Analysis of Financial Statements_3

Introduction to Mergers and Acquisition

We have been learning about the companies coming together to from another company and companies taking over the existing companies to expand their business.

Mergers are a tool used by companies for the purpose of expanding their operations and increasing their profits.

Usually mergers occur in a consensual setting where executives from the target company help those from the purchaser in a due diligence process to ensure that the deal is beneficial to both parties. Acquisitions can also happen through a hostile takeover by purchasing the majority of outstanding shares of a company in the open market against the wishes of the target's board. In the United States, business laws vary from state to state whereby some companies have limited protection against hostile takeovers. One form of protection against a hostile takeover is the shareholder rights plan, otherwise known as the "poison pill".

Historically, mergers have often failed to add significantly to the value of the acquiring firm's shares. Corporate mergers may be aimed at reducing market competition, cutting costs (for example, laying off employees), reducing taxes, removing management, "empire building" by the acquiring managers, or other purposes which may not be consistent with public policy or public welfare. Thus they can be heavily regulated, requiring, for example, approval in the US by both the Federal Trade Commission and the Department of Justice.

In this context, it would be essential for us to understand what corporate restructuring and mergers and acquisitions are all about.

All our daily newspapers are filled with cases of mergers, acquisitions, spin-offs, tender offers, & other forms of corporate restructuring. Thus important issues both for business decision and public policy formulation have been raised. No firm is regarded safe from a takeover possibility. On the more positive side Mergers & Acquisition’s may be critical for the healthy expansion and growth of the firm. Successful entry into new product and geographical markets may require Mergers & Acquisition’s at some stage in the firm's development. Successful competition in international markets may depend on capabilities obtained in a timely and efficient fashion through Mergers & Acquisition's. Many have argued that mergers increase value and efficiency and move resources to their highest and best uses, thereby increasing shareholder value. .

Merger:

Laws in India use the term 'amalgamation' for merger. The Income Tax Act,1961 [Section 2(1A)] defines amalgamation “as the merger of one or more companies with another or the merger of two or more companies to form a new company, in such a way that all assets and liabilities of the amalgamating companies become assets and liabilities of the amalgamated company and shareholders not less than nine-tenths in value of the shares in the amalgamating company or companies become shareholders of the amalgamated company”

So hence, Merger is also defined as amalgamation. Merger is the fusion of two or more existing companies. All assets, liabilities and the stock of one company stand transferred to transferee company in consideration of payment in the form of:

· Equity shares in the transferee company,

· Debentures in the transferee company,

· Cash, or

· A mix of the above modes.

Laws in India use the term 'amalgamation' for merger. The Income Tax Act, 1961 [Section 2(1A)] defines amalgamation as the merger of one or more companies with another or the merger of two or more companies to form a new company, in such a way that all assets and liabilities of the amalgamating companies become assets and liabilities of the amalgamated company and shareholders not less than nine-tenths in value of the shares in the amalgamating company or companies become shareholders of the amalgamated company

Acquisition:

Acquisition in general sense is acquiring the ownership in the property. In the context of business combinations, an acquisition is the purchase by one company of a controlling interest in the share capital of another existing company. An acquisition may be defined “as an act of acquiring effective control by one company over assets or management of another company without any combination of companies.” Thus, in an acquisition two or more companies may remain independent, separate legal entities, but there may be a change in control of the companies

Types of acquisition

An acquisition can take the form of a purchase of the stock or other equity interests of the target entity, or the acquisition of all or a substantial amount of its assets.

• Share purchases - in a share purchase the buyer buys the shares of the target company from the shareholders of the target company. The buyer will take on the company with all its assets and liabilities.
• Asset purchases - in an asset purchase the buyer buys the assets of the target company from the target company. In simplest form this leaves the target company as an empty shell, and the cash it receives from the acquisition is then paid back to its shareholders by dividend or through liquidation. However, one of the advantages of an asset purchase for the buyer is that it can "cherry-pick" the assets that it wants and leave the assets - and liabilities - that it does not. This leaves the target in a different position after the purchase, but liquidation is nevertheless usually the end result.

Methods of Acquisition:

An acquisition may be affected by

(a) agreement with the persons holding majority interest in the company management like members of the board or major shareholders commanding majority of voting power;

(b) purchase of shares in open market;

(c) to make takeover offer to the general body of shareholders;

(d) purchase of new shares by private treaty;

(e) Acquisition of share capital through the following forms of considerations viz. means of cash, issuance of loan capital, or insurance of share capital.

Takeover:

A ‘takeover’ is acquisition and both the terms are used interchangeably.

When an acquisition is 'forced' or 'unwilling', it is called a takeover. In an unwilling acquisition, the management of 'target' company would oppose a move of being taken over. But, when managements of acquiring and target companies mutually and willingly agree for the takeover, it is called acquisition or friendly takeover.

Under the Monopolies and Restrictive Practices Act, takeover meant acquisition of not less than 25 percent of the voting power in a company. While in the Companies Act (Section 372), a company's investment in the shares of another company in excess of 10 percent of the subscribed capital can result in takeovers. An acquisition or takeover does not necessarily entail full legal control. A company can also have effective control over another company by holding a minority ownership.

.

Purpose of Mergers and Acquisition

Motives behind M&A

These motives are considered to add shareholder value:

Ø Economies of scale: This refers to the fact that the combined company can often reduce duplicate departments or operations, lowering the costs of the company relative to theoretically the same revenue stream, thus increasing profit.

Ø Increased revenue/Increased Market Share: This motive assumes that the company will be absorbing a major competitor and double its power (by capturing increased market share) to set prices.

Ø Cross selling: For example, a bank buying a stock broker could then sell its banking products to the stock broker's customers, while the broker can sign up the bank's customers for brokerage accounts. Or, a manufacturer can acquire and sell complementary products.

Ø Synergy: is the magic force that allows for enhanced cost efficiencies of the new business. Synergy takes the form of revenue enhancement and cost savings. By merging, the companies hope to benefit from the following:.

1. Economies of scale - Yes, size matters. Whether it's purchasing stationery or a new corporate IT system, a bigger company placing the orders can save more on costs. Mergers also translate into improved purchasing power to buy equipment or office supplies - when placing larger orders, companies have a greater ability to negotiate prices with their suppliers.

2. Acquiring new technology - To stay competitive, companies need to stay on top of technological developments and their business applications. By buying a smaller company with unique technologies, a large company can maintain or develop a competitive edge.

3. Improved market reach and industry visibility - Companies buy companies to reach new markets and grow revenues and earnings. A merge may expand two companies' marketing and distribution, giving them new sales opportunities. A merger can also improve a company's standing in the investment community: bigger firms often have an easier time raising capital than smaller ones.

That said, achieving synergy is easier said than done - it is not automatically realized once two companies merge. Sure, there ought to be economies of scale when two businesses are combined, but sometimes a merger does just the opposite. In many cases, one and one add up to less than two.

Ø Taxes: A profitable company can buy a loss maker to use the target's tax write-offs. In the United States and many other countries, rules are in place to limit the ability of profitable companies to "shop" for loss making companies, limiting the tax motive of an acquiring company.

Ø Geographical or other diversification: This is designed to smooth the earnings results of a company, which over the long term smoothens the stock price of a company, giving conservative investors more confidence in investing in the company. However, this does not always deliver value to shareholders (see below).

Ø Resource transfer: resources are unevenly distributed across firms (Barney, 1991) and the interaction of target and acquiring firm resources can create value through either overcoming information asymmetry or by combining scarce resources.

These motives are considered to not add shareholder value:

Ø Diversification: While this may hedge a company against a downturn in an individual industry it fails to deliver value, since it is possible for individual shareholders to achieve the same hedge by diversifying their portfolios at a much lower cost than those associated with a merger.

Ø Overextension: Tend to make the organization fuzzy and unmanageable.

Ø Manager's hubris: manager's overconfidence about expected synergies from M&A which results in overpayment for the target company.

Ø Empire Building: Managers have larger companies to manage and hence more power.

Ø Manager's Compensation: In the past, certain executive management teams had their payout based on the total amount of profit of the company, instead of the profit per share, which would give the team a perverse incentive to buy companies to increase the total profit while decreasing the profit per share (which hurts the owners of the company, the shareholders); although some empirical studies show that compensation is rather linked to profitability and not mere profits of the company. .

Ø Vertical integration: Companies acquire part of a supply chain and benefit from the resources.

Other possible purposes for acquisition are short listed below: -

(1)Procurement of supplies:

1. to safeguard the source of supplies of raw materials or intermediary product;

2. to obtain economies of purchase in the form of discount, savings in transportation costs, overhead costs in buying department, etc.;

3. to share the benefits of suppliers economies by standardizing the materials.

(2)Revamping production facilities:

1. to achieve economies of scale by amalgamating production facilities through more intensive utilization of plant and resources;

2. to standardize product specifications, improvement of quality of product, expanding market and

3. aiming at consumers satisfaction through strengthening after sale services;

4. to obtain improved production technology and know-how from the offeree company

5. to reduce cost, improve quality and produce competitive products to retain and

6. improve market share.

(3) Market expansion and strategy:

1. to eliminate competition and protect existing market;

2. to obtain a new market outlets in possession of the offeree;

3. to obtain new product for diversification or substitution of existing products and to enhance the product range;

4. strengthening retain outlets and sale the goods to rationalize distribution;

5. to reduce advertising cost and improve public image of the offeree company;

6. Strategic control of patents and copyrights.

(4) Financial strength:

1. to improve liquidity and have direct access to cash resource;

2. to dispose of surplus and outdated assets for cash out of combined enterprise;

3. to enhance gearing capacity, borrow on better strength and the greater assets backing;

4. to avail tax benefits;

5. to improve EPS (Earning Per Share).

(5) General gains:

1. to improve its own image and attract superior managerial talents to manage its affairs;

2. to offer better satisfaction to consumers or users of the product.

(6) Own developmental plans:

The purpose of acquisition is backed by the offeror company’s own developmental plans.

A company thinks in terms of acquiring the other company only when it has arrived at its own development plan to expand its operation having examined its own internal strength where it might not have any problem of taxation, accounting, valuation, etc. but might feel resource constraints with limitations of funds and lack of skill managerial personnel’s. It has to aim at suitable combination where it could have opportunities to supplement its funds by issuance of securities, secure additional financial facilities, eliminate competition and strengthen its market position.

(7) Strategic purpose:

The Acquirer Company view the merger to achieve strategic objectives through alternative type of combinations which may be horizontal, vertical, product expansion, market extensional or other specified unrelated objectives depending upon the corporate strategies. Thus, various types of combinations distinct with each other in nature are adopted to pursue this objective like vertical or horizontal combination.

(8) Corporate friendliness:

Although it is rare but it is true that business houses exhibit degrees of cooperative spirit despite competitiveness in providing rescues to each other from hostile takeovers and cultivate situations of collaborations sharing goodwill of each other to achieve performance heights through business combinations. The combining corporates aim at circular combinations by pursuing this objective.

(9) Desired level of integration:

Mergers and acquisition are pursued to obtain the desired level of integration between the two combining business houses. Such integration could be operational or financial. This gives birth to conglomerate combinations. The purpose and the requirements of the offeror company go a long way in selecting a suitable partner for merger or acquisition in business combinations.

Advantages of mergers and takeovers

Advantages & Disadvantages to:

(a) The acquirer company,

(b) Target company,

(c) Shareholder of the target company, and

(d) Shareholder of the acquirer company

(a) The acquirer company:

From an acquirer’s point of view, advantages of an acquisition include a shorter lead time to market, generally a lower cost vis-à-vis quick expansion and a renewed competitive edge. The motives that drive an acquirer would vary from case to case, but could broadly be classified as:

(i) Production:

· Acquire a new technology.

· Add manufacturing capacities.

· Operational synergies resulting in improved margins.

· Reduce procurement costs.

(ii) Marketing:

· Acquire new brands, products or markets

· Acquire distribution network

· Increase market share

· Synergies in marketing and distribution.

(iii) Financial:

· Enhance entity value

· Increase leveraging capability

· Lower cost of capital

· Cash inflows

· Cheaper working capital

· Tax benefits

(iv ) Tax benefits:

Exemption is allowed under approved amalgamation scheme by CBDT with regard to

· Capital gain

· Accumulated losses and unabsorbed available for set-off purposes

· Amortization of preliminary expenses.

(b) Target company:

From the seller’s (target company’s) perspective, a divestiture is contemplated when it is a mean of:

· Existing a business and cutting risks by cashing out now before competitive intensity increases

· To get rid of unrelated business and redeploy resources in core business area

(c) Shareholder of the target company:

In a successful takeover:

· All studies reveal that target company stockholders end up with huge increments in wealth in comparison to the market value of their holdings before the takeover activity.

· The wealth increment can be attributed to the premium paid by the acquirer company.

· Typically, when information about a potential takeover trickles in or rumours pervade the stock market, the market price of the target company moves upwards. The stock price improvement begins before the takeover is announced even one month in advance.

In a unsuccessful takeover:

· If the tender offer meets with failure, the target company’s share price typically remains high, in the post failure announcement scenario. Reason? The prospect of future tender offer that would strengthen share price.

· In the eventuality of no further acquisition, the share price generally tends to start sliding downwards and could even fall back to the pre-offer level. Should subsequent bids happen, the scenario reverses, with share price of the target company improving further.

· Once the failure of a takeover becomes very clear , the share price has a tendency to slip very fast to its pre-offer level.

(d) Shareholder of the acquirer company:

In a successful takeover:

· The returns to shareholders are a function of the building up of the synergies between each other as also the future strategies that the acquired firm would follow. All successful takeovers involve a premium and the justification for the premium is addressed by the expected synergy and /or improved management of the resources of the target company. so the question is whether the above factors would translate in a escalation of wealth which would suffice to offset the premium.

Consideration of Mergers and Takeover

Mergers and takeovers are two different approaches to business combinations. Mergers are pursued under the Companies Act, 1956 vide sections 391/394 thereof or may be envisaged under the provisions of Income-tax Act, 1961 or arranged through BIFR under the Sick Industrial Companies Act, 1985 whereas, takeovers fall solely under the regulatory framework of the SEBI Regulations, 1997.

Minority shareholders rights

SEBI regulations do not provide insight in the event of minority shareholders not agreeing to the takeover offer. However section 395 of the Companies Act, 1956 provides for the acquisition of shares of the shareholders. According to section 395 of the Companies Act, if the offerer has acquired at least 90% in value of those shares may give notice to the non-accepting shareholders of the intention of buying their shares. The 90% acceptance level shall not include the share held by the offerer or it’s associates. The procedure laid down in this section is briefly noted below.

1. In order to buy the shares of non-accepting shareholders the offerer must have reached the 90% acceptance level within 4 months of the date of the offer, and notice must have been served on those shareholders within 2 months of reaching the 90% level.

2. The notice to the non-accepting shareholders must be in a prescribed manner. A copy of a notice and a statutory declaration by the offerer (or, if the offerer is a company, by a director) in the prescribed form confirming that the conditions for giving the notice have been satisfied must be sent to the target.

3. Once the notice has been given, the offerer is entitled and bound to acquire the outstanding shares on the terms of the offer.

4. If the terms of the offer give the shareholders a choice of consideration, the notice must give particulars of options available and inform the shareholders that he has six weeks from the date of the notice to indicate his choice of consideration in writing.

5. At the end of the six weeks from the date of the notice to the non-accepting shareholders the offerer must immediately send a copy of notice to the target and pay or transfer to the target the consideration for all the shares to which the notice relates. Stock transfer forms executed on behalf of the non-accepting shareholders by a person appointed by the offerer must also be sent. Once the company has received stock transfer forms it must register the offerer as the holder of the shares.

6. The consideration money, which is received by the target, should be held on trust for the person entitled to shares in respect of which the sum was received.

7. Alternatively, if the offerer does not wish to buy the non-accepting shareholder’s shares, it must still within one month of company reaching the 90% acceptance level give such shareholders notice in the prescribed manner of the rights that are exercisable by them to require the offerer to acquire their shares. The notice must state that the offer is still open for acceptance and specify a date after which the right may not be exercised, which may not be less than 3 months from the end of the time within which the offer can be accepted. If the offerer fails to send such notice it (and it’s officers who are in default) are liable to a fine unless it or they took all reasonable steps to secure compliance.

8. If the shareholder exercises his rights to require the offerer to purchase his shares the offerer is entitled and bound to do so on the terms of the offer or on such other terms as may be agreed. If a choice of consideration was originally offered, the shareholder may indicate his choice when requiring the offerer to acquire his shares. The notice given to shareholder will specify the choice of consideration and which consideration should apply in default of an election.

9. On application made by an happy shareholder within six weeks from the date on which the original notice was given, the court may make an order preventing the offerer from acquiring the shares or an order specifying terms of acquisition differing from those of the offer or make an order setting out the terms on which the shares must be acquired.

In certain circumstances, where the takeover offer has not been accepted by the required 90% in value of the share to which offer relates the court may, on application of the offerer, make an order authorizing it to give notice under the Companies Act, 1985, section 429. It will do this if it is satisfied that:

a. the offerer has after reasonable enquiry been unable to trace one or more shareholders to whom the offer relates;

b. the shares which the offerer has acquired or contracted to acquire by virtue of acceptance of the offerer, together with the shares held by untraceable shareholders, amount to not less than 90% in value of the shares subject to the offer; and

c. the consideration offered is fair and reasonable.

The court will not make such an order unless it considers that it is just and equitable to do so, having regard, in particular, to the number of shareholder who has been traced who did accept the offer.

Alternative modes of acquisition

The terms used in business combinations carry generally synonymous connotations and can be used interchangeably. All the different terms carry one single meaning of “merger” but each term cannot be given equal treatment in the discussion because law has created a dividing line between ‘take-over’ and acquisitions by way of merger, amalgamation or reconstruction. Particularly the takeover Regulations for substantial acquisition of shares and takeovers known as SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 1997 vide section 3 excludes any attempt of merger done by way of any one or more of the following modes:

(a) by allotment in pursuant of an application made by the shareholders for right issue and under a public issue;

(b) preferential allotment made in pursuance of a resolution passed under section 81(1A) of the Companies Act, 1956;

(c) allotment to the underwriters pursuant to underwriters agreements;

(d) inter-se-transfer of shares amongst group, companies, relatives, Indian promoters and Foreign collaborators who are shareholders/promoters;

(e) acquisition of shares in the ordinary course of business, by registered stock brokers, public financial institutions and banks on own account or as pledges;

(f) acquisition of shares by way of transmission on succession or inheritance;

(g) acquisition of shares by government companies and statutory corporations;

(h) transfer of shares from state level financial institutions to co-promoters in pursuance to agreements between them;

(i) acquisition of shares in pursuance to rehabilitation schemes under Sick Industrial Companies (Special Provisions) Act, 1985 or schemes of arrangements, mergers, amalgamation, De-merger, etc. under the Companies Act, 1956 or any other law or regulation, Indian or Foreign;

(j) acquisition of shares of company whose shares are not listed on any stock exchange. However, this exemption in not available if the said acquisition results into control of a listed company;

(k) such other cases as may be exempted from the applicability of Chapter III of SEBI regulations by SEBI.

The basic logic behind substantial disclosure of takeover of a company through acquisition of shares is that the common investors and shareholders should be made aware of the larger financial stake in the company of the person who is acquiring such company’s shares. The main objective of these Regulations is to provide greater transparency in the acquisition of shares and the takeovers of companies through a system of disclosure of information.

Escrow account

To ensure that the acquirer shall pay the shareholders the agreed amount in redemption of his promise to acquire their shares, it is a mandatory requirement to open escrow account and deposit therein the required amount, which will serve as security for performance of obligation.

The Escrow amount shall be calculated as per the manner laid down in regulation 28(2). Accordingly:

For offers which are subject to a minimum level of acceptance, and the acquirer does want to acquire a minimum of 20%, then 50% of the consideration payable under the public offer in cash shall be deposited in the Escrow account.

Payment of consideration

Consideration may be payable in cash or by exchange of securities. Where it is payable in cash the acquirer is required to pay the amount of consideration within 21 days from the date of closure of the offer. For this purpose he is required to open special account with the bankers to an issue (registered with SEBI) and deposit therein 90% of the amount lying in the Escrow Account, if any. He should make the entire amount due and payable to shareholders as consideration. He can transfer the funds from Escrow account for such payment. Where the consideration is payable in exchange of securities, the acquirer shall ensure that securities are actually issued and dispatched to shareholders in terms of regulation 29 of SEBI Takeover Regulations.

Procedure for Takeover

and Acquisition

Public announcement:

To make a public announcement an acquirer shall follow the following procedure:

1. Appointment of merchant banker:

The acquirer shall appoint a merchant banker registered as category – I with SEBI to advise him on the acquisition and to make a public announcement of offer on his behalf.

2. Use of media for announcement:

Public announcement shall be made at least in one national English daily one Hindi daily and one regional language daily newspaper of that place where the shares of that company are listed and traded.

3. Timings of announcement:

Public announcement should be made within four days of finalization of negotiations or entering into any agreement or memorandum of understanding to acquire the shares or the voting rights.

4. Contents of announcement:

Public announcement of offer is mandatory as required under the SEBI Regulations. Therefore, it is required that it should be prepared showing therein the following information:

(1) paid up share capital of the target company, the number of fully paid up and partially paid up shares.

(2) Total number and percentage of shares proposed to be acquired from public subject to minimum as specified in the sub-regulation (1) of Regulation 21 that is:

a) The public offer of minimum 20% of voting capital of the company to the shareholders;

b) The public offer by a raider shall not be less than 10% but more than 51% of shares of voting rights. Additional shares can be had @ 2% of voting rights in any year.

(3) The minimum offer price for each fully paid up or partly paid up share;

(4) Mode of payment of consideration;

(5) The identity of the acquirer and in case the acquirer is a company, the identity of the promoters and, or the persons having control over such company and the group, if any, to which the company belong;

(6) The existing holding, if any, of the acquirer in the shares of the target company, including holding of persons acting in concert with him;

(7) Salient features of the agreement, if any, such as the date, the name of the seller, the price at which the shares are being acquired, the manner of payment of the consideration and the number and percentage of shares in respect of which the acquirer has entered into the agreement to acquirer the shares or the consideration, monetary or otherwise, for the acquisition of control over the target company, as the case may be;

(8) The highest and the average paid by the acquirer or persons acting in concert with him for acquisition, if any, of shares of the target company made by him during the twelve month period prior to the date of the public announcement;

(9) Objects and purpose of the acquisition of the shares and the future plans of the acquirer for the target company, including disclosers whether the acquirer proposes to dispose of or otherwise encumber any assets of the target company:

Provided that where the future plans are set out, the public announcement shall also set out how the acquirers propose to implement such future plans;

(10) The ‘specified date’ as mentioned in regulation 19;

(11) The date by which individual letters of offer would be posted to each of the shareholders;

(12) The date of opening and closure of the offer and the manner in which and the date by which the acceptance or rejection of the offer would be communicated to the share holders;

(13) The date by which the payment of consideration would be made for the shares in respect of which the offer has been accepted;

(14) Disclosure to the effect that firm arrangement for financial resources required to implement the offer is already in place, including the details regarding the sources of the funds whether domestic i.e. from banks, financial institutions, or otherwise or foreign i.e. from Non-resident Indians or otherwise;

(15) Provision for acceptance of the offer by person who own the shares but are not the registered holders of such shares;

(16) Statutory approvals required to obtained for the purpose of acquiring the shares under the Companies Act, 1956, the Monopolies and Restrictive Trade Practices Act, 1973, and/or any other applicable laws;

(17) Approvals of banks or financial institutions required, if any;

(18) Whether the offer is subject to a minimum level of acceptances from the shareholders; and

(19) Such other information as is essential fort the shareholders to make an informed design in regard to the offer.