Mergers and Acquisition

Motives for Merging

Firms merge to fill certain objectives. The overriding goal for merging is maximization of the
owner’s wealth as reflected in the acquirer’s share price. More specific motives include
growth or diversification, synergy, fund raising, increased managerial skill or technology, tax
considerations, increased ownership liquidity, and defense against takeover. These motives
should be pursued when they lead to owner wealth maximization.

Growth or Diversification

Companies that desire rapid growth in size or market share or diversification in the range of
their products may find that a merger can fulfill this objective. Instead of relying entirely on
internal or “organic” growth, the firm may achieve its growth or diversification objectives
much faster by merging with an existing firm. Such a strategy is often less costly than the
alternative of developing the necessary production capacity. If a firm that wants to expand
operations can find a suitable going concern, it may avoid many of the risks associated with
the design, manufacture, and sale of additional or new products. Moreover, when a firm
expands or extends its product line by acquiring another firm, it may remove a potential
competitor.

Synergy

The synergy of mergers is the economies of scale resulting from the merged firms’ lower
overhead. These economies of scale from lowering the combined overhead increase earnings
to a level greater than the sum of the earnings of each of the independent firms. Synergy is
most obvious when firms merge with other firms in the same line of business because many
redundant functions and employees can be eliminated. Staff functions, such as purchasing
and sales, are probably most greatly affected by this type of combination.

Fund Raising

Often, firms combine to enhance their fund-raising ability. A firm may be unable to obtain
funds for its own internal expansion but able to obtain funds for external business
combinations. Quite often, one firm may combine with another that has high liquid assets and
low levels of liabilities. The acquisition of this type of “cashrich” company immediately
increases the firm’s borrowing power by decreasing its financial leverage. This should allow
funds to be raised externally at lower cost.

Increased Managerial Skill or Technology

Occasionally, a firm will have good potential that it finds itself unable to develop fully
because of deficiencies in certain areas of management or an absence of needed product or
production technology. If the firm cannot hire the management or develop the technology it
needs, it might combine with a compatible firm that has the needed managerial personnel or
technical expertise. Of course, any merger should contribute to maximizing the owners’
wealth.

Tax Considerations

Quite often, tax considerations are a key motive for merging. In such a case, the tax benefit
generally stems from the fact that one of the firms has a tax loss carryforward. This means
that the company’s tax loss can be applied against a limited legal constraints on mergers and
acquisitions exist—especially when a proposed acquisition will lead to reduced competition.
The various antitrust laws, which are enforced by the Federal Trade Commission (FTC) and
the Justice Department, prohibit business combinations that eliminate competition. tax loss
carryforward In a merger, the tax loss of one of the firms that can be applied against a limited
amount of future income of the merged firm over 20 years or until the total tax loss has been
fully recovered, whichever comes first. amount of future income of the merged firm over 20
years or until the total tax loss has been fully recovered, whichever comes first. Two
situations could actually exist. A company with a tax loss could acquire a profitable company
to use the tax loss. In this case, the acquiring firm would boost the combination’s aftertax
earnings by reducing the taxable income of the acquired firm. A tax loss may also be useful
when a profitable firm acquires a firm that has such a loss. In either situation, however, the
merger must be justified not only on the basis of the tax benefits but also on grounds
consistent with the goal of owner wealth maximization. Moreover, the tax benefits described
can be used only in mergers—not in the formation of holding companies—because only in
the case of mergers are operating results reported on a consolidated basis. An example will
clarify the use of the tax loss carryforward.

Increased Ownership Liquidity

The merger of two small firms or of a small and a larger firm may provide the owners of the
small firm(s) with greater liquidity. This is due to the higher marketability associated with the
shares of larger firms. Instead of holding shares in a small firm that has a very “thin” market,
the owners will receive shares that are traded in a broader market and can thus be liquidated
more readily. Also, owning shares for which market price quotations are readily available
provides owners with a better sense of the value of their holdings. Especially in the case of
small, closely held firms, the improved liquidity of ownership obtainable through merger
with an acceptable firm may have considerable appeal.

Defense against Takeover

Occasionally, when a firm becomes the target of an unfriendly takeover, it will acquire
another company as a defensive tactic. Such a strategy typically works like this: The original
target firm takes on additional debt to finance its defensive acquisition; because of the debt
load, the target firm becomes too highly leveraged financially to be of any further interest to
its suitor. To be effective, a defensive takeover must create greater value for shareholders
than they would have realized had the firm been merged with its suitor.

Reverse Mergers
 Reverse Takeovers (RTO)

A reverse takeover (RTO) is a process whereby private companies can become

publicly traded companies without going through an initial public offering (IPO).

To begin, a private company buys enough shares to control a publicly-traded

company. The private company's shareholder then exchanges its shares in the private
company for shares in the public company. At this point, the private company has
effectively become a publicly-traded company.

An RTO is also sometimes referred to as a reverse merger or a reverse IPO.

How a Reverse Takeover (RTO) Works

By engaging in an RTO, a private company can avoid the expensive fees associated
with setting up an IPO. However, the company does not acquire any additional funds
through an RTO, and it must have enough funds to complete the transaction on its
own.

While not a requirement of an RTO, the name of the publicly-traded company

involved is often changed as part of the process. For example, the computer company
Dell (DELL) completed a reverse takeover of VMware tracking stock (DVMT) in
December 2018 and returned to being a publicly traded company. It also changed its
name to Dell Technologies.1

Additionally, the corporate restructuring of one—or both—of the merging companies

is adjusted to accommodate the new business design. Prior to the RTO, it is not
uncommon for the publicly-traded company to have had little to no recent activity,
existing as more of a shell corporation. This allows the private company to shift its
operations into the shell of the public entity with relative ease, all while avoiding the
costs, regulatory requirements, and time constraints associated with an IPO. While a
traditional IPO may require months or years to complete, an RTO may be completed
in just weeks.

Sometimes RTOs are referred to as the "poor man’s IPO." This is because studies
have shown that companies that go public through an RTO generally have lower
survival rates and performance in the long-run, compared to companies that go
through a traditional IPO to become a publicly traded company.

Special Considerations

Unlike conventional IPOs—which can be canceled if the equity markets are

performing poorly—reverse mergers aren’t generally put on hold. Many private
companies looking to complete a reverse merger have often taken a series of losses,
and a percentage of the losses can be applied to future income as a tax loss
carryforward.2
 On the flip side, reverse mergers can reveal weaknesses in the private company’s
management experience and record keeping. As well, many reverse mergers fail; they
end up not fulfilling the promised expectations when they eventually begin trading.

A foreign company may an RTO as a mechanism to gain entry into the U.S.
marketplace. For example, if a business with operations based outside of the U.S.
purchases enough shares to have a controlling interest in a U.S. company, it can move
to merge the foreign-based business with the U.S.-based business.

 Reverse Mergers: Advantages and Disadvantages

What Are the Implications of a Reverse Merger?

Reverse mergers are also commonly referred to as reverse takeovers or reverse initial
public offerings (IPOs). A reverse merger is a way for private companies to go public,
and while they can be an excellent opportunity for investors, they also have certain
disadvantages.

Understanding Reverse Mergers

Reverse mergers typically occur through a simpler, shorter, and less

expensive process than a conventional IPO. With an IPO, private companies
hire an investment bank to underwrite and issue shares of the new soon-to-
be public entity.

Aside from filing the regulatory paperwork and helping authorities review the
deal, the bank also helps to establish interest in the stock and provide advice
on appropriate initial pricing. The traditional IPO necessarily combines the go-
public process with the capital-raising function.2 A reverse merger separates
these two functions, making it an attractive strategic option for corporate
managers and investors alike.

In a reverse merger, investors of the private company acquire a majority of

the shares of a public shell company, which is then combined with the
purchasing entity. Investment banks and financial institutions typically use
shell companies as vehicles to complete these deals. These simple shell
companies can be registered with the Securities and Exchange Commission
(SEC) on the front end (prior to the deal), making the registration process
relatively straightforward and less expensive. To consummate the deal, the
private company trades shares with the public shell in exchange for the shell's
stock, transforming the acquirer into a public company.1

Advantages of Reverse Mergers

Reverse mergers have advantages that make them attractive options for
private companies, such as a simplifed way to go public and with less risk.

A Simplified Process
Reverse mergers allow a private company to become public without raising
capital, which considerably simplifies the process. While conventional IPOs
can take months (even over a calendar year) to materialize, reverse mergers
can take only a few weeks to complete (in some cases, in as little as 30
days).34 This saves management time and energy, ensuring that there is
sufficient time devoted to running the company.

Less Risk
Undergoing the conventional IPO process does not guarantee that the
company will ultimately go public. Managers can spend hundreds of hours
planning for a traditional IPO. But if stock market conditions become
unfavorable to the proposed offering, the deal may be canceled, and all of
those hours will amount to a wasted effort. Pursuing a reverse merger
minimizes this risk.

Less Dependence on Market Conditions

As mentioned earlier, the traditional IPO combines both the go-public and
capital-raising functions. As the reverse merger is solely a mechanism to
convert a private company into a public entity, the process is less dependent
on market conditions (because the company is not proposing to raise capital).
Since a reverse merger functions solely as a conversion mechanism, market
conditions have little bearing on the offering. Rather, the process is
undertaken in an attempt to realize the benefits of being a public entity.

Benefits of a Public Company

Private companies—generally those with $100 million to several hundred
million in revenue—are usually attracted to the prospect of going public. Once
this happens, the company's securities are traded on an exchange and enjoy
greater liquidity. The original investors gain the ability to liquidate their
holdings, providing a convenient exit alternative to having the company buy
back their shares. The company has greater access to capital markets, as
management now has the option of issuing additional stock through
secondary offerings. If stockholders possess warrants—the right to purchase
additional stock at a pre-determined price—the exercise of these options
provides additional capital infusion into the company.

Public companies often trade at higher multiples than private companies.

Significantly increased liquidity means that both the general public and
institutional investors (and large operational companies) have access to the
company's stock, which can drive its price. Management also has more
strategic options to pursue growth, including mergers and acquisitions.

As stewards of the acquiring company, they can use company stock as the
currency with which to acquire target companies. Finally, because public
shares are more liquid, management can use stock incentive plans in order to
attract and retain employees.

Disadvantages of a Reverse Merger

A reverse merger can be simpler, but it also requires adherence to regulations and due
diligence to be successful.

Due Diligence Required

Managers must thoroughly vet the investors of the public shell company. What are
their motivations for the merger? Have they done their homework to make sure the
shell is clean and not tainted? Are there pending liabilities (such as those stemming
from litigation) or other "deal warts" hounding the public shell? If so, shareholders of
the public shell may merely be looking for a new owner to take possession of these
problems. Thus, appropriate due diligence should be conducted, and transparent
disclosure should be expected (from both parties).

Investors of the public shell should also conduct reasonable diligence on the private
company, including its management, investors, operations, financials, and possible
pending liabilities (i.e., litigation, environmental problems, safety hazards, and labor
issues).

Risky Stock Will Be Dumped

If the public shell's investors sell significant portions of their shares right after the
merger, this can materially and negatively affect the stock price. To reduce or
eliminate the risk that the stock will be dumped, clauses can be incorporated into a
merger agreement, designating required holding periods.6

No Demand for Shares Post Merger

After a private company executes a reverse merger, will its investors really obtain
sufficient liquidity? Smaller companies may not be ready to be a public company.
There may be a lack of operational and financial scale. Thus, smaller companies may
not attract analyst coverage from Wall Street. After the reverse merger is
consummated, the original investors may find little demand for their shares. Reverse
mergers do not replace sound fundamentals. For a company's shares to be attractive to
prospective investors, the company itself should be attractive operationally and
financially.

Regulatory and Compliance Burden

A potentially significant setback when a private company goes public is that managers
are often inexperienced in the additional regulatory and compliance requirements of
 being a publicly-traded company. These burdens (and costs in terms of time and
money) can prove significant, and the initial effort to comply with additional
regulations can result in a stagnant and underperforming company if managers devote
much more time to administrative concerns than to running the business.

To alleviate this risk, managers of the private company can partner with investors of
the public shell who have experience in being officers and directors of a public
company. The CEO can additionally hire employees (and outside consultants) with
relevant compliance experience. Managers should ensure that the company has the
administrative infrastructure, resources, road map, and cultural discipline to meet
these new requirements after a reverse merger.

 Reverse Triangular Merger

A reverse triangular merger is the formation of a new company that occurs when an
acquiring company creates a subsidiary, the subsidiary purchases the target company,
and the subsidiary is then absorbed by the target company.

A reverse triangular merger is more easily accomplished than a direct merger because
the subsidiary has only one shareholder—the acquiring company—and the acquiring
company may obtain control of the target's nontransferable assets and contracts.

A reverse triangular merger, like direct mergers and forward triangular mergers, may
be either taxable or nontaxable, depending on how they are executed and other
complex factors set forth in Section 368 of the Internal Revenue Code. If nontaxable,
a reverse triangular merger is considered a reorganization for tax purposes.

Understanding Reverse Triangular Mergers

In a reverse triangular merger, the acquirer creates a subsidiary that merges into the
selling entity and then liquidates, leaving the selling entity as the surviving entity and
a subsidiary of the acquirer. The buyer’s stock is then issued to the seller’s
shareholders.

Because the reverse triangular merger retains the seller entity and its business
contracts, the reverse triangular merger is used more often than the triangular merger.

In a reverse triangular merger, at least 50% of the payment is the stock of the acquirer,
and the acquirer gains all assets and liabilities of the seller. Because the acquirer must
meet the bona fide needs rule, a fiscal year appropriation may be obligated to be met
only if a legitimate need arises in the fiscal year for which the appropriation was
made.

Since the acquirer must meet the continuity of business enterprise rule, the entity must
continue the target company’s business or use a substantial portion of the target’s
business assets in a company.
 The acquirer must also meet the continuity of interest rule, meaning the merger may
be made on a tax-free basis if the shareholders of the acquired company hold an
equity stake in the acquiring company. In addition, the acquirer must be approved by
the boards of directors of both entities.

 A Guide to Spotting a Reverse Merger

How Do You Spot a Reverse Merger?

Many companies perform reverse mergers, also known as reverse takeovers, as

opposed to other, more traditional forms of raising capital. A reverse merger is when a
private company becomes a public company by purchasing control of the public
company. The shareholders of the private company usually receive large amounts of
ownership in the public company and control of its board of directors.

Once this is complete, the private and public companies merge into one publicly
traded company.

Understanding How to Spot Reverse Mergers

There are many benefits and disadvantages to investing in reverse mergers. To be

successful, you must ask yourself if you can handle investing in a company that could
take a long time to turn around.

You should also learn how the merger works and in what ways the reverse merger
would benefit shareholders for the private and public company. While this can be a
time-consuming process, the rewards can be tremendous—especially if you find the
diamond in the rough that becomes a large, successful publicly traded company.

Signals of Reverse Mergers

To be successful in identifying reverse mergers, stay alert. By paying attention to the

financial media, it is possible to find opportunities in potential reverse mergers.

It is also wise to participate in opportunities that are trying to raise at least $500,000
and are expected to do sales of at least $20 million during the first year as a public
company.

Some potential signals to follow if you're looking to find your own reverse-merger
candidates:

Look for appropriate capitalization. Generally, reverse mergers succeed for

companies that don't need the capital right away. Normally, a successful publicly
traded company will have at least sales of $20 million and $2 million in cash.
 The best companies for a possible reverse merger are those that are looking to raise
$500,000 or more as working capital. Some good examples of successful reverse
mergers include: Armand Hammer successfully merging into Occidental Petroleum,
Ted Turner's completion of a reverse merger with Rice Broadcasting to form Turner
Broadcasting, and Muriel Seibert taking her brokerage firm public by merging with J.
Michaels, a furniture company in Brooklyn.

Advantages of Reverse Mergers

There are many advantages to performing reverse mergers, including:

The ability for a private company to become public for a lower cost and in less time
than with an initial public offering. When a company plans to go public through an
IPO, the process can take a year or more to complete. This can cost the company
money and time. With a reverse merger, a private company can go public in as little
as 30 days.

Public companies have higher valuations compared with private companies. Some of
the reasons for this include greater liquidity, increased transparency and publicity, and
most likely faster growth rates compared to private companies.

Reverse mergers are less likely to be canceled or put on hold because of the adverse
effects of current market conditions. This means that if the equity markets are
performing poorly or there is unfavorable publicity surrounding the IPO, underwriters
can pull the offering off the table.

The public company can offer a tax shelter to the private company. In many cases, the
public company has taken a series of losses. A percentage of the losses can be carried
forward and applied to future income. By merging the private and public company, it
is possible to protect a percentage of the merged company's profits from future taxes.

Disadvantages of Reverse Mergers

Reverse mergers also have some inherent disadvantages, such as:

 Some reverse mergers come with unseen circumstances, such as liability

lawsuits and sloppy record keeping.
 Reverse stock splits are very common with reverse mergers and can
significantly reduce the number of shares owned by stockholders.
 Many chief executive officers of private companies have little or no
experience running a publicly traded company.
 Many reverse mergers do little of what is promised and the company ends up
trading on the OTC bulletin board and providing shareholders with little to no
additional value or liquidity.
Effects of Mergers and Acquisitions (M&A)
 How does a Merger Affect Shareholders?

How Stock Price Is Affected

In the days leading up to a merger, the share price of both underlying companies are
differently impacted, based on a host of factors, such as macroeconomic conditions,
market capitalizations, as well as the execution of the merger process itself. But
generally speaking, shareholders of the acquiring firm usually experience a temporary
drop in share value. In contrast, shareholders in the target firm typically observe a rise
in share value during the same pre-merge period, mainly due to stock price arbitrage,
which describes the action of trading stocks that are subject to takeovers or mergers.
Simply put: the spike in trading volume tends to inflate share prices.

After a merge officially takes effect, the stock price of the newly-formed entity
usually exceeds the value of each underlying company during its pre-merge stage. In
the absence of unfavorable economic conditions, shareholders of the merged company
usually experience favorable long-term performance and dividends.

Shareholder Voting Power and Dilution

The shareholders of both companies may experience a dilution of voting power due to
the increased number of shares released during the merger process. This phenomenon
is prominent in stock-for-stock mergers, when the new company offers its shares in
exchange for shares in the target company, at an agreed-upon conversion rate.

Shareholders of the acquiring company experience a marginal loss of voting power,

while shareholders of a smaller target company may see a significant erosion of their
voting powers in the relatively larger pool of stakeholders.
Changes in Management

After a merger is complete, the new company will likely undergo certain noticeable
leadership changes. Concessions are usually made during merger negotiations, and a
shuffling of executives and board members in the new company often results.

 How Company Stocks Move During an Acquisition

Which Stock Rises and Which Stock Falls?

When one company acquires another, the stock prices of both entities tend to move in
predictably opposite directions, at least over the short-term. In most cases, the target
company's stock rises because the acquiring company pays a premium for the
acquisition, in order to provide an incentive for the target company's shareholders to
approve the takeover. Simply put, there's no motive for shareholders to greenlight
such action if the takeover bid equates to a lower stock price than the current price of
the target company.
 Of course, there are exceptions to the rule. Namely: if a target company's stock price
recently plummeted due to negative earnings, then being acquired at a discount may
be the only path for shareholders to regain a portion of their investments back. This
holds particularly true if the target company is saddled with large amounts of debt,
and cannot obtain financing from the capital markets to restructure that debt.

On the other side of the coin, the acquiring company's stock typically falls
immediately following an acquisition event. This is because the acquiring company
often pays a premium for the target company, exhausting its cash reserves and/or
taking on significant debt in the process. But there are many other reasons an
acquiring company's stock price may fall during an acquisition, including:

Investors believe the premium paid for the target company is too high.
There are problems integrating different workplace cultures.
Regulatory issues complicate the merger timeline.
Management power struggles hamper productivity.
Additional debt or unforeseen expenses are incurred as a result of the purchase.

It's important to remember that although the acquiring company may experience a
short-term drop in stock price, in the long run, it's share price should flourish, as long
as its management properly valued the target company and efficiently integrates the
two entities.

Pre-Acquisition Volatility

Stock prices of potential target companies tend to rise well before a merger or
acquisition has officially been announced. Even a whispered rumor of a merger can
trigger volatility that can be profitable for investors, who often buy stocks based on
the expectation of a takeover. But there are potential risks in doing this, because if a
takeover rumor fails to come true, the stock price of the target company can
precipitously drop, leaving investors in the lurch.

Generally speaking, a takeover suggests that the acquiring company's executive team
feels optimistic about the target company's prospects for long-term earnings growth.
And more broadly speaking, an influx of mergers and acquisitions activity is often
viewed by investors as a positive market indicator.

 What Happens to Call Options If a Company Is Bought?

The announcement that a company is buying another is typically good news for
shareholders in the company being purchased, because the price offered is generally
at a premium to the company's fair market value. But for some call option holders, the
favorability of a buyout situation largely depends on the strike price of the option they
own, as well as the price being paid in the offer.
 A call option affords holders the right to purchase the underlying security at a set
price at any time before the expiration date. But it would be economically illogical to
exercise the option to purchase the share if the set price were higher than the current
market price. In the case of a buyout offer, where a set amount is offered per share,
this effectively limits how high the share price will rise, assuming that no other offers
are made, and that the existing offer is accepted. So, if the offer price is below the
strike price of the call option, the option can easily lose the majority of its value. On
the other hand, options with strike prices below the offer price will see a spike in
value.

Consider the following real-life event: On December 4, 2006, Station Casinos

received a buyout offer from its management for $82 per share. The change in the
value of the option on that day indicates that some option holders fared well, while
others took hits. Case in point: on that day, options expiring on January 9, 2007, with
a strike price of $70--well below the $82 offer price, rose from $11.40 to $17.30,
representing a whopping 52% increase. In contrast, those same options with a strike
price of $90--well above the $82 offer price, fell from $3.40 to $1.00, representing a
staggering 71% loss.

In conclusion, some call option holders handsomely profit from buyouts if the offer
price exceeds the strike price of their options. But option holders will suffer losses if
the strike price is above the offer price.

References:
https://www.investopedia.com/terms/m/mergersandacquisitions.asp