Company X buys all of Company Y's assets for cash, which means that Company Y will have only cash and debt, if any. Of course, Company Y becomes merely a shell and will eventually liquidate or enter other areas of business. Another acquisition deal known as a reverse merger enables a private company to become publicly listed in a relatively short time period.
Reverse mergers occur when a private company that has strong prospects and is eager to acquire financing buys a publicly listed shell company with no legitimate business operations and limited assets.
The private company reverse merges into the public company , and together they become an entirely new public corporation with tradable shares. The seller will obviously value the company at the highest price possible, while the buyer will attempt to buy it for the lowest price possible. Fortunately, a company can be objectively valued by studying comparable companies in an industry, and by relying on the following metrics:.
Admittedly, DCF is tricky to get right, but few tools can rival this valuation method. In a few cases, acquisitions are based on the cost of replacing the target company. For simplicity's sake, suppose the value of a company is simply the sum of all its equipment and staffing costs.
The acquiring company can literally order the target to sell at that price, or it will create a competitor for the same cost. Naturally, it takes a long time to assemble good management, acquire property, and purchase the right equipment. This method of establishing a price certainly wouldn't make much sense in a service industry wherein the key assets people and ideas are hard to value and develop.
In general, "acquisition" describes a transaction, wherein one firm absorbs another firm via a takeover. The term "merger" is used when the purchasing and target companies mutually combine to form a completely new entity. Because each combination is a unique case with its own peculiarities and reasons for undertaking the transaction, use of these terms tends to overlap.
Two of the key drivers of capitalism are competition and growth. When a company faces competition, it must both cut costs and innovate at the same time.
One solution is to acquire competitors so that they are no longer a threat. Companies may also look for synergies. By combining business activities, overall performance efficiency tends to increase, and across-the-board costs tend to drop as each company leverages off of the other company's strengths. Friendly acquisitions are most common and occur when the target firm agrees to be acquired; its board of directors and shareholders approve of the acquisition, and these combinations often work for the mutual benefit of the acquiring and target companies.
Unfriendly acquisitions, commonly known as hostile takeovers, occur when the target company does not consent to the acquisition.
Hostile acquisitions don't have the same agreement from the target firm, and so the acquiring firm must actively purchase large stakes of the target company to gain a controlling interest, which forces the acquisition. Generally speaking, in the days leading up to a merger or acquisition, shareholders of the acquiring firm will see a temporary drop in share value. At the same time, shares in the target firm typically experience a rise in value.
This is often due to the fact that the acquiring firm will need to spend capital to acquire the target firm at a premium to the pre-takeover share prices. After a merger or acquisition officially takes effect, the stock price usually exceeds the value of each underlying company during its pre-takeover stage. In the absence of unfavorable economic conditions , shareholders of the merged company usually experience favorable long-term performance and dividends.
Note that the shareholders of both companies may experience a dilution of voting power due to the increased number of shares released during the merger process. This phenomenon is prominent in stock-for-stock mergers , when the new company offers its shares in exchange for shares in the target company, at an agreed-upon conversion rate.
Shareholders of the acquiring company experience a marginal loss of voting power, while shareholders of a smaller target company may see a significant erosion of their voting powers in the relatively larger pool of stakeholders. Horizontal integration and vertical integration are competitive strategies that companies use to consolidate their position among competitors.
Horizontal integration is the acquisition of a related business. A company that opts for horizontal integration will take over another company that operates at the same level of the value chain in an industry—for instance when Marriott International, Inc. Vertical integration refers to the process of acquiring business operations within the same production vertical.
A company that opts for vertical integration takes complete control over one or more stages in the production or distribution of a product. Apple, for example, acquired AuthenTec, which makes the touch ID fingerprint sensor technology that goes into its iPhones. Marriott International. Securities and Exchange Commission. Form 8-K. Career Advice. Your Privacy Rights. To change or withdraw your consent choices for Investopedia. Common economic forces govern the share prices of both companies, and thus the negotiated exchange ratio is more likely to remain equitable to acquirers and sellers at closing.
But there are ways for an acquiring company to structure a fixed-share offer without sending signals to the market that its stock is overvalued. Acquirers that offer such a floor typically also insist on a ceiling on the total value of shares distributed to sellers. That might have helped Bell Atlantic in its bid for TCI in —which would have been the largest deal in history at the time. An even more confident signal is given by a fixed-value offer in which sellers are assured of a stipulated market value while acquirers bear the entire cost of any decline in their share price before closing.
As with fixed-share offers, floors and ceilings can be attached to fixed-value offers—in the form of the number of shares to be issued. It just has to compare the value of the company as an independent business against the price offered.
The only risks are that it could hold out for a higher price or that management could create better value if the company remained independent. The latter case certainly can be hard to justify. If the bid were rejected, Seller Inc.
So uncertain a return must compete against a bird in the hand. In essence, shareholders of the acquired company will be partners in the postmerger enterprise and will therefore have as much interest in realizing the synergies as the shareholders of the acquiring company. If the expected synergies do not materialize or if other disappointing information develops after closing, selling shareholders may well lose a significant portion of the premium received on their shares. Essentially, then, the board must act in the role of a buyer as well as a seller and must go through the same decision process that the acquiring company follows.
At the end of the day, however, no matter how a stock offer is made, selling shareholders should never assume that the announced value is the value they will realize before or after closing. Selling early may limit exposure, but that strategy carries costs because the shares of target companies almost invariably trade below the offer price during the preclosing period.
Of course, shareholders who wait until after the closing date to sell their shares of the merged company have no way of knowing what those shares will be worth at that time. The questions we have discussed here—How much is the acquirer worth? How likely is it that the expected synergies will be realized? But those concerns should not play a key role in the acquisition decision. The actual impact of tax and accounting treatments on value and its distribution is not as great as it may seem.
The way an acquisition is paid for affects the tax bills of the shareholders involved. On the face of it, a cash purchase of shares is the most tax-favorable way for the acquirer to make an acquisition because it offers the opportunity to revalue assets and thereby increase the depreciation expense for tax purposes. Conversely, shareholders in the selling company will face a tax bill for capital gains if they accept cash.
After all, if the selling shareholders suffer losses on their shares, or if their shares are in tax-exempt pension funds, they may favor cash rather than stock. But if sellers are to realize the deferred tax benefit, they must be long-term shareholders and consequently must assume their full share of the postclosing synergy risk.
Some managers claim that stock deals are better for earnings than cash deals. But this focus on reported earnings flies in the face of economic sense and is purely a consequence of accounting convention. In the United States, cash deals must be accounted for through the purchase-accounting method. This approach, which is widespread in the developed world, records the assets and liabilities of the acquired company at their fair market value and classifies the difference between the acquisition price and that fair value as goodwill.
The goodwill must then be amortized, which causes a reduction in reported earnings after the merger is completed. This approach requires companies simply to combine their book values, creating no goodwill to be amortized. Therefore, better earnings results are reported. Although it can dramatically affect the reported earnings of the acquiring company, it does not affect operating cash flows.
Goodwill amortization is a noncash item and should not affect value. Managers are well aware of this, but many of them contend that investors are myopically addicted to short-term earnings and cannot see through the cosmetic differences between the two accounting methods. Research evidence does not support that claim, however. Studies consistently show that the market does not reward companies for using pooling-of-interests accounting.
Nor do goodwill charges from purchase accounting adversely affect stock prices. In fact, the market reacts more favorably to purchase transactions than to pooling transactions. The message for management is clear: value acquisitions on the basis of their economic substance—their future cash flows—not on the basis of short-term earnings generated by accounting conventions. We present two simple tools for measuring synergy risk, one for the acquirer and the other for the seller.
A useful tool for assessing the relative magnitude of synergy risk for the acquirer is a straightforward calculation we call shareholder value at risk. SVAR is simply the premium paid for the acquisition divided by the market value of the acquiring company before the announcement is made.
The index can also be calculated as the premium percentage multiplied by the market value of the seller relative to the market value of the buyer. The greater the premium percentage paid to sellers and the greater their market value relative to the acquiring company, the higher the SVAR.
In those cases, SVAR underestimates risk. Buyer Inc. In a cash deal, its SVAR would therefore be 1. But if Seller Inc. To calculate Buyer Inc. The question for sellers is, What percentage of the premium is at risk in a stock offer? The answer is the percentage of ownership the seller will have in the combined company. In our hypothetical deal, therefore, the premium at risk for Seller Inc. Once again, the premium-at-risk calculation is actually a rather conservative measure of risk, as it assumes that the value of the independent businesses is safe and only the premium is at risk.
The cash SVAR percentage is calculated as the premium percentage multiplied by the relative size of the seller to the acquirer. If Buyer Inc. Since no synergy expectations are built into the price of those shares now, Seller Inc. In other words, Seller Inc. But in a fixed-share transaction, Seller Inc. Although we have taken a cautionary tone in this article, we are not advocating that companies should always avoid using stock to pay for acquisitions.
We have largely focused on deals that have taken place in established industries such as hotels and insurance. Stock issues are a natural way for young companies with limited access to other forms of financing, particularly in new industries, to pay for acquisitions.
Learn more about the different types of mergers below. When two existing companies decide to unite into a single new company, this is called a merger. Merger agreements are designed to increase shareholder value through growth. Apart from the benefit to company shareholders, there are also benefits to company operations. Some mergers will help both companies expand their reach, while others will expand activities into new segments and markets. Here are a few more reasons why companies take part in mergers:.
Mergers create a single legal entity by combining two previously existing, separate businesses. Acquisitions do not result in a new company being formed. Instead, an acquiring company purchases and absorbs the second company. While mergers are fully voluntary, acquisitions might not be. The acquired company is often liquidated. There are five main types of mergers, each of which offers unique benefits and challenges to the companies in question.
A conglomerate is formed by two or more companies that participate in unrelated activities. For example, two firms in different industries that have nothing in common will team up to enhance value.
This is called a pure conglomerate. A mixed conglomerate merger occurs when two or more organisations aim to gain market extensions. A second type of company merger is called a congeneric or product extension merger. They also operate in the same sector. Both expand their product range by merging, thus gaining access to a wider target audience. While a congeneric merger involves companies selling similar products in similar markets, a market extension involves companies that compete with similar products in different markets.
By merging, they gain access to a wider market and client base. Both companies could be considered broadly equal, because they offer the same product types. By fusing together, they create a new legal entity with far greater value.
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