Question

1. Takeover is a general and imprecise term referring to the transfer of control of a firm from one group of shareholders to another. This can occur through any one of three means: acquisitions, proxy contests, and going-private transactions. Discuss THREE (3) basic legal procedures that one firm can use to acquire another firm.

2. One important reason for an acquisition is that the combined firm may generate greater revenues than two separate firms. Increase in revenue may come from marketing gains, strategic benefits, and increase in market power. Briefly describe this revenue enhancement to the company.                                                                                

Answer 1

a. Takeover is a general and imprecise term referring to the transfer of control of a firm from one group of shareholders to another. This can occur through any one of three means: acquisitions, proxy contests, and going-private transactions. Discuss THREE (3) basic legal procedures that one firm can use to acquire another firm.

What Is a Takeover?

A takeover occurs when one company makes a successful bid to assume control of or acquire another. Takeovers can be done by purchasing a majority stake in the target firm. Takeovers are also commonly done through the merger and acquisition process. In a takeover, the company making the bid is the acquirer and the company it wishes to take control of is called the target.

Takeovers are typically initiated by a larger company seeking to take over a smaller one. They can be voluntary, meaning they are the result of a mutual decision between the two companies. In other cases, they may be unwelcome, in which case the acquirer goes after the target without its knowledge or some times without its full agreement.

In corporate finance, there can be a variety of ways for structuring a takeover. An acquirer may choose to take over controlling interest of the company’s outstanding shares, buy the entire company outright, merge an acquired company to create new synergies, or acquire the company as a subsidiary.

KEY TAKEAWAYS

• A takeover occurs when an acquiring company successfully closes on a bid to assume control of or acquire a target company.
• Takeovers are typically initiated by a larger company seeking to take over a smaller one.
• Takeovers can be welcome and friendly, or they may be unwelcome and hostile.
• Companies may initiate takeovers because they find value in a target company, they want to initiate change, or they may want to eliminate the competition.

Understanding Takeovers

Takeovers are fairly common in the business world. However, they may be structured in a multitude of ways. Whether both parties are in agreement or not, will often influence the structuring of a takeover.

Keep in mind, if a company owns more than 50% of the shares of a company, it is considered controlling interest. Controlling interest requires a company to account for the owned company as a subsidiary in its financial reporting, and this requires consolidated financial statements. A 20% to 50% ownership stake is accounted for more simply through the equity method. If a full-on merger or acquisition occurs, shares will often be combined under one symbol.

Types of Takeovers

Takeovers can take many different forms. A welcome or friendly takeover will usually be structured as a merger or acquisition. These generally go smoothly because the boards of directors for both companies usually consider it a positive situation. Voting must still take place in a friendly takeover. However, when the board of directors and key shareholders are in favor of the takeover, takeover voting can more easily be achieved.

Usually, in these cases of mergers or acquisitions, shares will be combined under one symbol. This can be done by exchanging shares from the target’s shareholders to shares of the combined entity.

An unwelcome or hostile takeover can be quite aggressive as one party is not a willing participant. The acquiring firm can use unfavorable tactics such as a dawn raid, where it buys a substantial stake in the target company as soon as the markets open, causing the target to lose control before it realizes what is happening.

The target firm’s management and board of directors may strongly resist takeover attempts by implementing tactics such as a poison pill, which allows the target’s shareholders to purchase more shares at a discount to dilute the potential acquirer’s holdings and voting rights.

A reverse takeover happens when a private company takes over a public one. The acquiring company must have enough capital to fund the takeover. Reverse takeovers provide a way for a private company to go public without having to take on the risk or added expense of going through an initial public offering (IPO).

A creeping takeover occurs when one company slowly increases its share ownership in another. Once the share ownership gets to 50% or more, the acquiring company is required to account for the target’s business through consolidated financial statement reporting.The 50% level can thus be a significant threshold, particularly since some companies may not want the responsibilities of controlling ownership. After the 50% threshold has been breached, the target company should be considered a subsidiary.

Creeping takeovers may also involve activists who increasingly buy shares of a company with the intent of creating value through management changes. An activist takeover would likely happen gradually over time.

50%

The ownership threshold for controlling vs. non-controlling ownership.

Reasons for a Takeover

There are many reasons why companies may initiate a takeover. An acquiring company may pursue an opportunistic takeover, where it believes the target is well priced. By buying the target, the acquirer may feel there is long-term value. With these takeovers, the acquiring company usually increases its market share, achieves economies of scale, reduces costs, and increases profits through synergies.

Some companies may opt for a strategic takeover. This allows the acquirer to enter a new market without taking on any extra time, money, or risk. The acquirer may also be able to eliminate competition by going through a strategic takeover.

There can also be activist takeovers. With these takeovers, a shareholder seeks controlling interest ownership to initiate change or acquire controlling voting rights.

Companies that make attractive takeover targets include:

• Those with a unique niche in a particular product or service
• Small companies with viable products or services but insufficient financing
• Similar companies in close geographic proximity where combining forces could improve efficiency
• Otherwise viable companies that pay too much for debt that could be refinanced at a lower cost if a larger company with better credit took over
• Companies with good potential value but management challenges

Funding Takeovers

Financing takeovers can come in many different forms. When the target is a publicly-traded company, the acquiring company can buy shares of the business in the secondary market. In a friendly merger or acquisition, the acquirer makes an offer for all of the target’s outstanding shares. A friendly merger or acquisition will usually be funded through cash, debt, or new stock issuance of the combined entity.

When a company uses debt, it's known as a leveraged buyout. Debt capital for the acquirer may come from new funding lines or the issuance of new corporate bonds.

Example of a Takeover

ConAgra initially attempted a friendly acquisition of Ralcorp in 2011. When initial advances were rebuffed, ConAgra intended to work a hostile takeover. Ralcorp responded by using the poison pill strategy. ConAgra responded by offering $94 per share, which was significantly higher than the $65 per share Ralcorp was trading at when the takeover attempt began. Ralcorp denied the attempt, though both companies returned to the bargaining table the following year.

The deal was ultimately made as part of a friendly takeover with a per-share price of $90.4 By this time, Ralcorp had completed the spinoff of its Post cereal division, resulting in approximately the same offering price by ConAgra for a slightly smaller total business.

b. One important reason for an acquisition is that the combined firm may generate greater revenues than two separate firms. Increase in revenue may come from marketing gains, strategic benefits, and increase in market power. Briefly describe this revenue enhancement to the company.

A corporate merger or acquisition can have a profound effect on a company’s growth prospects and long-term outlook. But while an acquisition can transform the acquiring company literally overnight, there is a significant degree of risk involved, as mergers and acquisitions (M&A) transactions overall are estimated to only have less than a 30% chance of success.

In the sections below, we discuss why companies undertake M&A transactions, the reasons for their failures, and present some examples of well-known M&A transactions. Many successful people, like Christine Lagarde, are known for studying the topic.

KEY TAKEAWAYS

• Companies will buy or merge with another company in hopes of boosting the growth of their own business or to fend off competition, among other reasons.
• But there are risks—things that can lead to a failed M&A deal—such as overpaying or the inability to properly integrate the two companies.
• M&A can affect a company in a number of ways, including its capital structure, stock price, and future growth prospects.
• Some M&A deals are key successes, such as Gilead Sciences-Pharmasset in 2011, while others are notorious flops, e.g. AOL-Time Warner in 2000.

Why Companies Engage in M&A?

Growth

Many companies use M&A to grow in size and leapfrog their rivals. in contrast, it can take years or decades to double the size of a company through organic growth.

Competition

This powerful motivation is the primary reason why M&A activity occurs in distinct cycles. The urge to snap up a company with an attractive portfolio of assets before a rival does so generally results in a feeding frenzy in hot markets. Some examples of frenetic M&A activity in specific sectors include dot-coms and telecoms in the late 1990s, commodity and energy producers in 2006-07, and biotechnology companies in 2012-14.2 3 4

Synergies

Companies also merge to take advantage of synergies and economies of scale. Synergies occur when two companies with similar businesses combine, as they can then consolidate (or eliminate) duplicate resources like branch and regional offices, manufacturing facilities, research projects, etc. Every million dollars or fraction thereof thus saved goes straight to the bottom line, boosting earnings per share and making the M&A transaction an “accretive” one.

Domination

Companies also engage in M&A to dominate their sector. However, a combination of two behemoths would result in a potential monopoly, and such a transaction would have to run the gauntlet of intense scrutiny from anti-competition watchdogs and regulatory authorities.

Tax Purposes

Companies also use M&A for tax reasons, although this may be an implicit rather than an explicit motive. For instance, since, until recently, the U.S. has the highest corporate tax rate in the world, some of the best-known American companies have resorted to corporate “inversions.”

This technique involves a U.S. company buying a smaller foreign competitor and moving the merged entity’s tax home overseas to a lower-tax jurisdiction, in order to substantially reduce its tax bill.

Why M&A Fails?

Integration Risk

In many cases, integrating the operations of two companies proves to be a much more difficult task in practice than it seemed in theory. This may result in the combined company being unable to reach the desired targets in terms of cost savings from synergies and economies of scale. A potentially accretive transaction could therefore well turn out to be dilutive.

Overpayment

If company A is unduly bullish about company B’s prospects—and wants to forestall a possible bid for B from a rival—it may offer a very substantial premium for B. Once it has acquired company B, the best-case scenario that A had anticipated may fail to materialize.

For instance, a key drug being developed by B may turn out to have unexpectedly severe side-effects, significantly curtailing its market potential. Company A’s management (and shareholders) may then be left to rue the fact that it paid much more for B than what it was worth. Such overpayment can be a major drag on future financial performance.

Culture Clash

M&A transactions sometimes fail because the corporate cultures of the potential partners are so dissimilar. Think of a staid technology stalwart acquiring a hot social media start-up and you may get the picture.

M&A Effects

Capital Structure

M&A activity obviously has long-term ramifications for the acquiring company or the dominant entity in a merger than it does for the target company in an acquisition or the firm that is subsumed in a merger.

For the target company, an M&A transaction gives its shareholders the opportunity to cash out at a significant premium, especially if the transaction is an all-cash deal. If the acquirer pays partly in cash and partly in its own stock, the target company’s shareholders get a stake in the acquirer, and thus have a vested interest in its long-term success.

For the acquirer, the impact of an M&A transaction depends on the deal size relative to the company’s size. The larger the potential target, the bigger the risk to the acquirer. A company may be able to withstand the failure of a small-sized acquisition, but the failure of a huge purchase may severely jeopardize its long-term success.

Once an M&A transaction has closed, the acquirer’s capital structure will change, depending on how the M&A deal was designed. An all-cash deal will substantially deplete the acquirer’s cash holdings. But as many companies seldom have the cash hoard available to make full payment for a target firm outright, all-cash deals are often financed through debt. While this increases a company’s indebtedness, the higher debt load may be justified by the additional cash flows contributed by the target firm.

Many M&A transactions are also financed through the acquirer’s stock. For an acquirer to use its stock as currency for an acquisition, its shares must often be premium-priced, to begin with, else making purchases would be needlessly dilutive. As well, management of the target company also has to be convinced that accepting the acquirer’s stock rather than hard cash is a good idea. Support from the target company for such an M&A transaction is much more likely to be forthcoming if the acquirer is a Fortune 500 company than if it is ABC Widget Co.

Market Reaction

Market reaction to news of an M&A transaction may be favorable or unfavorable, depending on the perception of market participants about the merits of the deal. In most cases, the target company’s shares will rise to a level close to that of the acquirer’s offer, assuming of course that the offer represents a significant premium to the target’s previous stock price. In fact, the target’s shares may trade above the offer price if the perception is either that the acquirer has low-balled the offer for the target and may be forced to raise it, or that the target company is coveted enough to attract a rival bid.

There are situations in which the target company may trade below the announced offer price. This generally occurs when part of the purchase consideration is to be made in the acquirer’s shares and the stock plummets when the deal is announced. For example, assume the purchase price of $25 per share of Targeted XYZ Co. consists of two shares of an acquirer valued at $10 each and $5 in cash. But if the acquirer’s shares are now only worth $8, Targeted XYZ Co. would most likely be trading at $21 rather than $25.

There are a number of reasons why an acquirer’s shares may decline when it announces an M&A deal. Perhaps market participants think that the price tag for the purchase is too steep. Or the deal is perceived as not being accretive to EPS (earnings per share). Or perhaps investors believe that the acquirer is taking on too much debt to finance the acquisition.

An acquirer’s future growth prospects and profitability should ideally be enhanced by the acquisitions it makes. Since a series of acquisitions can mask deterioration in a company’s core business, analysts and investors often focus on the “organic” growth rate of revenue and operating margins—which excludes the impact of M&A—for such a company.

In cases where the acquirer has made a hostile bid for a target company, the latter’s management may recommend that its shareholders reject the deal. One of the most common reasons cited for such rejection is that the target’s management believes the acquirer’s offer substantially undervalues it. But such rejection of an unsolicited offer can sometimes backfire, as demonstrated by the famous Yahoo-Microsoft case.