KEY ARTICLE TAKEAWAYS
Learn the difference between a merger and an acquisition
Learn how acquisitions are structured by private equity buyers and strategic buyers
Understand the challenges of a “merger of equals”
What is the difference between a merger and an acquisition?
Standard finance vernacular can be confusing to business owners who have never been through a transaction.
Many of us “finance types” in investment banking use all manner of acronyms and industry jargon that might mean nothing to a business owner, but can be very important to them when they are going through an acquisition.
Most people talk about mergers and acquisitions as being one and the same, but there are some important differences of which you should be aware. While an acquisition can take the legal form of a merger, we are going to discuss how these terms are typically used in practice.
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What is an acquisition?
Ignoring the legal technicalities of how acquisitions can use the structure of a merger, an acquisition typically denotes one company paying cash or other consideration to the shareholders of another company to “acquire” it or ultimately to own it. In an acquisition, it is usually very clear who is the “buyer” and who is the “seller”.
Acquisitions can take many forms. Strategic or industry buyers might pay cash to acquire 100% of the assets or stock of a company, or they might use a combination of cash and some of their own stock to purchase the seller’s company. At the end of the transaction, the selling shareholders end up with cash (or other consideration like notes or stock), and the buyer ends up owning the operating business. It is rare that a strategic buyer would buy less than 100% of the seller’s business.
Private equity recapitalization (acquisitions as recapitalizations)
Private equity firms also acquire companies in acquisitions, but typically through a different transaction structure.
Most private equity firms acquire companies in what is called a “recapitalization.” In a recapitalization transaction, the private equity firm will use some of its own cash and usually cash from a lender (debt) to set up a new company that will purchase a majority interest in the seller’s business. In most cases, the private equity firm will purchase 70-100% of the seller’s interests in a majority recapitalization.
But what happens to the seller’s interests that are not purchased by the private equity firm?
In what is often referred to as a “rollover investment” the seller “rolls over” the portion of their stock that is not purchased by the private equity firm into the new company that is used to purchase the seller’s company.
For example, assume a private equity firm agrees to purchase 80% of the equity interests in a business that the parties agree is worth $50 million. In this case, the private equity firm will need to come up with 80% of $50 million ($40 million) to pay the seller. The private equity firm in our example sets up a new company and invests $20 million of its own capital and the new company borrows $20 million.
In our example, the seller ends up with $40 million in cash (funded by the $20 million from the private equity firm and $20 million from a lender), and $10 million in equity in the new company (its rollover investment). The new company then has $30 million in equity capital ($20 million from the private equity firm and $10 million from the seller), and $20 million in debt.
Because of the debt financing used by the acquiring company (set up by the private equity firm), even though the seller sold 80% of the business (which suggests the seller would retain 20% of the equity), because there is only $30 million in equity being used to finance the purchase, the seller’s rollover investment of $10 million actually represents 33% of the equity in the new company.
Most private equity firms will sell the new company in 4-7 years, at which point the seller would also be able to sell their equity position.
In many cases, the seller’s rollover investment might be worth more in their second sale (sometimes called a “second bite at the apple”) than they received in cash in the first sale.
What is a merger?
While some acquisitions take the legal form of a merger (in our example, the legal structure might call for a merger of the seller’s business into the new company created by the private equity firm), here we are going to ignore the legal technicalities and talk about how mergers are considered in practice.
A merger involves two (or more) companies (we will call them Company A and Company B) combining operations and shareholder bases. A merger can take various forms, but the basic one is one in which the shareholders of Company A exchange their shares for shares in Company B.
In some rare cases, the valuations of Company A and Company B are identical, so that the shareholders of Company A end up owning 50% of the combined company, and the shareholders of Company B also own 50% of the combined company. This is rare because it is unusual that two companies would be valued exactly the same.
In most cases, the valuations for Company A and Company B are different, which will determine the relative ownership interests in the combined company. In our example, if Company A were worth $50 million and Company B were worth $100 million, the combined entity would be worth $150 million. Company A shareholders would own 33% ($50 million out of $150 million) and Company B shareholders would own the other 67%.
What are the 3 types of mergers?
The three main types of mergers are horizontal, vertical, and conglomerate.
- Horizontal Mergers: Companies in the same industry and stage of business merge to reduce costs, decrease competition, or expand product or service offerings.
- Vertical Mergers: Companies in the same industry but different stages of business merge to gain more control of the industry.
- Conglomerate Mergers: Brings companies in unrelated businesses together to reduce risk.
Where mergers go wrong - the challenges of a proposed “merger of equals”
From a practical perspective, many business owners think of a merger as a “combination of equals.” We have received dozens of calls from business owners who are contemplating a merger with another firm. They might believe that a larger company will be able to fetch a higher valuation, or there might be some other perceived benefit to bringing the two (or more) companies together.
While a “merger of equals” sounds good in theory, it usually fails in practice.
To have effective integration of the businesses and to successfully execute its go-forward strategy, the combined business is going to need a single leader and management team. The management teams might be combined and redundant positions eliminated, but having multiple leaders will make decision making very difficult and will inhibit effective integration.
We have seen multiple horror stories of companies entering into a “merger of equals,” only to disintegrate once the leaders of the respective businesses become territorial about their own teams, products, or culture. As a result, the businesses fail to integrate and ultimately fail to execute on their business plan. Turnover increases, and the overall value of the combined business is less than the sum of the two companies that merged.
With a merger, smart business owners will decide ahead of time (before the merger is consummated) who will be in charge, what personnel changes will need to be made, what product changes should be implemented, how sales strategies will be executed, and many other operational and strategic considerations.
Agreeing on these important strategic and tactical initiatives ahead of time will surface issues before the merger is completed. If the challenges are too great to overcome, then at least the leaders of the businesses will have avoided the mess of having to undo an unsuccessful marriage.
What is merger and acquisition strategy?
Merger and acquisition strategy is the driving idea or purpose behind a deal—or in other words—the motivations of the company or investor that determine the type of deal. In mergers and acquisitions, there are two types of buyers—strategic buyers and financial buyers—and the most common objectives of M&As are reducing risk and improving financial performance.
Do mergers and acquisitions create value?
If you are considering selling your company, make sure to get an objective assessment of your business ahead of time so you are not surprised by the buyer. Click on the red banner above to take our CoPilot Assessment. CoPilot will help you identify what specific risks your business has that decrease company value. CoPilot identifies over 90 different types of potential risks your company could have that will make your business less valuable in the eyes of an investor. Get the test ahead of time and build value today with CoPilot.
M&A consulting for your highest return
If you are considering either an acquisition or a merger and would like to discuss alternatives or how you can best position your company, please feel free to reach out to us at chris@classvipartners.com.
AUTHORED BY:
Bobby Motch | Head of Sponsor Coverage | Class VI Securities, LLC
As head of Sponsor Coverage, Bobby is responsible for managing financial and strategic sponsor engagement, developing sponsor-related content, and managing Class VI’s Buyer CoPilot program. Prior to his role as Head of Sponsor Coverage, Bobby was responsible for executing and closing transactions and supporting Class VI clients through financial analysis, modeling, market outreach, industry research, and valuations.
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