First, a definition. What do we mean by a “friendly” merger or acquisition transaction? Hostile takeovers are rare and so most M&A transactions are friendly, or cooperative. A friendly, successfully completed M&A transaction is usually the end-product of an intensive planning and screening process undertaken by the acquiring firm. An acquiring firm may be searching for a new strategic direction brought on by changing technology innovation. Or, perhaps the potential acquirer is facing competitive pressures and is seeking a competitive advantage through financial or operational efficiencies that could be gained through a merger. This latter reason is an especially frequent occurrence in mature industries where consolidation of competitors is taking place via friendly, planned mergers.
Another difference between a hostile and a friendly merger or acquisition is that the latter is negotiated in a less hostile manner. There’s no proverbial “gun to the head” of the target’s board members, even where negotiations might get intense. A friendly merger is a planned and negotiated transaction conducted under a more open and friendlier atmosphere. In the United States, over 99% of all US companies are privately held.[1] These private companies’ merger activities would not trigger the reporting requirements[2] that are applicable to publicly held corporations’ mergers. However, even in the case of an M&A transaction involving only privately held companies, the Securities Act of 1933’s anti-fraud provisions would be triggered where the transaction involves the issuance of securities to investors in connection with the transaction.
Distinguishing Friendly Mergers from Hostile Takeovers
M&A negotiations are very complex, especially where one or both of the companies are publicly-held, subjecting them to federal securities laws framework. For example, Schedule D of the Williams Act controls how public companies solicit proxies from their public shareholders when the transaction must be by their votes[3]. Or, for example, under the Delaware corporate law, which governs Delaware-incorporated companies, the sale of all assets by one company to another requires stockholders to approve the sale and dissolution of the selling corporation[4]. On occasion, a negotiated, planned merger or acquisition may warp into hostile takeover attempts after negotiations break down. But, even more rarely, the opposite may also develop. That is, a hostile takeover may morph during the corporate hostilities and end up as a “friendly” takeover, as the acquirer capitulates to the efforts of the acquirer.
While hostile takeovers are typically acquisitions, friendly takeovers may be either mergers or acquisitions. In hostile takeovers, careful, longer-term planning is usually missing from the equation as acquirers must act quickly and without a full understanding or knowledge of the operations of the business to be acquired. Recall that hostile buyers seek acquisitions that the market has mispriced due to poor performing managers lacking strong board governance oversight. So, rather than seeking a merger with the target, a hostile acquirer wants a quick transaction, resulting in the acquisition of key assets.Therefore, unless an initial hostile acquisition reverses course and turns into a friendly, negotiated deal, the end result in most hostile takeovers will be an acquisition deal structure, which means that only one firm – usually the acquirer – survives.
Another difference between hostile and non-hostile takeovers is the form of payment. In hostile takeovers, cash is the dominant form of payment because the target company shareholders may not fully understand the value of the acquirer’s share price in the future after the completion of the acquisition. Thus, in most cases, hostile acquirers know that they must pay premiums over current market prices to quickly gain the acceptance of target shareholders. In comparison, in non-hostile, friendly takeovers, the boards of both firms are better able to negotiate and structure a deal using a form of payment that will include a package of acquirer’s stock and cash in exchange for the stock of the target company’s shareholders.
Benefits of Merging
By its nature, a friendly merger or acquisition plan requires the availability of willing target companies. So, the question is why target companies willingly agree to mergers or acquisitions when they will invariably make some of their jobs redundant. Let us examine three key, strategic reasons why companies put themselves up for sale.
- The Target Companies’ Assets Are Undervalued
Cheap corporate assets are a major reason behind many acquisitions. The stock market may misprice a company’s true value because investors believe the company has lost its competitive advantage or that its management has made poor business decisions or corporate investments. So, when an acquirer comes calling with an offer to pay a premium over that current stock price, board members must listen as is mandated by directors’ duty of due care owed to stockholders.[5] Their fiduciary duty requires them to listen and evaluate fair offers from acquirers.
- Diversification of Products or Markets Resulting by Merger
The ideal merger is one where the new total value of the combined company is greater than the sums of their stand-alone values. One approach to creating this stronger, more valuable company is through the diversification of products or markets that will be delivered by the merged company.
An important reason to merge may be to acquire a product, technology or manufacturing capability for something that company needs. It’s sometimes cheaper and faster to acquire a company that already makes or has what one needs than to make it oneself.
Market diversification is another strategy that may benefit the company post-merger. For example, a company may avoid trade restrictions by producing products within the borders of countries previously reached only via exports. Using the foreign production plants of one of the merger partners can open doors to new markets for the other merger partner.
Implementing Financial or Operating Strategies
In mature industries, where a few companies dominate market share, such as computer hardware and software or banking and financial services, mergers provide a natural exit for companies as an industry consolidates. Consolidation is the process by which market dominant firms merge to reduce their operating and financial costs, gain new customers and revenues and reduce industry competition.
The Process of a Merger or Acquisition
Depending on the circumstances facing a potential acquirer, most corporations begin a planned merger or acquisition by developing a new business plan. The new business plan is designed to analyze the current competitive environment faced by a company. The internal review will examine the company’s financial performance, revenue and profit growth potential, product lines, and competitive threats and opportunities. The objective of this review is to produce a new vision for the future and a business plan for achieving the vision.
After a business plan is developed, management and the board will begin to review options for growing the company’s revenue and profitability. The key question that will naturally emerge is whether the company can reach its financial objectives through organic growth, based on its own markets and products. If the answer to that question is no, then management and the board will open a discussion on how a merger or acquisition could help it accomplish the new financial objectives.
With board approval, management will begin developing an acquisition plan to explore potential target companies. A major early decision will be whether to seek a merger or to acquire a company. The decision depends on the long-term, strategic goals set out for the company in the business plan. The board must be prepared to address several fundamental questions. For example, will a merger or acquisition better serve the interest of shareholder value? Will government agencies approve a merger that may decrease competition in the markets served by the combined firms? Can it acquire a target company for a fair price?
The first step in the search process is to develop selection criteria in order to screen potential target companies. Basic selection criteria usually include purchase price, profit margin, recent revenue growth and market position of the candidate (including market share and industry ranking). A broker or investment banker may be retained to help support the search process.
The scope of the search process will be determined by the purpose behind the merger or acquisition. For example, the search for a long-term strategic merger partner will be longer and more complicated than a search for an acquisition of a company with a product line that will expand or complement the acquirer’s product lines.
The search process may eventually produce a list of hundreds of companies, so the next step would be to screen the target list to whittle it down to a few select candidates. Of primary importance in screening is to set clear variables to guide the process. The variables often used in screening include:
– What is the primary industry of the target company? Does the company operate in more than one industry? In what markets are the target company’s products sold? Are these global or domestic markets? Is the typical customer a consumer or a business or government? What is the growth rate of the target’s markets? What are the company’s annual revenue, profitability, current long-term debt and return on equity? What about the target’s stock price performance?
The screening process should produce a short list of target companies that meet the established criteria. The final list of companies will be the product of a search committee team comprised of high-level executives supplemented by a group of outside management consultants, accountants and attorneys. In addition, the acquiring firm usually retains an investment banking firm early in the process, perhaps many months prior to a formal board meeting, to discuss potential targets.
Contacting and Working With the Target Company
A transaction might begin with an informal discussion by board members or top executives of the acquirer and the target. In public companies, board members often hold seats with multiple companies, opening the doors to informal discussions which can lead to the first contact.
The potential acquirer’s board will first view a confidential presentation by the search committee. For a public company, secrecy is important, as a leak of a possible merger or acquisition will influence the markets and the stock prices of both companies. The search committee presents the list of potential targets, listing each of the targets’ strengths, weakness and potential fit with the acquirer’s business. The board can then authorize the search committee to move forward with contacting the target companies’ chief executives or board chairmen. Typically, the search committee will use either investment bankers or corporate counsel to approach the target’s decision-makers.
Assuming the target company’s representatives agree to have further preliminary discussions or begin serious negotiations, the next step would be to enter into a letter of intent that sets out preliminary issues that need to be explored further or negotiated. For example, these might include the form of payment and selecting the executive team members that will form the leadership team of the new company. Most terms of the letter of intent are nonbinding because the parties want the option to walk away from the merger discussion.
However, there are two major provisions that ARE generally binding, which are:
- Nondisclosure of confidential information. The nondisclosure agreement, either embedded as a provision in the letter or as an appendix, prohibits both parties from disclosing non-public confidential information that the parties exchange as the negotiations progress.
- Financing contingency. The parties will also stipulate to the condition precedent that a final definitive merger or acquisition agreement will be subject to the availability of financing.
Early in the preliminary discussions, the parties will negotiate the scope of the due diligence investigation that each company will conduct on the other. Board members and corporate officers owe a fiduciary duty of care to shareholders. Thus, directors and officers must undertake careful and thorough examinations of accounting and financial records, tax records, business plans, compensation plans and government regulatory records before merging. The letter of intent may specify terms on the scope and records that will be disclosed to the other side during the conduct of the due diligence investigation. The due diligence phase may begin immediately upon the execution of the letter of interest by both parties.
The effect of the letter is to open the negotiations process even as the due diligence investigation is conducted in parallel. A signed letter of interest provides both sides with a stand still agreement; that is, both companies agree not to pursue other potential merger discussions or negotiations during the due diligence. Therefore, it is incumbent on both parties to move quickly from due diligence to a proposed term sheet.
Upon completion of the due diligence investigation, the acquiring firm will develop and propose a term sheet containing proposed final terms for the transaction. The term sheet is not a final binding agreement. However, the term sheet guides both parties to drafting a final agreement.
The sheet spells out the payment terms for the merged or acquired company and details concerning the structure and timing of the payments. Payment may be in the form of stock, cash, or other assets. The term sheet also may discuss regulatory steps such as measures to alleviate antitrust issues. Finally, and most importantly, the term sheet presents the basis for the acquirer’s valuation of the target, which is used to establish the total price to be paid for the target company.
Valuation and Tax Implications
The total value of a target company is often based on its discounted free cash flow annually, usually for the past five to ten years. Free cash flow is net income minus capital investments, leaving the company with cash flow that it can use to pay down debt, engage in projects or to pay dividends. While companies may use other methods to value companies, free cash flows are often the starting points.
A merger or acquisition transaction is an exchange of the stock or assets of the target company for cash, stock of the acquiring company or a combination of both cash and stock consideration. Let’s look at some of the tax ramifications of each.Hostile acquisitions are often cash-only as the acquiring firm seeks to close the transaction quickly to avoid possible competition from other bidders. Purchases of assets are also typically done through cash transactions. A cash acquisition is a taxable event to the shareholders of the acquired company, as they must pay capital gains or income tax on profits they make on their cash payments. A cash acquisition does not usually result in capital gains for the acquirer’s shareholders.
In a stock exchange transaction, the shareholders may receive stock in the acquirer or merged company in exchange for their stock in the old company or target. A major benefit to shareholders is that a stock exchange is a tax-free transaction as neither company’s shareholders have to “recognize” a taxable gain as a consequence of their stock conversions. The shareholders will recognize a taxable event when they later sell their shares gained through the merger. When the shareholder of the acquired or merged company receives a combination of cash and stock for their shares, the cash portion of the consideration can be taxable capital gain. However, the stock portion will only be taxable on disposition of that stock.
Laws Applicable to Planned Mergers or Acquisitions
As soon as there is a likelihood of a transaction, the acquiring firm must:
- File a Hart-Scott-Redino Act[6] Notice to the FTC if the value of the contemplated transaction exceeds $88.7 million (as of 2019)
- Prepare Regulation 13 D proxy solicitation[7] disclosures pursuant to the requirements of the Williams Act.
Many of the federal antitrust and securities laws that we’ve discussed in other contexts also should be referenced in the context of friendly mergers. Let’s, therefore, go over some of the key federal laws and how they apply.
The Sherman Antitrust Act[8] prohibits agreements that unreasonably restrain competition and prohibits monopolization, attempted monopolization and conspiracies to monopolize trade. Each section can be used to challenge mergers. In United States v. Microsoft,[9] the FTC relied on Section 2 to pursue various antitrust claims against Microsoft involving its pricing policies and computer source code that the FTC argued prevented and undermined competition in the software industry.
The Federal Trade Commission established the Federal Trade Commission to enforce Section 5(a) of the FTC Act which prohibited “unfair methods of competition”[10]. Section 7 of the Act made it illegal for one company to acquire the stock of another company if such a stock transaction would adversely affect competition.
The Clayton Act prohibits mergers and all other forms of acquisitions that may substantially lessen competition. Under Section 3,[11] parties are prohibited from entering into certain tying and exclusive-dealing agreements. The Clayton Act closed a loophole in the Sherman Act by prohibiting merger activities aimed at curbing competition.
Another loophole was closed with the passage of the Celler-Kefauver Act,[12] which allowed the FTC to prohibit assets as well as stock purchases. After Celler-Kefauver, companies could no longer get around the Clayton Act by acquiring the assets of a target company rather than merging.
The Hart-Scott-Rodino Antitrust Improvement Act established a waiting period before a merger to give the government the opportunity to evaluate whether the proposed transaction would violate antitrust laws and required notice to prosecutors of the effects of the proposed merger.
Federal securities laws are usually applicable only when either company is a public company. However, if investor capital is solicited to fund a private merger then the anti-fraud provisions of the Securities Act would apply to such fundraising activates.
The Securities Act of 1933 governs mergers because the Supreme Court’s definition of security includes an “investment contract.”[13] The Securities Act of 1934 regulates disclosure requirements for proxy fights. While proxy fights are more associated with hostile takeovers than with friendly mergers, the disclosure requirements under section 14 also apply to friendly mergers. Similarly, Sections 16(a) & (b) of 1934 Act, which define non-public information and penalties for insider trading of securities, may be raised in the context of both hostile and non-hostile acquisitions.
The Williams Act’s requirement that any entity reaching 5% or more of the outstanding common shares in a corporation file a notice with the SEC within ten days of reaching the threshold level applies to all mergers and acquisitions, hostile or friendly.
The Sarbanes-Oxley Act[14] requires certification of all financial statements filed with the SEC by public corporations. The Act is an important facilitator in the public’s access to accurate and trustworthy financial data that is the foundation for making informed judgments on proposed hostile or friendly mergers.
Finally, the SEC Regulation FD[15] forces companies’ managements and their advisors to use simple, clear and understandable language in producing disclosure documents for investors.
In our last module, we’ll turn to post-merger issues, including implementing business plans and achieving the goals of the merger. We’ll also look at some other merger and acquisition issues, such as international mergers and taking merged companies private.
[1] Mary Ellen Biery, Sagework Stats, 4 Things You Don’t Know About Private Companies, Forbes, May 25, 2013, https://www.forbes.com/sites/sageworks/2013/05/26/4-things-you-dont-know-about-private-companies/#20bcf8ec291a , last accessed Feb. 17, 2019.
[2] 15 U.S.C. Sections 78a et seq.
[3] 17 CFR 240.13d-101 (Schedule 13D Information to be included in statements filed).
[4] Del.Code Ann. tit. 8, § 271(a).
[5] Francis v. United Jersey Bank 432 A.2d 814 (N.J. 1981).
[6] 15 U.S.C. §18a.
[7] 17 C.F.R. §230.501 et seq.
[8] 15 U.S.C. §1.
[9] United States v. Microsoft Corp., 253 F.3d 34 (D.C. Cir. 2001).
[10] 15 U.S.C. §45(a).
[11] 15 U.S.C. §14.
[12] 81 P.L. 899.
[13] SEC v. W. J. Howey Co., 328 U.S. 293 (1946).
[14] 107 P.L. 204.
[15] 17 C.F.R. § 230.501.