BUS403: Negotiations and Conflict Management (2016.A.01)

Transactions can be mergers or acquisitions, made with cash or stock, and they can be friendly or hostile.

Learning Objectives

Choose the best strategy and method for completing a merger or acquisition

Key Takeaways

Key Points

• A cash deal is one whereby the acquirer buys the target's outstanding equity (or assets ) with cash. The acquirer may raise cash through a debt or equity offering or internally finance the deal using the firm's cash on hand.
• A stock deal is one whereby the acquirer offers its own shares for the shares of the target. Usually this involves the acquirer floating new shares or using internally held treasury shares.
• The ongoing status of the target's owners dictates whether the transaction is a merger (retained) or acquisition (replaced).
• Whether a purchase is perceived as being a "friendly" one or a "hostile" depends significantly on how the proposed acquisition is communicated to and perceived by the target company's board of directors, employees, and shareholders.

Key Terms

• shares in treasury: Stock that is bought back by the issuing company, reducing the amount of outstanding stock on the open market.
• liquidation: The selling of the assets of a business as part of the process of dissolving the business.

Basic Strategies of M&A:

1. The buyer buys the shares, and therefore the control, of the target company. Ownership control of the company in turn conveys effective control over the assets of the company. However, since the company is acquired intact as a going concern, this form of transaction carries with it all of the liabilities accrued by that business over its past and all of the risks that company faces in its commercial environment.
2. The buyer buys the assets of the target company. The cash the target receives from the sell-off is netted against outstanding liabilities and returned to equity holders (owners). This type of transaction leaves the target company as an empty shell, if the buyer buys out the entirety of the target's assets (a liquidation). A buyer often structures the transaction in order to "cherry-pick" the assets that it wants and leaves out the assets and liabilities that it does not. A disadvantage of this structure is the tax that many jurisdictions – particularly outside the United States – impose on transfers of individual assets, whereas stock transactions can frequently be structured as like-kind exchanges or other arrangements that are tax-free or tax-neutral.

Basic Methods of Financing M&A:

Cash

1. Cash on hand: The buyer consumes financial slack (excess cash or unused debt capacity) and may decrease its debt rating. There are no major transaction costs.
2. Issue of stock: The buyer increases financial slack, which may improve its debt rating and reduce the cost of debt (although not WACC as cost of equity will increase). Transaction costs include fees for preparation of a proxy statement, an extraordinary shareholder meeting, and registration.

Stock

Payment is made in the form of the acquiring company's stock, issued to the shareholders of the acquired company at a given ratio proportional to the valuation of the acquired company's stock. If the buyer pays with stock, the financing possibilities are:

1. Issue of stock (same effects and transaction costs as described above).
2. Shares in treasury: The buyer increases financial slack (if they don't have to be repurchased on the market), which may improve its debt rating and reduce the cost of debt (although not WACC as cost of equity will increase). Transaction costs include brokerage fees if shares are repurchased in the market; otherwise, there are no major costs.

There are some elements to think about when choosing the form of payment. When submitting an offer, the acquiring firm should consider other potential bidders and think strategically. The form of payment might be decisive for the seller. With pure cash deals, there is no doubt on the real value of the bid. Therefore, a cash offer preempts competitors better than securities. Taxes are a second element to consider and should be evaluated with the counsel of competent tax and accounting advisers. Third, with a share deal the buyer's capital structure might be affected and the control of the buyer modified. If the issuance of shares is necessary, shareholders of the acquiring company might prevent such capital increase at the general meeting of shareholders. This risk is removed with a cash transaction.

In the aftermath of a merger, there will be accounting issues to consider. The balance sheet of the buyer will be modified, and thus the decision maker should take into account the effects on the reported financial results. For example, in a pure cash deal (financed from the company's current account), liquidity ratios might decrease. On the other hand, in a pure stock for stock transaction (financed from the issuance of new shares), the company might show lower profitability ratios (e.g. ROA). However, economic dilution must prevail towards accounting dilution in the decision making process.

Hostile vs. Friendly:

Whether a purchase is perceived as being a "friendly" one or a "hostile" depends significantly on how the proposed acquisition is communicated to and perceived by the target company's board of directors, employees, and shareholders. It is normal for deal communications to take place in a so-called "confidentiality bubble," wherein the flow of information is restricted pursuant to confidentiality agreements. In the case of a friendly transaction, the companies cooperate in negotiations. In the case of a hostile deal, the board and/or management of the target is unwilling to be bought or the target's board has no prior knowledge of the offer. Hostile acquisitions can, and often do, ultimately become "friendly," as the acquirer secures endorsement of the transaction from the board of the acquiree company. This usually requires an improvement in the terms of the offer through negotiation.

Airline M&A: The aviation industry has seen increased consolidation through M&A activity in the last 20 years. Pictured is a plane belonging to United Airlines, one of the world's largest carriers, fresh off a 2010 merger with Continental Airlines.