Another form of acquisition is by financial institutions such as private equity firms that seek to own — but not directly operate — the target of acquisition, generally to drive up its value and sell it again.
M&A is governed by Section 7 of the Clayton Act, covering instances in which the result of the merger or acquisition “may be substantially to lessen competition, or to tend to create a monopoly.” This is often the case when two or more companies merge horizontally, reducing or eliminating competition for the product or service they provide. The Federal Trade Commission (FTC) and the Department of Justice (DOJ) often intervene in proposed combinations, or may even order the breakup of existing conglomerates.
In addition to the considerations of Section 7, companies involved in mergers and acquisitions must also be aware of any regulatory hurdles that may loom from other government agencies.
Elements to Consider
A properly executed merger or acquisition often leads to higher valuations for the remaining companies or merged company, though there may be a high cost in employee turnover, whether through downsizing or simple attrition.
The most basic element in mergers and acquisitions is value. The acquiring entity must negotiate or otherwise offer a proper price for the target it seeks to acquire. The target firm must likewise receive what it considers to be fair value — or more — for what it is surrendering.
If the target company is publicly traded, a commonly used tool is to utilize the price-to-earnings (P/E) ratio. If similar companies are trading at a 12-to-1 P/E ratio, the acquiring company can start with that valuation and enhance their offer as needed.
Another method is based on what is called the enterprise-value-to-sales (EV/Sales) ratio, which can be used for both private and public companies’ valuations. EV/Sales ratio calculations result in a multiple of the target company’s revenues based on what comparable companies earn.
Sometimes, the offer can be merely the replacement value of the target company. At other times, a complicated process known as discounted cash flow (DCF) can be employed.
To arrive at an acceptable offer price, the acquiring company must first have the necessary financing in place. This can often involve issuing shares to purchase the target, or there could be a combination of shares and cash. The acquirer can also agree to assume the target’s debt. In some cases, the deal can be financed through an initial public offering (IPO) on the stock exchanges.
Due Diligence and Documentation
Even before an acquisition/merger price has been agreed upon, the acquiring entity must carry out its own due diligence. Due diligence means that the buyer takes the necessary steps to confirm pertinent information about the seller, including debt, leases, contracts, finances, impending lawsuits, customers, employee contracts, and more.
The due diligence process begins with the signing of a letter of intent. The buyer then assembles a team to conduct the necessary research. The team will generally include professionals from the legal and financial fields with experience in M&A, along with others, including investors and consultants.
Once the team is assembled, the task at hand is to collect all pertinent documents to gather a picture of the company’s overall health and relative value. Documents can include contracts, company financial records, stockholder information (if it’s a public company), leases, regulatory information, insurance papers, legal records including lawsuits past and pending, and more.
Once a completed picture is painted of the company’s financial status, strategic position, and operational assets, the two parties can move toward a final price.
The Importance of Having a Skilled Legal Team
M&A can take months to years to complete, depending on the size and nature of the companies involved. Needless to say, legal issues abound all along the route to successful completion.
The final acquisition agreement, which follows upon completion of due diligence, is absolutely essential. It needs to be crafted to afford protections to both the seller and buyer, which requires the input and counsel of knowledgeable attorneys. The letter of intent, though not generally binding, should also be vetted by experienced M&A attorneys. After all, it gives the buyer access to the target company’s resources and records.