Welcome back to our series – Mergers and Acquisitions Made Simple! In this blogpost, we will further explore key aspects of M&A, including M&A transaction stages, common valuations methods, deal structuring techniques and different types of mergers. It may get a little technical, so do feel free to leave a comment or contact any of our investment club members if you would like to learn more!
5 stages of an M&A transaction
M&A transactions vary based on complexity and factors, leading to diverse structures. The 5-stage process outlined is flexible and subject to change depending on the transaction’s complexity.
- Non-Disclosure Agreement
The initial phase of an M&A transaction involves the creation of a Non-Disclosure Agreement (NDA), outlining key commercial terms and conditions based on precursory negotiations between the parties. There will be legal counsel on both-sides review, followed by the countersigning and sending back process.
- Release of Information Memorandum
Then, phase-one information memorandum is released. This document is usually smaller and less extensive, for preliminary due diligence only. However, some larger and more competitive processes might release more information earlier on to facilitate due diligence – the extent to information released will depend on the process. The sell side will give a deadline to submit a non-binding bid, also known as a non-binding offer (NBO). The format of the bid is dependent on the sellside, and usually a definite value, for example, [xx million USD], needs to be given.
- Due Diligence
Due diligence is a critical phase in which both the buyer and seller assess and analyse information regarding the target company or assets, aiming to identify potential risks. The sell-side shortlists candidates to proceed into further due diligence with a binding bid date. Additionally, they provide access to additional due diligence reports. Concurrently, in preparation for the bid, the buy-side initiates negotiations on other elements of the deal, such as financing, warranties, and indemnity insurance. The due diligence process at this stage is extensive, with the buy-side engaging multiple consultants, lawyers, and lenders to prepare an informed opinion for bid submission. Buyers may conduct their own due diligence, sometimes supplemented by vendor due diligence from the client itself.
- Submit binding bid
After finalising due diligence, the prospective purchaser, along with advisors, reviews the transaction details, including final price, warranties, indemnities, and limitations. When submitting the binding bid, it is generally not favoured to revise your initial bid downwards as it impacts the credibility of future bids.
These details are then incorporated into a Share Purchase Agreement (SPA) or an Assets Purchase Agreement (APA), depending on whether shares or the business itself are being acquired. The completion of an M&A transaction involves the payment of the full purchase consideration for complete ownership and control of the company. The closing date is when the legal transfer occurs.
- Closing
Closing stage involves the settlement of legal documents. Discussed details are incorporated into a Share Purchase Agreement (SPA) or an Assets Purchase Agreement (APA), depending on the industry and whether shares or the business itself are being acquired. The completion of an M&A transaction involves the payment of the full purchase consideration for complete ownership and control of the company. The closing date is when the legal transfer occurs.
Common valuation methods used for M&A
There are three common approaches when evaluating the company including market approach, income approach and asset-based approach.
Market Approach
This approach looks at the prices of similar businesses or transactions to estimate the value of a company. However, this method may not be useful for evaluating companies in niche areas where there is a lack of competitors. The most common multiples for the market approach are EV/EBITDA (Enterprise Multiple) and EV/Revenue (EV/R). These multiples are compared against competitors with similar industry classification, type of company (private/public), size and so on.
Enterprise Value (EV) is the measure of a company’s total market value, rather than just the equity value (or market capitalisation). EV helps to compute the value that is not just attributable to shareholders, but also other stakeholders such as debt holders. A simplified formula for EV is as follows: EV = Market Capitalisation + Total Debt − Cash and Cash Equivalents. EV is approximated by this, but the full formula has other adjustments.
EBITDA = Net Income + Interest Expense + Taxes + Depreciation + Amortization
This is often used in valuation as a proxy for cash flow, although for many industries it is not a useful metric as EBITDA ignores the depreciating effects of assets. Hence, for capital-intensive industries such as mining and infrastructure, EBITDA will not give an accurate proxy for cash flow, and EBIT multiples are often favoured.
The EV/R looks at a company’s revenue-generating ability, while the EV/EBITDA looks at a company’s ability to generate operating cash flows. EV/EBITDA considers operating expenses, while EV/R looks at just the top line. The advantage that EV/R has is that it can be used for companies that are yet to generate income or profits, such as the case with Amazon and Tesla in their early days.
Income Approach
A commonly used approach under the income approach would be the Discounted Cash Flow (DCF) valuation. The DCF is an intrinsic valuation method that allows investors to understand the company’s value independently. It is the forecast of a company’s unlevered free cash flow (cash available to debt and equity investors) discounted back to today’s value, which is called the Net Present Value (NPV). The discount rate, also known as the Weighted Average Cost of Capital (WACC), represents the required rate of return expected by its investors. A company’s WACC is likely to be higher if its stock is relatively volatile or if its debt is seen as risky because investors will want greater returns to compensate them.
A DCF valuation is detailed, with assumptions clearly stated, and can determine the intrinsic value of a business. However, a DCF model is prone to certain problems such as its sensitivity to assumptions and fixed capital structure. Minor adjustments to DCF assumptions can change the valuation result significantly. As for the other disadvantage, the company’s capital structure may change as it decides to take on more debt as it matures, therefore affecting the WACC.
Asset-Based Approach
Investors can use the asset-based valuation as an alternative in the event that the company does not have equity. The asset-based value may also be required for private companies in certain types of analysis as added due diligence. The asset-based value is equivalent to the company’s book value or shareholder’s equity. The calculation is obtained by subtracting liabilities from assets.
Companies in the investment niche such as financial or real estate investment, where assets are calculated based on income or market approach, can opt for an asset-based valuation.
However, drawbacks of such a method include the disregard of a company’s potential earnings. Another con of an asset-based approach may be the complexity involving the valuation of intangible assets. Lastly, having a high value based on assets does not represent the business’s profitability.
Ways of Structuring an M&A Deal
Merger vs Acquisition
In a merger, two companies combine to become one legal entity. The board of directors from both companies would approve the merger and seek shareholder approval. In an acquisition, one company purchases another outright and takes over the entire business operations.
Tender offer/Share purchase
The buyer would purchase the target company’s shares from the shareholders, with a large amount often held by the public. The price is usually set higher than the market price to entice the target company’s shareholders to sell. This premium is often known as the takeover or the control premium. One prime example of this would be Elon Musk’s USD $44 Billion bid for Twitter in 2022.
Asset Acquisition
As the name suggests, the buyer only purchases assets and assumes certain liabilities indicated in the purchase agreement. This structure is often utilised when only a single business unit is of interest to the buyer. Acquisition of assets is typical during bankruptcy proceedings where other companies bid for various assets of the bankrupt company
Types of Mergers
Horizontal Merger
This type of merger or acquisition occurs between firms that operate in the same industry, for which they may or may not be competitors. Some notable examples of such a type of merger would be: Disney and Pixar, Exon and Mobil, Volkswagen and Porsche.
Oftentimes, mergers of this type offer a few benefits such as a natural reduction in competition (Exxonmobil for example), ability to leverage economies of scale, increased talent pool and resources, larger customer base. However, this kind of mergers will also have some negative ramifications as it leads to antitrust issues since there is decreased competition in the industry after a merger has occurred.
Vertical Merger
A vertical merger is between companies involved at different stages in the supply chain process for a common good or service. Examples of this kind of merger include: eBay and PayPal, IKEA’s acquisition of Romanian and Baltic Forests, FedEx’s acquisition of Mupa.
The benefits of this kind of merger are that of operations improvements as seen from the case of IKEA, allowing it to prove that it is logging sustainably which is key in today’s financial landscape. There can also be financial synergies as well as management efficiencies brought about by the vertical merger. However, like horizontal mergers, vertical mergers also face scrutiny especially when they can block democratic access to raw materials. For instance, no other company can access the Romanian and Baltic Forests owned by IKEA.
Conclusion
Congrats! You have reached the end of our part 2 blog on the series: Mergers and Acquisitions Made Simple. In addition to what we have learnt so far, there are also various types of mergers that are not covered in this blog such as congeneric and conglomerate mergers. Still, we trust that you have gained more knowledge on the types of mergers that firms do to develop their businesses. Stay tuned for the last part of our blogpost series!