Mergers and Acquisitions (Hardcover)

Chapter One

1.1 INTRODUCTION 2

1.2 CENTRAL ROLE OF STRATEGIC PLANNING IN THE MERGER AND ACQUISITION PROCESS 3 (a) General 3 (b) Investment Considerations 4 (i) Strategic Fit 4 (ii) Speed of Implementation 5 (iii) Cost of Implementation 5 (iv) Synergistic Benefits 5 (c) Impact of Globalization 6 (d) Enhanced Risk 6

1.3 TYPES OF M&A ACTIVITY 6 (a) General 6 (b) Mergers versus Acquisitions 6 (c) Large Public versus Small Private Acquisitions 7 (i) Strategic Impact 7 (ii) Regulatory Requirements 8 (iii) Stock or Asset Purchases 9 (iv) Leverage of the Parties to the Transaction 9 (v) Risk Profile of the Transaction 9 (d) Strategic versus Financial Acquisitions 10 (e) Portfolio Acquisitions of Holding Companies 10 (f) Other Characterizations of Acquisitions 11 (g) Divestitures versus Sales of an Entire Business 11

1.4 TRANSACTION OVERVIEWS 11

(a) General 11 (b) Acquisition Process 12 (i) From Process Initiation through Target Qualification 12 (ii) From Valuation through Preliminary Agreement 13 (iii) From Due Diligence to Approval to Proceed to Contract 14 (iv) Contract and Close 14 (v) Postacquisition Integration 15 (c) Sales Process 16 (i) Prenegotiation Preparation 16

(ii) Negotiation 17 (iii) Due Diligence 17 (iv) Contract and Close 18 (d) Divestiture Process 18 (i) Divestiture Planning 19 (ii) Transaction Preparation 19 (iii) Transaction Execution 20 (e) Importance of Proper Planning and Disciplined Implementation 20

1.5 ROLE OF THE FINANCIAL MANAGER IN MERGERS AND ACQUISITIONS 20

(a) General 20 (b) Coordination 21 (i) Internal Coordination 22 (ii) Coordination of External Experts 22 (c) Financial Analysis 23 (i) Financial Criteria and Metrics 23 (ii) Valuation 23 (d) Determination of Deal Structure 23 (i) Assets versus Stock 24 (ii) Earn-Outs 24 (iii) Working Capital Adjustments 24 (e) Due Diligence 24 (i) Establishing Due Diligence Objectives 24 (ii) Managing the Due Diligence Process 25 (iii) Reporting on Results 25

1.1 INTRODUCTION

Historically, mergers and acquisitions (M&As) have always been a factor in the expansion and consolidation of the modern industrial base of the United States and other advanced economies. However, over the last decade or so, M&As have emerged as a particularly significant market force. This trend is reflected in the volume of M&A activity, measured in terms of both dollars and the number of transactions consummated. The dollar volume of M&A activity in the United States exceeded $1 trillion in 1998 and has reached or exceeded that benchmark almost every year since. During that same period, the number of announced M&A transactions has consistently exceeded 7,500 annually.

Understandably, the largest of these transactions, large public company combinations, have been the most visible. These large transactions typically entail enormous transfers of value and affect thousands of employees and hundreds of thousands of investors. However, smaller transactions, such as those involving the sale of closely held businesses and the divestitures of business units-usually to larger, publicly traded companies-dwarf the number of combinations involving publicly traded entities.

Although these smaller transactions generally fall under the radar of the financial press and the casual business observer, they have consistently accounted for over 90% of all transactions by volume for the last several decades. They are clearly an important source of growth for publicly traded companies and, more relevantly, they are the types of transactions that are very likely to be encountered by business professionals, especially financial professionals, in the course of their careers.

Not only do these transactions differ in terms of size and visibility, they also differ significantly in terms of dynamics and process. The remainder of this chapter discusses these differences and other important factors that provide background and context for the more fulsome discussions of the acquisition and sales process that appear in the chapters that follow. This initial foundational discussion focuses on:

The role of M&A activity in the context of overall corporate strategy

Important definitions of, and distinctions among, the various types of M&A transactions

Descriptions of the various types of transactions, highlighting differences in the nature of their execution

An overview of the central role the financial manager generally plays in the various types of M&A transactions

1.2 CENTRAL ROLE OF STRATEGIC PLANNING IN THE MERGER AND ACQUISITION PROCESS

(a) GENERAL. Any meaningful discussion of M&As should start with an understanding of the role of strategic planning in the corporate decision-making process. Most companies reinforce or update their business development strategy annually. Typically, the end product of this planning process is the articulation of a limited number of strategic objectives whose implementation begins with translating them into concrete investment activities. The categories of the investment options available are limited. They take the form of internal development (build), acquisition (buy), or strategic partnership (ally).

It should also be understood that, even in those cases in which a formal, structured strategic planning process is not employed, a company will still be guided by a stated or implied business strategy that is broadly understood within the organization. That strategy may result in a planning document, or it may simply be a shared understanding within a business of the need and intent to fill important gaps in the company's portfolio and infrastructure.

An expansive description of the strategic planning process is beyond the scope of this discussion. Suffice it to say that companies typically chart a strategic direction that is expressed in the form of long-term objectives and that the realization of those objectives must be driven by specific investment activities. These objectives typically fall into these broad categories:

Developing or acquiring new products for current markets

Expanding the distribution channels for existing products

Developing or acquiring new products for new markets

Achieving economies of scale in order to lower production costs

Increasing brand recognition of products and/or services

Developing or acquiring new technology, intellectual property, or research and development (R&D) capability

Establishing control over sources of supply by expanding operations toward suppliers' markets (backward integration)

Expanding operations toward customers' markets (forward integration)

(b) INVESTMENT CONSIDERATIONS. Frequently, the approach employed to accomplish strategic objectives is purely acquisition-based, but, as noted, acquisitions are just one of the three broad investment options (build, buy, or ally) available to further these objectives. These options are significantly different from one another in terms of risks, benefits, advantages, and disadvantages. The differences revolve around the trade-offs among a number of variables, particularly those of strategic fit, speed of implementation, cost of implementation, and anticipated synergistic benefits.

(i) Strategic Fit. It is axiomatic that the investment option must support the entity's strategic objective. Internal development generally provides the greatest potential for control and customization, and often the greatest assurance of strategic fit. Acquisitions and strategic alliances, when they can be implemented, generally will provide an approximate fit. However, occasionally the assets needed to accomplish a key strategic objective are unique, that is, truly one of a kind.

If such an asset does not exist in the marketplace (e.g., customized infrastructure technology), then acquisition can be automatically ruled out as an option. Alternatively, the unique assets coveted (e.g., intellectual property assets) may be owned by another entity, and acquisition of that entity or strategic partnership with it may be the only options available.

(ii) Speed of Implementation. One of the primary factors an enterprise must consider when making an investment decision is the importance of speed in accomplishing the strategic objective at hand. If speed is a primary consideration, acquisition is likely to be the most attractive alternative, assuming some or all of the assets acquired are a good strategic fit. This is particularly the case when market entry or market expansion is the objective. Internal development may provide a more precise fit, but the market opportunity may have passed by the time an internally developed initiative is implemented. Strategic alliances may also be a viable option, but execution can be difficult and time-consuming and, by definition, requires a sharing of the benefits derived.

(iii) Cost of Implementation. Cost is clearly a key consideration. Strategic alliances can be attractive because their costs (as well as their benefits) are shared. Acquisition, however, is generally the most expensive option, because it will often entail paying a premium over the cost of internal development.

(iv) Synergistic Benefits. When acquisition or strategic alliance is the option exercised, there is generally a presumption that, by combining assets and/or capabilities, benefits can be realized that are greater than what would be expected if the two companies operated independently. In the case of an acquisition, these anticipated synergies must be considered in the context of any purchase premium paid by the acquiring company. (Purchase premiums are discussed in greater detail in section 3.2(c).)

The investment option chosen will involve the weighing of these, and perhaps other, variables specific to the facts and circumstances of a given situation. Frequently, acquisition is the favored option, because it best satisfies the company's objectives in the context of these decision variables-or at least appears to do so.

(c) IMPACT OF GLOBALIZATION. The recent, accelerated pace of globalization has had a significant impact on strategic thinking and strategic plan implementation in the corporate world. Driven primarily by technological innovation, competition has intensified in many industries. To a greater extent than ever, this has led to strategic initiatives that focus on more aggressive market expansion and on rapidly attaining economies of scale and substantially enhanced efficiencies. This in turn has placed increased emphasis on the rapid implementation of strategic initiatives.

(d) ENHANCED RISK. Arguably, the interplay of the factors just noted has given primacy to speed of implementation and provided significant impetus to acquisition as an investment option in many cases. In situations where acquisitions are the chosen path to achieving strategic objectives, this choice is generally accompanied by increased risk. That risk derives from the likelihood of imperfect strategic fit, the high probability of paying a premium for the assets acquired, and the exposure inherent in integrating the purchased properties into the fabric of a separate business. For these reasons, a thoughtful, well-planned, and disciplined approach to acquisitions is critical, if these risks are to be mitigated.

1.3 TYPES OF M&A ACTIVITY

(a) GENERAL. M&A transactions can be characterized in a number of ways. These different characterizations provide important context for discussions of the transaction process, regulatory compliance, and the strategic and financial impact of the different types of transactions. The major categories of transactions are described in sections 1.3(b) through (g).

(b) MERGERS VERSUS ACQUISITIONS. The term "merger" technically means the absorption of one corporation into another corporation. Typically, in a merger, the selling corporation's shareholders receive stock in the buying corporation. However, the term "merger" is frequently used more loosely-for example, to include a consolidation that is technically the combination of two or more corporations to form a new corporation.

In a true merger (as opposed to an acquisition), the acquirer becomes directly liable for all the liabilities of the acquired corporation, often an undesirable result. In a pure stock purchase or acquisition, the acquired company can be kept as a separate subsidiary and, while its liabilities continue to exist, they do not become legal claims against the assets or earnings of the acquirer. However, assumption of liabilities by the acquirer can be avoided by a special structure known as a triangular merger, in which the acquirer sets up a subsidiary and then merges it with the acquired company. The more significant issue is often not whether the transaction is a merger or a stock acquisition, but whether it qualifies for tax-free treatment under Section 368 of the Internal Revenue Code. (The tax treatment of M&As is discussed in greater detail in Chapter 9.)

(c) LARGE PUBLIC VERSUS SMALL PRIVATE ACQUISITIONS. Arguably, the most important distinction among types of acquisitions revolves around size. Mergerstat data confirms that a reasonable dividing line between large, public company acquisitions and small, nonpublic acquisitions, as determined by magnitude of purchase price, is $500 million. This is because the vast majority of transactions that are larger than $500 million involve the sale of a public company, and those falling below that benchmark are sales of private companies or divestitures of business units by larger companies. This distinction is important because large transactions have dynamics and requirements that are substantially different from those of smaller transactions, and those differences have a significant impact on the acquisition process for each. These differences and their impact are briefly described in the paragraphs that follow and are illustrated in Exhibit 1.1.

(i) Strategic Impact. Large public transactions are almost invariably transformational in nature. They involve the combination of two large entities that can be expected to have strong positions in the same or adjacent markets. Such combinations generally result in an entity of great size, with substantially expanded product breadth and depth, market reach, and overall capabilities. In contrast, smaller transactions are generally nontransformational in nature and fulfill important, but limited, strategic objectives. While they may materially advance the strategic position of the acquirer, they rarely are significant enough to transform the acquirer's business.

(Continues...)

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Excerpted from Mergers and Acquisitionsby William Gole Joseph Morris Copyright © 2007 by John Wiley & Sons, Ltd. Excerpted by permission.
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