Synergies, Types of mergers, Why mergers fail, Merger process, Acquisition consideration

<< Effects of discountsâ€“Not effecting volume, Extension of credit, Factoring, Management of creditors, Mergers & Acquisitions

Acquisition Consideration, Valuation of shares >>

Corporate Finance FIN 622

Lesson 33

MERGERS & ACQUISITIONS

In this hand out we shall take up following topics:

Synergies

Types of mergers

Why mergers fail?

Merger process

Acquisition consideration

Synergies and Types of Synergies: (Continued from Lecture 32)

It results from complementary activities .for instance, one firm may have substantial amount of financial

resources while the other has profitable investment opportunities.

Synergy is the energy or force created by the working together of various parts or processes. Synergy in

business is the benefit derived from combining two or more elements (or businesses) so that the

performance of the combination is higher than that of the sum of the individual elements (or businesses).

The enhanced result of two or more people, groups or organizations working together is called synergy. In

other words, one and one equal three! It comes from the Greek "synergia," which means joint work and

cooperative action. The word is used quite often to mean that combining forces produces a better product.

However, in the field of software development, synergy is not the result. In many cases, the more people

assigned to a programming job, the more the quality suffers.

The idea that the value and performance of two companies combined will be greater than the sum of the

separate individual parts.

Types of Synergies:

1-Operational synergies Discussed in Lecture 32

2- Financial synergies

Financial synergies:

If the future cash flow stream of two companies is not positively correlated then combining the two will

reduce the variability of cash flow or will bring stability in cash flow thus may increase the value by having

cheaper financing available. Lenders and creditors like to have stable cash flow that signals the ability of

company to settle its short term and long term obligations.

Diversification normally reduces the risk. If the earnings of two combined entities remain unchanged then

there are still chances of increased firm value. In this case, the reduction in the risk level will add value to

the firm.

From shareholders' stand point if there are no operating economies in a merger, then it will not add value to

the shareholders' wealth.

This should be noted that managers often consider the total risk as this effect the job security and

diversification argument can make sense from a managerial stand point if not a shareholders'.

If the future cash flow of merged entities is not perfectly positively correlated then by merging the two cash

flow variations can be reduced.

Other synergies:

Surplus Human Resources: companies with skilled managers and staff can best utilize these resources only if

they have problems to solve. The acquisition of inefficient companies is sometimes the only way of using

skilled human resources

Surplus cash flow: companies with large amounts of surplus cash may see the acquisition of other

companies as the only possible application for these funds.

Market power: horizontal mergers may enable the company to seek a degree of monopoly power which

could increase its profitability.

Organic growth: growth using mergers and acquisition is speedier than the organic growth.

Types of Mergers

From the perspective of business structures, there is a whole host of different mergers. Here are a few

types, distinguished by the relationship between the two companies that are merging:

· Horizontal merger - Two companies that are in direct competition and share the same product lines

and markets.

109

Corporate Finance FIN 622

Vertical merger - A customer and company or a supplier and company. Think of a cone supplier

merging with an ice cream maker.

Market-extension merger - Two companies that sell the same products in different markets.

Product-extension merger - Two companies selling different but related products in the same

market.

Conglomeration - Two companies that have no common business areas.

There are two types of mergers that are distinguished by how the merger is financed. Each has

certain implications for the companies involved and for investors:

o Purchase Mergers - As the name suggests, this kind of merger occurs when one company

purchases another. The purchase is made with cash or through the issue of some kind of

debt instrument; the sale is taxable.

Acquiring companies often prefer this type of merger because it can provide them with a

tax benefit. Acquired assets can be written-up to the actual purchase price, and the

difference between the book value and the purchase price of the assets can depreciate

annually, reducing taxes payable by the acquiring company. We will discuss this further in

part four of this tutorial.

Consolidation Mergers - With this merger, a brand new company is formed and both companies are bought

and combined under the new entity. The tax terms are the same as those of a purchase merger.

Profitable growth constitutes one of the prime objectives of most of the business firms. It can be achieved

internally either through the process of introducing /developing new products or by expanding / enlarging

the capacity of existing products the firm is engaged. Alternatively the growth process can be facilitated

externally by the acquisitions of existing business firms. This acquisition is technically referred to as

mergers, acquisitions, amalgamations, takeovers, absorption, consolidation etc.

Mergers are a tool used by companies for the purpose of expanding their operations and increasing their

profit.

Usually mergers occur in a consensual setting where executives from the target company help those from

the purchaser in a due diligence process to ensure that the deal is beneficial to both parties. Acquisitions can

also happen through a hostile takeover by purchasing the majority of outstanding shares of a company in

the open market against the wishes of the target's board. In most of the countries, business laws vary from

state to state whereby some companies have limited protection against hostile takeovers. One form of

protection against a hostile takeover is the shareholder rights plan, otherwise known as the "poison pill".

Why mergers fail?

Lack of planning or overoptimistic planning

Planning is a crucial exercise that will help determine the success or failure of a merging organization.

However, many merging organizations do not have adequate or complete integration and implementation

plans in place. Only one out of five companies that have acquired another has developed a clear and

satisfactory implementation plan.

Putting the forecast results on paper is much simpler than actually achieving them. During the planning

phase the synergies may be over-estimated because of the subjective judgment issues in estimations.

A major downside of the planning process is that it can take the focus away from daily business activities. It

can also fail to address serious HR issues and activities that can have a strong impact on the organization.

Another flaw in many M&A plans is that they often include expectations that are unrealistic and that will

stretch the merging organizations beyond their capabilities.

Human integration

As discussed above, the early stages of mergers and acquisitions (i.e.

Planning and negotiation) are often carried out in secret and do not usually involve human resources in the

discussions.

This lack of involvement by human resources can have a detrimental impact on the merger, since it means

that many issues that are directly linked to the success or failure of the merger will have been overlooked.

If legal and financial experts are driving the strategic work behind the integration, then a number of

important considerations critical for the financial success of the merger, such as the productivity of the new

110

Corporate Finance FIN 622

employees, may be overlooked unless human resources and corporate communications staff members

provide their input.

Corporate culture

Even if two companies seem to have all the right ingredients in place for a successful merger, cultural

differences can break the deal. It is not enough for two companies to appear to fit well on paper; at the end

of the day, if the people are not able to work together, the merger will not succeed. Poor communications

and inability to manage cultural differences are the two main causes of failed mergers. Cultural differences

that cannot be resolved affect communications, decision-making, productivity and employee turnover at all

levels of the organization.

All the best laid plans exhaustive analyses of strategies, marketing tactics, legal issues, etc. can fall apart

if the people cannot work together. If the two workforces fail to unite behind the strategic goals underlying

the consolidation, even the best financial deals and most rigorous legal contracts fail to guarantee success.

An example which demonstrates the importance of cultural differences is the Daimler Chrysler merger. The

post-merger phase highlighted the difficulty of trying to integrate two very divergent cultures. Even though

in the beginning, Daimler-Benz and Chrysler both expressed their commitment to working together and

sharing work practices and product development methods, this commitment did not materialize, a

phenomenon exemplified by the Daimler management's unwillingness to use Chrysler parts in Mercedes

cars.

Lack of communications:

Employee communications is considered as being one of the most important issues which needs to be

addressed during a merger or acquisition process. Poor communication between people at all levels of the

organization, and between the two organizations that are merging, is one of the principal reasons why

mergers fail.

Middle management and lower level employees in particular are kept in the dark when it comes to merger

issues. Most of companies customize merger information for middle management and lower levels of

employees. Therefore, it is not surprising that many managers find themselves learning more about their

corporation from reading the daily business section of the newspaper than from their own superiors.

Not only is lack of communication a serious issue for merging organizations, the deliberate withholding of

information from employees on the part of the senior executives who are dealing with the merger, is also a

major problem, and contributes to confusion, uncertainty and a loss of trust and loyalty on the part of

employees. In some cases, companies even feel the need to lie to their employees by making reassuring

statements about the continuity of their roles and pay packages, and by falsely stating that there will be no

redundancies.

Lack of information, no clear direction and confusing messages, all boil down to uncertainty, which is

destructive.

Talent Departure:

An increase in the turnover rate of productive employees is one of the greatest prices of corporate mergers.

Mergers and acquisitions often lead to the loss of the merging companies' greatest assets: talented

employees and key decision-makers. According to the American Management Association, one out of four

top performers leaves the company within 3 months of the announcement of an event involving major

change in the organization and 47% of senior managers in the acquired company leave within the first year.

A Wall Street Journal article estimated that 50-75% of managers in companies that have merged plan to

leave within three years. Yet the decision to merge or acquire is often based on the desire to gain a talented

workforce, and new knowledge and expertise. This obvious contradiction is not dealt with satisfactorily by

company leaders who are not taking sufficient steps to resolve this problem. They need to realize that when

employees leave the company following a merger or acquisition, they are taking with them the knowledge

and expertise that was part of the reason the merger occurred in the first place.

Employees are the most important assets companies have. Yet they are totally forgotten about when a deal

is being done. The boards and senior management just don't get it.

111

Corporate Finance FIN 622

Frequently, employees do not leave of their own free will following an M&A transaction, as companies

reduce their headcounts and downsize in a bid to reduce costs. At the same time, however, companies in

today's economy seem to be rated more and more on their innovative capabilities and unique expertise,

which reinforces the notion that employees are a company's greatest assets.

Not only do merging companies suffer a drop in productivity as a result of losing talented employees, but

lower morale and a sense of insecurity on the part of the employees who remain in the newly-merged

organization can also lead to productivity problems.

Remaining employees end up distrusting their employer and often become reluctant to safeguard the

interests of the new company. They also become de-motivated to work to their best abilities.

The resulting loss of creative power can cripple a corporation that is competing within a rapidly changing

industry.

Loss of Customers:

With the loss of employees also comes the loss of customers during mergers and acquisitions. Some of the

most talented employees, responsible for bringing in valuable business to their organizations, are often the

ones who leave, resulting in the loss of key customers.

All companies need to remember: it's the people who produce profits, represent the company, establish

rapport with the customers, and, ultimately, are the ones that will make the combined company succeed.

Even if merging companies succeed in retaining the employees that bring in the business, customers may

still decide to take their business to other companies if they fear that their level of service is going to

deteriorate in the newly merged organization. Lack of communication on the part of management is

therefore the culprit not only when it comes to the employees of the merging organizations, but also when

it comes to their customers.

Merger and Acquisition Process:

Determining the Target (Company)

Once the management has decided to expand through mergers and acquisitions, it must determine the

prospective target company in the sector it is interested in.

First step in this regard would be to evaluate the feasibility from commercial and financial viewpoint. M &

A transactions are carried out as going concern and purchase of assets basis, we will highlight the areas that

need special focus by the management:

Organizational information: that includes management, skill and expertise, other employees, payroll

structure and appointment terms, unionization, benefit plans.

Sales & Marketing: historic sales trend and analysis, products strengths, market share, sales net work,

market reputation.

Technology: Technical expertise required to run the targeted company, future assessment, research &

development required.

Financial & Accounting information: historical accounts, profitability analysis, assets and liabilities true

position, accounting policies, equity analysis.

Cash & Bank: details of bank accounts, collaterals against loans, details of agreements like leases, forward

rates, etc.

Tax: tax computations like for depreciation, deferred tax, any pending case with tax department,

outstanding liabilities for income and sales tax, rather for other taxes as well.

Formulation of Scheme:

Once the prospecting phase is over, the companies seek the help of legal and financial consultants to

finalize the details of proposed scheme of merger.

Memorandum of Association:

The object clause of amalgamated company should be examined to see if it permits continuation of the

business amalgamating (transfer) company by it, if it does not, then suitable amendments / alteration must

be made in the manner prescribed in the companies act.

Intimation to Stock Exchange and Notification:

112

Corporate Finance FIN 622

As soon as the offer of merger is made, the stock exchanges where these companies are listed should be

notified and the fact of the offer should be announced in the newspapers. To ensure proper disclosure, the

announced is made in the form approved by the regional stock exchange.

Directors Approval of the Proposed Scheme

The proposed scheme of merger should be submitted to the Board of Director of each company for their

approval.

Shareholders Approval:

The scheme, once approved by the Board of Directors, should be placed before shareholders at a general

meeting for their approval. It is not a legal necessity, but the company in practice gets the scheme approved

by its shareholders before they file an application for the sanction of the court.

Transfer of Assets and Liabilities, issuance of Shares, etc.

Finally, the companies can implement the scheme by transferring assets and liabilities by issuing of shares

and given any other consideration to the members of the amalgamating company, as per the scheme of

merger.

Cultural due diligence

When merging with another firm, most companies focus more on the deal than on the subsequent

integration of the companies. This may explain, at least in part, why most of them fail.

Despite popular beliefs to the contrary, the single greatest barrier to business success is the one

erected by culture.

How important is culture in an organization? In recent years it has been acknowledged as being as

significant a factor in international business as the bottom line. While the mergers and acquisitions boom

has slowed somewhat in 2002, the percentage of acquisitions across borders has continued to increase,

expected to reach 50 percent of all M&A activity by 2003.

According to the International Labor Organization, 70 percent of mergers and acquisitions worldwide fail

to meet their strategic objectives within two years. International consultants KPMG revealed in a recent

study "the overwhelming cause for failure of M & As is the people and the cultural differences." Meaning

that in the majority of instances, these business ventures run aground due to organizational culture conflicts.

Since knowledge is power, the obvious approach is for the acquiring party to perform a cultural due

diligence before making the final decision, to determine if there is cultural synergy between the partners.

This is often rejected by the company being investigated, however, since it requires allowing the (as yet

uncommitted) outside faction full access to HR policy and company personnel.

113

Table of Contents: