MERGERS, ACQUISITIONS & CORPORATE RESTRUCTURING

Syllabus
Unit 1: Introduction to Corporate Restructuring
Introduction of Mergers, Types of Mergers, Merger Strategy-Growth, Synergy,
Operating Synergy, Financial Synergy, Diversification, Other Economic Motives,
Hubris Hypothesis of Takeovers, Other Motives, Tax Motives Financial Evaluation,
Joint Venture and Strategic Alliances.
Unit 3: Valuation of Mergers
Methods of Valuation – Cash flow Basis, Earning Potential Basis, Growth Rate,
Market Price etc. Computation of Impact on EPS and Market Price, Determination of
Exchange Ratio, Impact of Variation in Growth of the Firms, MBO, LBO, Boot
Strapping; Criteria for Negotiating Friendly Takeover, Financing of Merger.

What are Mergers & Acquisitions (M&A)?

Mergers and acquisitions (M&A) refer to transactions between two

companies combining in some form. Although mergers and acquisitions
(M&A) are used interchangeably, they come with different legal meanings.
In a merger, two companies of similar size combine to form a new single
entity.

On the other hand, an acquisition is when a larger company acquires a

smaller company, thereby absorbing the business of the smaller company.
M&A deals can be friendly or hostile, depending on the approval of the
target company’s board.

Summary

 Mergers and acquisitions (M&A) refer to transactions involving

two companies that combine in some form.
 M&A transactions can be divided by type (horizontal,
vertical, conglomerate) or by form (statutory, subsidiary,
consolidation).
 Valuation is a significant part of M&A and is a major point of
discussion between the acquirer and the target.
Mergers and Acquisitions (M&A) Transactions – Types
1. Horizontal

A horizontal merger happens between two companies that operate in

similar industries that may or may not be direct competitors.

2. Vertical

A vertical merger takes place between a company and its supplier or a

customer along its supply chain. The company aims to move up or down
along its supply chain, thus consolidating its position in the industry.

3. Conglomerate

This type of transaction is usually done for diversification reasons and is

between companies in unrelated industries.

Mergers and Acquisitions (M&A) – Forms of Integration

1. Statutory

Statutory mergers usually occur when the acquirer is much larger than the
target and acquires the target’s assets and liabilities. After the deal, the
target company ceases to exist as a separate entity.

2. Subsidiary

In a subsidiary merger, the target becomes a subsidiary of the acquirer but

continues to maintain its business.

3. Consolidation

In a consolidation, both companies in the transaction cease to exist after

the deal, and a completely new entity is formed.

Reasons for Mergers and Acquisitions (M&A) Activity

Mergers and acquisitions (M&A) can take place for various reasons, such as:
1. Unlocking synergies

The common rationale for mergers and acquisitions (M&A) is to create

synergies in which the combined company is worth more than the two
companies individually. Synergies can be due to cost reduction or higher
revenues.

Cost synergies are created due to economies of scale, while revenue

synergies are typically created by cross-selling, increasing market share, or
higher prices. Of the two, cost synergies can be easily quantified and
calculated.

2. Higher growth

Inorganic growth through mergers and acquisitions (M&A) is usually a

faster way for a company to achieve higher revenues as compared to
growing organically. A company can gain by acquiring or merging with a
company with the latest capabilities without having to take the risk of
developing the same internally.

3. Stronger market power

In a horizontal merger, the resulting entity will attain a higher market share
and will gain the power to influence prices. Vertical mergers also lead to
higher market power, as the company will be more in control of its supply
chain, thus avoiding external shocks in supply.

4. Diversification

Companies that operate in cyclical industries feel the need to diversify their
cash flows to avoid significant losses during a slowdown in their industry.
Acquiring a target in a non-cyclical industry enables a company to diversify
and reduce its market risk.

5. Tax benefits

Tax benefits are looked into where one company realizes significant taxable
income while another incurs tax loss carryforwards. Acquiring the company
with the tax losses enables the acquirer to use the tax losses to lower its tax
liability. However, mergers are not usually done just to avoid taxes.

Forms of Acquisition

There are two basic forms of mergers and acquisitions (M&A):

1. Stock purchase

In a stock purchase, the acquirer pays the target firm’s shareholders cash
and/or shares in exchange for shares of the target company. Here, the
target’s shareholders receive compensation and not the target. There are
certain aspects to be considered in a stock purchase:

 The acquirer absorbs all the assets and liabilities of the target – even
those that are not on the balance sheet.
 To receive the compensation by the acquirer, the target’s
shareholders must approve the transaction through a majority vote,
which can be a long process.
 Shareholders bear the tax liability as they receive the compensation
directly.

2. Asset purchase

In an asset purchase, the acquirer purchases the target’s assets and pays
the target directly. There are certain aspects to be considered in an asset
purchase, such as:

 Since the acquirer purchases only the assets, it will avoid assuming
any of the target’s liabilities.
 As the payment is made directly to the target, generally, no
shareholder approval is required unless the assets are significant (e.g.,
greater than 50% of the company).
 The compensation received is taxed at the corporate level as capital
gains by the target.
3. Method of payment

There are two methods of payment – stock and cash. However, in many
instances, M&A transactions use a combination of the two, which is called a
mixed offering.

4. Stock

In a stock offering, the acquirer issues new shares that are paid to the
target’s shareholders. The number of shares received is based on an
exchange ratio, which is finalized in advance due to stock price fluctuations.

5. Cash

In a cash offer, the acquirer simply pays cash in return for the target’s
shares.

Mergers and Acquisitions (M&A) – Valuation

In an M&A transaction, the valuation process is conducted by the acquirer,

as well as the target. The acquirer will want to purchase the target at the
lowest price, while the target will want the highest price.

Thus, valuation is an important part of mergers and acquisitions (M&A), as

it guides the buyer and seller to reach the final transaction price. Below are
three major valuation methods that are used to value the target:

 Discounted cash flow (DCF) method: The target’s value is

calculated based on its future cash flows.
 Comparable company analysis: Relative valuation metrics for public
companies are used to determine the value of the target.
 Comparable transaction analysis: Valuation metrics for past
comparable transactions in the industry are used to determine the
value of the target.
What are M&A Synergies?

A synergy arises in a merger or acquisition when the combined value of the

two firms is higher than the pre-merger value of both firms combined. For
example, if firm A has a value of $500M, firm B has a value of $75M, and the
merged firm has a value of $625M, there is a $50M synergy for this merger.
This guide will outline what you need to know about M&A synergies.

Synergies arise out of cost reductions, due to efficiencies in the newly

combined firm. Alternatively, they may arise due to new net
incremental revenues brought about by the merged firm.

There are different types of synergies. The two most common tangible
types are cost savings and revenue upside arising out of the merged firm.
However, there are other “softer” synergies that may also arise due to a
merger. One example is a common corporate culture that will allow the
merged firm to be more easily successful.

How are Synergies Estimated?

One approach to the way merger synergies are forecasted is by comparing

like-transactions. In other words, comparable acquisitions are reviewed as a
starting point for potential synergies. Initially, it may be difficult to
quantitatively estimate synergies as the operations merge as the logistic
intricacies are not yet known until post-merger. Thus, synergies may be first
estimated qualitatively.

Another approach is to look internally at the two companies and perform as

much analysis as possible. A bottom-up analysis should be performed to
see how the acquiring firm expects the target firm’s assets and operations
to line up and what cost savings can be made. This second approach is
more detailed and possibly more accurate, however, it is very challenging
for anyone outside of the deal to perform themselves.

10 Examples of Ways to Estimate M&A Synergies:

1. Analyze headcount and identify any redundant staff members that

can be eliminated (i.e. the new company doesn’t need two CFOs).
2. Look at ways to consolidate vendors and negotiate better terms with
them (i.e. purchase goods/services at lower prices).
3. Evaluate any head office or rent savings by combining offices.
4. Estimate the value saved by sharing resources that aren’t at 100%
utilization (i.e. trucks, planes, transportation, factories, etc.).
5. Look for opportunities to increase revenue by upselling
complementary products or increase prices by eliminating a
competitor.
6. Reduce professional services fees.
7. Operating efficiency improvements from sharing “best practices.”
8. Human capital improvements from “top grading” exercises and
potential ability to attract superior talent at NewCo.
 9. Improve distribution strategy by serving customers with closer
locations
10. Geo-arbitrage – Reduce labor costs by hiring in other countries if the
target is in another country.

Hard vs Soft M&A Synergies

There are two main types of synergies, hard and soft. Hard synergies refer
to costs savings, and soft synergies refer to revenue increases.

Risks for Synergies

Synergies are not effective immediately after the merger takes place.
Typically, these synergies are realized two or three years after the
transaction. This period is known as the “phase in” period, where
operational efficiencies, cost savings, and incremental new revenues are
slowly absorbed into the newly merged firm.

In fact, in the short term costs may actually go up as the integration

incurring one-time expenses and a short-term inefficiency due to lack of
history working together and culture clashes. If a culture clash is too great,
synergies may never be realized.

Types of Synergies

Synergy can be categorized into two forms: operating synergy and financial
synergy.

1. Operating synergy

Operating synergies create strategic advantages that result in higher

returns on investment and the ability to make more investments and more
sustainable excess returns over time. Furthermore, operating synergies can
result in economies of scale, allowing the acquiring company to save costs
in current operations, whether it be through bulk trade discounts from
increased buyer power, or cost savings by eliminating redundant business
lines.
Types of operating synergies to value include:

 Horizontal Integration: Economies of scale, which reduce costs, or

from increased market power, which increases profit
margins and sales.
 Vertical Integration: Cost savings from controlling the value chain
more comprehensively.
 Functional Integration: When a firm with strengths in one
functional area acquires another firm with strengths in a different
functional area, the potential synergy gains arise from specialization
in each respective functional area.

2. Financial synergy

Financial synergies refer to an acquisition that creates tax benefits,

increased debt capacity and diversification benefits. In terms of tax benefits,
an acquirer may enjoy lower taxes on earnings due to higher depreciation
claims or combined operating loss carry forwards. Second, a larger
company may be able to incur more debt, reducing its overall cost of
capital. And lastly, diversification may reduce the cost of equity, especially if
the target is a private or closely held firm.

Diversification Acquisition

DEFINITION of Diversification Acquisition

Diversification acquisition is a corporate action whereby a company takes a
controlling interest in another company to expand its product and service
offerings. One way to determine if a takeover comes under diversification
acquisition is to look at the two companies Standard Industrial
Classification (SIC) codes. When the two codes differ, it means that they
conduct dissimilar business activities. The acquirer may believe the unrelated
company unlocks synergies that promote growth or reduce prevailing risks in
other operations. Mergers and acquisitions (M&A) often take place to
complement existing business operations in the same industry.

BREAKING DOWN Diversification Acquisition

Diversification acquisition often occurs when a company needs to lift
shareholder confidence and believe making an acquisition can facilitate a pop
in the stock or buoy earnings growth. Takeovers between two companies that
share the same SIC code are considered related or horizontal
acquisitions, whereas two different codes fit in the framework of an unrelated
takeover.

Big corporations typically find themselves involved in diversification

acquisitions either to minimize the potential risks of one business component
not performing well in the future, or to maximize the earnings potential of
running a diverse operation. For example, Kellogg's (K) recently snapped up
organic protein bar manufacturer RXBAR for $600 million to lift its struggling
line of cereals and bars. It also presented an opportunity for the legacy food
manufacturer to make headway in the rapidly growing natural food industry.
We've seen similar moves from other large consumer staples companies
struggling to stay relevant with cookie cutter products and minimal digital
presence. Consumer products giants Unilever (UL) recently forked over $1
billion for Dollar Shave Club in its first foray into the razor business.

Common Misconceptions about Diversification

Acquisitions
There's a common belief that acquisitions instantly bolster earnings growth or
reduce operational risks, but in truth, creating new value takes time. Not every
purchase will generate greater returns, higher earnings, and capital
appreciation. In fact, many companies don't ever live up to their
acquisition valuation. Some companies will never get enough traction to push
a product while others may be limited in the resources they receive from the
parent company.

Some investors also assume unrelated acquisitions are a superior method of

reducing risk. Two unrelated companies with separate revenue streams and
earnings drivers should theoretically face different challenges. The trouble is
the parent company plays an instrumental role in molding investor's sentiment
around subsidiary brands. If the corporation is faced with backlash for
misconduct, it would trickle down and infect the smaller business units.
What is a Leveraged Buyout (LBO)?

In corporate finance, a leveraged buyout (LBO) is a transaction where a

company is acquired using debt as the main source of consideration. These
transactions typically occur when a private equity (PE) firm borrows as much
as they can from a variety of lenders (up to 70 or 80 percent of the
purchase price) and funds the balance with their own equity.

Why do PE firms use so much leverage?

Simply put, the use of leverage (debt) enhances expected returns to the
private equity firm. By putting in as little of their own money as
possible, PE firms can achieve a large return on equity (ROE) and internal
rate of return (IRR), assuming all goes according to plan. Since PE firms are
compensated based on their financial returns, the use of leverage in an LBO
is critical in achieving their targeted IRRs (typically 20-30% or higher).

While leverage increases equity returns, the drawback is that it also

increases risk. By strapping multiple tranches of debt onto an operating
company the PE firm is significantly increasing the risk of the transaction
(which is why LBOs typically pick stable companies). If cash flow is tight and
the economy of the company experiences a downturn they may not be able
to service the debt and will have to restructure, most likely wiping out all
returns to the equity sponsor.

What is a Management Buyout (MBO)?

A management buyout (MBO) is a corporate finance transaction where the

management team of an operating company acquires the business by
borrowing money to buy out the current owner(s). An MBO transaction is a
type of leveraged buyout (LBO) and can sometimes be referred to as a
leveraged management buyout (LMBO).

In an MBO transaction, the management team believes they can use their
expertise to grow the business, improve its operations, and generate a
return on their investment. The transactions typically occur when the
owner-founder is looking to retire or a majority shareholder wants out.

Lenders often like financing management buyouts because they ensure

continuity of the business’ operations and executive management team.
The transition often sits well with customers and clients of the business, as
they can expect the quality of service to continue.

Why a Management Buyout?

 Management buyouts are preferred by large companies seeking the

sale of unimportant divisions or owners of private businesses who
choose to withdraw.
 They are undertaken by management teams because they want to
get the financial incentive for the company’s potential growth more
explicitly than they can otherwise do so as employees.
 Business owners find management buyouts appealing, as they can be
assured of the commitment of the management team and that the
team will provide downside protection against negative press.
Unit 2: Legal Framework
Legal Aspects of Mergers/ Amalgamation and Acquisition, Provisions of Companies
Act, Regulation by SEBI, Takeover Code: Scheme of Amalgamation, Approval from
Court. Valuation of a Business.

Regulations by SEBI, Scheme of Amalgamation, Approval

from Court
Companies Act, 1956

Sections 390 to 394 of the Companies Act govern a merger of two or more companies
under Indian law. The Merger Provisions are in fact worded so widely, that they would
provide for and regulate all kinds of corporate restructuring that a company may
possibly undertake; such as mergers, amalgamations, demergers, spin-off / hive off,
and every other compromise, settlement, agreement or arrangement between a
company and its members and / or its creditors.

Scheme of Mergers and Acquisitions

Procedure for merger and amalgamation is different from takeover. Mergers and
amalgamations are regulated under the provisions of the Companies Act, 1956
whereas takeovers are regulated under the SEBI (Substantial Acquisition of Shares
and Takeovers) Regulations.

Although chapter V of the Companies Act, 1956 comprising sections 389 to 396-A
deals with the issue and related aspects covering arbitration, compromises,
arrangements and reconstructions but at different times and under different
circumstances in each case of merger and amalgamation application of other
provisions of the Companies Act, 1956 and ruled made there-under may necessarily
be attracted.

A scheme of compromise or arrangement must be approved by a resolution passed

by not less than three-fourths in value of the total creditors (or class of creditors) or
members (or class of members), as the case may be, present and voting either in
person or through proxies. There is no rigid formula for determining a class of creditors
or members. It is the discretionary power of the court to determine these classes.
Essentially, ‘class’ means persons whose rights are so similar that they can be
combined together with a view to achieve a common interest. Generally, secured
creditors and unsecured creditors could form distinct classes of creditors and
members can be categorized into preference shareholders and common equity
shareholders.
 Subsequent to the scheme being approved by the members and/or creditors, a petition
for sanctioning of the scheme is filed with the appropriate court within whose
jurisdiction the registered office of the transferor and the transferee company is
situated. The approved arrangement is, unless prejudicial to public interest or interest
of the creditors, sanctioned by the court and a certified copy of the order is required to
be filed with the Registrar of Companies.

Procedure under the Merger Provisions

Since a merger essentially involves an arrangement between the merging companies

and their respective shareholders, each of the companies proposing to merge with the
other must make an application to the Company Court having jurisdiction over such
company for calling meetings of its respective shareholders and/or creditors. The
Court may then order a meeting of the creditors/shareholders of the company. If the
majority in number representing 3/4th in value of the creditors/shareholders present
and voting at such meeting agrees to the merger, then the merger, if sanctioned by
the Court, is binding on all creditors/ shareholders of the company. The Court will not
approve a merger or any other corporate restructuring, unless it is satisfied that the
company has disclosed all material facts. The order of the Court approving a merger
does not take effect until the company with the Registrar of Companies files a certified
copy of the same.

The Merger Provisions constitute a comprehensive code in themselves, and under

these provisions Courts have full power to sanction any alterations in the corporate
structure of a company that may be necessary to effect the corporate restructuring
that is proposed. For example, in ordinary circumstances a company must seek the
approval of the Court for effecting a reduction of its share capital. However, if a
reduction of share capital forms part of the corporate restructuring proposed by the
company under the Merger Provisions, then the Court has the power to approve and
sanction such reduction in share capital and separate proceedings for reduction of
share capital would not be necessary.

Applicability of Merger Provisions to Foreign Companies.

Section 394 vests the Court with certain powers to facilitate the reconstruction or
amalgamation of companies, i.e. in cases where an application is made for sanctioning
an arrangement that is:

 For the reconstruction of any company or companies or the amalgamation of any two
or more companies; and
 Under the scheme the whole or part of the undertaking, property or liabilities of any
company concerned in the scheme (referred to as the ‘transferor company’) is to be
transferred to another company (referred to as the transferee company’). 
Section
394 (4) (b) makes it clear that:

Securities Laws

As per the ICDR Regulations, if the acquisition of an Indian listed company

involves
the issue of new equity shares or securities convertible into equity shares
by the target to the acquirer, the provisions of Chapter VII contained in ICDR
Regulations will be applicable in addition to the provisions of the Companies Act
mentioned above. We have highlighted below some of the relevant provisions of the
Preferential Allotment Regulations.

Approvals for the Scheme

The scheme of merger / amalgamation is governed by the provisions of Section 391-

394 of the Companies Act. The legal process requires approval to the schemes as
detailed below.

Approvals from Shareholders

In terms of Section 391, shareholders of both the amalgamating and the amalgamated
companies should hold their respective meetings under the directions of the respective
high courts and consider the scheme of amalgamation. A separate meeting of both
preference and equity shareholders should be convened for this purpose. Further, in
terms of Section 81(1A), the shareholders of the amalgamated company are required
to pass a special resolution for issue of shares to the shareholders of the
amalgamating company in terms of the scheme of amalgamation.

Approval from Creditors / Financial Institutions / Banks

Approvals are required from the creditors, banks and financial institutions to the
scheme of amalgamation in terms of their respective agreements / arrangements with
each of the amalgamating and the amalgamated companies as also under Section
391.

Approval from Respective High Court

Approvals of the respective high court(s) in terms of Section 391-394, confirming the
scheme of amalgamation are required. The courts issue orders for dissolving the
amalgamating company without winding-up on receipt of the reports from the official
liquidator and the regional director, Company Law Board, that the affairs of the
amalgamating company have not been conducted in a manner prejudicial to the
interests of its members or to public interests.
Report of Chairman to the Court

The chairman of the meeting must within the time fixed by the court or where no time
is fixed within 7 days of the date of the meeting, report the result of the meeting to the
court. The report should state accurately the number of creditors or class of creditors
or the numbers of members or class of members, as the case may be, who were
present and who voted at the meeting either in person or by proxy, their individual
values and the way the voted.

REGULATORY FRAMEWORK FOR MERGER/AMALGAMATION

 UNIT 4 MACR

 Defense against Hostile Takeover,

 Poisson Pill,
 Bear Hug,
 Greenmail,
 Pacman defense,
 Post-Merger H.R. and Cultural Issues.
 Recent cases of Mergers and Acquisitions .

UNIT 5 MACR
 Controversies and Dilemma in Accounting for M&A
 Pooling of interest method,
 Purchase Method,
 IFRS 3

Controversies and Dilemma in Accounting for M&A

1. DEAL STRUCTURE
Three alternatives exist for structuring a transaction: (i) stock purchase, (ii) asset
sale, and (iii) merger. The acquirer and target have competing legal interests and
considerations within each alternative. It is important to recognize and address
material issues when negotiating a specific deal structure. Certain primary
considerations relating to deal structure are: (i) transferability of liability, (ii)
third party contractual consent requirements, (iii) stockholder approval, and (iv)
tax consequences.

Transferability of Liability. Unless contractually negotiated to the contrary,

upon the consummation of a stock sale, the target’s liabilities are transferred to
the acquirer by operation of law. Similarly, the surviving entity in a merger will
assume by operation of law all liabilities of the other entity. However, in an
asset sale, only those liabilities that are designated as assumed liabilities are
assigned to the acquirer while the non-designated liabilities remain obligations
of the target.

Third Party Consents. To the extent that the target’s existing contracts have a
prohibition against assignment, a pre-closing consent to assignment must be
obtained. No such consent requirement exists for a stock purchase or merger
unless the relevant contracts contain specific prohibitions against assignment
upon a change of control or by operation of law, respectively.

Stockholder Approval. The target’s board of directors can grant approval of an

asset sale at the corporate level without obtaining individual stockholder
approval. However, all selling stockholders are required to grant approval
pursuant to a stock sale. When unanimity is otherwise unachievable in the stock
sale context, a merger can be employed as an alternative whereby the acquirer
and target negotiate a mutually acceptable stockholder approval threshold
sufficient to consummate the deal. However, under Delaware law (and most
other jurisdictions that follow a similar corporate doctrine), non-consenting
stockholders to an asset sale or merger shall be entitled to exercise appraisal
rights if they question the adequacy of the deal consideration.

Tax Consequences. A transaction can be taxable or tax-free depending upon

structure. Asset sales and stock purchases have immediate tax consequences for
both parties. However, certain mergers and/or reorganizations/recapitalizations
can be structured such that at least a portion of the sale proceeds (in the form of
acquirer’s stock a/k/a “boot”) can receive tax deferred treatment. (1) From an
acquirer’s perspective, an asset sale is most desirable because a “step up” in
basis occurs such that the acquirer’s tax basis in the assets is equal to the
purchase price, which is usually the fair market value (fmv). This enables the
acquirer to significantly depreciate the assets and improve profitability post-
closing. A target would be liable for the corporate tax for an asset sale and its
shareholders would also pay a tax on any subsequent dividends. (2) Upon a
stock purchase, the selling shareholders would pay long term capital gains
provided they owned the stock for at least a year. However, the acquirer would
only obtain a cost basis in the stock purchased and not the assets, which would
remain unchanged and cause an unfavorable result if the fmv is higher. (3) A
third possibility would be to defer at least some of the tax liability via a
merger/recapitalization whereby the boot remains tax free until its eventual
future sale. (4) Compromises are possible including, by way of example, an
“h(10) election” whereby the parties consummate a stock purchase with all of
the aforementioned results being the same except, for tax purposes, the deal is
deemed an asset deal and the acquirer obtains the desired basis step-up in the
assets.

2. CASH VERSUS EQUITY

The method of payment for a transaction may be a decisive factor for both
parties. Deal financing centers on the following:

Cash. Cash is the most liquid and least risky method from the target’s
perspective as there is no doubt as to the true market value of the transaction
and it removes contingency payments (excluding the possibility of an earn out)
all of which may effectively pre-empt rival bids better than equity. From the
acquirer’s perspective, it can be sourced from working capital/excess cash or
untapped credit lines but doing so may decrease the acquirer’s debt rating
and/or affect its capital structure and/or control going forward.

Equity. This involves the payment of the acquiring company's equity, issued to
the stockholders of the target, at a determined ratio relative to the target’s value.
The issuance of equity may improve the acquirer’s debt rating thereby reducing
future cost of debt financings. There are transaction costs and risks in terms of a
stockholders meeting (potential rejection of the deal), registration (if the
acquirer is public), brokerage fees, etc. That said, the issuance of equity will
generally provide more flexible deal structures.

The ultimate payment method may be determinative of what value the acquirer
places on itself (e.g., acquirer’s tend to offer equity when they believe their
equity is overvalued and cash when the equity is perceived as undervalued).

3. WORKING CAPITAL ADJUSTMENTS

M&A transactions typically include a working capital (W/C) adjustment as a
component of the purchase price. The acquirer wants to insure that it acquires a
target with adequate W/C to meet the requirements of the business post-closing,
including obligations to customers and trade creditors. The target wants to
receive consideration for the asset infrastructure that enabled the business to
operate and generate the profits that triggered the acquirer’s desire to buy the
business in the first place. An effective W/C adjustment protects the acquirer
against the target initiating (i) accelerated collection of debt, or (ii) delayed
purchase of inventory/selling inventory for cash or payment of creditors. The
typical W/C adjustment includes the delta between the sum of cash, inventory,
accounts receivable, and prepaid items minus accounts payable and accrued
expenses. In terms of measuring the W/C, the definitive agreement will include
a mechanism that compares the actual W/C at the closing against a target level,
which target level is viewed as the normal level for the operation of the business
based on a historical review of the target’s operations over a defined period of
time. Certain unusual or atypical factors, “one-offs”, add-backs, and cyclical
items will also be considered as part of the W/C calculation. The true-up
resulting from the post-closing W/C adjustment will usually occur within a few
months of the closing and, to the extent that disputes between the parties arise
concerning the calculation, dispute procedures are set forth in the definitive
agreement.

4. ESCROWS AND EARN-OUTS

The letter of intent should clearly indicate any contingency to the payment of
the purchase price in a transaction, including any escrow and any earn-out. The
purpose of an escrow is to provide recourse for an acquirer in the event there are
breaches of the representations and warranties made by the target (or upon the
occurrence of certain other events). Although escrows are standard in M&A
transactions, the terms of an escrow can vary significantly. Typical terms
include an escrow dollar amount in the range of 10% to 20% of the overall
consideration with an escrow period ranging from 12 to 24 months from the
date of the closing. Earn-out provisions are less common and are most often
used to bridge the gap on valuation that may exist between the target and the
acquirer. Earn-out provisions are typically tied to the future performance of the
business, with the target and/or its stockholders only receiving the additional
consideration to the extent certain milestones are met. When drafting earn-out
terms, it is important to have the milestones be as objective as possible. Typical
milestones include future revenue and other financial metrics. From the target’s
perspective, the concern with earn-outs is that post-closing the target loses
control over the company and decisions made by the acquirer post-closing can
dramatically impact the ability to achieve the milestones that were established.

5. REPRESENTATIONS AND WARRANTIES

The acquirer will expect the definitive agreement to include detailed
representations and warranties by the target with respect to such matters as
authority, capitalization, intellectual property, tax, financial statements,
compliance with law, employment, ERISA and material contracts. It is critical
for the target and target’s counsel to review these representations carefully
because breaches can quickly result in indemnification claims from the acquirer.
The disclosure schedules (which describe exceptions to the representations)
should be considered the target’s “insurance policy” and should be as detailed
as possible. One of the more debated representations is the “10b-5”
representation, which requires the target to make a general statement that no rep
or warranty contains any untrue statement or omits to state a material fact
necessary to make any of them not misleading. Targets are typically
uncomfortable with such a broad statement, but without such a representation an
acquirer often will question whether the target is withholding certain
information. Acquirers and targets also struggle with the appropriateness of
knowledge qualifiers throughout the representations. The target typically tries to
insert knowledge qualifiers in many of the material representations (for
example, with respect to whether the target’s intellectual property has infringed
the rights of any other third party), but the acquirer will want these types of risk
to lie with the target.

6. TARGET INDEMNIFICATION
Target indemnification provisions are always highly negotiated in any M&A
transaction. One of the initial issues to be determined is what types of
indemnification claims will be capped at the escrow amount. In some instances
all claims may be capped at the escrow. It is common to have a few exceptions
to this cap – any claims resulting from fraud and/or intentional
misrepresentation usually go beyond the escrow and often instead are capped at
the overall purchase price. In addition, breaches of “fundamental reps” (such as
intellectual property or tax) may go beyond the escrow as well. Another
business term related to indemnification to negotiate relates to whether there
will be a “basket” for indemnification purposes. In order to avoid the nuisance
of disputes over small amounts, there is typically a minimum claim amount
which must be reached before which the acquirer may seek indemnification –
which could include a true “deductible” in which the acquirer is not permitted to
go back to the first dollar once the threshold is achieved.

7. JOINT AND SEVERAL LIABILITY

Related to the concept of indemnification is the issue of joint and several
liability. As most transactions involve multiple target stockholders, one of the
primary issues to consider regarding indemnification, from the acquirer’s
perspective, is to what extent each of the target’s stockholders will participate in
any indemnification obligations post-closing (i.e., whether joint and several, or
several but not joint, liability will be appropriate). Under joint liability each
target stockholder is individually liable to the acquirer for 100% of the future
potential damages. However, if the liability is several, each target stockholder
pays only for that target stockholder’s relative contribution to the damages. It
goes without saying that the acquirer will almost always desire to make each
target stockholder responsible for the full amount of any future potential claims.
However, target stockholders will generally resist this approach but, even more
so, where there are controlling stockholders and/or financial investors (both of
which traditionally resist joint and several liability in every situation).

8. CLOSING CONDITIONS
A section of the definitive agreement will include a list of closing conditions
which must be met in order for the parties to be required to close the
transaction. These are often negotiated at the time of the definitive agreement
(although sometimes a detailed list will be included in the letter of intent).
These conditions may include such items as appropriate board approval, the
absence of any material adverse change in the target’s business or financial
conditions, the absence of litigation, the delivery of a legal opinion from target’s
counsel and requisite stockholder approval. One of the more heavily negotiated
closing conditions is the stockholder voting threshold which must be achieved
for approval of the transaction. Although the target’s operative documents and
state law may require a lower threshold, acquirers typically request a very high
threshold of approval (90% - 100%) out of concern that stockholders who have
not approved the transaction might exercise appraisal rights. The target should
review its stockholder structure carefully before committing to such a high
threshold (although from a target perspective, the more stockholders approve
the transaction the better, but the target just does not want the acquirer to have
the ability to walk away from the transaction).

9. HSR/TIMING ISSUES
In connection with any transaction, the parties should review long-term lead
items as soon as possible. For example, the parties should complete an analysis
to determine whether a Hart-Scott-Rodino filing will be required to be made
and, if so, at what point such filing will be completed (occasionally it is filed
after the letter of intent is executed but is often filed upon the execution of
definitive agreement). Although the 30-day waiting period can be waived, the
necessity of making an HSR filing can significantly delay the closing of a
transaction. A second potential lead items is determining if any third party
notices or consents (as further described above) will be required and the process
by which such notices or consents shall be made.

10. NON-COMPETES & NON-SOLICITS

Within the context of an M&A transaction, a covenant not to compete or solicit
is a promise by the selling shareholder(s) of the target to not, for a certain post-
closing time frame or after termination of employment with the target/acquirer,
(i) engage in a defined business activity that is competitive with the
target’s/acquirer’s, or (ii) attempt to lure away customers or employees of the
target/acquirer. Enforceability of such restrictions requires that the restrictions
be (A) reasonable in time and scope, and (B) supported by consideration.
Because the M&A context involves the sale of a business and payment to the
selling shareholders of typically a material amount of consideration, courts
generally have deemed such consideration adequate for purposes of
enforceability both in terms of scope (i.e., any material business competitive
with that of the target/acquirer) and multiple years of duration.

REFERENCE - https://www.morse.law/news/issues-in-ma-transactions

Pooling of interest method

Pooling-of-interests was a method of accounting that governed how
the balance sheets of two companies were added together during an
acquisition or merger. The Financial Accounting Standards Board (FASB)
issued Statement No. 141 in 2001, ending the usage of the pooling-of-
interests method.
The FASB then designated only one method—purchase accounting—to
account for business combinations. In 2007, FASB further evolved its stance,
issuing a revision to Statement No. 141 that the purchase method was to be
superseded by yet another improved methodology—the purchase acquisition
method.

The pooling-of-interests method allowed assets and liabilities to be transferred

from the acquired company to the acquirer at book values. Intangible assets,
such as goodwill, were not included in the calculation. The assets and
liabilities were simply summed together for a net number in each category
when combining both balance sheets.

The purchase accounting method recorded assets and liabilities at fair

value as opposed to book value, and any excess paid above the fair value
price was recorded as goodwill, which needed to be amortized and expensed
over a certain time period, which was not the case in the pooling-of-interests
method.

The purchase acquisition method is the same as the purchase accounting

method except that goodwill is subject to annual impairment tests instead of
amortization, which was done to placate businesses that had to start paying
expenses due to the amortization of goodwill.

 Pooling-of-interests was an accounting method that governed how the

balance sheets of two companies that were merged would be
combined.
 The pooling-of-interests method was replaced by the purchase
accounting method, which itself was replaced by the current method,
the purchase acquisition method.
 The pooling-of-interests method combined the assets and liabilities of
both companies at book value.
 Intangible assets, such as goodwill, were not included in the pooling-of-
interests method and were therefore preferred over the purchase
accounting method, as it did not result in having to pay amortized costs,
negatively impacting earnings.
 The adjustment by FASB to incorporate impairment tests before
including amortized expenses reduced the impact of the purchase
accounting method.

REFERNCE- https://www.investopedia.com/terms/p/poolingofinterests.asp
 Purchase Method
Purchase acquisition accounting is a method of reporting the purchase of a
company on the balance sheet of the company that acquires it. It treats the
target firm as an investment. There is no pooling of assets. Rather, the assets
of the target firm are added to the balance sheet of the acquirer at a price that
reflects their fair market value. This, in turn, increases the acquirer's fair
market value. Liabilities of the target are subtracted from the fair value of the
assets.

The amount paid by the acquirer over the net value of the target's assets and
liabilities is considered goodwill, which is kept on the balance sheet and
amortized yearly.

Purchase acquisition accounting is a set of guidelines for recording the purchase

of a company on the consolidated statement of financial position of the
company that buys it.

This is the standard documentation for recording the assets and liabilities of a
company with subsidiaries. It is most relevant to public companies since
privately-held firms have fewer reporting requirements.

The concept of purchase acquisition accounting was introduced in 2008 by the

major accounting authorities, the Financial Accounting Standards
Board (FASB) and the International Accounting Standards Board (IASB). It
replaces the previous method, known as purchase accounting.

Acquisition accounting was preferred because it strengthened the concept of fair

market value at the time of a transaction. It also adds accounting for
contingencies and non-controlling interests, which were not considered under
the previous method.

It treats the target firm as an investment. There is no pooling of assets.

REFERENCES -
https://www.investopedia.com/terms/p/purchaseacquisition.asp
https://corporatefinanceinstitute.com/resources/ebooks/investment-
banking/purchase-accounting-merger-acquisition/

IFRS 3
IFRS 3 establishes principles and requirements for how an acquirer in a
business combination:
 recognises and measures in its financial statements the assets and
liabilities acquired, and any interest in the acquiree held by other parties;
 recognises and measures the goodwill acquired in the business
combination or a gain from a bargain purchase; and
 Determines what information to disclose to enable users of the financial
statements to evaluate the nature and financial effects of the business
combination.
The core principles in IFRS 3 are that an acquirer measures the cost of the
acquisition at the fair value of the consideration paid; allocates that cost to the
acquired identifiable assets and liabilities on the basis of their fair values;
allocates the rest of the cost to goodwill; and recognises any excess of acquired
assets and liabilities over the consideration paid (a ‘bargain purchase’) in profit
or loss immediately. The acquirer discloses information that enables users to
evaluate the nature and financial effects of the acquisition.
REFERENCE - https://www.ifrs.org/issued-standards/list-of-standards/ifrs-3-
business-combinations/
A 3 statement model links the income statement, balance sheet, and cash flow
statement into one dynamically connected financial model. 3 statement models
are the foundation on which more advanced financial models are built, such as
discounted cash flow (DCF) models, merger models, leveraged buyout (LBO)
models, and various other types of financial models.

REFERENCE-
https://corporatefinanceinstitute.com/resources/knowledge/modeling/3-
statement-model/