Mergers and Acquisitions (M&A)
JAMSHAID MANZOOR
CPA, CMA, MBA, IFRS, UAE Taxation Certified, Advanced Accounting Certified KHDA, Financial Management Certified CPD London, Management Accounting Expert BCC London. Group Risk Management, Taxation & IFRS Manager - UAE
The term mergers and acquisitions (M&A) refers to the consolidation of companies or their major business assets through financial transactions between companies. A company may purchase and absorb another company outright, merge with it to create a new company, acquire some or all of its major assets, make a?tender offer?for its stock, or stage a hostile takeover. All are M&A activities.
The term M&A also is used to describe the divisions of?financial institutions?that deal in such activity.
What's an Acquisition?
Understanding Mergers and Acquisitions:
The terms mergers and acquisitions are often used interchangeably, however,?they have slightly different meanings.
When one company takes over another and establishes itself as the new owner, the purchase is called an acquisition.
On the other hand, a merger describes two firms, of approximately the same size, that join forces to move forward as a single new entity, rather than remain separately owned and operated.?This action is known as a?merger of equals.
Case in Point:
Both Daimler-Benz and Chrysler ceased to exist when the two firms merged, and a new company, DaimlerChrysler, was created. Both companies' stocks were surrendered, and new company stock was issued in its place.
In a brand refresh, the company underwent another name and ticker change as the Mercedes-Benz Group AG (MBG) in February 2022.
A purchase deal will also be called a merger when both CEOs agree that joining together is in the best interest of both of their companies.
Unfriendly or?hostile takeover?deals, in which target companies do not wish to be purchased, are always regarded as acquisitions.
A deal can be classified as a merger or an acquisition based on whether the acquisition is friendly or hostile and how it is announced.
In other words, the difference lies in how the deal is communicated to the target company's?board of directors, employees, and?shareholders.
M&A deals generate sizable profits for the investment banking industry, but not all mergers or acquisition deals close.
Mergers and Acquisitions (M&A) Transactions – Types:
1. Horizontal:
A horizontal merger happens between two companies that operate in similar industries that may or may not be direct competitors.
2. Vertical:
A vertical merger takes place between a company and its supplier or a customer along its?supply chain. The company aims to move up or down along its supply chain, thus consolidating its position in the industry.
3. Conglomerate:
This type of transaction is usually done for?diversification?reasons and is between companies in unrelated industries.
Mergers and Acquisitions (M&A) – Forms of Integration:
1. Statutory:
Statutory mergers usually occur when the acquirer is much larger than the target and acquires the target’s assets and liabilities. After the deal, the target company ceases to exist as a separate entity.
2. Subsidiary:
In a subsidiary merger, the target becomes a subsidiary of the acquirer but continues to maintain its business.
3. Consolidation:
In a consolidation, both companies in the transaction cease to exist after the deal, and a completely new entity is formed.
Reasons for Mergers and Acquisitions (M&A) Activity:
Mergers and acquisitions (M&A) can take place for various reasons, such as:
1. Unlocking Synergies:
The common rationale for mergers and acquisitions (M&A) is to create synergies in which the combined company is worth more than the two companies individually. Synergies can be due to cost reduction or higher revenues.
Cost synergies are created due to?economies of scale, while revenue synergies are typically created by cross-selling, increasing market share, or higher prices. Of the two, cost synergies can be easily quantified and calculated.
2. Higher Growth:
Inorganic growth through mergers and acquisitions (M&A) is usually a faster way for a company to achieve higher revenues as compared to growing organically. A company can gain by acquiring or merging with a company with the latest capabilities without having to take the risk of developing the same internally.
3. Stronger Market Power:
In a?horizontal merger, the resulting entity will attain a higher market share and will gain the power to influence prices. Vertical mergers also lead to higher market power, as the company will be more in control of its supply chain, thus avoiding external shocks in supply.
4. Diversification:
Companies that operate in cyclical industries feel the need to diversify their cash flows to avoid significant losses during a slowdown in their industry. Acquiring a target in a non-cyclical industry enables a company to diversify and reduce its market risk.
5. Tax Benefits:
Tax benefits?are looked into where one company realizes significant taxable income while another incurs tax loss carry forwards. Acquiring the company with the tax losses enables the acquirer to use the tax losses to lower its tax liability. However, mergers are not usually done just to avoid taxes.
Forms of Acquisition:
There are two basic forms of mergers and acquisitions (M&A):
1. Stock Purchase:
In a stock purchase, the acquirer pays the target firm’s shareholders cash and/or shares in exchange for shares of the target company. Here, the target’s shareholders receive compensation and not the target. There are certain aspects to be considered in a stock purchase:
2. Asset Purchase:
In an asset purchase, the acquirer purchases the target’s assets and pays the target directly. There are certain aspects to be considered in an asset purchase, such as:
Method of Payment:
There are two methods of payment – stock and cash. However, in many instances, M&A transactions use a combination of the two, which is called a mixed offering.
1. Stock:
In a stock offering, the acquirer issues new shares that are paid to the target’s shareholders. The number of shares received is based on an exchange ratio, which is finalized in advance due to stock price fluctuations.
2. Cash:
In a cash offer, the acquirer simply pays cash in return for the target’s shares.
Mergers and Acquisitions (M&A) – Valuation:
In an M&A transaction, the valuation process is conducted by the acquirer, as well as the target. The acquirer will want to purchase the target at the lowest price, while the target will want the highest price.
Thus, valuation is an important part of mergers and acquisitions (M&A), as it guides the buyer and seller to reach the final transaction price. Below are three major valuation methods that are used to value the target:
Mergers:
In a merger, the?boards of directors?for two companies approve the combination and seek shareholders' approval.
For example, in 1998, a merger deal occurred between the Digital Equipment Corporation and Compaq, whereby Compaq absorbed the Digital Equipment Corporation.
Acquisitions:
In a simple acquisition, the acquiring company obtains the majority stake in the acquired firm, which does not change its name or alter its organizational structure.
An example of this type of transaction is Manulife Financial Corporation's 2004 acquisition of John Hancock Financial Services, wherein both companies preserved their names and organizational structures.
Consolidations:
Consolidation?creates a new company by combining core businesses and abandoning the old corporate structures. Stockholders of both companies must approve the consolidation, and subsequent to the approval, receive common?equity?shares in the new firm.
For example, in 1998, Citicorp and Travelers Insurance Group announced a consolidation, which resulted in Citigroup.
Tender Offers:
In a tender offer, one company offers to purchase the outstanding stock of the other firm at a specific price rather than the market price. The acquiring company communicates the offer directly to the other company's shareholders, bypassing the management and board of directors.
For example, in 2008, Johnson & Johnson made a tender offer to acquire Omrix Biopharmaceuticals for $438 million. The company agreed to the tender offer and the deal was settled by the end of December 2008.
Acquisition of Assets:
In an acquisition of assets, one company directly acquires the assets of another company. The company whose assets are being acquired must obtain approval from its shareholders. The purchase of assets is typical during?bankruptcy?proceedings, wherein other companies bid for various assets of the bankrupt company, which is liquidated upon the final transfer of assets to the acquiring firms.
Management Acquisitions:
In a management acquisition, also known as a?management-led buyout (MBO), a company's executives purchase a controlling stake in another company, taking it private. These former executives often partner with a financier or former corporate officers in an effort to help fund a transaction. Such M&A transactions are typically financed disproportionately with debt, and the majority of shareholders must approve it.
For example, in 2013, Dell Corporation announced that?it was acquired by its founder, Michael Dell.
How Mergers Are Structured:
Mergers can be structured in a number of different ways, based on the relationship between the two companies involved in the deal:
Mergers may also be distinguished by following two financing methods, each with its own ramifications for investors.
Purchase Mergers:
As the name suggests, this kind of merger occurs when one company purchases another company. The purchase is made with cash or through the issue of some kind of debt instrument. The sale is taxable, which attracts the acquiring companies, who enjoy the tax benefits. 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.
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.
How Acquisitions Are Financed:
A company can buy another company with cash, stock, assumption of debt, or a combination of some or all of the three. In smaller deals, it is also common for one company to acquire all of another company's assets.
Company X buys all of Company's Y assets for cash, which means that Company Y will have only cash (and debt, if any). Of course, Company Y becomes merely a shell and will eventually?liquidate?or enter other areas of business.
Another acquisition deal known as a?reverse merger?enables a private company to become publicly listed in a relatively short time period.
Reverse mergers occur when a private company that has strong prospects and is eager to acquire financing buys a publicly listed shell company with no legitimate business operations and limited assets.
The private company reverses merges into the?public company, and together they become an entirely new public corporation with tradable shares.
How Mergers and Acquisitions Are Valued:
Both companies involved on either side of an M&A deal will value the target company differently. The seller will obviously value the company at the highest price possible, while the buyer will attempt to buy it for the lowest price possible. Fortunately, a company can be objectively valued by studying comparable companies in an industry, and by relying on the following metrics.
Price-to-Earnings Ratio (P/E Ratio):
With the use of a?price-to-earnings ratio (P/E ratio), an acquiring company makes an offer that is a multiple of the earnings of the target company. Examining the P/E for all the stocks within the same industry group will give the acquiring company good guidance for what the target's P/E multiple should be.
Enterprise-Value-to-Sales Ratio (EV/Sales):
With an?enterprise-value-to-sales ratio (EV/sales), the acquiring company makes an offer as a multiple of the revenues while being aware of the?price-to-sales (P/S ratio)?of other companies in the industry.
Discounted Cash Flow (DCF):
A key valuation tool in M&A, a?discounted cash flow (DFC)?analysis determines a company's current value, according to its estimated future cash flows.
Forecasted?free cash flows?(net income + depreciation/amortization (capital expenditures) change in working capital) are discounted to a present value using the company's?weighted average cost of capital (WACC). Admittedly, DCF is tricky to get right, but few tools can rival this valuation method.
Replacement Cost:
In a few cases, acquisitions are based on the?cost of replacing?the target company. For simplicity's sake, suppose the value of a company is simply the sum of all its equipment and staffing costs. The acquiring company can literally order the target to sell at that price, or it will create a competitor for the same cost.
Naturally, it takes a long time to assemble good management, acquire property, and purchase the right equipment. This method of establishing a price certainly wouldn't make much sense in a service industry wherein the key assets (people and ideas) are hard to value and develop.
Frequently Asked Questions
How Do Mergers Differ from Acquisitions?
In general, "acquisition" describes a transaction, wherein one firm absorbs another firm via a takeover. The term "merger" is used when the purchasing and target companies mutually combine to form a completely new entity. Because each combination is a unique case with its own peculiarities and reasons for undertaking the transaction, use of these terms tends to overlap.
Why Do Companies Keep Acquiring Other Companies Through M&A?
Two of the key drivers of capitalism are competition and growth. When a company faces competition, it must both cut costs and innovate at the same time. One solution is to acquire competitors so that they are no longer a threat. Companies also complete M&A to grow by acquiring new product lines, intellectual property, human capital, and customer bases. Companies may also look for synergies. By combining business activities, overall performance efficiency tends to increase, and across-the-board costs tend to drop as each company leverages off of the other company's strengths.
What Is a Hostile Takeover?
Friendly acquisitions are most common and occur when the target firm agrees to be acquired; its board of directors and shareholders approve of the acquisition, and these combinations often work for the mutual benefit of the acquiring and target companies.
Unfriendly acquisitions, commonly known as hostile takeovers, occur when the target company does not consent to the acquisition.
Hostile acquisitions don't have the same agreement from the target firm, and so the acquiring firm must actively purchase large stakes of the target company to gain a controlling interest, which forces the acquisition.
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How Does M&A Activity Affect Shareholders?
Generally speaking, in the days leading up to a merger or acquisition, shareholders of the acquiring firm will see a temporary drop in share value. At the same time, shares in the?target firm?typically experience a rise in value. This is often due to the fact that the acquiring firm will need to spend capital to acquire the target firm at a premium to the pre-takeover share prices.
After a merger or acquisition officially takes effect, the stock price usually exceeds the value of each underlying company during its pre-takeover stage. In the absence of unfavourable?economic conditions, shareholders of the merged company usually experience favourable long-term performance and dividends.
Note that the shareholders of both companies may experience a?dilution?of voting power due to the increased number of shares released during the merger process. This phenomenon is prominent in?stock-for-stock mergers, when the new company offers its shares in exchange for shares in the target company, at an agreed-upon?conversion rate. Shareholders of the acquiring company experience a marginal loss of voting power, while shareholders of a smaller target company may see a significant erosion of their voting powers in the relatively larger pool of stakeholders.
What Is the Difference Between a Vertical and Horizontal Merger or Acquisition?
Horizontal integration?and?vertical integration?are competitive strategies that companies use to consolidate their position among competitors.
Horizontal integration is the acquisition of a related business. A company that opts for horizontal integration will take over another company that operates at the same level of the?value chain?in an industry—for instance when Marriott International, Inc. acquired Starwood Hotels & Resorts Worldwide, Inc.
Vertical integration refers to the process of acquiring business operations within the same production vertical. A company that opts for vertical integration takes complete control over one or more stages in the production or distribution of a product. Apple, for example, acquired AuthenTec, which makes the touch ID fingerprint sensor technology that goes into its iPhones.
Benefits of Combining Forces:
Some of the benefits of M&A deals have to do with efficiencies and others have to do with capabilities, such as:
Potential Drawbacks:
Although mergers and acquisitions are expensive undertakings, there are potential rewards. And there are disadvantages, or reasons not to purchase an acquisition, including:
M&A is growth strategy corporations often use to quickly increase its size, service area, talent pool, customer base, and resources in one fell swoop. The process is costly, however, so the businesses need to be sure the advantage to be gained is substantial.?
How we will deal to Mergers & Acquisitions as per IFRS?
IFRS 3 must be applied when accounting for business combinations, but does not apply to:
Determining whether a Transaction is a Business Combination:
IFRS 3 provides additional guidance on determining whether a transaction meets the definition of a business combination, and so accounted for in accordance with its requirements. This guidance includes:
Method of Accounting for Business Combinations:
Acquisition Method:
The acquisition method is used for all business combinations.
Steps in applying the acquisition method are:
Identifying An Acquirer:
The guidance in?IFRS?10?Consolidated Financial Statements?is used to identify an acquirer in a business combination, i.e., the entity that obtains 'control' of the acquiree.
If the guidance in IFRS 10 does not clearly indicate which of the combining entities is an acquirer, IFRS 3 provides additional guidance which is then considered:
Acquisition Date:
An acquirer considers all pertinent facts and circumstances when determining the acquisition date, i.e., the date on which it obtains control of the acquiree. The acquisition date may be a date that is earlier or later than the closing date.
IFRS 3 does not provide detailed guidance on the determination of the acquisition date and the date identified should reflect all relevant facts and circumstances. Considerations might include, among others, the date a public offer becomes unconditional (with a controlling interest acquired), when the acquirer can effect change in the board of directors of the acquiree, the date of acceptance of an unconditional offer, when the acquirer starts directing the acquiree's operating and financing policies, or the date competition or other authorities provide necessarily clearances.
Acquired Assets and Liabilities:
IFRS 3 establishes the following principles in relation to the recognition and measurement of items arising in a business combination:
Exceptions to the Recognition and Measurement Principles:
The following exceptions to the above principles apply:
??????????Liabilities and contingent liabilities within the scope of IAS 37 or IFRIC 21 – for transactions and other events within the scope of IAS 37 or IFRIC 21, an acquirer applies IAS 37 or IFRIC 21 (instead of the Conceptual Framework) to identify the liabilities it has assumed in a business combination.
??????????Contingent liabilities and contingent assets – the requirements of IAS 37 Provisions, Contingent Liabilities and Contingent Assets do not apply to the recognition of contingent liabilities arising in a business combination; an acquirer does not recognise contingent assets acquired in a business combination.
??????????Income taxes – the recognition and measurement of income taxes is in accordance with IAS 12 Income Taxes.
??????????Employee benefits – assets and liabilities arising from an acquiree's employee benefits arrangements are recognised and measured in accordance with IAS 19 Employee Benefits.
??????????Indemnification assets - an acquirer recognises indemnification assets at the same time and on the same basis as the indemnified item.
??????????Reacquired rights – the measurement of reacquired rights is by reference to the remaining contractual term without renewals.
??????????Share-based payment transactions - these are measured by reference to the method in IFRS 2 Share-based Payment
??????????Assets held for sale – IFRS 5 Non-current Assets Held for Sale and Discontinued Operations is applied in measuring acquired non-current assets and disposal groups classified as held for sale at the acquisition date.
In applying the principles, an acquirer classifies and designates assets acquired and liabilities assumed on the basis of the contractual terms, economic conditions, operating and accounting policies and other pertinent conditions existing at the acquisition date.
For example, this might include the identification of derivative financial instruments as hedging instruments, or the separation of embedded derivatives from host contracts. However, exceptions are made for lease classification (between operating and finance leases) and the classification of contracts as insurance contracts, which are classified on the basis of conditions in place at the inception of the contract.
Acquired intangible assets must be recognised and measured at fair value in accordance with the principles if it is separable or arises from other contractual rights, irrespective of whether the acquiree had recognised the asset prior to the business combination occurring. This is because there is always sufficient information to reliably measure the fair value of these assets. There is no 'reliable measurement' exception.
Goodwill:
Goodwill is measured as the difference between:
i.????????????????The value of the consideration transferred (generally at fair value)
ii.???????????????The amount of any non-controlling interest (NCI, see below), and
iii.?????????????In a business combination achieved in stages (see below), the acquisition-date fair value of the acquirer's previously-held equity interest in the acquiree, and
?
This can be written in simplified equation form as follows:
Goodwill = Consideration transferred + Amount of non-controlling interests + Fair Value of Previous Equity Interests + Net Assets Recognised
If the difference above is negative, the resulting gain is a bargain purchase in profit or loss, which may arise in circumstances such as a forced seller acting under compulsion.
However, before any bargain purchase gain is recognised in profit or loss, the acquirer is required to undertake a review to ensure the identification of assets and liabilities is complete, and that measurements appropriately reflect consideration of all available information.
Choice in the measurement of non-controlling interests (NCI):
IFRS 3 allows an accounting policy choice, available on a transaction-by-transaction basis, to measure non-controlling interests (NCI) either at:
The choice in accounting policy applies only to present ownership interests in the acquiree that entitle holders to a proportionate share of the entity's net assets in the event of a liquidation (e.g., outside holdings of an acquiree's ordinary shares). Other components of non-controlling interests at must be measured at acquisition date fair values or in accordance with other applicable IFRSs (e.g., share-based payment transactions accounted for under?IFRS?2?Share-based Payment).
Business Combination Achieved in Stages (Step Acquisitions):
Prior to control being obtained, an acquirer accounts for its investment in the equity interests of an acquiree in accordance with the nature of the investment by applying the relevant standard, e.g.,?IAS?28?Investments in Associates and Joint Ventures?(IFRS?11)?Joint Arrangements,?IAS?39?Financial Instruments: Recognition and Measurement?or?IFRS?9?Financial Instruments.
As part of accounting for the business combination, the acquirer remeasures any previously held interest at fair value and takes this amount into account in the determination of goodwill as noted above.
Any resultant gain or loss is recognised in profit or loss or other comprehensive income as appropriate.
The accounting treatment of an entity's pre-combination interest in an acquiree is consistent with the view that the obtaining of control is a significant economic event that triggers a remeasurement. Consistent with this view, all of the assets and liabilities of the acquiree are fully remeasured in accordance with the requirements of IFRS 3 (generally at fair value). Accordingly, the determination of goodwill occurs only at the acquisition date. This is different to the accounting for step acquisitions under IFRS 3.
Measurement Period:
If the initial accounting for a business combination can be determined only provisionally by the end of the first reporting period, the business combination is accounted for using provisional amounts. Adjustments to provisional amounts, and the recognition of newly identified asset and liabilities, must be made within the 'measurement period' where they reflect new information obtained about facts and circumstances that were in existence at the acquisition date.
The measurement period cannot exceed one year from the acquisition date and no adjustments are permitted after one year except to correct an error in accordance with?IAS 8.
Related Transactions and Subsequent Accounting:
General Principles:
In General:
When determining whether a particular item is part of the exchange for the acquiree or whether it is separate from the business combination, an acquirer considers the reason for the transaction, who initiated the transaction and the timing of the transaction.
Contingent Consideration:
Contingent consideration must be measured at fair value at the time of the business combination and is taken into account in the determination of goodwill. If the amount of contingent consideration changes as a result of a post-acquisition event (such as meeting an earnings target), accounting for the change in consideration depends on whether the additional consideration is classified as an equity instrument or an asset or liability:
Acquisition Costs:
Costs of issuing debt or equity instruments are accounted for under?IAS?32. All other costs associated with an acquisition must be expensed, including reimbursements to the acquiree for bearing some of the acquisition costs.
Examples of costs to be expensed include finder's fees; advisory, legal, accounting, valuation and other professional or consulting fees; and general administrative costs, including the costs of maintaining an internal acquisitions department.
Pre-Existing Relationships and Reacquired Rights:
If the acquirer and acquiree were parties to a pre-existing relationship (for instance, the acquirer had granted the acquiree a right to use its intellectual property), this must be accounted for separately from the business combination. In most cases, this will lead to the recognition of a gain or loss for the amount of the consideration transferred to the vendor which effectively represents a 'settlement' of the pre-existing relationship. The amount of the gain or loss is measured as follows:
a.????The favourable/unfavourable contract position and
b.????Any stated settlement provisions in the contract available to the counterparty to whom the contract is unfavourable.
However, where the transaction effectively represents a reacquired right, an intangible asset is recognised and measured on the basis of the remaining contractual term of the related contract excluding any renewals. The asset is then subsequently amortised over the remaining contractual term, again excluding any renewals.
Contingent Liabilities:
Until a contingent liability is settled, cancelled or expired, a contingent liability that was recognised in the initial accounting for a business combination is measured at the higher of the amount the liability would be recognised under?IAS?37?Provisions, Contingent Liabilities and Contingent Assets, and the amount less accumulated amortisation under?IAS?18?Revenue.
Contingent payments to employees and shareholders:
As part of a business combination, an acquirer may enter into arrangements with selling shareholders or employees. In determining whether such arrangements are part of the business combination or accounted for separately, the acquirer considers a number of factors, including whether the arrangement requires continuing employment (and if so, its term), the level or remuneration compared to other employees, whether payments to shareholder employees are incremental to non-employee shareholders, the relative number of shares owns, linkages to valuation of the acquiree, how the consideration is calculated, and other agreements and issues.
Where share-based payment arrangements of the acquiree exist and are replaced, the value of such awards must be apportioned between pre-combination and post-combination service and accounted for accordingly.
Indemnification (Compensation for Harm or Loss) Assets:
Indemnification assets recognised at the acquisition date (under the exceptions to the general recognition and measurement principles noted above) are subsequently measured on the same basis of the indemnified liability or asset, subject to contractual impacts and collectability. Indemnification assets are only derecognised when collected, sold or when rights to it are lost.
Other Issues:
In addition, IFRS 3 provides guidance on some specific aspects of business combinations including:
Disclosure:
Disclosure of Information About Current Business Combinations:
An acquirer is required to disclose information that enables users of its financial statements to evaluate the nature and financial effect of a business combination that occurs either during the current reporting period or after the end of the period but before the financial statements are authorised for issue.
Among the disclosures required to meet the foregoing objective are the following:
Disclosure of Information About Adjustments of Past Business Combinations:
An acquirer is required to disclose information that enables users of its financial statements to evaluate the financial effects of adjustments recognised in the current reporting period that relate to business combinations that occurred in the period or previous reporting periods.
Among the disclosures required to meet the foregoing objective are the following:
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