Mergers and Acquisitions (M&A)- Meaning, Documentation & Process
Mergers and Acquisitions
Mergers and acquisitions (M&A) are transactions in which the ownership of companies, other business organizations, or their operating units are transferred or consolidated with other entities. As an aspect of strategic management, M&A can allow enterprises to grow or downsize, and change the nature of their business or competitive position.
From a legal point of view, a merger is a legal consolidation of two entities into one, whereas an acquisition occurs when one entity takes ownership of another entity’s stock, equity interests or assets. From a commercial and economic point of view, both types of transactions generally result in the consolidation of assets and liabilities under one entity, and the distinction between a “merger” and an “acquisition” is less clear. A transaction legally structured as an acquisition may have the effect of placing one party’s business under the indirect ownership of the other party’s shareholders, while a transaction legally structured as a merger may give each party’s shareholders partial ownership and control of the combined enterprise. A deal may be euphemistically called a merger of equals if both CEOs agree that joining together is in the best interest of both of their companies, while when the deal is unfriendly (that is, when the management of the target company opposes the deal) it may be regarded as an “acquisition”.
An acquisition/takeover is the purchase of one business or company by another company or other business entity. Specific acquisition targets can be identified through myriad avenues including market research, trade expos, sent up from internal business units, or supply chain analysis. Such purchase may be of 100%, or nearly 100%, of the assets or ownership equity of the acquired entity. Consolidation/ amalgamation occurs when two companies combine to form a new enterprise altogether, and neither of the previous companies remains independently. Acquisitions are divided into “private” and “public” acquisitions, depending on whether the acquiree or merging company (also termed a target) is or is not listed on a public stock market. Some public companies rely on acquisitions as an important value creation strategy. An additional dimension or categorization consists of whether an acquisition is friendly or hostile.
“Acquisition” usually refers to a purchase of a smaller firm by a larger one. Sometimes, however, a smaller firm will acquire management control of a larger and/or longer-established company and retain the name of the latter for the post-acquisition combined entity. This is known as a reverse takeover. Another type of acquisition is the reverse merger, a form of transaction that enables a private company to be publicly listed in a relatively short time frame. A reverse merger occurs when a privately held company (often one that has strong prospects and is eager to raise financing) buys a publicly listed shell company, usually one with no business and limited assets.
The combined evidence suggests that the shareholders of acquired firms realize significant positive “abnormal returns” while shareholders of the acquiring company are most likely to experience a negative wealth effect. The overall net effect of M&A transactions appears to be positive: almost all studies report positive returns for the investors in the combined buyer and target firms. This implies that M&A creates economic value, presumably by transferring assets to management teams that operate them more efficiently.
There are also a variety of structures used in scouring control over the assets of a company, which have different tax and regulatory implications:
- The buyer buys the shares, and therefore control, of the target company being purchased. Ownership control of the company in turn conveys effective control over the assets of the company, but 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.
- The buyer buys the assets of the target company. The cash the target receives from the sell-off is paid back to its shareholders by dividend or through liquidation. This type of transaction leaves the target company as an empty shell, if the buyer buys out the entire assets. A buyer often structures the transaction as an asset purchase to “cherry-pick” the assets that it wants and leave out the assets and liabilities that it does not. This can be particularly important where foreseeable liabilities may include future, unquantified damage awards such as those that could arise from litigation over defective products, employee benefits or terminations, or environmental damage. A disadvantage of this structure is the tax that many jurisdictions, particularly outside the United States, impose on transfers of the individual assets, whereas stock transactions can frequently be structured as like-kind exchanges or other arrangements that are tax-free or tax-neutral, both to the buyer and to the seller’s shareholders.
The terms “demerger”, “spin-off” and “spin-out” are sometimes used to indicate a situation where one company splits into two, generating a second company which may or may not become separately listed on a stock exchange.
Documentation/ Process of M & A
The documentation of an M&A transaction often begins with a letter of intent. The letter of intent generally does not bind the parties to commit to a transaction, but may bind the parties to confidentiality and exclusivity obligations so that the transaction can be considered through a due diligence process involving lawyers, accountants, tax advisors, and other professionals, as well as business people from both sides.
After due diligence is complete, the parties may proceed to draw up a definitive agreement, known as a “merger agreement”, “share purchase agreement” or “asset purchase agreement” depending on the structure of the transaction. Such contracts are typically 80 to 100 pages long and focus on five key types of terms:
- Conditions, which must be satisfied before there is an obligation to complete the transaction. Conditions typically include matters such as regulatory approvals and the lack of any material adverse change in the target’s business.
- Representations and warranties by the seller with regard to the company, which are claimed to be true at both the time of signing and the time of closing. Sellers often attempt to craft their representations and warranties with knowledge qualifiers, dictating the level of knowledge applicable and which seller parties’ knowledge is relevant. Some agreements provide that if the representations and warranties by the seller prove to be false, the buyer may claim a refund of part of the purchase price, as is common in transactions, involving privately held companies (although in most acquisition agreements involving public company targets, the representations and warranties of the seller do not survive the closing). Representations regarding a target company’s net working capital are a common source of post-closing disputes.
- Covenants, which govern the conduct of the parties, both before the closing (such as covenants that restrict the operations of the business between signing and closing) and after the closing (such as covenants regarding future income tax filings and tax liability or post-closing restrictions agreed to by the buyer and seller parties).
- Termination rights, which may be triggered by a breach of contract, a failure to satisfy certain conditions or the passage of a certain period of time without consummating the transaction, and fees and damages payable in case of a termination for certain events (also known as breakup fees).
- Provisions relating to obtaining required shareholder approvals under state law and related SEC filings required under federal law, if applicable, and terms related to the mechanics of the legal transactions to be consummated at closing (such as the determination and allocation of the purchase price and post-closing adjustments (such as adjustments after the final determination of working capital at closing or earnout payments payable to the sellers), repayment of outstanding debt, and the treatment of outstanding shares, options and other equity interests).
- An indemnification provision, which provides that an indemnitor will indemnify, defend, and hold harmless the indemnitee(s) for losses incurred by the indemnitees as a result of the indemnitor’s breach of its contractual obligations in the purchase agreement.
Post-closing, adjustments may still occur to certain provisions of the purchase agreement, including the purchase price. These adjustments are subject to enforceability issues in certain situations. Alternatively, certain transactions use the ‘locked box’ approach where the purchase price is fixed at signing and based on seller’s equity value at a pre-signing date and an interest charge.
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