A Guide to Mergers and Acquisitions

13 minutes

Understanding Mergers and Acquisitions

Mergers and acquisitions refer to business transactions in which businesses are combined.

Mergers occur when two or more companies join to form a single new legal entity. This process is generally voluntary, and involve companies of similar size, customer base, and operations. Thus, it is often described as a "merger of equals.”

On the other hand, acquisitions involve one entity taking over another. Unlike mergers, acquisitions are typically not voluntary, with one company actively purchasing another. Larger companies usually acquire smaller ones. If a smaller company acquires a larger one and retains its name for the post-acquisition entity, it is termed a reverse takeover.

Both mergers and acquisitions lead to the consolidation of assets and liabilities under a single entity, making the distinction between the two less clear. As a result, the terms are often used interchangeably, and modern corporate restructurings are commonly referred to as merger and acquisition (or M&A) transactions.

shaking hands

Target Company vs. Acquiring Company

In a merger or acquisition, the company that is acquired is called the target company or acquiree. On the other hand, the company that makes the purchase is referred to as the acquiring company or acquirer.

Company Purchases as Asset Purchases vs Equity Purchases

Companies can structure mergers and acquisitions as either asset purchases or equity (stock) purchases.

  • Asset Purchase: In an asset purchase, the target company sells some or all of its business assets and liabilities to the acquirer. The acquirer and target company agree on which assets and liabilities to transfer. Asset purchases are common in technology transactions where the acquirer is primarily interested in specific intellectual property rights but does not want to assume liabilities or other contractual relationships. Companies also use this structure when the acquirer aims to acquire a particular division or unit of a company that is not a separate legal entity.
  • Equity Purchase: In an equity purchase, the acquirer purchases equity interests in the target company from one or more selling shareholders of the target company. By acquiring the equity, the acquirer obtains all the assets and liabilities of the target entity.

Each structure has distinct tax and regulatory implications, which influence the choice of structure based on the transaction’s specific circumstances and goals.

What Is the Difference Between a Vertical and Horizontal Merger or Acquisition?

Vertical Mergers and Acquisitions

A vertical merger or acquisition, also known as vertical integration, occurs when businesses within the same supply chain combine. This approach can result in cost savings and increased efficiency. There are two types of vertical integration:

  • Backward Integration: A company acquires its supplier.
  • Forward Integration: A company acquires its customer.

Companies pursue vertical mergers and acquisitions for several reasons:

  • Increasing efficiency
  • Reducing costs
  • Increasing profits by expanding business
  • Gaining merger synergy (operational, financial, and managerial)
  • Ensuring greater quality control
  • Improving the flow and control of information along the supply chain

Horizontal Mergers and Acquisitions

A horizontal merger or acquisition occurs when competitors in the same industry combine. The potential advantages include:

  • Increasing market share and reducing competition in the industry
  • Offering a wider range of products and covering different geographical territories
  • Leveraging economies of scale to reduce costs
  • Sharing complementary skills and resources

Conglomerate Mergers and Acquisitions

A conglomerate merger or acquisition involves the combination of unrelated businesses. The advantages include:

  • Diversifying to reduce the risk of loss
  • Creating new investment opportunities
  • Gaining access to a new pool of customers
  • Increasing efficiencies through the exchange of best practices and expertise

Triangular Mergers

A triangular merger is a common type of merger where the target company merges with a subsidiary wholly owned by the acquirer. Generally, the acquirer creates this subsidiary specifically to facilitate the acquisition of the target. In a triangular merger, the target becomes a wholly-owned subsidiary of the acquirer after the transaction. The key advantage of this structure is that the acquirer avoids assuming the target’s liabilities since the merger occurs between the target and the subsidiary.

There are two types of triangular mergers: forward and reverse.

  • Forward Triangular Mergers: In a forward triangular merger, the target company merges into the subsidiary, with the subsidiary surviving the merger. The target company ceases to exist.
  • Reverse Triangular Mergers: In a reverse triangular merger, the subsidiary merges into the target company, with the target company surviving the merger. The subsidiary ceases to exist. This structure is useful when it is important to maintain the target's identity, such as when the target is organized under a special statute, holds rights, licenses, or contracts that are not easily transferable, or when maintaining the target’s current operations is crucial.

Reverse Mergers

A reverse merger occurs when a privately held company acquires a majority stake in a publicly traded company. Businesses often use this process to bypass the traditional initial public offering (IPO), which can be time-consuming and costly.

In a reverse merger, the private company, usually with strong growth potential and a need for financing, acquires a publicly listed shell company that has minimal assets and no significant business operations. This allows the private company to go public relatively quickly.

Friendly Takeover vs. Hostile Takeover

Friendly Takeover: A friendly takeover occurs when the management of the target company approves the acquisition. In this scenario, the bidder approaches the target company's board of directors with the offer. If the board believes that accepting the offer benefits the shareholders, it recommends that the shareholders accept it. The approval and cooperation of the target company’s management characterize this type of takeover.

Hostile Takeover: A hostile takeover occurs when an acquiring company takes control of a target company without the approval or consent of the target company's board of directors. The term "hostile" reflects the resistance from the target company’s management. The acquirer bypasses the board and goes to the shareholders directly, believing that the target company is undervalued or seeking to change its operations through activist investors.

There are two common ways to carry out a hostile takeover:

  • Tender Offer: The acquirer offers to buy shares from the target company's shareholders at a higher price than the current market price. The goal is to acquire enough voting shares—usually over 50%—to gain a controlling equity interest in the target company.
  • Proxy Vote (Proxy Fight): The acquirer attempts to persuade the existing shareholders to vote out the current management and replace it with a new management team that would support the takeover. This approach involves gaining shareholder support to change the board of directors.

Additionally, an acquirer may choose to purchase enough stock on the open market to gain a controlling interest in the target company.

Defenses Against Hostile Takeovers

To block unwanted takeovers, companies often use pre-emptive or reactive defenses. Here are some common strategies:

Crown Jewel Defense:

In this strategy, a provision in the company's bylaws requires the sale of its most valuable assets in the event of a hostile takeover. This makes the company less attractive to the acquirer.

Differential (or Differentiated) Voting Rights (DVRs):

Companies can establish shares with differential voting rights, where some shares carry greater voting power than others. This makes it more difficult for a hostile bidder to gain enough votes for control, particularly if management holds a large portion of the high-voting shares. However, this strategy can also increase the risk of a creeping takeover, allowing the controlling shareholder to sell their stake at a premium without consulting other shareholders.

Employee Stock Ownership Program (ESOP):

By establishing an ESOP, companies can use a tax-qualified plan to give employees a substantial ownership interest. Employees are likely to support the existing management, making it harder for a hostile takeover to succeed.

Golden Parachute:

The company enters into contracts with key executives that provide them with lucrative benefits (e.g. stock options, cash bonuses, and large severance packages) if the company is taken over and their employment is terminated as a result. These contracts increase the cost of acquisition and discourage potential hostile acquirers.

Greenmail:

The target company buys back its shares from a hostile acquirer at a premium, known as greenmail. In return, the hostile acquirer agrees to stop the takeover attempt and not to buy more shares for a specified period.

Pac-Man Defense:

The target company aggressively buys stock in the hostile acquirer in an attempt to scare off the acquirer. This strategy can be expensive and may increase the target company's debts, potentially leading to financial losses or lower dividends for shareholders in the future.

People Poison Pill:

The company changes its corporate charter to require all key executives to resign in the event of a takeover. This can make the company less attractive to the acquirer.

Poison Pill (Shareholder Rights Plan):

The company allows existing shareholders to buy newly issued shares at a discount if any single shareholder buys more than a specified percentage of the company’s stock. The discounted price does not apply to the buyer who triggered this defense, thereby diluting the buyer’s ownership interest of the acquiring company and makes the takeover more expensive.

Impact of Mergers and Acquisitions on Shareholders

Pre-Merger/Acquisition:

  • Acquiring Company: Share prices typically drop temporarily in the days leading up to a merger or acquisition, due to the anticipated costs of the acquisition.
  • Target Company: Share prices usually rise as investors expect a premium offer for their shares.

Post-Merger/Acquisition:

Combined Company: The stock price generally exceeds the combined value of the individual companies, provided there are no adverse economic conditions.

Shareholders: Shareholders of both companies may experience diluted voting power due to the increase in the number of shares issued during the merger or acquisition process. However, shareholders generally benefit from long-term performance and dividends.

Mergers and Acquisitions Process

Preliminary Assessment and Information Memorandum

When a purchaser has not yet been identified, the merger and acquisition transaction typically begins with an information memorandum created by the seller. This document aims to gauge market interest and secure the maximum value for the sale of the company or its business.

It provides the potential purchaser with enough information to decide whether to pursue the acquisition of the target company/business, without revealing confidential or sensitive business information about the target. Interested purchasers, if more than one, usually sign a Non-Disclosure Agreement (NDA) to ensure the confidentiality of the target company’s sensitive data.

Negotiation and Letter of Intent

If only one potential purchaser is involved, the purchaser and seller typically address preliminary matters (such as competition/antitrust law issues, employment law, licensing, and fiscal implications) before or during due diligence. They outline the proposed terms in a non-binding letter of intent.

In cases with multiple interested purchasers, the parties often conduct due diligence before addressing these primary matters.

Due Diligence

Due diligence is conducted to evaluate the target company or business. If there is one potential purchaser, their advisors usually carry out the buyer’s due diligence. Alternatively, the seller may perform its own due diligence to facilitate the sale, identify potential issues, and influence negotiations, pricing, or warranties.

Due diligence may cover legal, fiscal, and financial areas to identify key risks, determine fair pricing, and enhance bargaining power. Legally, it examines various aspects of the target, including corporate matters, contractual obligations, employment, data protection, intellectual property, insurance, and regulatory compliance.

Negotiations and Closing

Once due diligence is complete, the prospective purchaser reviews the findings with its advisors to assess their impact on the transaction. If the purchaser remains interested, the parties negotiate the transaction details, including the final price or a mechanism to determine it, as well as the terms of warranties, indemnities, and limitations. The parties then formalize these terms in a Share Purchase Agreement (SPA) or an Asset Purchase Agreement (APA), depending on whether shares or business assets are being acquired.

Post-closing Implementation/Integration

The SPA or APA typically includes post-closure clauses outlining further obligations for the parties, such as finalizing asset transfers, obtaining consents, issuing notifications, implementing a price adjustment mechanism, or entering into ancillary contracts. Additionally, the parties may conduct a post-closing integration process to combine the companies or businesses, aiming to maximize synergies and ensure the deal's success.

Business Valuation

In mergers and acquisitions, businesses are commonly valued in two ways:

  • Enterprise Value: This represents the total value of the business, excluding its capital structure. It reflects the core value of the business accruing to both equity owners and creditors.
  • Equity Value: This is the total value of the business attributable to the shareholders, also known as market capitalization for publicly listed companies.

US Federal Tax Treatment

Mergers and acquisitions may qualify for tax-free treatment (i.e. tax deferral) if they meet certain conditions. Generally, this tax benefit applies when securities are exchanged. On the other hand, any cash or similar payments (referred to as boot) involved in the transaction are subject to taxation.

Section 368 of the US Internal Revenue Code (IRC), which defines “reorganization,” provides rules that govern the tax-free treatment of reorganizations. IRC section 368 identifies seven types of reorganizations (Types A through G), with Types A through D being the most relevant.

Type A

Type A reorganizations refer to statutory asset acquisition mergers under US state laws, typically requiring shareholder approval by a majority vote. In this type, the acquiring company acquires all assets and liabilities of the target company.

To qualify for tax-free treatment, the transaction must meet the continuity of interest requirement, which mandates that the acquirer make at least 40% of payment to the target in the form of the acquirer's stock. The target is not subject to tax as long as the target distributes property received to its shareholders and fully ceases to exist. The acquirer retains the original basis in the acquired assets. The target’s shareholders pay tax on the lesser of boot or gain.

Type B

Type B reorganizations involve exchanging stock of the acquirer for stock of the target, with the acquirer controlling the target after the merger. Type B reorganizations permit no boot, ensuring that no taxes are incurred at either the company or shareholder level.

Type C

Type C reorganizations are also asset acquisitions, but the acquiring company does not have to acquire all of the target company’s assets and liabilities. IRS safe harbor rules require that the acquiring company purchase at least 70% of the gross assets and 90% of the net assets of the target, although smaller amounts may qualify depending on the facts and circumstances.

The acquiring company must offer at least 80% of the payment in the form of its voting stock, or 100% if the target company has substantial liabilities that are assumed by the acquiring company. The target distributes stock, compensation, and any remaining assets to shareholders. Tax treatment mirrors that of Type A reorganizations.

Type D

Type D reorganizations are similar to Type C, but without the voting stock requirement. However, after the merger, the target company’s shareholders must own more than 50% of the stock of the acquiring corporation (i.e. the target’s shareholders control the acquirer), typically requiring use of voting stock to achieve this.

Others

  • Type E: Type E reorganizations are not mergers but corporate recapitalizations, which refers to changes in the capital structure of a corporation (i.e. an exchange by a corporation of one type of security—stock or debt—for another.
  • Type F: Type F reorganizations are not mergers but corporate migrations (i.e. a change in the place of incorporation, identity, or form of a corporation).
  • Type G: Type G reorganizations are related to mergers within bankruptcy proceedings, where assets are distributed to shareholders in a transaction that otherwise qualifies for tax-free treatment.

Additional Requirements for Tax-Free Mergers and Acquisitions

Apart from statutory requirements, there are additional requirements established through court decisions or regulations. These additional requirements aim to ensure that historical shareholders of the target company maintain an interest in the same business, preventing the merger from being equivalent to a sale. Four primary requirements exist:

Continuity of Interest: This requirement, which originally arose in court cases, aims to ensure that target shareholders retain a stake in the business post-merger. Regulations stipulate that at least 40% of consideration received by target shareholders must be in the form of the acquiring company’s stock. Although there has been debate over share sales after the merger while maintaining tax-free treatment, current regulations do not restrict this, especially for widely traded companies.

Continuity of Business Operations: The acquiring corporation must continue the target's business or use a significant portion of its assets for business purposes. Examples in regulations suggest that operating one of the target’s three historical lines of business or using one-third of its assets meets this requirement.

Business Purpose: The merger or acquisition must serve a business purpose beyond benefiting shareholders. This requirement is typically straightforward to meet.

Subsequent Transfers of Assets: Generally, assets cannot be transferred outside the corporate group post-merger, although exceptions exist if such transfers do not disrupt the continuity of interest requirement.

Special Rules for International Mergers and acquisitions

In cross-border mergers and acquisitions, specific tax rules govern the transfer of property to foreign corporations. IRC section 367 provides special rules to prevent indefinite deferral of US taxes on gains from transferred assets. Generally, any untaxed income or gain from assets or stock that is transferred abroad must be recognized for US tax purposes, although exceptions and qualifications may apply. Additionally, IRC section 367 includes special provisions for the cross-border transfer of intellectual property.

Resources

Further information is available at:

Mergers and AcquisitionsCorporate Taxation