&A) constitute one of the most important methods for securing inorganic growth.

 

MERGERS:

 

         A merger is a tool used by companies for the purpose of expanding their operations often aiming at an increase of their long term profitability. There are different types of actions that a company can take when deciding to move forward using M&A. Usually mergers occur in a consensual (occurring by mutual consent) setting where executives from the target company help those from the purchaser in a due diligence process to ensure that the deal is beneficial to both parties. Acquisitions can also happen through a hostile takeover by purchasing the majority of outstanding shares of a company in the open market against the wishes of the target’s board.

 

 The Main Idea:

 

         One plus one makes three: this equation is the special alchemy of a merger or an acquisition. The key principle behind buying a company is to create shareholder value over and above that of the sum of the two companies. Two companies together are more valuable than two separate companies - at least, that’s the reasoning behind M&A.

 

        This rationale is particularly alluring to companies when times are tough. Strong companies will act to buy other companies to create a more competitive, cost-efficient company. The companies will come together hoping to gain a greater market share or to achieve greater efficiency. Because of these potential benefits, target companies will often agree to be purchased when they know they cannot survive alone.

         

        In business or economics a merger is a combination of two companies into one larger company. Such actions are commonly voluntary and involve stock swap or cash payment to the target. Stock swap is often used as it allows the shareholders of the two companies to share the risk involved in the deal. A merger can resemble a takeover but result in a new company name (often combining the names of the original companies) and in new branding; in some cases, terming the combination a “merger” rather than an acquisition is done purely for political or marketing reasons.

 

Historically, mergers have often failed to add significantly to the value of the acquiring firm’s shares. Corporate mergers may be aimed at reducing market competition, cutting costs (for example, laying off employees, operating at a more technologically efficient scale, etc.), reducing taxes, removing management, “empire building” by the acquiring managers, or other purposes which may or may not be consistent with public policy or public welfare

 

Classifications of Mergers:

 

           From the perspective of business structures, there is a whole host of different mergers. Here are a few types, distinguished by the relationship between the two companies that are merging:

 

•           Horizontal mergers take place where the two merging companies produce similar product in the same industry. A typical example of this would be the merger of the German auto-manufacturer Daimler-Benz and American car-maker Chrysler Corporation. A more recent example would be the merger of Mittal Steel with the French firm Arcelor.

 

•           Vertical mergers occur when two firms, each working at different stages in the production of the same good, combine. It may be recalled that the UPA Governments taking over the reins at the centre took place against a backdrop of rather difficult conditions persisting in the international oil market which resulted in the crude-oil price crossing the threshold of $50 a barrel and then touching $74 per barrel sometime in April, 2006. The unprecedented rise in international fuel prices led the Ministry of Petroleum & Natural Gas to explore various alternatives including g rationalization of customs and excise duties to soften the impact of increasing global prices on the consumer. One of the alternatives which has been the subject of intensive national debate is the proposal to merge the existing Oil PSUs into two vertically integrated behemoths – one centering around ONGC, and the other around Indian Oil Corporation which, is yet to take off. 

 

•           Congeneric mergers occur where two merging firms are in the same general industry, but they have no mutual buyer/customer or supplier relationship, such as a merger between a bank and a leasing company. Example: Prudential’s acquisition of Bache & Company.

 

•           Conglomerate mergers occur when a merger of firms engaged in unrelated lines of activity tales place.

 

          There are two types of mergers that are distinguished by how the merger is financed. Each has certain implications for the companies involved and for investors:

 

o                Purchase Mergers - As the name suggests, this kind of merger occurs when one company purchases another. The purchase is made with cash or through the issue of some kind of debt instrument; the sale is taxable.

 

           Acquiring companies often prefer this type of merger because it can provide them with a tax benefit. Acquired assets can be written-up to the actual purchase price, and the difference between the book value and the purchase price of the assets can depreciate annually, reducing taxes payable by the acquiring company. We will discuss this further in part four of this tutorial.

 

o          Consolidation Mergers - With this merger, a brand new company is formed and both companies are bought and combined under the new entity. The tax terms are the same as those of a purchase merger.

 

         The completion of a merger does not ensure the success of the resulting organization; indeed, many mergers (in some industries, the majority) result in a net loss of value due to problems. Correcting problems caused by incompatibility—whether of technology, equipment, or corporate culture— diverts resources away from new investment, and these problems may be exacerbated by inadequate research or by concealment of losses or liabilities by one of the partners. Overlapping subsidiaries or redundant staff may be allowed to continue, creating inefficiency, and conversely the new management may cut too many operations or personnel, losing expertise and disrupting employee culture. These problems are similar to those encountered in takeovers. For the merger not to be considered a failure, it must increase shareholder value faster than if the companies were separate, or prevent the deterioration of shareholder value more than if the companies were separate.

 

 

ACQUISITIONS:

 

            An acquisition, also known as a takeover, is the buying of one company (the ‘target’) by another. An acquisition may be friendly or hostile. In the former case, the companies cooperate in negotiations; in the latter case, the takeover target is unwilling to be bought or the target’s board has no prior knowledge of the offer. Acquisition usually refers to a purchase of a smaller firm by a larger one. Sometimes, however, a smaller firm will acquire management control of a larger or longer established company and keep its name for the combined entity. This is known as a reverse takeover

 

Whether a purchase is considered a merger or an acquisition really depends on whether the purchase is friendly or hostile and how it is announced. In other words, the real difference lies in how the purchase is communicated to and received by the target company’s board of directors, employees and shareholders. It is quite normal though for M&A deal communications to take place in a so called ‘confidentiality bubble’ whereby information flows are restricted due to confidentiality agreements.

 

 

As you can see, an acquisition may be only slightly different from a merger. In fact, it may be different in name only. Like mergers, acquisitions are actions through which companies seek economies of scale, efficiencies and enhanced market visibility. Unlike all mergers, all acquisitions involve one firm purchasing another - there is no exchange of stock or consolidation as a new company. Acquisitions are often congenial, and all parties feel satisfied with the deal. Other times, acquisitions are more hostile.

 

In an acquisition, as in some of the merger deals we discuss above, a company can buy another company with cash, stock or a combination of the two. Another possibility, which is common in smaller deals, is for one company to acquire all the assets of another company. Company X buys all of Company Y’s assets for cash, which means that Company Y will have only cash (and debt, if they had debt before). Of course, Company Y becomes merely a shell and will eventually liquidate or enter another area of business.

 

Another type of acquisition is a reverse merger, a deal that enables a private company to get publicly-listed in a relatively short time period. A reverse merger occurs when a private company that has strong prospects and is eager to raise financing buys a publicly-listed shell company, usually one with no business and limited assets. The private company reverse merges into the public company, and together they become an entirely new public corporation with tradable shares.

 

Regardless of their category or structure, all mergers and acquisitions have one common goal: they are all meant to create synergy that makes the value of the combined companies greater than the sum of the two parts. The success of a merger or acquisition depends on whether this synergy is achieved.

 

Types of acquisition

• The buyer buys the shares, and therefore control, of the target company being purchased. Ownership control of the company in turn conveys effective control over the assets of the company, but since the company is acquired intact as a going business, this form of transaction carries with it all of the liabilities accrued by that business over its past and all of the risks that company faces in its commercial environment.
• The buyer buys the assets of the target company. The cash the target receives from the sell-off is paid back to its shareholders by dividend or through liquidation. This type of transaction leaves the target company as an empty shell, if the buyer buys out the entire assets. A buyer often structures the transaction as an asset purchase to “cherry-pick” the assets that it wants and leave out the assets and liabilities that it does not. This can be particularly important where foreseeable liabilities may include future, unquantified damage awards such as those that could arise from litigation over defective products, employee benefits or terminations, or environmental damage. A disadvantage of this structure is the tax that many jurisdictions, particularly outside the United States, impose on transfers of the individual assets, whereas stock transactions can frequently be structured as like-kind exchanges or other arrangements that are tax-free or tax-neutral, both to the buyer and to the seller’s shareholders.

Distinction between Mergers and Acquisitions:

 

Although they are often uttered in the same breath and used as though they were synonymous, the terms merger and acquisition mean slightly different things.

 

When one company takes over another and clearly established itself as the new owner, the purchase is called an acquisition. From a legal point of view, the target company ceases to exist, the buyer “swallows” the business and the buyer’s stock continues to be traded.

 

In the pure sense of the term, a merger happens when two firms, often of about the same size, agree to go forward as a single new company rather than remain separately owned and operated. This kind of action is more precisely referred to as a “merger of equals”. Both companies’ stocks are surrendered and new company stock is issued in its place. For example, both Daimler-Benz and Chrysler ceased to exist when the two firms merged, and a new company, DaimlerChrysler, was created.

 

In practice, however, actual mergers of equals don’t happen very often. Usually, one company will buy another and, as part of the deal’s terms, simply allow the acquired firm to proclaim that the action is a merger of equals, even if it is technically an acquisition. Being bought out often carries negative connotations, therefore, by describing the deal as a merger, deal makers and top managers try to make the takeover more palatable.

 

A purchase deal will also be called a merger when both CEOs agree that joining together is in the best interest of both of their companies. But when the deal is unfriendly - that is, when the target company does not want to be purchased - it is always regarded as an acquisition.

 

 

INDIAN SCENARIO:

 

Some of the highlights of Indian Mergers and Acquisitions scenario as it stands (Source: http://ibef.org)

Indian outbound deals, which were valued at US$ 0.7 billion in 2000-01, increased to US$ 4.3 billion in 2005, and further crossed US$ 15 billion-mark in 2006. In fact, 2006 will be remembered in India’s corporate history as a year when Indian companies covered a lot of new ground. They went shopping across the globe and acquired a number of strategically significant companies. This comprised 60 per cent of the total mergers and acquisitions (M&A) activity in India in 2006. And almost 99 per cent of acquisitions were made with cash payments.

Mergers and Acquisitions

The total M&A deals for the year during January-May 2007 have been 287 with a value of US$ 47.37 billion. Of these, the total outbound cross border deals have been 102 with a value of US$ 28.19 billion, representing 59.5 per cent of the total M&A activity in India.

The total M&A deals for the period January-February 2007 have been 102 with a value of US$ 36.8 billion. Of these, the total outbound cross border deals have been 40 with a value of US$ 21 billion.

There were 111 M&A deals with a total value of about US$ 6.12 billion in March and April 2007. Of these, the number of outbound cross border deals was 32 with a value of US$ 3.41 billion.

There were 74 M&A deals with a total value of about US$ 4.37 billion in May 2007. Of these, the number of outbound cross border deals was 30 with a value of US$ 3.79 billion.

The sectors attracting investments by Corporate India include metals, pharmaceuticals, industrial goods, automotive components, beverages, cosmetics and energy in manufacturing; and mobile communications, software and financial services in services, with pharmaceuticals, IT and energy being the prominent ones among these.

 

Graphical representation of Indian outbound deals since 2000.

 

 

 

Here are the top 10 acquisitions made by Indian companies worldwide:

Acquirer	Target Company	Country targeted	Deal value ($ ml)	Industry
Tata Steel	Corus Group plc	UK	12,000	Steel
Hindalco	Novelis	Canada	5,982	Steel
Videocon	Daewoo Electronics Corp.	Korea	729	Electronics
Dr. Reddy’s Labs	Betapharm	Germany	597	Pharmaceutical
Suzlon Energy	Hansen Group	Belgium	565	Energy
HPCL	Kenya Petroleum Refinery Ltd.	Kenya	500	Oil and Gas
Ranbaxy Labs	Terapia SA	Romania	324	Pharmaceutical
Tata Steel	Natsteel	Singapore	293	Steel
Videocon	Thomson SA	France	290	Electronics
VSNL	Teleglobe	Canada	239	Telecom

If you calculate top 10 deals itself account for nearly US $ 21,500 million. This is more than double the amount involved in US companies’ acquisition of Indian counterparts.

 

 

FACTORS PROPELING M&A ACTIVITY:

 

Some people say that mergers and acquisitions occur because the greedy corporations want to acquire everything. As far as economic theory is concerned, the primary objective of a firm is to maximize profits, and thereby maximize shareholder wealth.

 

When evaluating a new company, it becomes very important to identify the answers to various questions concerning motives for merger and whether it has been actualized. On the other hand, investors need to know if the new entity would take them to the heights of capital markets where their aspirations regarding returns would get the wings and fire.

 

 

 

 

Some of the motives for mergers are as below:

 

1. Synergy: Synergic effect occurs when two substances or factors combine to produce a greater effect together than the sum of those together operating independently. The principle of 2+2 =5, this theory expects that there is really “something out there which creates the merged entity to maximize the shareholders value”. To put in other words, synergy is the ability of a merged company to create more shareholders value than standalone entity.

 

Financial synergy

 

The resultant feature of corporate merger or acquisition on the cost of capital of the combined or acquiring firm is called as financial synergy. It occurs as a result of the lower cost of internal financing versus external. A combination of firms with different cash flow positions and investment scenario may produce the synergic effect and achieve lower cost of capital. It means when the rate of cash flow of the acquirer firm is greater than that of the acquired firm, there is tendency to relocate the capital to the acquired firm and the investment opportunity of the latter increases. If the cash flows of the two entities are not perfectly correlated, the financial synergy can be expected thus reducing risk. The perceived reduction of the instability of the cash flow, would lead the suppliers to trust the firm, the combined debt capacity of the combined firm may be greater than the individual firms.

 

Operating synergy

 

Economies of scale and economies of scope exist in the industry and before the merger, the activities of the individual firms are insufficient to exploit these.

 

Synergy takes the form of revenue enhancement and cost reduction. Speaking of cutting down costs, this goal is typically achieved through economies of scale, particularly when it comes to sales and marketing, administrative, operating, and/or research and development costs. As for revenue synergies, these are achieved through product cross-selling, higher prices due to less competition, or staking a larger market share.

 

The merger of ICICI with ICICI Bank and the reverse merger of IDBI Bank with IDBI served multiple objectives. First, the institutions were strengthened financially. Second, they helped to avoid the complex processes of restructuring the weaker of the units and to foster financial stability. Finally, they have opened the possibilities of actively promoting universal banking.

 

When two companies in the same industry merge, the combined revenue tends to decline to the extent, they overlap with one another and some of the customers may also become alienated. For the merger to benefit the shareholders, there must be ample opportunities for the cost reduction, so that the initial lost value is recovered in due course through synergy.

 

To calculate the minimum value of the synergy required, to compensate the acquiring firm’s shareholders, we equate the post-merger share price with that of the pre-merger share price using the following:

 

(Pre-merger value of both the firms + synergies) = Pre-merger stock price

Post merger number of shares

 

2. Growth: Increasing a company’s growth is the most common reason behind merger. Growth can be achieved through investing in capital projects internally or externally by buying out the assets of outside companies. Emperical studies show that the faster growth rates are achieved through external growth by means of mergers and acquisitions.

 

Merging internationally provides an immediate growth opportunity to a firm which was once operating within a single country. There are various factors which encourage a firm to merge internationally for growth are:

 

1. A firm with surplus cash flows operating in a slow-growing economy can invest its cash in fast-growing economy.

 

2. The domestic markets if are too small to accommodate the corporate or if the domestic markets have already reached saturation can go for international markets.

 

3. Overseas expansion may sometimes enable the medium size companies to improve their capacity and ability to compete.

 

4. Size enables the companies to achieve the economies of scale.

 

In September 2002, Asian Paints India Ltd, announced its decision to acquire 50. 1 % controlling stake in the Singapore-based Berger International Ltd for a consideration of Rs. 57. 6 crore. The primary reason for the merger was to enter into the South-East Asian market that BIL offered. With this acquisition, Asian paints would have a combined capacity of about 100,000 tones and will have 27 manufacturing facilities worldwide.

 

3. Market Power : One of the main motives of a merger is to increase the share of a firm in the market. It means to increase the size of the firm and also leading to the monopoly power, hence the firm gets an opportunity to set prices at levels that are not sustainable in a more competitive market. There are three sources by which market power can be achieved. They are product differentiation, overcoming entry barriers and improving market share.

 

One important reason that companies combine is to eliminate competition. Acquiring a competitor is an excellent way to improve a firm’s position in the marketplace. It reduces competition, and allows the acquiring firm to use the target’s resources and expertise. Unfortunately, combining for this purpose is per se illegal under the antitrust acts as a predatory practice in restraint of trade. Consequently, whenever a merger is proposed, a major part of the resulting press release often deals with how this combination of firms is not anti-competitive, and is done to better serve the consumer. Even if the merger is not for the stated purpose of eliminating competition, the regulatory agencies may conclude that a merger is likely to be anti-competitive. For example, Canadian National’s attempt to merge with Burlington Northern Santa Fe was blocked because of concerns that the combination would prompt a series of mergers and acquisitions whose net effect would be to leave the continent with only two transcontinental railroads. Although eliminating competition may result in merger and acquisition activity, it is generally not acceptable to state this as the purpose of such activity.

 

Horizontal mergers take place with a motive to attain market power. It is of great concern to the government, because, it might lead to concentration or monopoly. Hence comparison between their efficiencies versus their effects of increased concentration must be made. Note that horizontal mergers are not the only type of mergers that can yield more market power. Vertical mergers can enable a company to capture sources of supplies, for example, that are of paramount importance to its competitors. This is why industry regulators routinely limit and even disallow horizontal and vertical mergers if there is even a hint of too much market power concentrating in the hands of only a few companies.

 

4. Corporate Tax Savings

 

Although tax savings may not be a primary motivation for a combination, it can sweeten the deal. When a purchase of either the assets or common stock of a company takes place, the tender offer less the stock’s purchase price represents a gain to the target company’s shareholders. Consequently, the target firm’s shareholders will usually experience a taxable gain. However, the acquiring company may reap tax savings depending on the market value of the target company’s assets when compared to the purchase price. The acquiring company can write up the target company’s assets by the amount that the market value exceeds the net book value of the target company’s assets. This difference can then be charged off to depreciation with resultant tax savings. This differs from goodwill in that goodwill is never tax deductible. Depending on the method of corporate combination, further tax savings may accrue to the owners of the target company.

 

Retirement or Cashing Out

 

For a family-owned business, when the owners wish to retire, or otherwise leave the business, and the next generation is uninterested in the business, the owners may decide to sell to another firm. For purposes of retirement or cashing out, if the deal is structured correctly, there can be significant tax savings. By using the pooling method, the sellers may be able to account for their sale of their interest as a tax-free exchange. Provided the sellers receive common stock of the purchasing company in exchange for their interest, they can assign the book value of their former investment to the shares received. Therefore, no tax would be due until the shares received are sold.

 

 

 

Other tax incentives

 

If a firm having operating losses merges with another firm which has taxable profits, then there will be a net gain to the acquiring firm often at the expense of the government. The losses can be used to reduce the taxable income. Even if the two firms, which have merged have current profits, a merger can reduce future tax liability as the variability of cash flows is lowered after the merger. One firm’s profit can be off-set by other firm’s losses thus resulting in tax savings. Smaller the correlation between the firm’s cash flows, larger is this effect.

 

5. Market/Business/Product Line Issues

 

Often mergers occur simply because one firm is in a market that another wants to enter. All of the target firm’s experience and resources (the employees’ expertise, business relationships, etc. ) are available by buying the targeted firm. This is a very common reason for acquisitions. For example, Monsanto acquired G. D. Searle because Monsanto wanted to acquire the pharmaceuticals and consumer chemicals (Aspartame) businesses. Sentry Insurance acquired John Deere Insurance Group to enter the market for insuring implement dealers, and transportation. CSK Automotive purchased All-Car to have access to the Central Wisconsin automotive parts market. Similarly, Canadian National purchased Wisconsin Central to enter the U. S. rail market. Whether the market is a new product, a business line, or a geographical region, market entry or expansion is a powerful reason for a merger.

 

Closely related to these issues are product line issues. A firm may wish to expand, balance, fill out or diversify its product lines. For example, merger and acquisition activities of Nortek/Peachtree Companies are primarily product line related.

 

6. Acquire Needed Resources

 

One firm may simply wish to purchase the resources of another firm or to combine the resources of the two firms. These resources may be tangible resources such a plant and equipment, or they may be intangible resources such as trade secrets, patents, copyrights, leases, etc. , or they may be talents of the target company’s employees. One reason given for the mergers in the petroleum industry is that companies wish to acquire the leases of their competitors. If acquiring a company for its talent seems strange, consider that Cisco Systems CEO John T. Chambers said, “Most people forget that in a high-tech acquisition, you are really only acquiring people . We are not acquiring current market share. We are acquiring futures”. It emphasize that often the reasons for mergers and acquisitions are quite similar to the reasons for buying any asset. Both firms and individuals purchase an asset for its utility.

 

7. Diversification: Diversification is another frequently cited reason for mergers. Actually, it was THE reason during the conglomerate merger wave. The idea was to circumvent regulatory restrictions on horizontal and vertical mergers by going outside a company’s industry into new markets and to achieve growth there.

 

International mergers provide diversification both geographically and also by product line. When various economies are not correlated, then the international mergers reduce the earning risk, inherent in being dependent on a single economy. Thus international mergers reduce systematic and unsystematic risk.

 

 

BASIC DOCUMENTATION:

 

         Documentation required for an M&A programme varies widely depending on the deal to be struck. However, the starting point frequently is the confidentiality agreement to be executed by the parties to safe guard the dissemination of their confidential non-public business information. Signing of the confidentiality agreement is often followed by a letter of intent or a Memorandum of Understanding which may be signed after the parties have agreed on certain preliminary terms and conditions. The essential terms of the deal, however, get captured in the definitive agreement once the parties agree that their legal rights and obligations pertaining to the proposed M&A activity or plan be placed in black and white. In addition to these, there is a specific company law requirement that there shall be a scheme of amalgamation or merger which has to be approved by the Members of the merging companies.

 

         The acquisition document usually sets out the merger consideration by ay of share swap and/ or cash payment,, the representations and warranties of the merging companies/ acquiring or to be acquired companies, pre-conditions to the M&A, if any, such as continuance of existing man power, circumstances under which the merger may be called off which must, of course, be before approval by the shareholders and other miscellaneous provisions.

 

        Where, however, the companies under merger are actually holding and subsidiary companies, separate agreements as above, may not be entered into between the two companies. Instead, it may be quite in order for the two companies to draw up more or less identical draft Scheme of Amalgamation which, on clearance by their respective Board of Directors, becomes the governing document which their members are to approve.

         

DOING THE DEAL:

 

Start with an Offer

 

When the CEO and top managers of a company decide that they want to do a merger or acquisition, they start with a tender offer. The process typically begins with the acquiring company carefully and discreetly buying up shares in the target company, or building a position. Once the acquiring company starts to purchase shares in the open market, it is restricted to buying 5% of the total outstanding shares before it must file with the SEC. In the filing, the company must formally declare how many shares it owns and whether it intends to buy the company or keep the shares purely as an investment.

 

 

 

Working with financial advisors and investment bankers, the acquiring company will arrive at an overall price that it’s willing to pay for its target in cash, shares or both. The tender offer is then frequently advertised in the business press, stating the offer price and the deadline by which the shareholders in the target company must accept (or reject) it.

 

The Target’s Response

 

Once the tender offer has been made, the target company can do one of several things:

 

•           Accept the Terms of the Offer - If the target firm’s top managers and shareholders are happy with the terms of the transaction, they will go ahead with the deal.

 

•           Attempt to Negotiate - The tender offer price may not be high enough for the target company’s shareholders to accept, or the specific terms of the deal may not be attractive. In a merger, there may be much at stake for the management of the target - their jobs, in particular. If they’re not satisfied with the terms laid out in the tender offer, the target’s management may try to work out more agreeable terms that let them keep their jobs or, even better, send them off with a nice, big compensation package.

 

Not surprisingly, highly sought-after target companies that are the object of several bidders will have greater latitude for negotiation. Furthermore, managers have more negotiating power if they can show that they are crucial to the merger’s future success.

 

•           Execute a Poison Pill or Some Other Hostile Takeover Defense – A poison pill scheme can be triggered by a target company when a hostile suitor acquires a predetermined percentage of company stock. To execute its defense, the target company grants all shareholders - except the acquiring company - options to buy additional stock at a dramatic discount. This dilutes the acquiring company’s share and intercepts its control of the company.

 

•           Find a White Knight - As an alternative, the target company’s management may seek out a friendlier potential acquiring company, or white knight. If a white knight is found, it will offer an equal or higher price for the shares than the hostile bidder.

 

Mergers and acquisitions can face scrutiny from regulatory bodies. For example, if the two biggest long-distance companies in the U.S., AT&T and Sprint, wanted to merge, the deal would require approval from the Federal Communications Commission (FCC). The FCC would probably regard a merger of the two giants as the creation of a monopoly or, at the very least, a threat to competition in the industry.

 

 

 

 

Closing the Deal

 

Finally, once the target company agrees to the tender offer and regulatory requirements are met, the merger deal will be executed by means of some transaction. In a merger in which one company buys another, the acquiring company will pay for the target company’s shares with cash, stock or both.

 

A cash-for-stock transaction is fairly straightforward: target company shareholders receive a cash payment for each share purchased. This transaction is treated as a taxable sale of the shares of the target company.

 

If the transaction is made with stock instead of cash, then it’s not taxable. There is simply an exchange of share certificates. The desire to steer clear of the tax man explains why so many M&A deals are carried out as stock-for-stock transactions.

 

When a company is purchased with stock, new shares from the acquiring company’s stock are issued directly to the target company’s shareholders, or the new shares are sent to a broker who manages them for target company shareholders. The shareholders of the target company are only taxed when they sell their new shares.

 

When the deal is closed, investors usually receive a new stock in their portfolios - the acquiring company’s expanded stock. Sometimes investors will get new stock identifying a new corporate entity that is created by the M&A deal.

 

STEPS INVOLVED IN M&A:

 

Section 391 to 394 of the Companies Act, 1956 contain the major provisions for amalgamations and acquisitions these sections would have to be read with the Companies (Court) Rules, 1959 which forms a complete procedural code for implementing mergers. The normal steps involved are:

 

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  1. Examination of Objects clause – The Memorandum of Association of both companies – the transferor company and the transferee company – should contain enabling for the amalgamation to take place. If such clause do not exist necessary alteration of the Memorandum of Association would have to put through at the outset.

 

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  1. Approval of the scheme by the Board of Directors – Respective Board of Directors of the transferor and the transferee companies is to approve the Scheme of Amalgamation including the exchange ratio. To enable the Board to take a decision, the draft Scheme of Amalgamation is prepared by the Legal Advisors, the Valuation Report is prepared by the Financial Advisors and a Merchant Banker would also give a Fairness Opinion Certificate on the Valuation Report.

 

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  1. Intimation to Stock Exchange – Since the decision of the Board on a proposed merger of the company is a price-sensitive information, both  the companies are inter-alia  required under clause 36 of the Listing Agreements with the Stock Exchange, to communicate the said price-sensitive information to the Stock Exchanges immediately after the Board Meeting deciding on the merger and/or according approval to the merger scheme.

 

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  1. Application to the Court for directions – The next step is to make an application under Section 391(1) to the High Court having jurisdiction over the company. The transferor company and the transferee company should make separate applications to the respective High Court. The application under Section 391(1) of the Act for an order convening a meeting of creditors and/or members is to be made by a Judge’s summons in Form 33 supported by an Affidavit in Form 34in terms of Rule 67 of the Companies (Court) Rules, 1959, A copy of the proposed Scheme of Amalgamation needs to be annexed to the Affidavit. Documents accompanying the summons would be a true copy of the Company’s updated Memorandum and Articles of Association and certified copy of the Board Resolution which authorizes making of the application to the Court.

 

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  1. High Court directions for convening shareholder’s Meeting – During the hearing of the summons, which is usually attended by the representatives of the merging companies as well as the Legal Consultants, the High Court gives directions under Rule 69 of the Court Rules in form 35 determining the class or classes of creditors and/or of members whose meeting or meetings are to be held for considering the proposed merger, fixing the date, time and place of the meeting, appointed by the Chairman who would preside over the meeting, fixing the quorum and the procedure to be followed at the meeting(s) including voting by proxy, the notice of the meeting and the advertisement thereof and the time within which the chairman of the meeting is to report to the Court the result of the meeting. In case a request has been made in the application for dispensing with holding of the creditors’ meeting, the Court may after considering the grounds for dispensation, direct the separate requirements of the Creditors’ Meeting be dispensed with.

 

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  1. Dispatch of Notice to Shareholders and Creditors – In order to convene the meeting of the Shareholders and Creditors, a Notice and an Explanatory Statement of the Meeting, as approved by the Court, should be dispatched by the transferor and the transferee companies under section 393 of the Act read with Rule 73 of the Court Rules to their respective shareholders and creditors together with the Scheme of Amalgamation at least 21 clear days prior to the date of the meeting. The Notice is to be drawn up in Form 36 of the Court Rules and a proxy form in Form 37 of the Court Rules is to be sent. The documents have to be mailed under certificate of posting.

 

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  1. Advertisement of the notice of the Meeting – Rule 74 of the Court Rules stipulates that the Notice of the Meeting should be advertised adopting the format specified in Form 38. The advertisement is to be issued by both the companies in English daily together with a translation thereof published in the regional language of the place where the registered office of the company is situated. Under Rule 76 of the Court Rules, the Chairman appointed for the meeting shall file with the Court-not less than 7 days prior to the date of the meeting – an affidavit confirming that the Notice has been dispatched to the Shareholders/ Creditors and that the same has been published in the newspapers as directed.

 

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  1. Holding of the Shareholders’ and Creditors’ Meeting – The Shareholders’/ Creditors’ Meeting would need to be held on the appointed date. Rule 77 of the Court Rules prescribes that the decision(s) of the meeting(s) held pursuant to Court Order on all resolution shall be ascertained only by taking a poll. The Amalgamation Scheme should be approver by the members/ creditors by a majority in number present in person or by proxy and this majority must represent at least 75% in value of the Shareholders/ Creditors present and voting on the poll.

 

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  1. Submission of the Chairman’s Report on the conduct of the Meeting to the Court - Pursuant to the Rule 78 of the Court Rules, the Chairman of the  Shareholders’/ Creditors’ meeting is required to submit to the Court within the time fixed by the judge or where no time has been fixed, within 7 days after the date of conclusion of the meeting, a Report in Form 39 of the Court Rules inter alia setting out therein the number of persons who attended & voted at their meeting personally or by proxy, their individual values and the percentage of members who voted in favour of or against the Scheme.

 

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  1. Filing of Resolution with the Registrar of Companies -  Within 30 days from the date of passing the resolution, a copy of the resolution passed by the Shareholders/ Creditors approving the Scheme of Amalgamation is required to be filed with the Registrar of Companies in Form 23 appended to the Companies (Central Government’s) General Rules and Forms, 1956.

 

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  1. Submission of Petition to the Court for sanction of the scheme – In terms of Rule 79 of the Court Rules, within 7 days from the date on which the Chairman submitted his report on the result of the meeting to the Court, the transferor and the transferee companies would be required to make a petition to the High Court for confirmation of the Scheme of Amalgamation. The petition has to be drawn up in Form 40 of the Court Rules. Rule 80 of the Court Rules enjoins that based on the petition the court will fix the date of hearing of the petition and direct that the notice of the hearing shall be advertised in the same newspapers in which the Notice of meeting had been announced or in such other newspaper as the court may direct. Such advertisement has to be issued not less than 10 days before the date fixed for the hearing. The said notice inter alia affirms that should any member or creditor of the transferor company raises written objections to the proposed amalgamation, no objection shall be raised to the said member or creditor being heard on its objection by the court.

 

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  1. Issue of Notice to Regional Director, Company Law Board, Registrar of Companies and to the Official Liquidator – On receipt of the petition, the Court issues Notice of the petition to the concerned Regional Director - Company Law Board – having jurisdiction over the transferor and the transferee companies, the respective Registrar of Companies as also to the Official Liquidator of the company which is to be dissolved upon the merger.

 

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  1. Conduct of Hearings and Issue of Order confirming the Scheme – Proceedings would begin with the Court hearing the objections, if any, ion the Amalgamation Scheme filed – in response to the advertisement vide Sl. 11 above – with the concerned Regional Director Company Law Board, the concerned Registrar of Companies and/or the Court by any member, creditor or any other person desirous of opposing the petition. Thereafter the Court may pass an order sanctioning the Amalgamation Scheme in Form 41 of the Companies (Court) Rules. The Court may also pass order in Form 42 directing that all properties, rights and powers of the transferor company to be specified in the schedule attached to the Order, be transferred without any further act or deed to the transferee company and all liabilities and duties of the transferor company be similarly transferred to the transferee without any further act or deed.

 

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  1. Transfer of Assets and Liabilities to the Transferee Company – Passing of the Order is pursuant to the Scheme of Amalgamation which provides that with effect from the Appointed Date and upon Scheme becoming effective, all assets including rights, licenses, know-how, trademark, patent etc. in relation to the transferor company or to which the transferor company is a party shall be in full force and effect on, against or in favour of the transferee company and may be enforced as fully and effectually as if, instead of the transferor company, the transferee company has been a party or beneficiary thereto without any further act or deed by the transferee company. This provision springs from Section 394(2) of the Companies Act, 1956 which empowers the Court to order for the transfer of any property or liability from the transferor to the transferee company.

 

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  1. Filing of Court Order with the Registrar of Companies by both the companies – Under Section 394 (3) of the Act read with Rule 81 of the Court Rules, the transferor and the transferee companies are required to file the Court’s Order sanctioning the Scheme of Amalgamation with the Registrar of Companies under their respective jurisdiction. The filing is to be made in Form 21 appended to the Companies (Central Government’s) General Rules and Forms, 1956. Under section 394(3) the time limit given for the filing is 30 days (substituted for 14 days with effect from 15.10.1965) from the date of issue of the Order. However, since the time- frame under Rule 81 still shows 14 days, it would be advisable to complete the filing within 14 days. The amalgamation takes effect from the date on which the Court’s Order is filed with the Registrar of Companies. Therefore, in the interest of synchronization of the Effective date of Merger, it would be advisable for both the transferor and the transferee companies to file the Order with their concerned Registrar of Companies on the same date.

 

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  1. Issue of Shares to the shareholders of the transferor Company – Pursuant to the sanctioned Scheme of amalgamation, the Shareholders of the transferor company would be issued shares in the transferee company as per the exchange ratio or the swap ratio approved under the scheme. This is made by way of an allotment following which the return of allotment in Form 2 would have to be submitted to the Registrar of Companies by the transferee company within 30 days from the allotment date in accordance with Section 75 of the Companies Act, 1956. Necessary entries in the Register/ Index of Members would also be made in compliance with Sections 150& 151 of the Act.    

 

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  1. Listing the new Shares – After making the allotment the transferee company will apply to the stock exchange where its securities are listed, for listing the new shares allotted to the shareholders of the transferor company.

 

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  1. Annexation of Court Order to the Memorandum of Association – Section 391(4) of the Act stipulates that a certified copy of the Court’s Order sanctioning the Scheme of Amalgamation is to be annexed to every copy of the Memorandum of Association issued by the transferee company failing which penal clauses would become applicable.

 

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  1.  Preservation of Books and Papers of the Transferee Company – In terms of Section 396A of the Companies Act, 1956 the books and papers of the amalgamated company are to be preserved and not to be disposed of without prior permission of the Central Government.

 

Although in a number of countries an additional approval under applicable Anti-Trust Laws is required, this is still not necessary under the Indian Law. Nevertheless, the stage has been set for a change with the introduction of the Competition Act, 2002. Once this Act becomes fully operational, acquisition and mergers would require the approval of the Competition Commission of India where the combined assets of the acquirer and the acquired enterprise in India crosses the various threshold sizes envisioned under the said law.

 

 

VALUATION OF SHARES:

 

The most commonly used methods of determining the exchange ratio or the swap ratio are as under:-

 

(1)   Net Asset Value per share – The relative Book Value or Net Realizable Value or Replacement Cost per share of the two firms are commonly used to determine the Exchange or the Swap Ratio. Under the Book Value approach, the Book Value of the firm is ascertained by initially considering the audited written-down value of the assets – i.e. historical cost of the assets less accumulated depreciation – deducting there from the external liabilities. The net worth so arrived at is to be adjusted for net appreciation/diminution in the value of investments and is reduced by the quantum of perceived contingent liabilities. The results adjusted net worth is then divided by the number of shares in the paid-up capital to give the Net Asset Value per share.

 

If the Book Value per share of the acquiring company so arrived at is say Rs. 20/- and the Book Value per share of the transferor company is say Rs.15/-, the swap ratio based on Book Value would be 15/20 i.e. 3:4. This means for every 4 shares in the transferor company, 3 new shares in the acquiring company would be issued to the shareholders of the transferor company.

 

While the Book Value methods affords a simply yet objective basis for computing the exchange ratio, a major shortcoming is that different companies follow different methods for accounting of depreciation reflecting subjective judgments which dilute objectivity. Again, since Book Value does not reflect the purchasing power of money,, the company – whether the transferor or the transferee with significantly older assets is some what unfairly prejudiced. The shortcomings are, however, mitigated by applying the methods after necessary re-valuation of assets based on either Net Realizable Value or Replacement Cost.

 

(2)   Capitalized Earnings Per Share – Under this method the average net maintainable profit of the Company (EBIDTA) is projected – based on the trend of past earnings – for a future term of say 3 to 5 years after adjusting for non-recurring, non-operating or abnormal items of income and expenditure to arrive at the Adjusted Operating Profit. The Adjusted Operating Profit is then capitalized on an expected rate of return (commonly the Price/Earnings multiple) to arrive at the capital employed in earning the said Adjusted Operating Profit.

 

To the said capital employed is added the value of surplus/non-operating assets such as investments and from the aggregate sum is deducted the contingent liabilities to give the total value of business for Equity Shareholders. This when divided by the number of shares in the paid-up capital gives the capitalized earnings value of the shares.

 

(3)   Market Value Per Share – The Swap Ratio may be based on the relative market price of the shares of the acquiring company and the target company. Assume that the shares of the acquiring company are quoted at an average market value of Rs.500 on the Stock Exchange whereas the shares of the target company are quoted at Rs.200. The exchange ratio based on the market price would then be 200:500 or 2:5. This signifies that for every 5 shares in the transferor company, 2 new shares in the acquiring company would be issued to the shareholders of the transferor company.

It is customary to work out the average Market Value of the shares taking into account the stock market quotations during the preceding 3 years i.e. considering the high and low of each month in the preceding 12 months and the high and low of 2 years preceding the last 12 months. Some Financial Advisors prefer to work out the weighted average market price by multiplying volume of shares dealt with during the year by price prevailing (average or closing) and then dividing the summation by total volume of shares traded during the period under computation.

 

(4)   Discounted Cash Flow – Under this method the projected free cash flows from business operations are discounted at the weighted average cost of capital to the providers of capital to the business and the sum total of such free cash flows is the value of the business.

 

It is, however, noteworthy that the process of valuation can hardly be reduced to a uniform and rigid mathematical exercise to cover all situations. In fact, experts in valuation recognize that valuation ultimately would need to be tempered by application of logical discretion, prudence and judgment taking into consideration all factors that affect the valuation matrix. The valuation matrix would include several subjective factors such as integrity, transparency and quality of the management, potential competition, prevailing sentiment which though not reflected in the balance sheet, greatly impact the valuation process. Similarly, the accounts of either company might have elements entailing window dressing or creation of secret reserves which needs to be addressed during the course of valuation. The role of Financial Advisors in this area is very crucial.

 

Although different values may be arriver at under each of the above methods, it is common for the Financial Advisors working out the merger consideration to determine the fair basis or fair value of amalgamation. Thus for the purpose of recommending a fair ratio of exchange it is necessary to arrive at a single value for the shares of the transferor and the transferee company. This is readily done by taking an average of the values obtained as above, either simple average or better still weighted average by allotment of weights to each of the above value per share to facilitate computation of a weighted fair value.

 

For instance, in a given amalgamation scenario the Financial Advisors may, after considering background factors, decide to allot a weight of 20% to the net asset value, 40% to the capitalized earnings value and 40% to the market value of both the companies. Although the methods of valuation are best left to the wisdom of Financial Advisors especially appointed to make the valuation and not laid down by the law, judicial precedents do recognize that the process involves multifarious qualitative factors and key underlying assumptions relevant to the acquiring and the target company tempered by their business dynamics and growth potentialities.

 

As can be expected, intangible assets valuation is more challenging because standard financial modeling/valuation techniques may not be readily applicable.  

   

 

MERGER FINANCING:

 

Merges and acquisitions may be financed in several ways. Merger financing can take place totally on the basis of securities or wholly in cash or partly by way of securities and partly in cash. In deciding on which option to use and in considering the relative merits the management team entrusted with the merger negotiations may consider the following aspects :-

(a)    Empirical evidence seems to indicate that acquisitions/ mergers financed by cash tends to be relatively more successful presumably because the transferee company acquiring in cash tends to be more circumspect and rigorous in evaluating the pros and cons of the merger especially during the process of financial & legal due diligence before parting with cash consideration.. Having said that, it may be relevant to state that exponents of M&A are yet to categorically lay down generally accepted criteria for a successful merger.

 

(b)    If exclusively cash compensation is paid, the shareholders of the transferor company neither bear the risk nor do they partake in the rewards of the merger. Consequently, from the acquirer’s perspective, there is no dilution in the shareholding interest of the existing members.

 

(c)    Cash compensation could be a taxable income in the hands of the shareholders of the transferor company, whereas issue of stock is not.

 

(d)    If the transferor company’s share price is quoting at a considerably higher value that that of the transferee company, the preference could be for meeting the merger consideration in shares since this tends to be relatively more cost-effective than payment in cash. Even otherwise, share swap is the most commonly accepted/ agreed merger consideration.

 

 

 

 

MERGER AND TAXATION LAW:

 

Under the Income-Tax Act, 1961, the transferor company is described as the amalgamating company while the transferee company is called the amalgamated company. Section 72A of the Income-Tax Act, 1961 stipulates that the accumulated loss and unabsorbed depreciation of the amalgamating company shall be deemed to be the loss or depreciation allowance of the amalgamated company for the previous year in which the amalgamation is effected and can be set-off or carried forward as per other provisions of the said act. However, the right of setoff is subject to the following conditions:

 

(a)    There has been an amalgamation of a company owning an individual undertaking

a ship or hotel with another company within the meaning of section 5 of the banking regulation act, 1949 with a specified bank as defined.

 

(b)   The amalgamating company has been in business from which loss has occurred or

depreciation has remained unabsorbed for a minimum period of 3 years.

 

(c)    The amalgamating company has held, continuously for a period of 2 years

preceding the date of amalgamation, at least 3/4^th of the book value of its fixed

assets.

 

(d)   The amalgamated company holds, continuously for a minimum period of 5 years

from the date of amalgamation, at least 3/4th the book value of the fixed assets

acquired under the amalgamation scheme.

 

(e)    The amalgamated company continues the business of the amalgamating company

for a minimum period of 5 years from the date of amalgamation and fulfils such

other conditions as may be prescribed to ensure that the amalgamation is for a

genuine business purpose.

 

On fulfillment of the above conditions, the unabsorbed business losses and the unabsorbed depreciation of the amalgamating company would be deemed to be the loss or depreciation as the case, of the amalgamated company for the year of amalgamation. This would give scope for a fresh term of 8 years for set off or carry forward.

 

 

Upon the amalgamation taking effect, a few other deductions such as the following are available to the amalgamated company under the income tax 1961 to the extent the same are available to and remains unabsorbed in the hands of the amalgamated company :-

 

1. Capital/revenue expenditure on in-house scientific research and contributions to approved scientific research associations/ approved national laboratory[section35]

 

1. Amortization of preliminary expenses [Section 35D]

 

1. Expenditure on in-house research & development facility [Section 35(2AB)]

 

1. Amortization of expenses incurred exclusively for the amalgamation [Section 35DD]

 

1. Amortization of expenses on prospecting etc. for development of certain minerals [Section 35E]

 

1. Amortization of telecom license fees incurred for acquiring right to operate telecom services [Section 35ABB]

 

1. Expenditure on acquisition of patent right, copy right, know-how. [Section 35AB]

 

 

CONCLUSION:

 

One size doesn’t fit all. Many companies find that the best way to get ahead is to expand ownership boundaries through mergers and acquisitions. For others, separating the public ownership of a subsidiary or business segment offers more advantages. At least in theory, mergers create synergies and economies of scale, expanding operations and cutting costs. Investors can take comfort in the idea that a merger will deliver enhanced market power.

 

By contrast, de-merged companies often enjoy improved operating performance thanks to redesigned management incentives. Additional capital can fund growth organically or through acquisition. Meanwhile, investors benefit from the improved information flow from de-merged companies.

 

M&A comes in all shapes and sizes, and investors need to consider the complex issues involved in M&A. The most beneficial form of equity structure involves a complete analysis of the costs and benefits associated with the deals.