What are Mergers and Acquisitions (M&A)?

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Definition:

Mergers and acquisitions (M&A) are financial transactions that result in the consolidation of two or more companies or their assets.

🤔 Understanding mergers and acquisitions

When mergers and acquisitions (M&As) occur, two companies join forces to become one. Although the terms merger and acquisition are often used together, they are actually two different types of transactions. A merger is when two companies combine assets to form a new company. Often the two existing companies will cease to exist, and they’ll form under a new name. An acquisition is when one company buys the ownership and assets of another company. Mergers and acquisitions aren’t the same as joint ventures. With mergers and acquisitions, the two companies become one — With joint ventures, two separate companies work together to share ownership of another entity.

Example

One of the most well-known examples of a mergers and acquisition transaction is the merger of Exxon and Mobil to form a single company, ExxonMobil. Both companies existed under the company Standard Oil, which the Supreme Court broke up into 34 individual companies in 1911, two of which were Exxon and Mobil. For most of the 20th century, the two companies operated as two separate entities. In 1999, Exxon and Mobil joined forces to create a single company. ExxonMobil is now the largest non-governmental oil company in the world.

Takeaway

Mergers and acquisitions are like getting married…

When two people get married, they take two separate lives and combine them into one. Similarly, mergers and acquisitions take two separate companies and combine them into one. Just as in a marriage one spouse might take the last name of the other, these M&A transactions might result in one company joining under the name of the other.

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What is a merger and acquisition?

Mergers and acquisitions (M&A) are business transactions where two separate companies consolidate into one. It’s often the case that one company buys the other, and the target company becomes a part of the company that purchased it. This type of transaction is an acquisition. A merger, on the other hand, is when two companies join together rather than one buying the other. In the case of a merger, the companies might exist under one of the original companies’ names, or they may start a new company under a new name.

What is the purpose of mergers and acquisitions?

Mergers and acquisitions (M&A) occur for many reasons, and companies entering into these deals will have their own motivations. One common reason for mergers and acquisitions is simply business growth. When one company buys another, or two companies join forces, the resulting company now has a much larger client base and market share, which is likely to result in an increase in revenue. At the same time, these deals reduce competition for businesses, because often they’ve just joined forces with a former competitor.

Another reason for mergers and acquisitions is that they help companies to diversify their portfolios. Just like individual investors often diversify portfolios by not putting all their money into one stock, companies do the same by diversifying their income streams and increasing the number of products they sell and markets they’re in.

What are the types of mergers and acquisitions?

There are several types of mergers and acquisitions (M&A), often categorized by the nature of the deal and whether it is one company buying another or two companies coming together.

  • Merger: A merger is a transaction where two existing companies join forces to form one company. Often the companies merge under the name and structure of one of the two companies.
  • Acquisition: An acquisition is a business transaction where one company buys another company. The acquired company (aka the target company) becomes a part of the acquiring company.
  • Consolidation: A consolidation is similar to a merger, where two companies join forces to create one new, larger company. The difference between the two deals is that with consolidation, the two companies form a new corporation with a new name. This is often called a merger of equals.
  • Tender offer: A tender offer occurs when one company offers to buy a significant share in another company. This process bypasses the requirements of the majority of shareholders agreeing to the deal. Instead of merging two companies, one entity is just buying a controlling share in another.
  • Acquisition of assets: An acquisition of assets is when, instead of buying a company in its existing form, one company purchases the assets of another. This type of sale often occurs when the target company is going under or filing for bankruptcy.
  • Management acquisition: A management acquisition (aka management buyout) occurs when a company’s management buys the majority of shares in the company. This often occurs using a leveraged buyout (LBO), which is when a purchase is heavily financed by debt, using the target company’s assets as collateral.

What is the structure of mergers?

Not all mergers are created equal. Here are the five primary models for company mergers:

  • Horizontal: A horizontal merger is one that occurs between two companies in the same industry to create a new, bigger company. An example of this type of merger might be one pizza delivery company acquiring a direct competitor.
  • Vertical: When a vertical merger takes place, two companies that each sell a part of the same finished product merge to form one company. These two companies exist at different points in the supply chain for one product. An example of a vertical merger could be a company that manufactures personal computers merging with a company that manufactures microprocessors.
  • Conglomerate: A conglomerate merger occurs between two companies in unrelated markets. In a pure conglomerate, the two companies have nothing in common at all. If the companies are seeking product or market extensions, it’s a mixed conglomerate merger. An example of a conglomerate merger might be a technology company merging with a women’s clothing company.
  • Market-extension merger: In the case of a market-extension merger, the two companies operate in different markets, but produce a similar product. This type of merger helps the companies expand their customer base. Suppose that a regional hair salon chain on the West Coast merged with a regional hair salon chain on the East Coast. The two companies offered the same service, but weren’t competing with one another.
  • Product-extension merger: In the case of a product-extension merger, two companies are in the same market selling products that are different, but related to one another. Imagine a company that sells peanut butter merging with one that sells jelly.

What is the M&A process?

Though every merger and acquisition (M&A) looks a bit different depending on who the players are, there are a few steps that will be present in most M&A deals.

  1. The first step a company has to complete is to find another company with which to go into business. Perhaps two companies already know they want to work together. Or it could be that a firm wants to acquire another and just doesn’t know which one yet. This step largely comes down to what a company’s motives are for entering into a merger or acquisition. Before getting too far ahead in the process, the buyer has to perform its due diligence, which is when it makes sure everything is accurate and in order at the company being acquired.
  2. After determining a target company, valuation has to take place. If one company is buying another, the buyer and seller have to agree on a sale price. There are many valuation methods companies can use, such as predicting future cash flows or determining the liquidation value of a company (in other words, assets minus liabilities). Assets may or may not include intangible assets such as intellectual property. The valuation phase will also be accompanied by negotiations, as each party will try to get a better deal for itself.
  3. Once two parties have found one another and have come to an agreement on a sale price, it’s time to write up the agreement. Just like you have to sign a contract whenever you enter into a business relationship with another party, companies have to do the same when entering into business with one another. The merger or acquisition agreement would include information such as the assets and inventory of each business and how the business will run moving forward.
  4. When everyone has agreed to the terms and signed the papers, the two companies can move forward with the merger or acquisition. This step includes transferring ownership of one company to another — or both companies forming a new company together. The parties will also have to file the necessary paperwork with the state in which they do business, such as articles of incorporation if they are forming a new corporation together.
  5. Anytime an acquisition takes place that accounts for more than 5% of a class of a company’s equity, the acquiring company has to notify the Securities and Exchange Commission (SEC) within 10 days. This notification is made publicly available.

How does valuation work?

The valuation step during the mergers and acquisitions (M&A) process is when the companies determine what a fair price is for the target company. Ultimately, the two companies must agree on a number.

There are several valuation methods that companies can use in mergers and acquisitions:

  • Discounted cash flow: The discounted cash flow method of valuation takes into account a company’s current value and its projected future cash flows. This valuation method is one of the most popular because it is forward-looking, rather than only taking into account historical data.
  • Book value: The book value is the value of a company’s assets after you subtract depreciation and impairment (a reduction of an asset’s value for accounting purposes). This valuation might be disadvantageous for target companies with intangible assets, as those won’t be counted in the book value.
  • Liquidation value: The liquidation value of a company is what it would be worth if the firm were to sell all its tangible assets and settle all its liabilities. This valuation method often makes sense when the target company is in distress. This method can be difficult, as each appraiser might name a different value.
  • Replacement cost value: The replacement cost value bases the valuation of a target company on what it would cost to replace it. In other words, how much would it cost to replace all the assets and human capital? This method was more common in the 1970s and 1980s, when the Securities and Exchange Commission (SEC) required that companies estimate their replacement values annually. The method is more common in international firms today.
  • Stock market value: The stock market value of a company is the price of its stock multiplied by the number of shares. This valuation method is available only to a public company, as private firms don’t have a stock market value. This method only takes into account public information, so it might be difficult to use when dealing with companies with extensive information available only to insiders.
  • Trading multiples of peer firms: The trading multiples value takes into account the stock market value and other financial information of similar companies in the market. These valuation multiples compare different financial metrics against one another — Earnings might include revenue, EBITDA (earnings before interest, taxes, depreciation, and amortization), or earnings per share.
  • Transaction multiples for comparable deals: When valuing a company for mergers and acquisitions, analysts consider the transaction price of comparable deals. Just like real estate agents analyze the price of comparable houses on the market when pricing a house, analysts do the same for companies.

Ultimately, there is no single best valuation method, and the results will almost certainly vary from one method to the next. It comes down to what the two companies can agree on.

What are some real-world examples of mergers and acquisitions?

Mergers and acquisitions (M&A) happen all the time. While many of the companies participating in these deals aren’t household names, the last several decades have seen transactions involving some massive companies. Here are a few examples:

  • In March 2019, The Walt Disney Company acquired 21st Century Fox. The purchase price of the deal came in at $71.3B. Disney already owned the Pixar, Marvel, and Star Wars brands. Thanks to the acquisition of 21st Century Fox, the company now also owns brands such as the remaining Marvel characters, FX Networks, National Geographic Partners, and Hulu.
  • In 2017, Amazon purchased Whole Foods for $13.7B, though the grocery chain continues to operate under its original name. The deal boosted the stock market value of both companies, and caused the stock of competing grocery stores to drop.
  • In 2016, the communications company AT&T announced its plans to acquire competitor Time Warner. The two companies went through a lengthy legal battle with the U.S. Justice Department, as the agency tried to block the deal as a violation of antitrust laws. A court ultimately ruled in favor of the acquisition. The cost of the purchase was $85.4B.
  • In 2014, the social media company Facebook acquired WhatsApp, a messaging app, for $19B. The purchase added another communication channel to the company’s portfolio. Facebook had purchased Instagram just a couple of years earlier.
  • In 2000, the Chase Manhattan Corporation acquired J.P. Morgan & Company to create the company as it is today, J.P. Morgan Chase & Co. The cost of the deal was $30.9B.

What’s a Special Purpose Acquisition Company (SPAC)?

A special purpose acquisition company, or SPAC, is a corporation expressly created to raise money through an initial public offering (IPO). After raising capital from the public, the SPAC—which has no operations of its own—may use the funds to acquire or merge with one or more existing businesses. If the SPAC doesn’t use the funds within an allotted time frame (often 18-24 months), the money is returned to investors, less fees. SPACs are sometimes referred to as “blank-check companies.”

While SPACs used to be pretty obscure, they’ve surged in popularity in recent years, even being christened the “new IPO.” These shell companies can make it faster (and cheaper) for a private company to become publicly traded, skipping on the time-consuming and expensive traditional IPO process.

Here are a few examples of recent SPACs: In August 2020, Lordstown Motors (an electric vehicle maker) announced its intention to go public through a $1.6 billion merger with a SPAC called DiamondPeak Holdings Corp. In 2019, Virgin Galactic (a space tourism and exploration company) and DraftKings (a sports gambling app) went public through SPACs.

But while SPACs are becoming more popular—in 2020, $24 billion have been raised through SPACs, and that’s just through early August—they have a few potential drawbacks. For one, investors don’t necessarily know what they’re investing in until the SPAC makes a deal. This can make it harder for investors to do their research. That uncertainty also comes with a price. If no deal gets struck, investors should get their money back (less fees), but in the meantime, they would’ve probably missed out on other opportunities.

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