THE BASIC FORMS OF ACQUISITIONS

There are three basic legal procedures that one firm can use to acquire another firm: (1) merger
or consolidation, (2) acquisition of stock, and (3) acquisition of assets.

Merger or Consolidation
A merger refers to the absorption of one firm by another. The acquiring firm retains its name
and its identity, and it acquires all of the assets and liabilities of the acquired firm. After a
merger, the acquired firm ceases to exist as a separate business entity.

Types of Merger
 Horizontal Merger
When two companies offer similar products or services, they may join together in an attempt to
lower costs and increase efficiency. This type of transaction is called a horizontal merger, and
because the deal reduces competition in the marketplace, such transactions are heavily regulated
by antitrust legislation. The 2002 merger of Hewlett-Packard (NYSE:HPQ) and Compaq
Computer was a horizontal merger, and although there was concern about reduced competition in
the high-end computer market, the Federal Trade Commission (FTC) unanimously approved the
transaction.
 Vertical merger
In contrast to a horizontal merger, a vertical merger occurs when two companies representing
different steps in the buyer-seller relationship or production process join forces. One of the most
well-known examples of a vertical merger took place in 2000 when internet provider America
Online combined with media conglomerate Time Warner (NYSE:TWX). The merger is
considered a vertical one because Time Warner supplied content to consumers through properties
like CNN and Time Magazine, while AOL distributed such information via its internet service.
 Congeneric merger
Companies that are in the same industry but do not have a competitive supplier or customer
relationship may choose to pursue a congeneric merger, which could allow the resultant
company to be able to provide more products or services to its customers. One widely cited
example of this type of deal is the 1981 merger between Prudential Financial (NYSE:PRU) and
stock brokerage company Bache & Co. Although both companies were involved in the financial
services sector, prior to the deal, Prudential was focused primarily on insurance while Bache
dealt with the stock market.
 Conglomerate merger
When two companies have no common business but decide to pool resources for some other
reason, the deal is called a conglomerate merger. Procter & Gamble (NYSE:PG), a consumer
goods company, engaged in just such a transaction with its 2005 merger with Gillette. At the
time, Procter & Gamble was largely absent from the men's personal care market, a sector led by
Gillette. The companies' product portfolios were complimentary, however, and the merger
created one of the world's biggest consumer product companies.
 Reverse merger
A reverse merger - also called a reverse acquisition or reverse takeover - allows a private
company to go public while avoiding the high costs and lengthy regulations associated with an
initial public offering. To do this, a private company purchases or merges with an existing public
company, which may be a "shell company", installs its own management and takes all the
necessary measures to maintain the public listing. For example, portable digital device-maker
Handheld Entertainment did this when it purchased Vika Corp in 2006, creating the company
known as ZVUE.
 Accretive merger
When one company acquires another company and the transaction increases the first company's
earnings per share, the deal is called an accretive merger. Another way to calculate this is to note
the price-earnings ratio (the ratio between the company's price per share compared to its per-
share earnings per year) between the acquiring firm and the target firm. If the price-earning ratio
of the acquiring firm is higher than that of the target firm, the merger is accretive. In other words,
the earnings of the target company add market value to the acquiring company. Whether or not a
transaction is accretive can change over time, based on changes in the two companies' stock
prices and earnings. For example, Hewlett-Packard announced a merger with services company
EDS in 2008, but said that the deal would become non-GAAP accretive in 2009 and GAAP
accretive in fiscal year 2010. 
 Dilutive merger
The opposite of an accretive merger is a dilutive one, in which a merger decreases the acquiring
company's earnings per share. Entering into a dilutive merger is not necessarily bad; in certain
circumstances, transactions that are initially dilutive may create value over time, such as when a
low-growth company purchases a high-growth company. If the price-earnings ratio of the target
firm is greater than that of the acquiring firm, the merger is dilutive. Copper mining company
Phelps Dodge entered a dilutive merger with Canadian nickel miners Inco and Falconbridge in
2006.

Consolidation
A consolidation is the same as a merger except that an entirely new firm is created. In a
consolidation, both the acquiring firm and the acquired firm terminate their previous legal
existence and become part of the new firm. In a consolidation, the distinction between
the acquiring and the acquired firm is not important. However, the rules for mergers and
consolidations are basically the same. Acquisitions by merger and consolidation result in
combinations of the assets and liabilities of acquired and acquiring firms.
There are some advantages and some disadvantages to using a merger to acquire a firm:
1. A merger is legally straightforward and does not cost as much as other forms of acquisition.
It avoids the necessity of transferring title of each individual asset of the acquired
firm to the acquiring firm.
2. A merger must be approved by a vote of the stockholders of each firm.1 Typically, votes
of the owners of two-thirds of the shares are required for approval. In addition, shareholders
of the acquired firm have appraisal rights. This means that they can demand that
their shares be purchased at a fair value by the acquiring firm. Often the acquiring firm
and the dissenting shareholders of the acquired firm cannot agree on a fair value, which
results in expensive legal proceedings.
EXAMPLE
Suppose firm A acquires firm B in a merger. Further, suppose firm B’s shareholders are given
one share of firm A’s stock in exchange for two shares of firm B’s stock. From a legal standpoint,
firm A’s shareholders are not directly affected by the merger. However, firm B’s shares cease to
exist. In a consolidation, the shareholders of firm A and firm B would exchange their shares for
the share of a new firm (e.g., firm C). Because the differences between mergers and
consolidations are not all that important for our purposes, we shall refer to both types of
reorganizations as mergers.

Acquisition of Stock
A second way to acquire another firm is to purchase the firm’s voting stock in exchange for
cash, shares of stock, or other securities. This may start as a private offer from the management
of one firm to another. At some point the offer is taken directly to the selling firm’s stockholders.
This can be accomplished by use of a tender offer. A tender offer is a public offer to
buy shares of a target firm. It is made by one firm directly to the shareholders of another firm.
The offer is communicated to the target firm’s shareholders by public announcements such as
newspaper advertisements. Sometimes a general mailing is used in a tender offer. However, a
general mailing is very difficult because it requires the names and addresses of the stockholders
of record, which are not usually available.
The following are factors involved in choosing between an acquisition of stock and
a merger:
1. In an acquisition of stock, no shareholder meetings must be held and no vote is required.
If the shareholders of the target firm do not like the offer, they are not required to accept
it and they will not tender their shares.
2. In an acquisition of stock, the bidding firm can deal directly with the shareholders of a
target firm by using a tender offer. The target firm’s management and board of directors
can be bypassed.
3. Acquisition of stock is often unfriendly. It is used in an effort to circumvent the target
firm’s management, which is usually actively resisting acquisition. Resistance by the
target firm’s management often makes the cost of acquisition by stock higher than the
cost by merger.
4. Frequently a minority of shareholders will hold out in a tender offer, and thus the target
firm cannot be completely absorbed.
5. Complete absorption of one firm by another requires a merger. Many acquisitions of
stock end with a formal merger later.

Acquisition of Assets
One firm can acquire another firm by buying all of its assets. A formal vote of the shareholders
of the selling firm is required. This approach to acquisition will avoid the potential problem of
having minority shareholders, which can occur in an acquisition of stock. Acquisition of assets
involves transferring title to assets. The legal process of transferring assets can be costly.

A Note on Takeovers
Takeover is a general and imprecise term referring to the transfer of control of a firm from one
group of shareholders to another.2 A firm that has decided to take over another firm is usually
referred to as the bidder. The bidder offers to pay cash or securities to obtain the stock or assets
of another company. If the offer is accepted, the target firm will give up control over its stock or
assets to the bidder in exchange for consideration (i.e., its stock, its debt, or cash).
For example, when a bidding firm acquires a target firm, the right to control the operating
activities of the target firm is transferred to a newly elected board of directors of the
acquiring firm. This is a takeover by acquisition.
Takeovers can occur by acquisition, proxy contests, and going-private transactions. Thus,
takeovers encompass a broader set of activities than acquisitions. Figure 30.1 depicts this.
If a takeover is achieved by acquisition, it will be by merger, tender offer for shares of
stock, or purchase of assets. In mergers and tender offers, the acquiring firm buys the voting
common stock of the acquired firm.
Takeovers can occur with proxy contests. Proxy contests occur when a group of shareholders
attempts to gain controlling seats on the board of directors by voting in new directors.
A proxy authorizes the proxy holder to vote on all matters in a shareholders’ meeting.
In a proxy contest, proxies from the rest of the shareholders are solicited by an insurgent
group of shareholders.
In going-private transactions, all the equity shares of a public firm are purchased by a small
group of investors. The group usually includes members of incumbent management and some
outside investors. The shares of the firm are delisted from stock exchanges and can no longer be
purchased in the open market.

Hostile vs Friendly Takeovers

A hostile takeover occurs when one corporation, the acquiring corporation, attempts to take over
another corporation, the target corporation, without the agreement of the target corporation’s
board of directors. A friendly takeover occurs when one corporation acquires another with both
boards of directors approving the transaction. Most takeovers are friendly, but hostile takeovers
and activist campaigns have become more popular since 2000 with the risk of activist hedge
funds.

A hostile takeover is usually accomplished by a tender offer or a proxy fight. In a tender offer,
the corporation seeks to purchase shares from outstanding shareholders of the target corporation
at a premium to the current market price. This offer usually has a limited time frame for
shareholders to accept. The premium over the market price is an incentive for shareholders to sell
to the acquiring corporation. The acquiring company must file a Schedule TO with the SEC if it
controls more than 5% of a class of the target corporation’s securities. Often, target corporations
acquiesce to the demands of the acquiring corporation if the acquiring corporation has the
financial ability to pull off a tender offer.

In a proxy fight, the acquiring corporation tries to persuade shareholders to use their proxy votes
to install new management or take other types of corporate action. The acquiring corporation
may highlight alleged shortcomings of the target corporation’s management. The acquiring
corporation seeks to have its own candidates installed on the board of directors. By installing
friendly candidates on the board of directors, the acquiring corporation can easily make the
desired changes at the target corporation. Proxy fights have become a popular method with
activist hedge funds in order to institute change.
Leveraged Buyout (LBO)

A leveraged buyout (LBO) is the acquisition of a company in which the buyer puts up only a
small amount of money and borrows the rest. The buyer's own equity thus "leverages" a lot more
money from others. The buyer can achieve this desirable result because the targeted acquisition
is profitable and throws off ample cash used to repay the debt. Such transactions are also known
as "bootstraps" or HLTs, i.e., "highly leveraged transactions." Since they first appeared in the
1960s and took hold in the 1970s, LBOs have had mixed reviews from business people and other
observers. Some see them as tools to streamline corporate structures, to rationalize meaninglessly
diversified companies, and to reward neglected stockholders. Others see the LBO as a
destructive force destroying economic and social values, the activity motivated by greed-driven
predation.

TYPES OF LBOS
LBOs are typically used for three purposes, each in the category of corporate acquisitions
generally. These are 1) taking a public company private, 2) financing spin-offs, and 3) carrying
out private property transfers frequently related to ownership changes in small business.

Public to Private
The first situation arises when an investor (or investment group) buys all of the outstanding stock
of a publicly traded company and thus turns the company into a privately-held enterprise
("taking private" in reverse of "going public"). These deals may be friendly or hostile, the two
terms related to management's point of view. Friendly cases typically involve the management
buying the company for itself with plans to operate it thereafter as a privately-held entity. Hostile
cases involve an investor or investor group intent on buying, reorganizing, and then reselling the
company again to realize a high return. The sale of the company may be to another company or
may be to the public in a stock offering. In the last case the situation actually amounts to a
transaction more aptly labeled public-to-private-to-public. There are other variants in the
disposition or in the payback of a third-party investor, although they tend to be rare, such as very
high dividend payments and recapitalization by other groups.
Spin-Offs
Public or private companies often wish to sell off elements of their business to get cash. In some
cases the seller may itself have been bought in an LBO and is spinning off assets to pay the
investors back. In such situations the spun-off element's management may itself be the buyer or
may be passive in the transaction. An LBO is used to purchase the subsidiary or division in
question. The fundamental financial logic of such deals, however, remains the same.

Private Deals
The last situation concerns cases where a privately held operation is bought by an investor group.
Such cases often arise when a small businesses owner, having reached retirement age, wishes to
divest him-or herself of the company and either cannot find a corporate buyer or does not wish to
sell to a company. The buying group itself may be the company's employees or individuals
associated in some way with the owner. These people organize an LBO because they only have
limited equity.