The article titled “What is Mergers and Acquisitions (M&A)?” was published by MGC Legal.
What is M&A?
A merger occurs when two or more firms combine to form one new company. A merger requires two companies to consolidate into a new entity with a new ownership and management structure (ostensibly with members of each firm). Mergers require no cash to complete but dilute each company’s individual power. In an acquisition, a corporation or investor group finds a target company and negotiates with its Board of Directors (BoD) to purchase it.
When one company takes over another and establishes itself as the new owner, the purchase is called an acquisition. In an acquisition, a new company does not emerge. Instead, the smaller company is often consumed and ceases to exist, with its assets becoming part of the larger company.
Why Do Companies Do M&A?
Mergers and acquisitions
(M&As) are the acts of consolidating companies or assets to stimulate growth, gaining competitive advantages, increasing market share or influencing supply chains.
What are the types of mergers?
The three main types of mergers are horizontal, vertical, and conglomerate.
- in a horizontal merger, companies at the same stage in the same industry merge to reduce costs, expand product offerings, or reduce competition. Many of the largest mergers are horizontal mergers to achieve economies of scale.
- in a vertical merger, a company buys a firm in the same industry, often involved in an earlier or later stage of the production or sales process. Buying a supplier of raw materials, a distribution company, or a customer gives the acquiring firm more control.
- A conglomerate merger brings together companies in unrelated businesses to reduce risk. Combining companies whose products have different seasonal patterns or respond differently to business cycles can result in more stable sales.
What are the forms of acquisitions?
There are two basic forms of mergers and acquisitions (M&A):
In a stock purchase, the acquirer pays the target firm’s shareholders cash and/or shares in exchange for shares of the target company. Here, the target’s shareholders receive compensation and not the target. There are certain aspects to be considered in a stock purchase:
- The acquirer absorbs all the target assets and liabilities – even those not on the balance sheet.
- To receive the compensation from the acquirer, the target’s shareholders must approve the transaction through a majority vote, which can be a long process.
- Shareholders bear the tax liability as they receive the compensation directly.
In an asset purchase, the acquirer purchases the target’s assets and pays the target directly. There are certain aspects to be considered in an asset purchase, such as:
- Since the acquirer purchases only the assets, it will avoid assuming any of the target’s liabilities.
- As the payment is made directly to the target, no shareholder approval is generally required unless the assets are significant (eg, greater than 50% of the company).
- The compensation received is taxed at the corporate level as capital gains by the target.
What Are Differences Between Mergers and Acquisitions?
The company acquiring the other company typically maintains its business name, legal structure and operations in an acquisition. In a merger situation, the companies involved may choose a new name that better reflects the vision of the new, joined company, or they may choose to use one of the existing company names to maintain brand awareness and loyalty.
From a legal standpoint, the company acquired by another company essentially ceases to exist under its previous name and as its legal entity. The acquiring company absorbs it, and if it sells or trades stock, it would be owned and managed by the acquiring company.
Although the two terms are often used interchangeably, certain situations are mergers, and others are acquisitions, depending on the terms of the business deal. If a company does not wish to be taken over by another, this situation is regarded as acquisition and may be referred to as a hostile takeover. The difference is often in how the merger or acquisition is presented to the employees, Board of Directors (BoD) and shareholders. However, many merger and acquisition situations are mutually beneficial and allow companies to grow their presence and expand their reach.
What are the advantages of mergers and acquisitions?
Improved Economic Scale
A larger business, or one that has joined forces with another, will typically have higher needs regarding materials and supplies. By purchasing the necessary raw materials and/or supplies at higher volumes, the business can improve its scale through lower costs and potentially pass those lower costs onto the end consumers.
Lower label costs
A merger or acquisition may result in multiple staff members doing the same job at each individual company. By coming together and eliminating extraneous staff, a business can reduce its overall labor costs while maintaining a stronger, more effective labor force. Those involved in the M&A may review the performance of individuals in similar roles and choose the best talent for each position in the new company.
Increased Market Share
When two companies operate in the same industry or provide similar goods or services, the newly formed company can enjoy a greater market share, tapping into the resources that both bring to the business deal.
More Financial Resources
All companies involved in a merger or acquisition pool their financial resources, increasing the overall financial capacity of the new company. New investment opportunities may present, or the company may be able to reach a wider audience with a larger marketing budget or more significant inventory capabilities.
Enhanced Distribution Capacities
A merger or acquisition may expand a company geographically, increasing its ability to distribute goods or services on a wider scale.
economies of scope
Mergers and acquisitions benefits include economy of scope, which refers to the reduction in production cost of one product due to the production of another related product. In other words, one product supports another to reduce the overall costs. Economies of scope typically occur when producing more products is more feasible and economical than making a single or fewer product. Mergers and acquisitions can sometimes lead to economies of scope that may be impossible to achieve through organic growth.
Competitive Edge in the Market
Mergers and acquisitions mean greater financial strength for both companies involved in the transaction. Greater economic power can lead to higher market share, more customer influence, and reduced competitive threat. In most cases, bigger companies are harder to compete against.
Access to New Markets
Breaking into a new market can be challenging, even for established businesses. While setting up a subsidiary or branch is always an option, a merger or acquisition can save companies time, effort, and money compared to starting from scratch.
Tax benefits are considered when one company realizes significant taxable income while another incurs tax loss carry forwards. Acquiring the company with the tax losses enables the acquirer to use the tax losses to lower its tax liability. However, mergers are not usually done to avoid taxes.
Companies that operate in cyclical industries feel the need to diversify their cash flows to avoid significant losses during a slowdown in their industry. Acquiring a target in a non-cyclical industry enables a company to diversify and reduce its market risk.
Stronger Market Power
In a horizontal merger, the resulting entity will attain a higher market share and gain the power to influence prices. Vertical mergers also lead to higher market power, as the company will control its supply chain more, thus avoiding external shocks in supply.
Inorganic growth through mergers and acquisitions (M&A) is usually faster for a company to achieve higher revenues than growing organically. A company can gain by acquiring or merging with a company with the latest capabilities without having to take the risk of developing the same internally.
The common rationale for mergers and acquisitions (M&A) is to create synergies in which the combined company is worth more than the two companies individually. Synergies can be due to cost reduction or higher revenues.
What Are The Disadvantages of Mergers and Acquisitions?
While mergers and acquisitions can be beneficial for the businesses involved, certain drawbacks may present all parties should carefully consider. Some examples of potential disadvantages associated with mergers and acquisitions include:
Increased Legal Costs
Merging two companies is a legal business transaction that often requires the involvement of several key professionals. Those involved will typically have to bring in lawyers who specialize in this type of deal and financial professionals who can assist with the assets and other financial details. The legal costs associated with merging and acquiring can be high.
Expenses Associated With The Deal
In addition to the need to pay the professionals assisting with the logistics of the merger or acquisition, the business acquiring the other would be responsible for paying a sum of money for that business and its assets. That cost may be viewed as a disadvantage for a business.
Potentially Lost Opportunities
The time, energy and money that goes into a merger or acquisition could require the businesses involved to forego other potential opportunities.
Mergers and Acquisitions (M&A) – Valuation
In an M&A transaction, the valuation process is conducted by the acquirer as well as the target. The acquirer will want to purchase the target at the lowest price, while the target will want the highest price.
Thus, valuation is an important part of mergers and acquisitions (M&A), as it guides the buyer and seller to reach the final transaction price. Below are three major valuation methods that are used to value the target:
- Discounted cash flow (DCF) method: The target’s value is calculated based on its future cash flows.
Comparable company analysis: Relative valuation metrics for public companies are used to determine the value of the target.
- Comparable transaction analysis: Valuation metrics for past comparable transactions in the industry are used to determine the value of the target.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.