Transaction Characteristics

The form of acquisition, payment method, and mindset of target management plays a major role in determining how transactions will be valued, how the transactions will occur, how the transaction will be taxed, and which regulatory rule may apply.

Form of Acquisition

An acquirer can purchase the target through a stock purchase or an asset purchase. A stock purchase occurs when the acquirer offers a target’s shareholders a combination of cash and stock in exchange for the target’s stock. For a stock purchase to be successful, 50% of the target’s shareholders must agree to the merger. The advantage of this is that when management is opposed to the merger, the acquirer can go around the management and convince the shareholders. The disadvantage with this is that it is a time-consuming task. In a stock purchase, the target company’s shareholders are liable to pay taxes on the gain but have no consequences at the corporate level. Acquirers generally assume the target’s liability in a stock purchase.

An asset purchase occurs when an acquirer buys a target’s assets, and payment is made to the target company. The advantage of this method is that it is faster to execute than a stock purchase, and a company can buy the most profitable parts of the target company. In an asset purchase, the target’s shareholders are not liable to pay tax, but the company itself will pay corporate tax. Acquirers avoid assuming the liabilities of a target company.

Method of Payment

A target company can be paid via a cash offering, security offering, or a mixed offering, a combination of cash and stocks. In a security offering, the target shareholders receive shares of the acquirer’s common stock. The exchange ratio is used to determine the number of shares the target’s shareholders will receive for each of their shares in the target company. Exchange ratios are negotiated in advance because of share price fluctuations. The acquirer’s cost is the product of the exchange ratio, the number of outstanding shares of the target, and the value of the stock given to target shareholders.

The payment method will influence the distribution of risk and reward between the acquirer and the target shareholders. A portion of risk and rewards associated with the estimated synergies and company value is assumed by the target shareholder in a stock offering. Security offering may be ideal when the acquirer’s shares are overvalued by the market relative to the target’s shares. Investors can sometimes interpret an acquirer’s stock offerings to signal that the company’s shares are overvalued. Changes in capital structure is another important consideration when deciding the method of payment.  For example, an acquirer’s financial risk and leverage increase if they borrow money for cash offerings. Issuing many new common stocks for stock offerings will dilute existing shareholders’ ownership interests.

Mindset of the Target Management

Mergers can either be hostile or friendly depending on how the target company’s senior managers and board members view the offer. This impacts what regulations must be followed, how long transactions take, how much value will be created and how it will be completed.

1. Friendly Mergers

Under normal circumstances, the acquirer will start the merger process by directly approaching target management. If both management teams agree to a potential deal, then the two start merger discussions among themselves. The target company’s shareholders are made aware of the merger discussion and the terms of the transaction.

Next, each party carries out due diligence to protect the companies’ shareholders by confirming the accuracy of representations during negotiations. Any discrepancies uncovered during due diligence could impact negotiations leading to readjustment of price and terms of the deal. If the inconsistencies are too great to ignore, either party can abandon the deal. If all else is ok, they will proceed to enter into a definitive merger agreement.

The definitive merger agreement is a contract written by both companies’ lawyers, which contains terms, conditions, warranties, termination details, and the rights of all parties. Much secrecy is maintained until the definitive agreement is reached. After both parties sign the definitive agreement, the transaction is announced to the public. In a friendly merger, the target company’s management endorses and encourages its shareholders to accept the merger. A proxy statement is provided to shareholders before deciding whether to accept the merger or reject it.

Once approvals have been obtained from regulatory bodies and shareholders, the companies’ attorneys file the documents with the securities regulators, and the merger is complete.

2. Hostile Mergers

A hostile merger is one where the target’s management is against the merger. The acquirer sidesteps the target’s management and submits its merger proposal directly to the board of directors. This tactic is known as the bear hug. If the offer is good enough, the board of directors will appoint a special committee to negotiate the target’s sale. In response to the bear hug, the target’s management will give in and negotiate with the acquirer, although this is not the case in many mergers.

If the bear hug is unsuccessful, the acquirer will approach the shareholders directly through a tender offer where the target shareholders are invited to tender their shares in exchange for the proposed payment. To gain control of the target company quickly, some companies offer cash tender offers because they are faster to execute than cash mergers.

Another method of taking over is through a proxy fight. A proxy fight is when a company seeks to take control of a target through a shareholder vote. The voters are asked to vote for the acquirer’s slate of directors, who will replace the target’s management when elected. From this point, the merger will evolve into a friendly merger.

Question

What advantages is an acquirer most likely to experience if they decide to buy the target through a stock purchase?

1. It is time-consuming.
2. In case the management opposes the merger, they can circumvent the management and deal with the shareholders directly.
3. More corporate taxes are paid.

Solution

The correct answer is B.

The advantage of stock purchase is that the acquirer can use the bear hug when management is opposed to the merger.

A is incorrect. This is a disadvantage of merging through stock purchase because shareholder approval is required.

C is incorrect. The acquirer will have no corporate-level tax liability because of the merger.

Reading 18: Mergers and Acquisition

LOS 18 (e) Contrast merger transaction characteristics by form of acquisition, method of payment, and attitude of target management.