CHAPTER THIRTEEN – Have you tried raising capital from various sources (like angels, VCs, bank loans, grants, etc) and failed? Then below is an in-depth guide on how to raise funds through an alternative financing option called Mergers and Acquisitions.
Mergers and acquisitions always involve existing businesses, and so they may not be on your list of plans for now; especially if you are just starting your business.
But as an entrepreneur, you need to understand the basics of mergers and acquisitions, regardless of which stage your business is presently at. This is because businesses merge on a regular basis and chances are high that your business may be involved in a merger in the future. In this chapter, you will learn the basics of mergers and acquisitions as well as how they work.
What Do Mergers and Acquisitions Mean?
Mergers and acquisitions represent the growth or expansion of a business. A merger refers to an arrangement where two companies come together to form one company with the aim of expanding their business operations.
Following a merger, the new company may assume the name of one of the merged companies, or carry a brand new name, which may be coined from the names of the merged companies.
An acquisition, on the other hand, refers to an arrangement where one company acquires another company with the aim of integrating the new company into their business model. Following an acquisition, the acquired company (or target company) is usually integrated into the acquiring company.
Most merger and acquisition deals can be very substantial in size, as they deal with very huge amounts of money. This explains why you are likely to hear about them on the news. Mergers can be categorized as follows:
- Horizontal mergers: These are mergers between two (or more) firms that offer similar products or services. Horizontal mergers are often driven by the need for a company to increase its market share by merging with a competitor. For example, the merger between Exxon and Mobil (to become Exxon-Mobil) was to allow both companies to have a larger share of the oil and gas market.
- Vertical mergers: These are mergers between two (or more) firms along the value-chain, such as a manufacturer merging with a supplier or distributor. Companies go into vertical mergers when they want to gain competitive advantage within the market and increase the reach of their offers. For example, Merck, a large manufacturer of pharmaceuticals, merged with Medco, a large distributor of the same products, in order to gain advantage in distributing its products.
- Conglomerate mergers: These are mergers between two companies in completely different industries, such as a technology company merging with an oil company. Conglomerate mergers help companies smooth out wide fluctuations in earnings and provide more consistency in long-term growth. For example, General Electric, by way of conglomerate mergers, has been able to diversify into other industries like financial services and television broadcasting.
- Reverse mergers: In a reverse merger, a private (and often smaller) company acquires or merges with a public (and often larger) company. This is usually done to help the private company bypass the lengthy process of going public. In other words, reverse mergers are used by private companies to go public without resorting to IPOs.
Mergers and acquisitions are particularly alluring to companies during harsh economic conditions. Two companies of about equal strengths will come together hoping to gain a greater market share or to achieve greater efficiency (merger).
Similarly, strong companies will act to buy weak companies to create a bigger, more competitive, and cost efficient company (acquisition). Because of the potential benefits, weak or small companies often agree to be purchased, especially when they know they cannot survive alone.
Why Do Companies Agree to Mergers and Acquisitions?
Ordinarily, when two businesses are combined into one, the value of the resulting company is equivalent to the total value of the two pre-existing companies.
However, there are times when a possible combination of two companies promises more value than that of the sum of both companies. In such cases, both companies may merge in order to benefit from this extra value.
For example, the value of Company A is $2 billion and the value of Company B is $2 billion, but if both companies are merged, the resulting company will have a total value of $5 billion. So, the merger creates additional value, which is called “synergy value.” You may be wondering how it’s possible for a synergy value to arise. Here are some possible sources:
- Revenues: After the merger, the resulting company realizes higher revenues than if the merged companies operate separately.
- Expenses: After the merger, the resulting company records lower expenses than if the merged companies operate separately.
- Cost of capital: After the merger, the resulting company experiences a lower overall cost of capital than if the merged companies operate separately.
Lower expenses is usually the biggest source of synergy value, as most mergers are driven by the need to cut costs. For example, the new company will cut back on staff costs by combining departments and eliminate unnecessary jobs and facilities. However, there are many other strategic reasons for mergers and acquisitions. These include the following:
- Gap filling: One company may have a major weakness (such as poor distribution), whereas the other company has some significant strength in the same regard. By merging the two companies, each company fills the strategic gaps that are necessary for long-term survival.
- Positioning: Merging two companies may help to take advantage of future opportunities that can be exploited when the two companies are merged. For example, a telecommunications company might improve its position for the future if it were to own a broad band service company. This positioning helps a company take advantages of emerging trends in the market.
- Broader market access: A company can tap into emerging global markets more quickly by acquiring or merging with a foreign company.
- Organizational competencies: Mergers and acquisitions help companies acquire additional human resources and intellectual capital, both of which can help improve innovative thinking and development within the company.
Mergers and Acquisitions can also be driven by basic business reasons, such as the following:
- Bargain purchase: Sometimes, it’s cheaper to acquire another company than to invest internally. For example, suppose your company is planning to expand on its fabrication facilities, and another company has very similar facilities that are idle or underutilized. Acquiring the company with unused facilities may be cheaper than building new facilities on your own.
- Short-term growth: The management of a company may be under pressure to turnaround sluggish growth and profitability. In such circumstance, a merger or acquisition can help to boost poor performance and improve shareholder value.
- Undervalued target company: The target company may be undervalued, in which case it would represent a very good investment. Acquiring a company for this reason is similar to what obtains in real estate development: Low-value property is acquired and improved (to be sold consequently, though).
- Diversification: For companies in very mature industries with very slim chances of future growth, it may be necessary to merge with or acquire another company that offers different product lines. This can help to smooth-out earnings and achieve more consistent long-term growth and profitability.
You should note, however, that traditional financial management does not always support diversification through mergers and acquisitions. It is widely held that investors are in the best position to diversify, not the management of companies, since managing a food processing company is different from running a software company.
After a merger or acquisition, a company will be able to become more efficient in various ways. It will also take advantage of economies of scale since it’s now a larger company. It will be able to negotiate lower prices on materials and save money overall.
Advantages and Disadvantages of Mergers and Acquisitions
As a corporate financing option, mergers and acquisitions have their fair share of advantages and disadvantages.
Six Advantages of Mergers and Acquisitions
Aside the inherent benefits that motivate companies to go into mergers and acquisitions (as explained earlier above), there are a number of other advantages, such as the following:
- Mergers and acquisitions do not require cash.
- Mergers may be accomplished tax-free for both parties.
- The target company realizes the appreciation potential of the merged quantity, instead of being limited to sales proceeds.
- Mergers and acquisitions enable the shareholders in smaller company to own a smaller piece of a larger pie, thereby increasing their overall net worth.
- A reverse merger enables the shareholders in a private company to own stock in a public company.
- An acquisition allows the acquiring firm to avoid many of the costly and time-consuming aspect of asset purchases, such as the assignment of lease and bulk-sales notifications.
4 Disadvantages of Mergers and Acquisitions are as follows:
- Diseconomies of scale may occur if the business becomes too large, leading to higher unit costs.
- There may be clashes of culture between the merged business, resulting in conflicts and friction that reduce the effectiveness of the integration.
- Mergers and acquisitions may make some workers redundant, especially at management levels, which may affect their motivation.
- There may be a conflict of objective between the merged businesses, making decisions more difficult to take and the business more difficult to run.
The Step by Step Process Involved in Mergers and Acquisitions
Mergers and acquisitions involve five phases:
1. The pre-acquisition review
If you are planning to take your business into a merger, the first step is to assess the situation of your business and determine if a merger and acquisition strategy is right and should be implemented. If you foresee difficulty in the future as regards maintaining your core competencies, market share, return on capital, or other key performance drivers, then a merger and acquisition may be necessary.
You should also ascertain if your business is undervalued. If your company fails to protect its valuation, it may become the target of an acquisition. So, the valuation of your company is always a core component of the pre-acquisition review phase, as it helps you know if a merger and acquisition arrangement will improve your company’s fortunes.
The primary focus of the pre-acquisition review is to figure out whether growth targets can be achieved internally. If not, then a merger and acquisition team should be formed to establish a set of criteria for the company to go through acquisition. The team will explain and plan how the business will grow after the merger.
2. Search and screening of targets
The second phase in the process of a merger and acquisition is to search for possible takeover candidates, or target companies. The target company must fulfill certain criteria so that they are a good fit for the acquiring company. For example, the performance drivers of the target company should complement the acquiring company.
During the screening phase, compatibility and fit should be assessed across a range of criteria, such as type of business, capital structure, organizational strengths, core competencies, market channels, relative size, and so on.
The search and screening process is performed in-house by the management of the acquiring company. Outside investment firms are not involved since the preliminary stages of the merger and acquisition must be highly guarded and independent.
3. Investigation and valuation of the target
The next phase involves carrying out a more detailed analysis of the target company. Before concluding that the target company is a good buy, the acquiring company needs to confirm that it’s really a good fit.
This process of investigation and valuation requires a thorough review of the operations, strategies, financials, and other aspects of the target company. This thorough review is known as the “due diligence.” The first phase of due diligence is initiated once a target company has been selected, and the main objective is to identify various synergy values that can be realized through a merger with the target company.
4. Acquisition through negotiation
After the target company has been selected, the negotiation process starts. The acquiring company will develop a negotiation plan based on the following key questions:
- How much resistance will we encounter from the target company?
- What are the benefits of merging with this company?
- What will our bidding strategy be?
- How much do we offer in the first round of bidding?
The commonest approach to acquiring another company is for both parties to reach agreement concerning the merger (that is, a negotiated merger will occur). This negotiated merger is sometimes called a “bear hug,” and it is the most preferred approach to a merger, since it involves agreement between both sides.
In cases where resistance is expected from the target company, the acquiring company will acquire a partial interest in the target, in what is sometimes called a “toehold position.” This toehold position mounts pressure on the target to accept the negotiation.
If the target is expected to strongly resist a takeover attempt, the acquiring company can negotiate directly with the shareholders of the target, bypassing the management. This is known as a tender offer, and it is characterized by the following:
- The offered price is above the target’s prevailing market price
- The offer is open for a limited period of time
- The offer is made to the public shareholders of the target
- The offer applies to a substantial, if not all, outstanding shares of stock
However, tender offers are more expensive than negotiated mergers due to the resistance by the management of the target company.
The second phase of the due diligence starts when the negotiation with target has commenced. This time, a much more intense level of due diligence will begin. Both companies, after agreeing to a negotiated merger, will launch a very detailed review to determine if the proposed merger will work.
5. Post merger integration
After the negotiation and review have been completed, the two companies will announce an agreement to merge. The deal is finalized in a formal merger and acquisition agreement. And the process of integrating both companies into a single entity starts.
The post-merger integration phase is one of the most difficult phases of the merger and acquisition process because there would be differences in the companies involved—differences in strategies, differences in culture, differences in information systems, and so on. So, this phase requires extensive planning and design throughout the entire organization.
The integration process can take place at three levels:
- Full integration: All functional areas will be merged into one company, and the new company will retain the “best practices” between the two companies.
- Moderate integration: Certain key functions or processes (such as production) will be merged together, and strategic decisions will be centralized within one company. However, the day-to-day operating decisions will remain autonomous.
- Minimal integration: Only selected personnel will be merged together in order to reduce redundancies, but both strategic decisions and operating decisions will remain decentralized an autonomous.
Five Strategic Reasons Why Mergers fail
The sad reality about mergers and acquisitions is that the expected synergy values may not be realized, in which case the merger is considered a failure. The following are some of the reasons why mergers fail:
- Cultural and social differences: Most problems with mergers can be traced to “people problems.” If the merged companies have wide differences in culture and values that are not well handled, then synergy values will not be realized.
- Poor strategic fit: The two companies involved may have strategies and objectives that are too different and are in conflict with one another.
- Poorly managed integration: The integration process requires a very high level of quality management. If the integration is poorly managed with little planning and design, chances are high that the merger will fail.
- Huge cost of acquisition: The acquiring company, in anticipation of a high synergy value, may pay a premium for the target company. However, if the expected synergy value is not realized, then the premium paid to acquire the target is never recouped, which means the goal of the merger has been defeated.
- Over-optimism: The acquiring company may be too optimistic in its projections about the target company, leading to bad decisions in the merger and acquisition process. An overly optimistic forecast or projection can lead to a failed merger.
While there are many more problems—including organizational resistance and loss of key personnel—that can lead to failed mergers, a solid due diligence procedure will help to avoid most, if not all, of these pitfalls.
A Case Study of Successful mergers and Acquisitions
M&As in Nigeria
- Sterling Bank
In January 2006, NAL merchant bank completed a merger with four other Nigerian banks—Magnum Trust Bank, NBM Bank, Trust Bank of Africa, and Indo-Nigeria Merchant Bank (INMB)—and adopted the name, “Sterling Bank.” The merged entities were successfully integrated and have operated as a consolidated banking group ever since.
Fast forward to mid 2011, Sterling Bank again acquired the franchise of Equitorial Trust Bank in an acquisition that expanded the bank’s presence to almost 200 branches spread across major cities in Nigeria. After the Sterling-ETB merger, the bank’s growth was significant, not only by balance sheet, but also in terms of branch network, asset base, and deposits. Significant leaps occurred as Sterling bank leaped from the 16th spot in the industry to 13th in assets stakes. And assets rose from 1.7% industry total to 2.7% as at Q4 2013.
M&As in the United States of America
- Pfizer and Warner-Lambert
Pfizer and Warner Lambert merged in 1999 to become the second largest drug manufacturer in the world. The deal, which was worth $90 billion in stock, followed Pfizer’s 3-month pursuit of Warner-Lambert, a fast-growing competitor at the time.
The merger was catalyzed by Warner-Lambert’s development of Lipitor, a cholesterol lowering drug that has gone on to become the top selling branded pharmaceutical with 2008 sales topping $12.4 billion.
Today, the merged entity, simply known as “Pfizer,” has been of tremendous importance to Pfizer’s continued dominance in the prescription drug market.
- NationsBank and Bank America
In 1998, NationsBank acquired Bank of America Corp for $64 billion in what was described as the largest bank merger in history at the time. The combined entity, renamed “Bank of America,” possessed combined assets of $570 billion. Bank of America has since gone on to become the largest bank holding company in America as well as the second largest bank in terms of market capitalization.
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