Mergers and Acquisitions

Transactions can be mergers or acquisitions, made with cash or stock, and they can be friendly or hostile.

Basic Strategies of Mergers and Acquisitions (M&A)

1. The buyer buys the shares and controls the target company. Ownership control of the company conveys effective control over the assets of the company. However, since the company is acquired intact as a going concern, this form of transaction carries with it all of the liabilities accrued by that business over its past and all of the risks that company faces in its commercial environment.
   
   
2. The buyer buys the assets of the target company. The cash the target receives from the sell-off is netted against outstanding liabilities and returned to equity holders (owners). This type of transaction leaves the target company as an empty shell if the buyer buys out the entirety of the target's assets (a liquidation). A buyer often structures the transaction to "cherry-pick" the assets that it wants and leaves out the assets and liabilities that it does not.
   
   A disadvantage of this structure is the tax many jurisdictions – particularly outside the United States – impose on transfers of individual assets. In contrast, stock transactions can frequently be structured as like-kind exchanges or other arrangements that are tax-free or tax-neutral.

Basic Methods of Financing M&A

Cash

1. Cash on hand: The buyer consumes financial slack (excess cash or unused debt capacity) and may decrease its debt rating. There are no major transaction costs.
   
   
2. Issue of stock: The buyer increases financial slack, which may improve its debt rating and reduce the cost of debt (although not WACC, as the cost of equity will increase). Transaction costs include fees to prepare a proxy statement, an extraordinary shareholder meeting, and registration.

Stock

Payment is made in the form of the acquiring company's stock, issued to the shareholders of the acquired company at a given ratio proportional to the valuation of the acquired company's stock. If the buyer pays with stock, the financing possibilities are:

1. Issue of stock (same effects and transaction costs as described above).
   
   
2. Shares in Treasury: The buyer increases financial slack (if they do not have to be repurchased on the market), which may improve its debt rating and reduce the cost of debt (although not WACC, as the cost of equity will increase). Transaction costs include brokerage fees if shares are repurchased in the market; otherwise, there are no major costs.

When submitting an offer, the acquiring firm should consider other potential bidders and think strategically. The form of payment might be decisive for the seller. With pure cash deals, there is no doubt on the real value of the bid.

Therefore, a cash offer preempts competitors better than securities. Taxes are a second element to consider and should be evaluated with the counsel of competent tax and accounting advisers.

Third, with a share deal the buyer's capital structure might be affected and the buyer's control modified. If the issuance of shares is necessary, shareholders of the acquiring company might prevent such capital increase at the general meeting of shareholders. This risk is removed with a cash transaction.

In the aftermath of a merger, there will be accounting issues to consider. The balance sheet of the buyer will be modified, and thus the decision maker should take into account the effects on the reported financial results.

For example, in a pure cash deal (financed from the company's current account), liquidity ratios might decrease. On the other hand, in a pure stock for stock transaction (financed from the issuance of new shares), the company might show lower profitability ratios (e.g. ROA). However, economic dilution must prevail towards accounting dilution in the decision-making process.

Hostile vs. Friendly

Whether a purchase is perceived as friendly or hostile depends significantly on how the proposed acquisition is communicated to and perceived by the target company's board of directors, employees, and shareholders. Deal communications commonly occur in a "confidentiality bubble," where the flow of information is restricted pursuant to confidentiality agreements.

During a friendly transaction, the companies cooperate in negotiations. However, in a hostile deal, the board and/or management of the target are unwilling to be bought, or the board has no prior knowledge of the offer. Hostile acquisitions can, and often do, ultimately become friendly as the acquirer secures endorsement of the transaction from the board of the acquiree company. This usually requires an improvement in the terms of the offer through negotiation.

Airline M&A: The aviation industry has seen increased consolidation through M&A activity in the last 20 years. Pictured is a plane belonging to United Airlines, one of the world's largest carriers, fresh off a 2010 merger with Continental Airlines.