The 5 Most Important Aspects Of A Merger

In a traditional merger, two companies are combined in an exchange of stock or other form of equity interest, usually without any cash consideration. Although the end result is a consolidation of the two businesses, which is similar to an acquisition, the business considerations for a merger are significantly different. Because each former owner of a merger partner will become a shareholder in the merged company, that level of continued involvement raises potential issues that should be addressed well in advance of the closing date.

In this regard, the five most important merger considerations are:

The Merger's Objectives - What does each party to the merger hope to achieve for themselves and their company? I've structured and negotiated a number of mergers and discovered that owners can have a wide range of business and personal goals. In a merger of equals between two companies of roughly the same size, the owners may want to create a larger competitor with more resources than either of the merger partners could generate on their own. In the case of a merger between a smaller and a much larger company, the owners of the smaller company may not be ready to sell their company but require the financial strength that their larger merger partner can provide. The need to meet a market threat from a larger competitor may also make a merger appealing. Another goal of a merger could be the ability to combine two companies' related markets or products.

I've also worked on mergers where one of the goals was to devise an exit strategy for the owners of one or both merger partners. A relatively small company's equity value could be significantly increased if it could merge with another to create a higher sales level and then grow from that stronger foundation. Using that growth to increase the value of the combined operation in preparation for a future sale can frequently provide a greater return to the owners than either company could generate on its own.

Although somewhat unusual, I've also worked on a merger as part of a bankruptcy reorganization plan where the merger strengthened and possibly even made the reorganization plan feasible. The post-bankruptcy company's lower debt load made it an appealing partner, whereas the other company could not only provide a clear path to profitability quickly, but also provided an appealing source of DIP or debtor-in-position financing during the bankruptcy proceeding.

The Merger's Rationale - Why Do It? Again, there are numerous reasons for a merger. Among the most common and significant are the economies of scale that can result from combining two smaller businesses to form a larger one. Two accounting departments are not required for the combined operations. Lower material pricing may be possible due to the higher volume of purchased goods.

There may also be cost savings from combining manufacturing or other operations, rationalizing equipment use, or assembling a work force from the most capable of the two groups. Additional savings may be found in insurance costs, professional services, occupancy costs, and sales personnel allocation, among other things.

When a small company merges with a larger one, the smaller of the two may require capital, personnel, or facilities that their partner can provide. Furthermore, a smaller market participant may simply require their partner's competitive strength to maintain or accelerate its growth.

The smaller merger partner may also require increased bonding capacity, a larger sales force, or access to a market already penetrated by its merger partner. One of the two companies may use the other's products and find it more appealing to merge with that company rather than buy or produce the products themselves.

Corporate Governance - Who will be in charge of the combined operations? Mergers that fail frequently fail because corporate governance provisions were not carefully defined ahead of time. The positions, responsibilities, and compensation of the smaller company's owners should always be established well in advance and confirmed with formal employment agreements as well as a stockholders' agreement when a smaller company merges with a larger one. (See FreeWorkbook Example 21, section 18 for an example of a stockholders' agreement.)

These considerations are even more important in a merger of equals. “Attorneys don't get rich off 49 percent / 51 percent deals; attorneys get rich off 50 percent / 50 percent deals,” said one attorney with whom I've worked on a number of transactions. It is critical to consider how a company will be managed following a merger, including who will serve on its board of directors, the decisions that can be made by the directors or those that require stockholder approval, certain “super voting” provisions, methods of breaking a decision deadlock, and termination provisions for all owners. Don't rely on chance when it comes to corporate governance.

What Goes Where - The value of a company's operations must be determined when it is sold. In the case of a merger, however, this evaluation process includes both merger partners. Rather than assigning a monetary value to either business, I usually compute each merger partner's relative contribution to the combined operation. I can examine from eight to twelve financial criteria that measure these relative contributions using pro forma consolidated income statements and balance sheets. These include, for example, each partner's percentage of consolidated sales, gross profits, and net profits, as well as total assets, working capital, various categories of liabilities, book value, and returns on both total assets and equity.

I can establish an equitable division of the combined company's ownership based on these relative contribution calculations, or at the very least provide a reasonable basis for the negotiations that will determine the final merger terms. The ownership levels are not mathematical, despite the fact that my relative contribution calculations are. Some requirements are more important than others. Intangible assets and non-measurable considerations are also important in determining ownership levels. But who gets what is at the top of the merger partners' priority list.

(Contact Me directly for your Free Workbook Examples 9 and 10 for relative contribution calculations.)

Exit Strategy - Typically, getting in is easier than getting out. Before finalizing a merger, it is critical to understand how the owners can convert their equity into a cash return. The owners may wish to construct the combined company and then sell it in five to six years. If that is the goal, the proposed methods for that future sale should be clearly stated in a stockholders' agreement.

Different provisions will apply if one group of partners wishes to keep ownership for ten years while the others wish to keep it for five. Furthermore, what happens if an owner's employment is terminated, whether voluntarily or involuntarily, or if an owner/employee dies or becomes disabled? Each of these events should be addressed in the stockholders' agreement, with future stock prices or equity values determined by reasonable formulas that eliminate the need for future negotiations or disputes. As previously stated, owning 25% of a company worth $20 million is usually preferable to owning 100% of a company worth $2 million. However, this is only true if the 25% ownership can be converted to cash. The timing and methods should be agreed upon by the partners well before the merger is completed.

When considering the aforementioned factors, keep in mind that a merger is more akin to a marriage than an acquisition. Ensure that all merger partners have similar objectives, realistic expectations, and defined exit strategies, and that all of this is outlined in a comprehensive pre-nuptial agreement, which we call a stockholders' agreement in the case of a corporate merger.

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