Mergers and Acquisitions – A Comprehensive Guide

An infographic explaining what mergers and acquisitions are, what the difference is between the two, types of M&A, the steps in the M&A process, and the risks involved.

Corporate restructuring occurs in the business world every day for various reasons, and mergers and acquisitions (M&A) are often a key part of a corporate growth strategy. It is simply the business’s nature to increase shareholder value and grow the business in one way or another. Thus, mergers and acquisitions can help organizations become more profitable, efficient, and powerful.

This comprehensive guide to mergers and acquisitions aims to provide useful information about mergers and acquisitions. We cover the terminology used in M&A, explain the different types, structures, and forms of integration, reasons for mergers and acquisitions, and its benefits. Finally, we will discuss the valuation and the steps involved in M&A.

What Are Mergers and Acquisitions?

Mergers and acquisitions is the process of consolidation of companies or assets through different types of financial transactions. For example, businesses often merge or acquire other companies to increase shareholder value and reach various goals, like exponential growth, gaining a competitive edge, expanding the product line and services, gaining expertise and skills, or expanding into new markets.

What Is the Difference Between Mergers and Acquisitions?

Although the terms “mergers” and “acquisitions” are often used interchangeably, they have slightly different meanings.

A merger happens when two or more companies form a new legal entity for mutual growth. In a merger of 2 public companies, the approval of both the company’s board of directors and the company’s shareholders is a requirement. In a merger, the two companies usually are similar in size.

On the other hand, an acquisition occurs when a company takes over another company outright or takes over a portion of a company’s corporate assets. In an acquisition, a larger company takes over a smaller company and absorbs its business. The acquired company usually ceases to exist. There are several ways in which a target company can be acquired, either through a friendly takeover or a hostile takeover. 

Hostile takeovers are always considered acquisitions. In this case, the acquiring company wants to buy the target company, but the target company’s management team does not want the company to get acquired, hence the name hostile takeover.

The underlying goal is the same in both mergers and acquisitions. In both cases, the acquiring entities want to grow in value and strength. Bigger businesses often purchase smaller ones to become more cost-efficient. In contrast, smaller entities allow themselves to be sold if the shareholders think it is in their best financial interest.

Transactions That Fall Under Mergers and Acquisitions

Here are the most common transactions that fall under mergers and acquisitions:

Mergers

A merger occurs when two similarly sized companies join together to form a new company. The new company often has a new name and adopts a new structure. An example of a successful merger is ExxonMobil. In 1998, Exxon and Mobil merged into ExxonMobil Corp. to reduce costs for both companies and to offset low oil prices in the market.

Acquisitions

This type of deal involves the acquiring company buying another company outright or acquiring a majority stake in another company and becoming the new owner. The acquired company often gets to keep its name, its brands, and its operations intact. Usually, the acquiring company is larger and far more solvent. An example of a successful acquisition was Amazon’s acquisition of Whole Foods. Acquisitions either involve the exchange of stocks or the cash purchase of the target company’s shares.

Tender Offers

These takeovers suggest that the target company does not agree with the acquisition, hence the name hostile takeover. This is where the tender offer comes in. In a tender offer, the acquiring company offers to buy some or all of the outstanding stocks from the target company’s shareholders at a specific price. This price is usually higher than the market price. This offer bypasses the board of directors and its management and goes directly to the target company’s shareholders. The higher-than-market price offer will give shareholders an incentive to sell their shares.

Management Acquisitions

Also called Management-led BuyOuts (MBO). This is when an organization’s management team pools finances to purchase the company or a part of the company they are managing. Funding often comes from personal resources and private equity firms. An example of an MBO is when Michael Dell, the CFO of Dell Corp, acquired Dell in 2013.

Acquisition of Assets

This type of transaction occurs when companies bid for another company’s assets after getting shareholder approval. This is particularly popular in the case of bankrupt companies.

Reverse Mergers

A reverse merger, also called a reverse IPO, occurs when a private company buys a majority interest in a public company to bypass the expensive and time-consuming process of going public. The public company is often a shell company with limited assets and no real business activities. A new company emerges after the reverse merger.

Leveraged Buyouts

A leveraged buyout also called an LBO, occurs when one company acquires another company using a significant amount of debt and little equity, typically 90% debt and 10% equity. The company doing the acquiring is typically a private equity firm. It sometimes will use its assets as leverage. The target company’s assets and cash flows are also used as collateral and to finance the cost of the debt. The debt can be financed through private equity, investment banks, or bond issues.  LBOs are often used to take public companies private or to spin off part of the company by selling it.

Types of Mergers and Acquisitions (based on the relationship between the entities)

Depending on the relationship between the entities involved in the deal, mergers and acquisitions can be structured in various ways.

An infographic explaining the five different types of mergers and acquisitions.

Horizontal – In a horizontal merger, two companies selling the same or similar products/services in the same market join forces and merge. They are often direct competitors, and the goal of the merger is to decrease competition, increase market share, and increase revenue resulting in increased profits. 

Vertical – A vertical merger is a merger within the supply chain. A vertical merger happens when a company and one of its suppliers or its customers merge. The company’s target is either up or down the supply chain. The aim is to improve the efficiency of operations. This type of merger often cuts time from the production/distribution process, increases quality control, and reduces competition as competing companies won’t be allowed to work with the partner company. An example would be if a juice processing company would buy its own orchards.

Conglomerate – A conglomerate M&A is a merger between two entities that have nothing in common. These companies operate in different markets and offer different products before the merger. The companies decide to come together to lower their business risks or share assets. As they are from different industries, they can extend greater services, increase sales, and boost market share.

Product Extension – This is a merger between two companies in the same market, selling different but related products. It allows the merging companies to join their products to get access to more customers. This will result in increased profits and a bigger market share.

Market Extension – This is a merger between two companies in different markets selling the same products. The goal is that the merging companies get access to a bigger market and a larger customer base, hopefully increasing revenue and profits.

Reasons for Mergers and Acquisitions

Mergers and acquisitions take place for a variety of reasons. Here are the most common ones:

Improved economies of scale: The cost of doing business usually goes down when companies merge. This is especially true in manufacturing industries. For example, when purchasing raw materials in greater quantities, those materials’ relative costs will significantly decrease. Operational efficiency also increases when 2 similar companies merge. For example, duplicate jobs in marketing, accounting, and purchasing functions can be eliminated, resulting in cost savings.

Better financial position: Another important reason for mergers and acquisitions is to benefit from the entity’s combined capital. Larger companies have better access to equity and debt financing sources at a lower cost, which will enable further expansion and investments. 

Growth acceleration (by diversification with technologically advanced products and markets): Growing through mergers and acquisitions is a speedier way to increase revenue than organic growth strategies. When a company merges or acquires a business with more advanced technologies and better capabilities, it can save time and money by not developing those technologies internally.

Increase market share and eliminate competition: Acquisitions of another company in the same industry are very popular. The acquiring company’s goal is to eliminate competition and increase its market share. Unfortunately, the acquiring company often has to pay a high purchase price for the target company.

Diversification: Businesses operating in cyclical industries often need to diversify their cash flows to avoid losses during slowdowns. They can benefit from acquiring a target company from the non-cyclical industry, as this will lower the market risk for the acquiring company due to diversification.

Reducing risk by merging with a company in a foreign country:  Cross-border mergers reduce the risk of localized recessions and foreign exchange risk.

Lower the cost in the supply chain: Acquiring a supplier or a distributor in the supply chain can significantly decrease costs, save time, and give more power to the acquiring company.

Tax advantages: Tax benefits are a driving force for mergers and acquisitions when one entity has a significant taxable income while the other company incurs tax losses. When a company takes over an entity with tax losses, it can use those tax losses to lower its own tax liabilities. This is called tax loss carryforward. Tax advantages that are often frowned upon result from an

M&As that involve a company in a region with a high-corporate-tax rate merging with a company in a low-corporate-tax rate location with the sole intention to locate the new company in the low-corporate-tax location to reduce tax liabilities get a lot of criticism.

Synergy in Mergers and Acquisitions

Synergy is often the most significant factor behind mergers and acquisitions. It refers to the concept that the combined value of the resulting company is greater than the values of the two companies as single entities. Generally, the main goal of M&A is to improve the financial performance of an organization.

When two companies merge, the resulting entity can generate a higher revenue than the sum of the two companies’ revenues. This synergy merge often raises the company’s stock price, thus benefitting the shareholders.

The synergy achieved from M&A activities is due to combined technology and skills, cost reduction, and increased revenues. Therefore, the synergy value obtained from mergers is usually substantial.

Steps Involved in Mergers and Acquisitions

The process of mergers and acquisitions can often be complex and can take a long time to complete.

Here are the basic steps in the mergers and acquisitions process.

1. Pre-acquisition review

The acquiring company needs to do a self-assessment. This includes the reason for the M&A and what they will gain from it, the valuation of the deal, and the company needs to develop a strategic growth plan for the company after the merger or acquisition has been completed. The acquiring company’s valuation will be on the low side as they will want to pay as little as possible.

2. Set search criteria for the target company and search/screen target

This involves looking for potential candidates for taking over. This step mainly focuses on scanning to find the best strategic match for the acquiring business. This includes evaluating geographic locations, expected profit margins, and more.

3. Investigation and valuation of the target

After completion of the initial screening and the selection of the target, the lengthy process of due diligence and in-depth fundamental analysis of the target company starts. The acquirer asks the target company to provide current and past financial information, information on any outstanding matters, etc. That will enable the acquirer to evaluate the target company further. The acquiring company might also consult financial advisors on the valuation of the target company.

4. Negotiations and acquisition

After the target is chosen, it is deal-making time. Then, negotiations start to reach a mutual agreement between the two companies for the deal’s long-term operation.

5. Post-Merger Integration

After the completion of the 5 steps, the participating businesses formally announce the merger agreement.

Please note that large mergers acquisitions require a premerger filing at the Federal Trade Commission (FTC) or the U.S. Department of Justice (DOJ). Generally, the deal must first have a minimum value and the parties must be a minimum size. Filing updates are updated annually.

Valuation of Mergers and Acquisitions

In mergers and acquisitions, both the acquirer as well as the target perform a valuation. While the acquiring company wants to buy the target at the lowest price possible, the target entity wants to get the highest price. This is why valuation is a significant aspect of M&A as it guides both entities to reach their final deal value prices.

Comparing similar companies in the same industry to determine the multiple the acquirer will pay for the target company is common practice. Still, there are some other popular valuation methods available to find the value of the target in an M&A deal.

Discounted Cash Flow – A critical valuation tool, DCF determines the company’s current value depending on the future cash flows.

Comparative Ratios – Several comparative metrics are used to value the target and make an offer. Price-to-Earnings Ratio (P/E ratio) and Enterprise Value-to-Sales Ratio (EV/sales) are comparable metrics acquiring companies mostly use.

Replacement cost – Sometimes, M&As are based on the cost of replacing the target company.

Risks of Mergers and Aqcuisitions

Mergers and acquisitions are strategies that some companies undertake to enable fast growth and reap the benefits of synergy in different business areas. However, M&A transactions also come with some risks and disadvantages that might turn the merger into a fiasco and might even lead to bankruptcy for the companies involved.

High costs of M&A: – Mergers and acquisitions can be expensive undertakings. The legal and administrative fees of the whole process can add up. Besides, sometimes, the acquiring company has to pay a very high price for the target company. This is often the case in a hostile takeover, as the target company’s shareholders will only agree to an acquisition if the price is above the market price. In other cases, such as in a leveraged buyout, there is a lot of debt that needs to be paid back at some point with interest. The company then runs the risk that its revenue is not enough to cover the loan’s payback with interest.

Integration Risks: In many cases, the plans for the actual merger look great, but in reality, things might be more difficult and do not always turn out the way they were planned. The expected increase in earnings often doesn’t happen in the short term because the economies of scale take longer to materialize, or maybe the consolidation of the different departments takes longer than expected. This will make investors nervous, and this can result in a drop in the stock price. Hopefully, the company can recover from this in the long run.

Two cultures are not compatible and clash: Combining two companies is difficult, and when both companies have opposite corporate cultures, the whole process might become insurmountable, and the M&A might fail. 

A clash of cultures happened after the acquisition of Whole Foods by Amazon in 2017. Before the acquisition, Whole Foods had a pretty “loose” corporate culture. The companies organization focused on self-managed teams and granted individual employees significant decision-making power. Managers had a lot of autonomy and could tailor product offerings to customer preferences. On the other hand, Amazon followed a pretty “tight” corporate culture where tight structure and precision ruled. Of course, this resulted in a clash where WholeFoods employees became very dissatisfied.

Wrong Timing: Many mergers and acquisitions happen during a bullish economy when market sentiment is high or when an industry sector expects high growth. Failures often happen when the economy takes a turn for the worst. In 2001, AOL and Time-Warner merged in one of the biggest mergers ever. Shortly after the merger, AOL posted a $100 billion loss putting both companies at risk. There were many reasons for this failure, including a culture clash and bad decision-making by executive management teams. The growing DOT-COM financial crash also contributed to the demise of this merger. 

Conclusion

While mergers and acquisitions are common in the business world, not all of them are successful. However, when they are executed the right way, during the right time, for the right reason, and with the right management team involved, they might be very successful and be able to take advantage of all the synergies the M&A offers. 

However, failures are inevitable for badly executed deals. Some of the biggest M&A failures have happened because of both internal and external issues. Internal issues like cultural clashes between the two companies or external issues like the overall economic conditions and geopolitical issues are often to blame for merger and acquisition failures.

Mergers and acquisitions are considered a critical component of any business strategy. M&A is a growth strategy corporations often use to quickly increase their size, customer base, expertise, talent pool, efficiency, and resources in one quick move. However, the process is costly, and the companies involved need to be sure the advantages to be gained are substantial and worth it.

Vikram R
Vikram Raghavan is a value investor, technologist, and Finexy co-founder. In addition to stock market investing, Vik also invests and advises startups on growth marketing and product management. Vik's work is focused on themes of marketplaces, micro-entrepreneurship, marketing automation, and user growth. Previously, Vikram led product and growth teams at Overstock.com, focusing on efforts across acquisition, new user experience, churn, and notifications/email. He holds an MBA in Finance from Temple University and a B.S. in Computer Information Systems and Finance from Bemidji State University.