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Module - 1
Introduction
With Indian corporate houses showing sustained growth over the last decade, many
have shown an interest in growing globally by choosing to acquire or merge with other
companies outside India. One such example would be the acquisition of Britains Corus
by Tata an Indian conglomerate by way of a leveraged buy-out. The Tatas also acquired
Jaguar and Land Rover in a significant cross border transaction. Whereas both
transactions involved the acquisition of assets in a foreign jurisdiction, both
transactions were also governed by Indian domestic law.
Whether a merger or an acquisition is that of an Indian entity or it is an Indian entity
acquiring a foreign entity, such a transaction would be governed by Indian domestic
law. In the sections which follow, we touch up on different laws with a view to educate
the reader of the broader areas of law which would be of significance. Mergers and
acquisitions are methods by which distinct businesses may combine. Joint ventures are
another way for two businesses to work together to achieve growth as partners in
progress, though a joint venture is more of a contractual arrangement between two or
more businesses.
amalgamation is an arrangement, whereby the assets and liabilities of two or more companies (amalgamating
companies) become vested in another company (the amalgamated company). The amalgamating companies
all lose their identity and emerge as the amalgamated company; though in certain transaction structures the
amalgamated company may or may not be one of the original companies. The shareholders of the
amalgamating companies become shareholders of the amalgamated company.
While the Companies Act does not define a merger or amalgamation, Sections 390 to 394 of the Companies
Act deal with the analogous concept of schemes of arrangement or compromise between a company, it
shareholders and/or its creditors. A merger of a company A with another company B would involve two
schemes of arrangements, one between A and its shareholders and the other between B and its shareholders.
Mergers may be of several types, depending on the requirements of the merging entities:
Horizontal Mergers. Also referred to as a horizontal integration, this kind of merger takes place between
entities engaged in competing businesses which are at the same stage of the industrial process.2 A horizontal
merger takes a company a step closer towards monopoly by eliminating a competitor and establishing a
stronger presence in the market. The other benefits of this form of merger are the advantages of economies of
scale and economies of scope.
Vertical Mergers. Vertical mergers refer to the combination of two entities at different stages of the
industrial or production process. For example, the merger of a company engaged in the construction business
with a company engaged in production of brick or steel would lead to vertical integration. Companies stand
to gain on account of lower transaction costs and synchronization of demand and supply. Moreover, vertical
integration helps a company move towards greater independence and self-sufficiency. The downside of a
vertical merger involves large investments in technology in order to compete effectively.
Congeneric Mergers. These are mergers between entities engaged in the same general industry and
somewhat interrelated, but having no common customer-supplier relationship. A company uses this type of
merger in order to use the resulting ability to use the same sales and distribution channels to reach the
customers of both businesses.3
Conglomerate Mergers. A conglomerate merger is a merger between two entities in unrelated industries.
The principal reason for a conglomerate merger is utilization of financial resources, enlargement of debt
capacity, and increase in the value of outstanding shares by increased leverage and earnings per share, and by
lowering the average cost of capital.4 A merger with a diverse business also helps the company to foray into
varied businesses without having to incur large start-up costs normally associated with a new business.
Cash Merger. In a typical merger, the merged entity combines the assets of the two companies and grants the
shareholders of each original company shares in the new company based on the relative valuations of the two
original companies. However, in the case of a cash merger, also known as a cash-out merger, the
shareholders of one entity receive cash in place of shares in the merged entity. This is a common practice in
cases where the shareholders of one of the merging entities do not want to be a part of the merged entity.
Triangular Merger. A triangular merger is often resorted to for regulatory and tax reasons. As the name
suggests, it is a tripartite arrangement in which the target merges with a subsidiary of the acquirer. Based on
which entity is the survivor after such merger, a triangular merger may be forward (when the target merges
into the subsidiary and the subsidiary survives), or reverse (when the subsidiary merges into the target and the
target survives).
B. ACQUISITIONS.
An acquisition or takeover is the purchase by one company of controlling interest in the share capital, or all
or substantially all of the assets and/or liabilities, of another company. A takeover may be friendly or hostile,
depending on the offerer companys approach, and may be effected through agreements between the offerer
and the majority shareholders, purchase of shares from the open market, or by making an offer for acquisition
of the offerees shares to the entire body of shareholders.
Friendly takeover. Also commonly referred to as negotiated takeover, a friendly takeover involves an
acquisition of the target company through negotiations between the existing promoters and prospective
investors. This kind of takeover is resorted to further some common objectives of both the parties.
Hostile Takeover. A hostile takeover can happen by way of any of the following actions: if the board rejects
the
offer, but the bidder continues to pursue it or the bidder makes the offer without informing the board
beforehand. The acquisition of one company (called the target company) by another (called the acquirer) that
is accomplished not by coming to an agreement with the target company's management, but by going directly
to the companys shareholders or fighting to replace management in order to get the acquisition approved. A
hostile
takeover
can
be
accomplished
through
either
tender
offer
or
proxy
fight.
Leveraged Buyouts. These are a form of takeovers where the acquisition is funded by borrowed money.
Often
the assets of the target company are used as collateral for the loan. This is a common structure when acquirers
wish to make large acquisitions without having to commit too much capital, and hope to make the acquired
business service the debt so raised.
Bailout Takeovers. Another form of takeover is a bail out takeover in which a profit making company
acquires
sick
company.
This
kind
of
takeover
is
usually
pursuant
to
scheme
of
reconstruction/rehabilitation with the approval of lender banks/financial institutions. One of the primary
motives for a profit making company to acquire a sick/loss making company would be to set off of the losses
of the sick company against the profits of the acquirer, thereby reducing the tax payable by the acquirer. This
would be true in the case of a merger between such companies as well.
C. STRATEGIC ALLIANCE
A partnership with another business in which you combine efforts in business efforts in a business effort
involving anything from getting a better price for goods by buying bulk together, to seeking business
together, with each of you providing part of the product. The basic idea behind alliances is to minimize risk
while maximising your leverage.
D. JOINT VENTURES.
A joint venture is the coming together of two or more businesses for a specific purpose, which may or may
not be for a limited duration. The purpose of the joint venture may be for the entry of the joint venture parties
into a new business, or the entry into a new market, which requires the specific skills, expertise, or the
investment of each of the joint venture parties. The execution of a joint venture agreement setting out the
rights and obligations of each of the parties is usually a norm for most joint ventures. The joint venture
parties may also incorporate a new company which will engage in the proposed business. In such a case, the
byelaws of the joint venture company would incorporate the agreement between the joint venture parties.
E. DEMERGERS.
A demerger is the opposite of a merger, involving the splitting up of one entity into two or more entities. An
entity which has more than one business, may decide to hive off or spin off one of its businesses into a
new entity. The shareholders of the original entity would generally receive shares of the new entity. If one of
the businesses of a company is financially sick and the other business is financially sound, the sick business
may be demerged from the company. This facilitates the restructuring or sale of the sick business, without
affecting the assets of the healthy business. Conversely, a demerger may also be undertaken for situating a
lucrative business in a separate entity. A demerger, may be completed through a court process under the
Merger Provisions, but could also be structured in a manner to avoid attracting the Merger Provisions.
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.
F. DIVESTITURES
A Divestiture is the sale of part of a company to a third party. Assets, product lines, subsidiaries, or divisions
are sold for cash or securities or some combination thereof. The buyers are typically other corporations or,
increasingly, investor groups together with the current managers of the divested operation.
J. EQUITY CARVE-OUTS More and more companies are using equity carve-outs to boost shareholder value.
A parent firm makes a subsidiary public through an initial public offering (IPO) of shares, amounting to a partial
sell-off. A new publicly-listed company is created, but the parent keeps a controlling stake in the newly traded
subsidiary
K. SPINOFFS
A spinoff occurs when a subsidiary becomes an independent entity. The parent firm distributes shares of the
subsidiary to its shareholders through a stock dividend. Since this transaction is a dividend distribution, no cash is
generated. Thus, spinoffs are unlikely to be used when a firm needs to finance growth or deals. Like the carve-out,
the subsidiary becomes a separate legal entity with a distinct management and board.
Basic Concepts
Mergers and acquisitions represent the ultimate in change for a business. No other event is more difficult,
challenging, or chaotic as a merger and acquisition. It is imperative that everyone involved in the process
has a clear understanding of how the process works. Hopefully this short course will provide you with a
better appreciation of what is involved. You might be asking yourself, why do I need to learn the merger and
acquisition (M & A) process?
Well for starters, mergers and acquisitions are now a normal way of life within the business world. In today's
global, competitive environment, mergers are sometimes the only means for long-term survival. In other
cases, such as Cisco Systems, mergers are a strategic component for generating long-term growth.
Additionally, many entrepreneurs no longer build companies for the long-term; they build companies for the
short-term, hoping to sell the company for huge profits. In her book The Art of Merger and Acquisition
Integration, Alexandra Reed Lajoux puts it best: Virtually every major company in the United States today
has experienced a major acquisition at some point in history.
M & A Defined
When we use the term "merger", we are referring to the merging of two companies where one new company
will continue to exist. The term "acquisition" refers to the acquisition of assets by one company from another
company. In an acquisition, both companies may continue to exist. However, throughout this course we will
loosely refer to mergers and acquisitions ( M & A ) as a business transaction where one company acquires
another company. The acquiring company will remain in business and the acquired company (which we will
sometimes call the Target Company) will be integrated into the acquiring company and thus, the acquired
company ceases to exist after the merger.
Merger Theories
Differential efficiency theory.
Inefficient management theory.
Synergy.
Pure diversification.
Strategic realignment to changing environment.
Hubris hypothesis
However, a difficulty would arise when the acquiring firm overestimates its impact on
improving the performance of the acquired firm. This may result in the acquirer paying
too much for the acquired firm. Alternatively, the acquirer may not be able to improve
the acquired firms performance up to the level of the acquisition value given to it.
When these surplus resources are indivisible and cannot be released, a merger enables
them to be optimally utilized. Even if the firm has no opportunity to expand within its
industry, it can diversify and enter into new areas. However, since it does not possess
the relevant skills related to that business, it will attempt to gain a toehold entry by
acquiring a firm in that industry, which has organizational capital alongwith
inadequate managerial capabilities.
than that which the sum of the two operating independently could
account for.
The ability of a combination of two firms to be more profitable
than the two firms individually.
There are two types of synergy:
Financial synergy.
Operating synergy.
Pure diversification.
Diversification provides numerous benefits to managers,
employees, owners of the firms and to the firm itself.
Diversification through mergers is commonly preferred to
diversification through internal growth, given that the firm may
lack internal resources or capabilities requires.
Strategic realignment to changing environment.
It suggests that the firms use the strategy of M&As as ways to
rapidly adjust to changes in their external environments. When a
company has an opportunity of growth available only for a
limited period of time slow internal growth may not be sufficient.
Hubris hypothesis
Module - II
Valuing synergy in M&A deals A
Every merger has its own unique reasons why the combining of two companies is a good business decision.
The underlying principle behind mergers and acquisitions ( M & A ) is simple: 2 + 2 = 5. The value of
Company A is $ 2 billion and the value of Company B is $ 2 billion, but when we merge the two companies
together, we have a total value of $ 5 billion. The joining or merging of the two companies creates additional
value which we call "synergy" value.
Synergy value can take three forms:
1. Revenues: By combining the two companies, we will realize higher revenues then if the two companies
operate separately.
2. Expenses: By combining the two companies, we will realize lower expenses then if the two companies
operate separately.
3. Cost of Capital: By combining the two companies, we will experience a lower overall cost of capital.
Economy of scale: This refers to the fact that the combined company can often reduce its fixed costs
by removing duplicate departments or operations, lowering the costs of the company relative to the same
revenue stream, thus increasing profit margins.
Economy of scope: This refers to the efficiencies primarily associated with demand-side changes,
such as increasing or decreasing the scope of marketing and distribution, of different types of products.
Increased revenue or market share: This assumes that the buyer will be absorbing a major
competitor and thus increase its market power (by capturing increased market share) to set prices.
Cross-selling: For example, a bank buying a stock broker could then sell its banking products to the
stock broker's customers, while the broker can sign up the bank's customers for brokerage accounts. Or, a
manufacturer can acquire and sell complementary products.
Synergy: For example, managerial economies such as the increased opportunity of managerial
specialization. Another example are purchasing economies due to increased order size and associated
bulk-buying discounts.
Taxation: A profitable company can buy a loss maker to use the target's loss as their advantage by
reducing their tax liability. In the United States and many other countries, rules are in place to limit the
ability of profitable companies to "shop" for loss making companies, limiting the tax motive of an
acquiring company.
Geographical or other diversification: This is designed to smooth the earnings results of a company,
which over the long term smoothens the stock price of a company, giving conservative investors more
confidence in investing in the company. However, this does not always deliver value to shareholders (see
below).
Resource transfer: resources are unevenly distributed across firms (Barney, 1991) and the interaction
of target and acquiring firm resources can create value through either overcoming information
asymmetry or by combining scarce resources.
Vertical integration: Vertical integration occurs when an upstream and downstream firm merges (or
one acquires the other). There are several reasons for this to occur. One reason is to internalize
an externality problem. A common example of such an externality is double marginalization. Double
marginalization occurs when both the upstream and downstream firms have monopoly power and each
firm reduces output from the competitive level to the monopoly level, creating two deadweight losses.
Following a merger, the vertically integrated firm can collect one deadweight loss by setting the
downstream firm's output to the competitive level. This increases profits and consumer surplus. A merger
that creates a vertically integrated firm can be profitable.[8]
Hiring: some companies use acquisitions as an alternative to the normal hiring process. This is
especially common when the target is a small private company or is in the startup phase. In this case, the
acquiring company simply hires the staff of the target private company, thereby acquiring its talent (if
that is its main asset and appeal). The target private company simply dissolves and little legal issues are
involved.
Absorption of similar businesses under single management: similar portfolio invested by two
different mutual funds namely united money market fund and united growth and income fund, caused the
management to absorb united money market fund into united growth and income fund.
However, on average and across the most commonly studied variables, acquiring firms' financial
performance does not positively change as a function of their acquisition activity.[9] Therefore, additional
motives for merger and acquisition that may not add shareholder value include:
Diversification: While this may hedge a company against a downturn in an individual industry it fails
to deliver value, since it is possible for individual shareholders to achieve the same hedge by diversifying
their portfolios at a much lower cost than those associated with a merger.
For the most part, the biggest source of synergy value is lower expenses. Many mergers are driven by the
need to cut costs. Cost savings often come from the elimination of redundant services, such as Human
Resources, Accounting, Information Technology, etc. However, the best mergers seem to have strategic
reasons for the business combination.
These strategic reasons include:
Positioning - Taking advantage of future opportunities that can be exploited when the two companies
are combined. For example, a telecommunications company might improve its position for the future if it
were to own a broad band service company. Companies need to position themselves to take advantage of
emerging trends in the marketplace.
Gap Filling - One company may have a major weakness (such as poor distribution) whereas the other
company has some significant strength. By combining the two companies, each company fills-in strategic
gaps that are essential for long-term survival.
Organizational Competencies - Acquiring human resources and intellectual capital can help improve
innovative thinking and development within the company.
Broader Market Access - Acquiring a foreign company can give a company quick access to emerging
global markets.
Mergers can also be driven by basic business reasons, such as:
Bargain Purchase - It may be cheaper to acquire another company then to invest internally. For
example, suppose a company is considering expansion of fabrication facilities. Another company has very
similar facilities that are idle. It may be cheaper to just acquire the company with the unused facilities then to
go out and build new facilities on your own.
Diversification - It may be necessary to smooth-out earnings and achieve more consistent long-term
growth and profitability. This is particularly true for companies in very mature industries where future growth
is unlikely. It should be noted that traditional financial management does not always support diversification
through mergers and acquisitions. It is widely held that investors are in the best position to diversify, not the
management of companies since managing a steel company is not the same as running a software
company.
Short Term Growth - Management may be under pressure to turnaround sluggish growth and
profitability. Consequently, a merger and acquisition is made to boost poor performance.
Undervalued Target - The Target Company may be undervalued and thus, it represents a good
investment. Some mergers are executed for "financial" reasons and not strategic reasons. For example,
Kohlberg Kravis & Roberts acquires poor performing companies and replaces the management team in
hopes of increasing depressed values.
Phase 4 - Acquire through Negotiation: Now that we have selected our target company, it's time to start the
process of negotiating a M & A. We need to develop a negotiation plan based on several key questions:
How much resistance will we encounter from the Target Company?
What are the benefits of the M & A for the Target Company?
What will be our bidding strategy?
How much do we offer in the first round of bidding?
The most common approach to acquiring another company is for both companies to reach agreement
concerning the M & A; i.e. a negotiated merger will take place. This negotiated arrangement is sometimes
called a "bear hug." The negotiated merger or bear hug is the preferred approach to a M & A since having
both sides agree to the deal will go a long way to making the M & A work.
Phase 5 - Post Merger Integration: If all goes well, the two companies will announce an agreement to merge
the two companies. The deal is finalized in a formal merger and acquisition agreement. This leads us to the
fifth and final phase within the M & A Process, the integration of the two companies. Every company is
different - differences in culture, differences in information systems, differences in strategies, etc. As a result,
the Post Merger Integration Phase is the most difficult phase within the M & A Process. Now all of a sudden
we have to bring these two companies together and make the whole thing work. This requires extensive
planning and design throughout the entire organization.
The integration process can take place at three levels:
1. Full: All functional areas (operations, marketing, finance, human resources, etc.) will be merged into one
new company. The new company will use the "best practices" between the two companies.
2. Moderate: Certain key functions or processes (such as production) will be merged together. Strategic
decisions will be centralized within one company, but day to day operating decisions will remain
autonomous.
3. Minimal: Only selected personnel will be merged together in order to reduce redundancies. Both strategic
and operating decisions will remain decentralized and autonomous. As mentioned at the start of this course,
mergers and acquisitions are extremely difficult. Expected synergy values may not be realized and
therefore, the merger is considered a failure.
Suppose
VA = Rs. 200 (Merging Company, or Acquirer)
VB = Rs. 50 (Merging Company, or Target)
VAB = Rs. 300 (Merged or Amalgamated Entity)
Therefore,
Synergy = VAB ( VA + VB ) = Rs. 50. If the premium paid for this merger is Rs. 20, Net gain from merger
of A and B will be Rs. 30 (i.e. Rs. 50 Rs. 20). It is this 30, because of which companies merge or acquire.
One of the essential steps in M&A is the valuation of the Target Company. Analysts use a wide range of
models in practice for measuring the value of the Target firm. These models often make very different
assumptions about pricing, but they do share some common characteristics and can be classified in broader
terms. There are several advantages to such a classification: it is easier to understand where individual models
fit into the bigger picture, why they provide different results and where they have fundamental
errors in logic.
There are only three approaches to value a business or business interest. However, there are numerous
techniques within each one of the approaches that the analysts may consider in performing a valuation. The
Approaches and Techniques are as follows: -
1. Income Approach
The Income Approach is one of three major groups of methodologies, called valuation approaches, used by
appraisers. It is particularly common in commercial real estate appraisal and in business appraisal. The
fundamental math is similar to the methods used for financial valuation, securities analysis, or bond pricing.
However, there are some significant and important modifications when used in real estate or business
valuation.
Under this approach two primary used methods to value a business interest include:
a) Discounted Cash flow method
b) Capitalized Cash flow method
Each of these methods depends on the present value of an enterprises future cash flows.
Discounted Cash flow Technique
The Discounted Cash flow valuation is based upon the notion that the value of an asset is the present value of
the expected cash flows on that asset, discounted at a rate that reflects the riskiness of those cash flows. The
nature of the cash flows will depend upon the asset, dividends for an equity share, coupons and redemption
value for bonds and the post tax cash flows for a project. The Steps involved in valuation under this method
are as under:
FCFE Technique (Free Cash Flow From Equity)
The Capitalized Cash flow technique of income approach is the abbreviated version of Discounted Cash flow
technique where the growth rate (g) and the discount rate (k) are assumed to remain constant in perpetuity.
This model is represented as under:
Value of Firm = Net Cash flow in year one ( k g )
2. Market Approach
The origin of market approach of business valuation is established in the economic rationale of
competition. It states that in case of a free market, the demand and supply effects direct the value of business
properties to a particular balance. The purchasers are not ready to pay higher amounts for the business and the
vendors are not ready to receive any amount, which is lower in comparison to the value of a corresponding
commercial entity. It is the value of a firm by performing a comparison between the firms concerned with
organizations in the similar location, of equal volume or operating in the similar sector.
It has a large number of resemblances with the comparable sales technique, which is generally utilized in case
of real estate estimation. The market value of shares of companies that are traded publicly and are involved in
identical commercial activities may be a logical signal of the value of commercial operation. In this case the
company shares are bought and sold in an open and free market. This process allows purposeful comparison
of the market value of shares.
The problem exists in distinguishing public companies, which are adequately corresponding to the company
concerned for this intention. In addition, in case of a private company, the liquidity of the equity is lower (put
differently, its shares are difficult to trade) in comparison to a public company. The value is regarded as
somewhat lesser in comparison to that a market-based valuation will render.
E.g. - Suppose a company operating in the same industry as ABC with comparable size and other situations
has been sold at Rs. 500 crores in last week provides a good measurement for valuation of business.
Considering the circumstances, 10 value of the business of ABC should be around Rs. 500 crores under
market approach.
3. Assets Approach
The first step in using the assets approach is to obtain a Balance Sheet as close as possible to the valuation
date. Each recorded asset including intangible assets must be identified, examined and adjusted to fair market
value. Now all liabilities are to be subtracted, again at fair market value, from the value of assets derived as
above to reach at the fair market value of equity of the business. It is important to note here that any
unrecorded assets or liabilities should also be considered while arriving at the value of business by the assets
approach.
Net Asset Value Approach
Net asset value (NAV) is a term used to describe the value of an entity's assets less the value of its liabilities.
The term is most commonly used in relation to open-ended or mutual funds due to the fact that shares of such
funds are redeemed at their net asset value.
Economic Value Added (EVA) Approach
Economic Value Added or EVA is an estimate of economic profit, which can be determined, among other
ways, by making corrective adjustments to GAAP accounting, including deducting the opportunity cost of
equity capital. EVA is similar to Residual Income (RI), although under some definitions there may be minor
technical differences between EVA and RI (for example, adjustments that might be made to NOPAT before it
is suitable for the formula below).
Market Value Added Approach (MVA)
Market Value Added (MVA) is the difference between the current market value of a firm and the capital
contributed by investors. If MVA is positive, the firm has added value. If it is negative, the firm has destroyed
value. The amount of value added needs to be greater than the firm's investors could have achieved investing
in the market portfolio, adjusted for the leverage (beta coefficient) of the firm relative to the market.
The formula for MVA is:
MVA = V K
Where:
MVA is market value added, V is the market value of the firm, including the value of the firm's equity and
debt K is the capital invested in the firm The higher the MVA the better it is. A high MVA indicates the
company has created substantial wealth for the shareholders. A negative MVA means that the value of
management's actions and investments are less than the value of the capital contributed to the company by the
capital market (or that wealth and value have been destroyed).
When one company decides to acquire another company, a series of negotiations will take place between
the two companies. The acquiring company will have a well-developed negotiating strategy and plan in
place. If the Target Company believes a merger is possible, the two companies will enter into a "Letter of
Intent."
The Letter of Intent outlines the terms for future negotiations and commits the Target Company to giving
serious consideration to the merger. A Letter of Intent also gives the acquiring company the green light to
move into Phase II Due Diligence. The Letter of Intent attempts to answer several issues concerning the
proposed merger:
1. How will the acquisition price be determined?
2. What exactly are we acquiring? Is it physical assets, is it a controlling interest in the target, is it intellectual
capital, etc.?
3. How will the merger transaction be designed? Will it be an outright purchase of assets? Will it be an
exchange of stock?
4. What is the form of payment? Will the acquiring company issue stock, pay cash, issue notes, or use a
combination of stock, cash, and/or notes?
5. Will the acquiring company setup an escrow account and deposit part of the purchase price? Will the
escrow account cover unrecorded liabilities discovered from due diligence?
6. What is the estimated time frame for the merger? What law firms will be responsible for creating the M & A
Agreement?
7. Will there be any adjustment to the final purchase price due to anticipated losses or events prior to the
closing of the merger?
M &
M & A Agreement
M & A Agreement
As the negotiations continue, both companies will conduct extensive Phase II Due Diligence in an effort to
identify issues that must be resolved for a successful merger. If significant issues can be resolved and both
companies are convinced that a merger will be beneficial, then a formal merger and acquisition agreement
will be formulated. The basic outline for the M & A Agreement is rooted in the Letter of Intent. However,
Phase II Due Diligence will uncover several additional issues not covered in the Letter of Intent.
Consequently, the M & A Agreement can be very lengthy based on the issues exposed through Phase II Due
Diligence. Additionally, both companies need to agree on the integration process. For example, a Transition
Service Agreement is executed to cover certain types of services, such as payroll.
The Target Company continues to handle payroll up through a certain date and once the integration process
is complete, the acquiring company takes over payroll responsibilities. The Transition Service Agreement will
specify the types of services, timeframes, and fees associated with the integration process.
Indemnification
Another important element within the M & A Agreement is indemnification. The M & A Agreement will specify
the nature and extent to which each company can recover damages should a misrepresentation or breach of
contract occur. A "basket" provision will stipulate that damages are not due until the indemnification amount
has reached a certain threshold. If the basket amount is exceeded, the indemnification amount becomes
payable at either the basket amount or an amount more than the basket amount. The seller (Target
Company) will insist on having a ceiling for basket amounts within the M & A Agreement.
Since both sides may not agree on indemnification, it is a good idea to include a provision on how disputes
will be resolved (such as binding arbitration). Finally, indemnification provisions may include a "right of sell
off" for the buyer since the buyer has deposited part of the purchase price into an escrow account. The Right
to Sell Off allows the buyer (acquiring company) to offset any indemnification claims against amounts
deferred within the purchase price of the merger. If the purchase price has been paid, then legal action may
be necessary to resolve the indemnification.
Module III
The SEBI may also require valuation of such infrequently traded shares by an independent valuer.
Mode of payment of offer price. The offer price may be paid in cash, by issue, exchange or transfer of shares
(Other than preference shares) of the acquirer, if the acquirer is a listed entity, by issue, exchange or transfer
of secured instruments of the acquirer with a minimum A grade rating from a credit rating agency registered
with the SEBI, or a combination of all of the above
Non-compete payments. Payments made to persons other than the target company under any non-compete
agreement exceeding 25% of the offer price arrived at as per the requirements mentioned above, must be
added to the offer price.
Pricing for indirect acquisition or control. The offer price for indirect acquisition or control shall be
determined with reference to the date of the public announcement for the parent company and the date of the
public announcement for acquisition of shares of the target company, whichever is higher, in accordance with
requirements set out above.
If the acquirer intends to dispose of / encumber the assets in the target company, except in the ordinary
course of business, then he must make such a disclosure in the public announcement or in the letter of offer to
the shareholders, failing which, the acquirer cannot dispose of or encumber the assets of the target company
for a period of 2 years from the date of closure of the public offer
Restrictions on the target company.
After the public announcement is made by the acquirer, the target
company is also subject to certain restrictions. The target company cannot then (a) sell, transfer, encumber or
otherwise dispose off or enter into an agreement for sale, transfer, encumbrance or for disposal of assets,
except in the ordinary course of business of the target company and its subsidiaries, (b) issue or allot any
securities carrying voting rights during the offer period, except for any subsisting obligations, and (c) enter
into any material contracts.
The following acquisitions / transfers would be exempt from the key provisions of the Takeover Code:
acquisition pursuant to a public issue;
acquisition by a shareholder pursuant to a rights issue to the extent of his entitlement and subject to
certain other restrictions;
inter-se transfer of shares amongst:
o qualifying Indian promoters and foreign collaborators who are shareholders,
o qualifying promoter, provided that the parties have been holding shares in the target company for a
period of at least three years prior to the proposed acquisition,
o the acquirer and PAC, where the transfer of shares takes place three years after the date of closure of
the public offer made by them under the Takeover Code and the transfer is at a price not exceeding
125% of the price determined as per the Takeover Code (as mentioned above);
acquisition of shares in the ordinary course of business by (a) banks and public financial institutions as
pledgees, (b) the International Finance Corporation, Asian Development Bank, International Bank for
Reconstruction and Development, Commonwealth Development Corporation and such other international
financial institutions;
acquisition of shares by a person in exchange of shares received under a public offer made under the
Takeover Code;
acquisition of shares by way of transmission on succession or inheritance;
transfer of shares from venture capital funds or foreign venture capital investors registered with the SEBI
to promoters of a venture capital undertaking or to a venture capital undertaking, pursuant to an
agreement between such venture capital fund or foreign venture capital investors, with such promoters or
venture capital undertaking;
change in control by takeover of management of the borrower target company by the secured creditor or
by restoration of management to the said target company by the said secured creditor in terms of the
Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002;
acquisition of shares in companies whose shares are not listed on any stock exchange, unless it results in
the acquisition shares/voting rights/control of a company listed in India; and
acquisition of shares in terms of guidelines or regulations regarding delisting of securities framed by the
SEBI.
Cash
Payment by cash. Such transactions are usually termed acquisitions rather than mergers because the
shareholders of the target company are removed from the picture and the target comes under the (indirect)
control of the bidder's shareholders.
Stock
Payment in the form of the acquiring company's stock, issued to the shareholders of the acquired company at
a given ratio proportional to the valuation of the latter.
Financing options
There are some elements to think about when choosing the form of payment. When submitting an offer, the
acquiring firm should consider other potential bidders and think strategically. The form of payment might be
decisive for the seller. With pure cash deals, there is no doubt on the real value of the bid (without
considering an eventual earn out). The contingency of the share payment is indeed removed. Thus, a cash
offer preempts competitors better than securities. Taxes are a second element to consider and should be
evaluated with the counsel of competent tax and accounting advisers. Third, with a share deal the buyers
capital structure might be affected and the control of the buyer modified.
If the issuance of shares is necessary, shareholders of the acquiring company might prevent such capital
increase at the general meeting of shareholders. The risk is removed with a cash transaction. Then, the
balance sheet of the buyer will be modified and the decision maker should take into account the effects on the
reported financial results. For example, in a pure cash deal (financed from the companys current account),
liquidity ratios might decrease. On the other hand, in a pure stock for stock transaction (financed from the
issuance of new shares), the company might show lower profitability ratios (e.g. ROA). However, economic
dilution must prevail towards accounting dilution when making the choice. The form of payment and
financing options are tightly linked. If the buyer pays cash, there are three main financing options:
Cash on hand: it consumes financial slack (excess cash or unused debt capacity) and may decrease
It consumes financial slack, may decrease debt rating and increase cost of debt. Transaction costs
include underwriting or closing costs of 1% to 3% of the face value.
Issue of stock: it increases financial slack, may improve debt rating and reduce cost of debt.
Transaction costs include fees for preparation of a proxy statement, an extraordinary shareholder meeting
and registration.
Shares in treasury: it increases financial slack (if they dont have to be repurchased on the market),
may improve debt rating and reduce cost of debt. Transaction costs include brokerage fees if shares are
repurchased in the market otherwise there are no major costs.
In general, stock will create financial flexibility. Transaction costs must also be considered but tend to have a
greater impact on the payment decision for larger transactions. Finally, paying cash or with shares is a way to
signal value to the other party, e.g.: buyers tend to offer stock when they believe their shares are overvalued
and cash when undervalued.[6]
DEBT RESTRUCTURING
Debt restructuring is a process that allows a private or public company facing cash flow problems and financial
distress, to reduce and renegotiate its delinquent debts in order to improve or restore liquidity and rehabilitate so that it
can continue its operations.
A debt restructuring is usually less expensive and a preferable alternative to bankruptcy. The main costs associated
with a business debt restructuring are the time and effort to negotiate with bankers, creditors, vendors and tax
authorities. Debt restructurings typically involve a reduction of debt and an extension of payment terms
Companies use debt restructuring to avoid default on existing debt or to take advantage of a lower interest
rate. A company will often issue callable bonds to allow them to readily restructure debt in the future. The
existing debt is called and then replaced with new debt at a lower interest rate. Companies can also
restructure their debt by altering the terms and provisions of the existing debt issue.
Related terms
Replacement of old debt by new debt when not under financial distress is referred to as Refinancing
Debt consolidation entails taking out one loan to pay off many others. This is often done to secure a lower interest
rate, secure a fixed interest rate or for the convenience of servicing only one loan
A program by which a company buys back its own shares from the marketplace, reducing the number of
outstanding shares. Share repurchase is usually an indication that the company's management thinks the
shares are undervalued. The company can buy shares directly from the market or offer its shareholder the
option to tender their shares directly to the company at a fixed price.
Because a share repurchase reduces the number of shares outstanding (i.e. supply), it increases earnings per
share and tends to elevate the market value of the remaining shares. When a company does repurchase shares,
it will usually say something along the lines of, "We find no better investment than our own company."
1. Shareholders may be presented with a tender offer whereby they have the option to submit (or tender) a portion or all of their
shares within a certain time frame and at a premium to the current market price. This premium compensates investors for tendering
their shares rather than holding on to them.
2. Companies buy back shares on the open market over an extended period of time.
Share Repurchase
Alternative to the payment of cash dividends, the company may purchase the shares
back. Purchase of shares outstanding can be done through the secondary market Stock
Exchange. Shares purchased are included in treasury stock account. Theoretically, the
value of the company before and after the purchase of shares will be the same again.
The Advantages of Stock Repurchases
Announcement of buy-back could be considered a positive signal by investors, because Stock repurchases
often driven by the motivation of managers who assume that the undervalued stock price (lower than they
should).
Shareholders have the option to Stock Repurchases. When need cash, they can sell the shares they acquire.
Conversely, if do not need cash, or evading taxes, they can invest back into the company stock.
The shareholders may have different preferences between cash dividends and Stock Repurchases (profits
derived from capital gains). Cash dividends tend to be unreliable because it gives a clear income (cash
received), and relatively stable.
The Company may pay the repurchase price is too high, to the detriment of current shareholders (who still
holds the shares).
Shareholders who sell their shares may not know exactly the implications and the Stock Repurchases
program effects. If it turns out to feel aggrieved, they can sue the company.
Buying back stock allows a company to pass on extra cash to shareholders without raising the
dividend. If the cash is temporary in nature it may prove more beneficial to pass on value to
shareholders through buybacks rather than raising the dividend.
Excellent Tool for Financial Reengineering:
In the case of profit making, h i g h d i v i d e n d p a y i n g c o m p a n i e s w h o s e s h a r e p r i c e s a r e l a n g u i s h i n g , buybacks can actually boost
their bottom lines since dividends attract taxes. A b u yb a c k a n d t h e s u b s e q u e n t n e u t r a l i s a t i o n o f
s h a r e s c a n r e d u c e d i v i d e n d outflows, and if the opportunity cost of funds used is lower than the
dividend savings, the company can laugh all the way to the bank.
Tax Implication:
Stock buybacks also raise the demand for the stock on the open market. This point is rather
self explanatory as the company is competing against other investors to purchase shares of its own
stock.
Backfire:
Buybacks can also backfire for a company competing in a high-growth industry because they may be
read as an admission that the company has few i m p o r t a n t n e w o p p o r t u n i t i e s o n w h i c h t o
o t h e r w i s e s p e n d i t s m o n e y. I n s u c h cases, long-term investors will respond to a buyback
announcement by selling the companys shares
The share buyback scheme might become a big disadvantage to the company when it
p a ys t o o m u c h f o r i t s o w n s h a r e s . I n d e e d , i t i s f o o l i s h t o b u y i n a n overpriced market.
Instead, the company should put the money into assets that can be easily converted back into cash. This
way, when the market swings the other way and is trading below its true value, shares of the company
can be bought back at a discount, ensuring current shareholders receive maximum benefit. Strictly,
acompany should repurchase its shares only when its stock is trading below its expected value
and when no better investment opportunities are available.
For example, if a company offers a swap ratio of 1:1.5, it will provide one share of its own company for
every 1.5 shares of the company being acquired.
This can also be applied as a debt/equity swap, when a company wants investors to trade their bonds
with the company being acquired for the acquiring company's own shares.
While earnings per share reflect prime facie the earnings power, there are some problems in an exchange ratio
based solely on current earnings per share of the merging companies because it fails to take into account the
following:
* The difference in the growth rates of earnings of the two companies
* The gains in earnings arising out of merger
* The differential risks associated with the earnings of the two companies
Moreover, there is the measurement problem of defining the normal level of current earnings. The current
earnings per share may be influenced by certain transient factors like a windfall profit, or an abnormal labor
problem, or a large tax relief. Finally, how can earnings per share, when they are negative, be used?
Market Price per share: The exchange ratio may be based on the relative market prices of the shares of the
acquiring firm and the target firm. For example, if the acquiring firms equity share sells for Rs 50 and the
target firms equity share sells for Rs 10 the exchange ratio based on the market price is 0.2 that is (10/50).
This means that 1 share of the acquiring firm will be exchanged for 5 shares of the target firm.
When the shares of the acquiring firm and the target firm are actively traded in a competitive market, market
prices have considerable merit. They reflect current earnings, growth prospects and risk characteristics. When
the trading is meagre market prices, however, may not be very reliable. In the extreme case market prices
may not be available if the shares are not traded. Another problem with market prices is that they may be
manipulated by those who have a vested interest.
Book value per share: The relative book values of the two firms may be used to determine the exchange
rate. For example, if the book value per share of the acquiring company is Rs 25 and the book value per share
of the target company is Rs 15, the book value based exchange ratio is 0.6 =(15/25).
The proponents of book value contend that it provides a very objectives basis. This however is not
convincing argument because book values are influenced by accounting policies which reflect subjective
judgments. There are still serious objections against the use of the book value.
1. Book values do not reflect changes in purchasing power of money.
2. Book values often are highly different from true economic values
Explanatory Statement
The company needs to make the following disclosures in the statement
1. The date of the Board meeting at which the proposal for buy back was approved by the BOD.
2. The necessity for the buy back
3. The company may specify one reason to be adopted for buy-back so that the shareholders
authorize the BOD for the same.
4. The maximum amount required under the buy back and the sources of funds fr om which the
buy back would be financed.
5. The basis of arriving at the buy-back price.
6. The number of securities that the company proposes to buy back.
7. a. The aggregate shareholding of the promoter and of the directors of the promoters, as on the
date of the notice convening the General Meeting.
b. Aggregate number of shares purchased or sold by such persons during a period of six months
preceding the date of the Board Meeting
c. The maximum and minimum price at which purchases and sales were made along with the
relevant dates.
8. Intention of the promoters and persons in control of the company to tender their shares for
buy-back indicating the number of shares and details of acquisition with dates and price.
9. A confirmation that there are no defaults subsisting in repayment of deposits, redemption of
debentures or preference shares or repayment of term loans to any financial institutions or banks.
10. A confirmation that the BOD has made a full enquiry into the affairs and prospects of the company and
is of the opinion.
a. that there will be no grounds on which the company could be found unable to pay its debts;
b.The company during that year, the company will be able to meet its liabilities as and when they
fall due and will not be rendered insolvent within a period of one year from that General Meeting date ; and
c. In forming their opinion for the above purposes, the directors have taken into account the
liabilities as if the company were being wound up under the provisions of the Companies Act, 1956
Who Is Merchant Banker?
A merchant banker, according to SEBI (Merchant Bankers) Regulations, 1992
is a person who is engaged in the business of issue management either by making arrangements regarding
selling, buying or subscribing to securities as manager, consultant, advisor or rendering corporate advisory
services in relation to such issue management
Merchant bankers render services to meet the needs of trade, industry and also investors by performing as
intermediary, consultant and a liaison. Merchant banking is a service oriented industry specializing in
investment and financial decision making, assisting in making corporate strategies, assessing capital needs
andhelping in procuring the equity and debt funds for corporate sectors and ultimately helping in establishing
favourable economic environment.
Contribution to a project or enterprise in the form of effort and toil. Sweat equity is the ownership
interest, or increase in value, that is created as a direct result of hard work by the owner(s). It is the
preferred mode of building equity for cash-strapped entrepreneurs in their start-up ventures, since they
may be unable to contribute much financial capital to their enterprise. In the context of real estate,
sweat equity refers to value-enhancing improvements made by homeowners themselves to their
properties. The term is probably derived from the fact that such equity is considered to be generated
from the "sweat of one's brow."
For example, consider an entrepreneur who has invested $100,000 in her start-up. After a year of
developing the business and getting it off the ground, she sells a 25% stake to an angel investor for
$500,000. This gives the business a valuation of $2 million (i.e. $500,000/0.25), of which the
entrepreneur's share is $1.5 million. Subtracting her initial investment of $100,000, the sweat equity
she has built up is $1.4 million.
Valuation of sweat equity can become a contentious issue when there are multiple owners in an
enterprise, especially when they are performing different functions. To avoid disputes and complications
at a later stage, it may be advisable to arrive at an understanding of how sweat equity will be valued at
the outset or initial stage itself.
Employee Stock Option (ESOP) and Sweat Equity (SE) are new tools, which are in use
by a lot of multinational companies and consulting companies coming to India and
engaging the real brain of Indian professionals who are offered ESOP/SE by such
companies as an incentive to them. In absence of any set law or precedent about its
Why ESOP or SE ?
The employee stock option plan is a good management tool for retention of human
talent and guarding against poaching of staff of a running organisa-tion by a rival
company.
When a company is newly formed or starts a new line of business, the company
engages the best executives and employees available, who bring in their IPR
(Intellectual Property Rights) and know-how, skill and expertise with them, which make
a value addition for the company. Certain key professionals would like to invest in the
companys capital and would like to risk their own contribution to the capital of the
company along with their own IPR, know-how, skill and expertise. Such employees
would like to be a strategic part of the promoter group and would like to make value
addition to their capital invested in the company. Such an employee is awarded
with Sweat Equity as an incentive to join the company.
As the company grows, the management would like to see that all its core
management team remains with them and further, such core management team is
given additional incentive as a reward for the efforts put in by them in managing the
company. Such employees are offered ESOP at a price which is less than the real value
of the share.
A great deal of flexibility is available in structuring sales to the ESOP. If a shareholder desires immediate
liquidity, the plan may obtain a bank loan and purchase the shares for cash. If a shareholder does not need
immediate liquidity, he may defer the tax on the sale by selling his shares to the trust on an instalment sale
basis, or by selling only a portion of his shares to the trust on a year-by-year basis.
A Readily Available Market for Minority Shareholders and Outside Investors
The ESOP also provides a readily available market for the minority shareholders and other outside
investors who desire to realize their gain or to liquidate a part or all of their investment for reinvestment in
other companies. If the ESOP acquires at least 30% ownership, a minority shareholder may also elect tax-free
rollover treatment under 1042 of the Internal Revenue Code.
A Tax-Advantaged Alternative to Sale or Merger
Purchase of an owners stock by an ESOP will almost always be more beneficial to the owner than sale or
merger. For example, in the case of a sale, the seller will incur an income tax, will lose control, will usually
lose his salary and fringe benefits, and will seldom be able to keep any retained equity. In comparison, there
will be no tax to the seller if he sells stock to the ESOP under the tax-free rollover provision of the 1984 Tax
Reform Act. In addition, under an ESOP, the seller can keep control, can continue to receive his salary and
fringe benefits, and can keep as much or as little of the stock as he desires.
An Effective Tool for Increasing Cash Flow and Net Worth
A company can reduce its corporate income taxes and increase its cash flow and net worth by simply issuing
treasury stock or newly issued stock to an ESOP in any amount up to 25% of eligible annual payroll. Using
this approach, a company may drastically reduce or even eliminate its corporate tax liability. The cash flow
impact can be dramatic. If the contribution to the ESOP is made in lieu of cash contributions to a profit
sharing plan, the cash flow savings are even more dramatic. Of course, the owners must consider that these
contributions of stock will result in some dilution of their ownership interest.
A Superior Employee Incentive Device
An Employee Stock Ownership Plan is designed to provide employees with the incentive of a piece of the
action, and to enable employees to share in the capital growth of the company. Employee stock ownership
gives employees a direct and vested interest in the success of their company, enables employees to share in
the profits of their own labor, and creates an identity of interest between management and labor.
As an employee incentive device, the ESOP is usually superior to other incentive plans. In an ordinary profit
sharing plan, for example, the funds are invested in stocks of unrelated companies, and the incentive effects
are minimal. In an ESOP, on the other hand, the employees acquire an ownership interest in their own
company, and the incentive element is maximized.
The ESOP is a flexible plan that can be used either in lieu of or in combination with other employee benefits
plans. Because of its many advantages, the ESOP is becoming an increasingly popular form of employee
benefit. The ESOP is particularly advantageous for companies whose rapid growth has required the
reinvestment of profits, resulting in a shortage of cash available for employee benefits. A collateral benefit is
that the ESOP often serves to diminish employee interest in unionization.
A New Way to Finance Debt Reduction
Companies frequently find it necessary to borrow money in order to finance corporate growth. One
disadvantage of debt financing is that repayment of the loan principal is not a deductible expense. An ESOP
can be used to mitigate this problem by having the company issue newly issued stock or treasury stock to an
ESOP. The resulting tax savings can then be applied against the principal payments so that tax-deductible
dollars are used to pay part, or all, of the loan principal.
How the Plan is Designed
An ESOP is a plan qualified by the Internal Revenue Service as an equity-based deferred compensation plan.
As such, it is in the same family as profit sharing plans and stock bonus plans.
An ESOP, however, differs from a profit sharing plan in that an ESOP is required to invest primarily in
employer securities, while a profit sharing plan is usually prohibited from investing primarily in employer
securities.
An ESOP also differs from profit sharing plans and from stock bonus plans in that an ESOP is permitted and
authorized to engage in leveraged purchases of company stock. Consequently, an ESOP required different
accounting procedures and a different method of allocating stocks and other investments among the
employees than other types of plans. For this reason, the plan should be designed by an ESOP specialist in
order to avoid Internal Revenue Service difficulties.
The ESOP, like a profit sharing plan, must cover all non-union employees who are at least age 21 and have
one year of service. An ESOP may either include or exclude union employees. In practical effect, share
ownership under the plan is usually proportionate to the relative salaries of the participants in the plan.
How do Stock Purchase Plans work?
Under a typical Stock Purchase Plan, employees are given an option to purchase their employer's stock
generally at a discounted price at the end of an offering period. Prior to each offering period, eligible
employees indicate if they wish to participate in the plan.
If the employee wishes to participate, he/she indicates the percentage or dollar amount of compensation
to be deducted from their payroll throughout the offering period. The percentage or dollar amount
employees are allowed to contribute varies by plan, however, the IRS limits the total purchase to
$25,000 annually.
Under most stock purchase plans, the purchase price is set at a discount from the fair market value.
While some plans provide that the discount is applied to the value on the stock on the purchase date
(e.g., 85% of the fair market value on that date), it is more common to apply the discount to the value
of the stock on the first or last day of the offering period, whichever is lower.
Most plans allow employees to increase or decrease their payroll deduction percentage at any time
during the offering period. Each plan is unique, your plan materials will detail how a specific plan
works.
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Two Types of Employee Stock Purchase Plans
There are two types of Employee Stock Purchase Plans, classified by their tax status:
Qualified Employee Stock Purchase Plans (Section 423)
Qualified Employee Stock Purchase Plans meet conditions described by Section 423 of the Internal
Revenue Code. There is special tax treatment for shares that are held for more than a year. A qualified
plan must meet the following requirements:
Only employees of the company (or its parent or subsidiary corporations) may participate in the
plan
The purchase plan must be approved by the shareholders of the company within the 12 months
before it is adopted by the board.
Any employee owning more than 5% of the company stock may not participate in the plan
All eligible employees must be allowed to participate in the plan, although certain categories of
employees may be excluded (e.g. employees employed less than two years)
All employees must enjoy the same rights and privileges under the plan, expect that the amount
of stock that may be purchased may be based on compensation differences
The purchase price may not be less than the lesser of 85% of the fair market value of the stock
1) at the beginning of the offering period, or 2) on the purchase date
The maximum offering period cannot exceed 27 months unless the purchase price is based
solely on the fair market value at time of purchase, in which case the offering period may be as
long as 5 years
An employee may not purchase more than $25,000 worth of stock (based on fair market value
on the first day of the offering period) for each calendar year in which the offering period is in
effect