Acquisition

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What is an 'Acquisition'

An acquisition is a corporate action in which a company buys most, if not all, of another firm's ownership stakes to assume control of it. An acquisition occurs when a buying company obtains more than 50% ownership in a target company. As part of the exchange, the acquiring company often purchases the target company's stock and other assets, which allows the acquiring company to make decisions regarding the newly acquired assets without the approval of the target company’s shareholders. Acquisitions can be paid for in cash, in the acquiring company's stock or a combination of both.

BREAKING DOWN 'Acquisition'

Huge deals dominate the business section of the newspaper, such as Dow Chemical's purchase of DuPont for for $130 billion in 2015. In any given year, however, far more small to medium-sized businesses merge with and acquire one another than do large companies.

Why Make an Acquisition?

Companies perform acquisitions for various reasons. They may be seeking to achieve economies of scale, greater market share, increased synergy, cost reductions, or new niche offerings. If they wish to expand their operations to another country, buying an existing company may be the only viable way to enter a foreign market, or at least the easiest way: The purchased business will already have its own personnel (both labor and management), a brand name and other intangible assets, ensuring that the acquiring company will start off with a good customer base.

Acquisitions are often made as part of a company's growth strategy when it is more beneficial to take over an existing firm's operations than it is to expanding on its own. Large companies eventually find it difficult to keep growing without losing efficiency. Whether because the company is becoming too bureaucratic or it runs into physical or logistical resource constraints, eventually its marginal productivity peaks. To find higher growth and new profits, the large firm may look for promising young companies to acquire and incorporate into its revenue stream.

When an industry attracts too many competitor firms or when the supply from existing firms ramps up too much, companies may look to acquisitions as a way to reduce excess capacity, eliminate the competition, or focus on the most productive providers.

If a new technology emerges that could increase productivity, a company may decide that it is most cost-efficient to purchase a competitor that already has the technology. Research and development may be too difficult or take too much time, so the company offers to buy the existing assets of a company that has already gone through that process.

 

What's the Difference Between an Acquisition and a Takeover?

There is no tangible or technical difference between an acquisition and a takeover; both words can be used interchangeably, though they carry slightly different connotations. Typically, "takeover" suggests that the target company is resisting or opposed to being bought. In contrast, "acquisition" is frequently used to describe more amicable transactions, or used in conjunction with the word merger, where both companies (usually of roughly equal size) are willing to join together, sometimes to form a third company.

Friendly and Hostile Acquisitions

Acquisitions can be either friendly or hostile. Friendly acquisitions occur when the target firm expresses its agreement to be acquired. Hostile acquisitions don't have the same agreement from the target firm, and the acquiring firm must actively purchase large stakes of the target company to gain a majority.

Friendly acquisitions often work towards a mutual benefit for both the acquiring and the target companies. The companies develop strategies to ensure that the acquiring company purchases the appropriate assets, including the review of financial statements and other valuations, and that the purchase accounts for any obligations that may come with the assets. Once both parties agree to the terms and meet any legal stipulations, the purchase moves forward.

Unfriendly acquisitions, more commonly referred to as hostile takeovers, occur when the target company does not consent to the acquisition. In this case, the acquiring company must attempt to gather a majority stake to force the acquisition to go forward. To acquire the necessary stake, the acquiring company can produce a tender offer designed to encourage current shareholders to sell their holdings in exchange for an above-market value price. To complete, a 30-day acquisition notice must be filed with the Securities and Exchange Commission (SEC) with a copy directed to the target company's board of directors.

Share Prices and Acquisitions

In either case, the acquiring company often offers a premium on the market price of the target company's shares to entice shareholders to sell. For example, News Corp.'s bid to acquire Dow Jones back in 2007 was equal to a 65% premium over the stock's market price.

When a firm acquires another entity, there usually is a predictable short-term effect on the stock price of both companies. In general, the acquiring company's stock will fall while the target company's stock will rise.

The reason the target company's stock usually goes up is, of course, the premium that the acquiring company typically has to pay for the target.

The acquiring company's stock usually goes down for a number of reasons. First, as we mentioned above, the acquiring company must pay more than the target company currently is worth to make the deal go through. Beyond that, there are often a number of uncertainties involved with acquisitions. Here are some of the problems the takeover company could face during an acquisition:

  • A turbulent integration process: problems associated with integrating different workplace cultures
  • Lost productivity because of management power struggles
  • Additional debt or expenses that must be incurred to make the purchase
  • Accounting issues that weaken the takeover company's financial position, including restructuring charges and goodwill

 

Ways of Financing an Acquisition

A purchasing company can finance an acquisition by raising private equity, receiving a bank loan or striking a mezzanine financing deal that involves elements of both debt and equity financing. It's also common for sellers to finance part of an acquisition; seller financing is more common in conjunction with a bank loan.

Ever since the financial crisis of 2007-2008, when many lenders were badly burned by toxic debt, raising money to acquire a target company has become more difficult. Lenders have modified their criteria for providing credit by raising down payment requirements and carefully scrutinizing potential cash flow.

Private equity financing often takes the form of venture capital – a professionally managed pool of funds that invest in high-growth opportunities – or private equity firms. This isn't always the case, but it has proven to be an effective means of raising funds from dispersed sources and channeling them toward entrepreneurial opportunities.

Equity financing involves the buyer company selling securities in order to raise money, then using that money for both the acquisition transaction and to provide additional cash for the new company.

Bank financing takes a variety of forms. The most common is to receive a cash flow-based loan, in which case the bank scrutinizes the cash flow, debt load and profit margins of the target company.

The target company's financials are more important than the acquiring firm's; after all, the target company is the asset that eventually generates the returns that are used to pay back the loan. If there is seller financing involved, the target company may take over the actual note after the acquiring company makes the down payment.

Asset-based financing is another option. In an asset-based loan, the lender looks at the collateral (the inventory, receivables and fixed assets of the target firm) rather than the cash flow and debt loan.

Evaluating an Acquisition Candidate

Before making an acquisition, it is imperative for a company to evaluate whether its target is a good candidate. In fact, officers of companies have a fiduciary duty to perform thorough due diligence before making any acquisition.

The first step in evaluating an acquisition candidate is determining whether the asking price is reasonable. The metrics investors use to place a value on an acquisition target vary from industry to industry; one of the primary reasons acquisitions fail to take place is that the asking price for the target company exceeds these metrics.

Potential buyers should also examine the target company's debt load. A company with reasonable debt at a high interest rate that a larger company could refinance for much less often is a prime acquisition candidate; unusually high liabilities, however, should send up a red flag to potential investors. (What's been called the worst deal in the history of U.S. finance, Bank of America's 2008 acquisition of Countrywide Financial, occurred through a failure to recognize such liabilities: See Why is due diligence important before a company acquisition?).

While most businesses face a lawsuit once in a while – huge companies such as Walmart get sued several times daily – a good acquisition candidate is one that isn't dealing with a level of litigation that exceeds what is reasonable and normal for its industry and size.

A good acquisition target has clean, organized financial statements. This makes it easier for the investor to do its due diligence and execute the takeover with confidence; it also helps prevent unwanted surprises from being unveiled after the acquisition is complete.

Three of Finance History's Largest Acquisitions

The late 1990s experienced a series of multi-billion-dollar acquisitions not previously seen. From Yahoo!'s 1999 $6 billion purchase of Broadcast.com to @Home's almost $7 billion purchase of Excite, companies were interested in growth now, profitability later (if ever). In the first few weeks of 2000, such acquisitions reached their zenith.

AOL and Time Warner
AOL, the most publicized online service of its day, had built a then-remarkable subscriber base of 30 million people by offering a software suite (available on compact discs!) that entitled users to hundreds of free hours. Yes, internet usage was measured in hours back then, and you'd have to use the service 24/7, for a month at a time, to take advantage of the offer in its entirety.

Meanwhile, Time Warner was decried as an "old media" company, despite having tangible businesses (publishing, television, et al.) and an enviable income statement. In a masterful display of overweening confidence, the young upstart purchased the venerable giant for $164 billion, dwarfing all records. The relative importance of the two companies was revealed in the new entity's name, AOL Time Warner.

Two years later, AOL Time Warner lost $99 billion. The new company's market value fell by $200 billion, or significantly more than the size of the original acquisition. AOL would have been better off withdrawing 350 million $100 bills and setting them all on fire. A few years later, the companies cited irreconcilable differences and ended the marriage. Today Time Warner is a $60.0 billion company; its erstwhile purchaser was acquired by Verizon in 2015 for $4.4 billion.

Vodafone and Mannesmann
Yet AOL's ephemeral takeover of Time Warner is merely the Western Hemisphere's record holder. A few months earlier, British telecommunications company Vodafone completed a rancorous if not completely hostile takeover of German wireless provider Mannesmann. The Vodafone/Mannesmann deal cost $183 billion, in 1999 dollars—or more precisely, $183 billion in 1999 Vodafone stock. Vodafone offered and Mannesmann ultimately accepted. The deal would have been historic even without the superlative currency figure, as it represented the first foreign takeover in modern German history. Today, Mannesmann survives under the name Vodafone D2, operating exclusively in Germany as the wholly owned subsidiary of its U.K. parent.

Express Scripts and Medco
Worldwide acquisitions tailed off considerably in the ensuing decade. The value of all corporate acquisitions in 2011 was lower than the corresponding number from 14 years earlier. In fact, the largest proposed acquisition of the period never even got off the ground. Similar to the Vodafone/Mannesmann deal, it would have involved America's second-largest mobile provider, AT&T, buying number four T-Mobile for $39 billion. (Continuing the parallel, T-Mobile is a subsidiary of Germany's Deutsche Telekom.) Even though the deal was endorsed by parties as diverse as major special interest groups, most state attorneys general and multiple labor unions, the U.S. Department of Justice cited antitrust reasons and sued. The principals pulled out, leaving a far less publicized deal as the biggest buyout of the year.

In 2012, St. Louis-based Express Scripts purchased Medco for $29 billion. Both companies administer prescription drug programs, process and pay claims, and indirectly act as bulk purchasers for their millions of customers. Since the acquisition, it's estimated that one in three Americans now falls under the Express Scripts aegis.

 

After the Acquisition

Most of the attention during an acquisition goes towards valuation, market shares and legalities. Little notice is given to what happens in the aftermath, even though the success of an acquisition usually hinges on how the new company handles its many responsibilities. A new, logical corporate structure needs to be established. Resources need to be re-allocated towards their most valuable ends. Accounting processes and information have to be combined in a legal, tax-efficient way. Pre-existing business relationships should be re-assessed – including relationships with staff.

Except in rare cases, the acquiring company has to learn new operations, new customers and new suppliers. First and foremost, the new ownership needs to meet its new employees. These employees are likely to be anxious about their job status and a changing culture. It's the responsibility of new leadership to communicate effectively, make honest and fair decisions, and try to minimize the risks and costs involved in this transition.

The immediate financial information has probably been carefully considered, but now the reality of actually operating a new business is front and center. There are new logistics for the delivery of goods and services and for the integration of technology. When mergers involve large numbers of new employees, a new business command structure needs to be designed, articulated and executed.

Some companies decide to bring in third-party help to smooth this transition. Some consultants specialize in merger and acquisition (M&A) transitions and accounting integration. This can be especially helpful for management that has never been involved in an acquisition before.

Ultimately, the success or failure of an M&A deal hinges on the reaction of shareholders and customers. Many won't care if mergers put money in shareholders' pockets and the customers' products and services don't see an interruption or decline in quality. Capital and cash need to keep flowing into the firm, or the rest doesn't matter.

One mark of a successful acquisition: The acquiring firm (or the new, combined entity) displays higher earnings per share (EPS) than it previously had. this is considered an accretive acquisition. If EPS is lower following an acquisition, it is considered dilutive.