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Chapter 16 Acquisitions and selling a business

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1 Chapter 16 Acquisitions and selling a business
Corporate Financial Strategy 4th edition Dr Ruth Bender Chapter 16 Acquisitions and selling a business

2 Acquisitions: contents
Learning objectives Some reasons for making an acquisition Relating synergies to value drivers Synergy checklist Adding value in an acquisition Classifying synergies Illustrative due diligence Financing the acquisition with cash Financing the acquisition with shares Buying a company for shares – some issues Buying a company for cash – some issues Acquisition strategies to enhance eps Financing the deal – who gets what? Financing strategy – regardless of the acquisition Earn-outs and deferred consideration Some defence strategies Indicative sales process

3 Acquisitions: learning objectives
Understand how and why companies make acquisitions. Critically evaluate the synergies claimed for an acquisition, and how they affect the valuation of the target business. Explain the different ways in which an acquisition can be financed, and understand how to select the most appropriate funding strategy. Appreciate the governance and finance issues surrounding hostile bids. Identify situations where an earn-out might be of use, and explain the advantages and disadvantages of this deal structure. Outline some key areas of consideration in the sale of a business.

4 Some reasons for making an acquisition
 Support strategy Complement strategy by adding in: products, markets, risk reduction, supply of raw materials, geographic expansion, etc.  Grow the business Support growth that can’t be achieved organically  Frustrate competitors Make an acquisition in order to prevent a competitor doing so  Show better profits Manipulating published financial results can improve appearance but does not add shareholder value  Managerial utility Acquisitions are quite good fun!

5 Relating synergies to value drivers
Examples of some possible synergies Increase sales growth Use Target distribution network for Bidder products, or vice versa. Complementary products can increase volumes for both. Increase operating profit margin Cost efficiencies (e.g. economies of scale or scope, or better procurement practices). Increase selling prices, e.g. due to economies of scope. Reduce cash tax rate More tax-efficient location of operations. Reduce incremental investment in capital expenditure Combine operations and sell off surplus assets. Reduce investment in working capital Combine operations and reduce inventories. Increase time period of competitive advantage Strengthened branding or R&D from the business combination. Reduce cost of capital Should only occur if one of the companies is not already financed in the most efficient manner.

6 Synergy checklist Strategic Financial Operational
Which of the value drivers will be affected by this transaction? In which direction? Why? Financial By how much will it change? When will this happen? Operational What critical success factors need to be in place to ensure this happens? What needs to be measured? Who is responsible for making it happen?

7 Adding value in an acquisition
Working capital Deal costs Cost efficiencies Zone of negotiation Increased sales Value to Vendor Value to Acquirer Maximum to pay

8 Classifying synergies
Synergies that any bidder could realize (E.g., arising through better management) Synergies that any bidder within the industry could realize (E.g. arising through consolidation of manufacturing, or distribution chains) Synergies unique to this bidder (E.g., involving the application of a particular brand or R&D capability)

9 Illustrative due diligence
Financial performance historical information systems of internal control accounting policies review of forecasts Taxation existing and potential liabilities arrangements (intra-group) transaction Economic and commercial industry analysis and key players PESTLE competitive position strategic assets order book contracts Production and operations technologies and systems Information systems IT systems and integration People and culture who’s who – management and lower tiers capabilities cultural fit Environmental and social potential liabilities legal & regulatory impact CR stance Intellectual property existence and ownership Legal and governance review of contracts potential problems and contingencies competition issues? Pensions scheme details deficit? (And assumptions) powers of trustees

10 Financing the acquisition with cash
Bidder Cash paid to shareholders Bidder Shareholders in Target Shareholders in Target Target Target’s shareholders have no stake in the business after the acquisition Target Before the acquisition After the acquisition

11 Financing the acquisition with shares
Bidder Bidder Shareholders in Target Shareholders in Target Target’s shareholders own shares in an enlarged Bidder after the acquisition Target Target Before the acquisition After the acquisition

12 Buying a company for shares – some issues
1. If the consideration is shares, who is buying whom? 2. Issuing new shares may dilute the voting control of a dominant shareholder – especially if the target has a block-holder 3. Selling shareholders share the risk of the transaction 4. Selling shareholders share the synergies 5. Both companies need to be valued 6. Offer a fixed number of shares, or fixed value? 7. Tax implications – sellers can defer a gain 8. May not be possible to offer shares in a cross-border transaction 9. Cash resources may not be available 10. Buying for shares may increase eps if acquirer has higher p/e

13 Buying a company for cash – some issues
1. Can we afford it? 2. How much will be bridge financing, how much will be longer term? 3. If bridging, when and how will a refinancing be effected? 4. Effect on the company’s credit rating, banking covenants, etc. 5. Where to raise the debt? (Banks or capital markets?) 6. Additional considerations for cross-border acquisitions – where do we raise the money? – in what currency? – tax issues, etc. 7. Buying for cash might increase eps if interest rates are less than inverse of target P/E

14 Acquisition strategies to enhance eps
‘Rule’ 1 Buy companies with a higher p/e using debt or an earn-out, to avoid dilution of eps in the short term Buy companies with a lower p/e using equity ‘Rule’ 2 Use debt if after-tax cost of debt is less than inverse of target p/e Enhancing eps is not the same as increasing shareholder value

15 Funding the deal – who gets what?
Seller gets Cash Shares Deal may not be structured as all cash or all debt – could be a mixture Deal may also be structured so that seller gets loan stock – still has some exposure to the buyer Need to consider raising funds conditionally Initial funding may not be the final structure. Borrow to do the deal, and then refinance. The refinancing may be with new debt (on better terms) or with convertibles, or with equity. Alternatively, the refinancing may be from selling assets. No further relationship between buyer and seller. No risk to seller. Buyer is geared. Cash/ debt Unlikely Buyer raises Buyer cannot afford debt, and seller does not want risk of shares, so rights issue or sale in market to fund deal, or cash underwritten offer Seller gains from synergies and shares all risks Shares

16 Financing strategies – regardless of the acquisition
GROWTH LAUNCH business risk – high financial risk – low funding – equity divi pay-out – nominal p/e high business risk – v. high financial risk – v. low funding – equity divi pay-out – nil p/e v. high MATURITY DECLINE business risk – med financial risk – medium funding – debt divi pay-out – high p/e – med business risk – low financial risk – high funding – debt divi pay-out – total p/e v. low H X The financial strategy for the acquisition should be in line with the company’s overall financing strategy Gearing X L Business risk H

17 Earn-outs and deferred consideration
BUYER CONSIDERATIONS Delays payment, or delays issue of new shares Limits eps dilution if share eventually issued at higher price Limits dilution of control, ditto Useful if future results of target are uncertain Retain managers’ commitment in handover period But… Is it sloppy negotiating? Can be difficult to combine businesses Who runs the business? Short termism. What happens after the earn-out? What if own share price falls before the end of the period? SELLER CONSIDERATIONS Gives possibility of more consideration at a later date May wish to earn salary in handover period Retains their involvement in their business But… Is it sloppy negotiating? May not want to stay on Protect against buyer changing the business model Will buyer have sufficient funds to meet the eventual liability? Fixed value or fixed number of shares for additional consideration? Will we be able to sell the shares? Tax issues need to be considered

18 Some defence tactics Make sure company is priced correctly Strategic issues and profit forecast Good relations with City Friendly shareholders Buy another company Sell/demerge units Look for a white knight Referral to competition authorities Joint ventures Poison pills

19 Indicative sales process
In the pre-sale period you need to choose advisers, undertake pre-sale grooming, review the alternatives Information memorandum to be prepared Identify potential purchasers and make contact. (Use confidentiality letters?) Initial meetings are likely to be off-site; after receiving indicative valuations, preferred bidders can have site visits Negotiations around price (often P/E-based), deal structure and conditions will lead to Heads of Agreement with preferred bidder Due diligence is done. (May use a data room) Legals completed – contracts, warranties, etc. Based on ‘Selling a Business, Corporate Finance Faculty, ICAEW, Feb 2009

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