Mergers and Acquisitions Basics. Negotiation and Deal Structuring

224 Pages·2010·1.89 MB·English

by  Donald DePamphilis (Auth.)

1
CHAPTER
Introduction to Negotiating
Mergers and Acquisitions
Pfizer,thepharmaceuticalindustrybehemoth,wasgrowingincreasingly
uneasyinearly2008.Ithadfewblockbusterdrugsinthepipeline,and
severalofitsmajorrevenue-generatingdrugswereabouttolosepatent
protection.Pfizerhadmadeseveralmajoracquisitionsearlierinthedecade
andnowlookedtoacquireanotherdrugcompanytooffsetpotentialrev-
enuelosses.CEOJeffreyKindlerplacedacalltoWyethPharmaceutical’s
chiefexecutivethatspring.
Talksheatedupinthesummermonthsbutappearedtocollapsewhen
theglobalbankingsystemwentintoameltdownthatSeptember.Eachin
aseriesofwhatappearedtoberestartsoverthenextseveralmonthsfal-
teredonWyeth’sconcernsthatPfizercouldnotfinancethedeal.Onlyin
lateJanuary2009,whenaconsortiumofbankssignedaloancommitment,
wasanagreementreached.
Pfizer,likemanyfirmsthathaveengagedinmergersandacquisitions
(M&As)overtheyears,followedapattern:managementdeterminedthat
anacquisitionwasthebestwaytoimplementthefirm’sbusinessstrategy;
atargetwasselectedthatfitwiththestrategy;andapreliminaryfinancial
analysisyieldedsatisfactoryresults.Itwasthentimetoapproachthetarget
andinitiatenegotiations,aprocessthatgenerallybeginswiththebuyer
establishingwhatitbelievestobeareasonableinitialofferpricerange
basedonpreliminaryinformation.Althoughapotentialbuyermaywishto
avoidbeingtoospecificatfirstcontact,itmaybeunavoidable.Theseller
maydemandsomeindicationofpricebeforeproceedingtoreleaseany
additionalinformationtothebuyer.Awisebuyerintentuponproceeding
willprovideatentativepurchasepriceorindicationofvalueforthetarget
firmsubjecttoperformingadequateduediligence.
Here,negotiationisconsideredaprocessthatbeginswhenthepro-
spectivebuyermakesitsinitialcontactwiththepotentialtargetfirm,and
thetargetexpressesinterestinexploringthepossibilityofbeingacquired.
Youwilllearnaboutcommonnegotiatingstrategiesandthecomplexities
ofdealstructuring.Alsohere,negotiationintheM&Acontextisviewed
Mergers and Acquisitions Basics ©22001111ElsevierInc.
ISBN:978-0-12-374949-9,DOI:10.1016/B978-0-12-374949-9.00001-4 Allrightsreserved. 
 Mergers and Acquisitions Basics
fromacomprehensive,ormacro,perspective,notthenarrowviewpoint
ofnegotiationoftenheldbyoneoranotherofthekeyparticipantswhose
close collaboration is required for success, whether they are lawyers,
accountants,investmentbankers,orbusinessmanagers.
Wordsinbold italicsaretheonesmostimportantforyoutounder-
standfully;theyareallincludedinaglossaryattheendofthebook.
Throughout this book, a firm that attempts to acquire or merge
withanothercompanyiscalledanacquiring company,acquirer,orbidder.
Thetarget companyortargetisthefirmbeingsolicitedbytheacquiring
company.Takeoversorbuyoutsaregenerictermsforachangeinthecon-
trollingownershipinterestofacorporation.1
Key ParticiPants in negotiating Mergers and
acquisitions
Manyindividualscontributetoasuccessfullycompletednegotiation.Four
groupsplaypivotalroles:seniororoperatingmanagement,investmentbank-
ers,lawyers,andaccountants.
Senior/Operating Management
Ultimately, senior management is responsible for the business strategy
adoptedbythefirmandthefirm’sdecisiontouseanacquisitiontoimple-
mentthisstrategyinordertoachievethefirm’svisionandobjectivesrather
than“goingitalone”orpartneringwithanotherfirm.Whenthedecisionto
acquireismade,seniormanagementmustassembleateamtofindsuitable
targetfirms,approachthetargets,andnegotiateandcompleteanacquisition.
Seniormanagementisresponsibleforcommunicatingitspreferences
abouthowtheacquisitionprocessshouldbemanaged,atimetableforcom-
pletingtheacquisition,andwhowillbethe“dealowner”—theindividual
responsibleformakingitallhappen.Managementpreferencesprovideguid-
ancebystipulatingselectioncriteriaforpotentialacquisitiontargets,and
mayincludetheindustryormarketsegmenttobetargeted;theapproxi-
matesizeofthefirmormaximumpurchaseprice;financialcharacteristics
ofadesirabletargetincludingprofitabilityandgrowthrate;andnonfinancial
attributessuchasintellectualproperty,manufacturing,ordistributioncapa-
bilities.Managementmayalsoexpressawillingnesstoengageinahostile
takeover.Preferencescouldalsoindicatemanagement’schoiceoftheform
1Foramoredetaileddiscussionofthismaterial,seeDePamphilis(2009).
Introduction to Negotiating Mergers and Acquisitions 
ofpayment(stock,cash,ordebt),willingnesstoaccepttemporaryearnings
persharedilution,preferenceforastockorassetpurchase,desireforpartial
orfullownership,andlimitationsoncontactingcompetitors.
The“dealowner”—frequentlyahigh-performingmanager—leadsthe
acquisitioneffortandthenegotiation,andshouldbeappointedbysenior
managementveryearlyintheprocess.Itcouldbeafull-orpart-time
positionforsomeoneinthefirm’sbusinessdevelopmentunitoranindi-
vidualexpectedtomanagetheoperationonceacquired.Somedealown-
ersaremembersofthefirm’sbusinessdevelopmentteamwithsubstantial
deal-makingexperience.Dependingoncircumstances,itmaymakesense
toappointtwodealowners:theindividualwhowillberesponsiblefor
eventualoperationandintegrationofthetargetandanexperienceddeal-
makerinasupportingrole.
Itisthedealowner’sresponsibilitytooverseethenegotiationprocess
andensurethatthefinalagreementofpurchaseandsalesatisfiestheacquir-
ingfirm’skeyobjectives.Inanassetpurchase,thecontractshouldentitlethe
acquirertorightstospecificproducts;patents;copyrightsorbrandnames;
andallneededproprietarytechnologies,processes,andskills.Thedealowner
(inconsultationwithseniormanagement)willhavetochoosewhichliabili-
tiestoassume.Withapurchaseoftargetstockallknownandunknownassets
andliabilitiestransfertothebuyer,andthedealownerultimatelyisrespon-
sibleforensuringthatathoroughduediligencehastakenplacesothatthe
extentoftheriskassumedbythebuyeriswellunderstood.
Investment Bankers
Amidtheturmoilofthe2008creditcrisis,thetraditionalmodelofthe
mega-independentinvestment bankasahighlyleveraged,largelyunregulated,
innovativesecuritiesunderwriterandM&Aadvisorfloundered.Lehman
Brotherswasliquidated,andBearStearnsandMerrillLynchwereacquired
bycommercialbanksJPMorganChaseandBankofAmerica,respectively.
InanefforttoattractretaildepositsandtoborrowfromtheU.S.Federal
ReserveSystem(the“Fed”),GoldmanSachsandMorganStanleyconverted
tocommercialbankholdingcompaniessubjecttoFedregulation.
Althoughtheeraofthethrivingindependentinvestmentbanking
behemothmaybeover,thefinancialmarketswillcontinuetorequire
investmentbankingservices.Traditionalinvestmentbankingactivitieswill
continuetobeindemand.Theyincludeprovidingstrategicandtactical
adviceandacquisitionopportunities;screeningpotentialbuyersandsell-
ers;makinginitialcontactwithasellerorbuyer;andprovidingnegotia-
tionsupport,valuation,anddeal-structuringguidance.Alongwiththese
 Mergers and Acquisitions Basics
traditionalinvestmentbankingfunctions,thelarge“universalbanks”(e.g.,
BankofAmerica/MerrillLynch)willmaintainsubstantialbroker-dealer
operations,servingwholesaleandretailclientsinbrokerageandadvisory
capacitiestoassistwiththecomplexityandoftenhugefinancingrequire-
mentsofthemega-transactions.Investmentbanksalsooftenprovidelarge
databasesofrecenttransactions,whicharecriticalinvaluingpotentialtar-
getcompanies.
Lawyers
LawyersplayapervasiveroleinmostM&Atransactions.Theyareinti-
matelyinvolvedinstructuringthedeal,evaluatingrisk,negotiatingmany
ofthetaxandfinancialtermsandconditions(basedoninputreceived
fromaccountants;seefollowingsection),arrangingfinancing,andcoor-
dinatingthetimingandsequenceofeventstocompletethetransaction.
Specifictasksincludedraftingandreviewingtheagreementofpurchase
andsaleandothertransaction-relateddocumentation,providingopinion
ofcounselletterstothelender,anddefiningduediligenceactivities.
The legal framework surrounding a typical large transaction has
becomesocomplexthatnooneindividualcanhavesufficientexpertise
toaddressalltheissues.Forthesecomplicatedtransactions,legalteamscan
consistofmorethanadozenattorneys,eachbringingspecializedexpertise
inagivenaspectofthelawsuchasM&As,corporate,tax,employeebene-
fits,realestate,antitrust,securities,environmental,andintellectualproperty.
Inahostiletransaction,theteammaygrowtoincludelitigationexperts.In
relativelysmallprivatetransactions,lawyersplayanactiveroleinpreacqui-
sitionplanning,includingestateplanningforindividualsorfamily-owned
firms,taxplanning,andworkingwithmanagementandothercompany
advisorstohelpbetterpositionaclientforasale.
Accountants
Accountantsadviseonthemostappropriatetaxandfinancialstructures
andonperformingfinancialduediligence.Theaccountant’sinputwill
affectnotonlyhowthetransactionisstructured,butultimatelytheafter-
taxamounteachpartywillpayorreceiveinthedeal.
Atransactioncanbestructuredinmanyways,eachstructurehaving
differenttaximplicationsforthepartiesinvolved.Becausethereisoftena
conflictinthetaxadvantagesassociatedwiththesalesagreementfromthe
buyer’sandseller’sperspective,theaccountantmustunderstandbothpoints
ofviewandfindamechanismwherebybothpartiesbenefit.Incometax,
Introduction to Negotiating Mergers and Acquisitions 
capitalgains,salestax,andsometimesgiftandestatetaxesareallatplayin
negotiatingamergeroracquisition.
Accountantsalsopreparefinancialstatementsandperformaudits.Many
agreementsrequirethatthebooksandrecordsoftheacquiredentitybe
preparedinaccordancewithGenerallyAcceptedAccountingPrinciples
(GAAP),sotheaccountantmustbeintimatelyfamiliarwiththoseprin-
ciplestoassurethattheyhavebeenappliedappropriately.Theaccountant
mustrecognizewhereGAAPhasnotbeenfollowed.Inperformingdue
diligence,accountantsalsoperformtheroleofauditorsbyreviewingthe
target’sfinancialstatementsandoperationsthroughaseriesofonsitevisits
andinterviewswithseniorandmiddle-levelmanagers.
Therolesofthelawyerandaccountantmayblurdependingonthe
sizeandcomplexityofthetransaction.Sophisticatedlawfirmswithexpe-
rienceinmergersandacquisitionsusuallyhavethecapacitytoassistwith
thetaxanalysis.Furthermore,lawyersareoftenrequiredtoreviewfinan-
cialstatementsforcompliancewithprevailingsecuritieslaws.Itishelpful,
especiallywhentherecanbeanoverlapofresponsibilities,todefineclearly
whichprofessionalwillberesponsibleforwhichtasks.
Prenegotiation: Profiling the target
MarKet and firM
Profilingrequirescollectinginformationonthetargetmarketandfirm,which
isthenusedtodevelopaninitialvaluationofthefirmaswellasabaseline
notionoftheinitialtermsandconditions(e.g.,anall-cashorall-stockoffer)
thatmightmakeanacquisitionproposalattractivetoatargetfirm.
Profiling the Market/Industry
Selectingatargetfirmbeginswithidentifyingatargetmarketorindustry
(i.e.,acollectionofmarkets)intermsofthosefactorsthatdeterminehow
firmscompeteandmakemoney.MichaelPorter’s“FiveForces”framework—
whichcharacterizesafirm’smarketorindustryenvironmentintermsofsuch
competitivedynamicsasthefirm’scustomers,suppliers,currentcompetitors,
potentialcompetitors,andproductorservicesubstitutes—isaconvenientway
togrouptheinformationrequiredtoevaluateafirm’sattractiveness.2Exhibit
1-1illustratesamodifiedPorterframework.3
2Porter(1985).
3Foramoredetaileddiscussionofmarketandfirmprofiling,seeDePamphilis(2009),5thedition,
Chapter4.
 Mergers and Acquisitions Basics
EXHIBIT 1-1 Defining Market/Industry Competitive Dynamics
[See Chapter 4 in DePamphilis (2009)]
Determinants of the Intensity of Industry Competition
Competition Among Potential for New Potential for Substitute
Existing Firms Affected Entrants Affected By: Products Affected By:
By: Scale/Scope Economies Relative Prices
Industry Growth Rate First Mover Advantage Relative Performance
Industry Concentration Legal Barriers (e.g., Relative Quality
Switching Costs Patents) Relative Service
Scale/Scope Economies Limited Access to Willingness of
Excess Capacity Distribution Channels Customers to Switch
Exit Barriers Product Differentiation
Current Competitor
Retaliation
Industry Profitability/
Cash Flow
Determinants of Actual Profits and Cash Flow
Bargaining Power of Bargaining Power of Bargaining Power of
Customers Affected By: Suppliers (Incl. Labor Force Affected
Buying Criteria Material, Service, and By:
Price Sensitivity Capital) Affected By: Degree of Unionization
Switching Costs Switching Costs Management/Labor
Number and Average Differentiation Harmony
Size of Buyers Number and Average Availability of Critical
Availability of Size of Suppliers Skills
Substitutes Availability of
Substitutes
Degree of Government Global Exposure
Regulation Affected By: Affected By:
Industry Concentration Dependence on Foreign
Potential for Natural Sales
Monopoly Extent of Foreign
Potential Risk to the Operations
Public Exchange Rate
Importance to National Volatility
Defense Political Risk
Thethreepotentialdeterminantsoftheintensityofcompetitionin
anindustryincludecompetitionamongexistingfirms,thethreatofentry
ofnewfirms,andthethreatofsubstituteproductsorservices.Although
thedegreeofcompetitiondetermineswhetherthereispotentialtoearn
abnormalprofits(i.e.,thoseinexcessofwhatwouldbeexpectedforthe
Introduction to Negotiating Mergers and Acquisitions 
degreeofassumedrisk),theactualprofitsorcashflowareinfluencedby
therelativebargainingpoweroftheindustry’scustomersandsuppliers.4
Awidevarietyofdataisrequiredtoanalyzeindustrycompetitivedynam-
ics:typesofproductsandservices;marketshareintermsofdollarsand
units;pricing;sellinganddistributionchannelsandassociatedcosts;type,
location,andageofproductionfacilities;productquality;customerservice;
compensationbymajorlaborcategory;researchanddevelopment(R&D)
expenditures;supplierperformancemetrics;andfinancialperformancein
termsofgrowthandprofitability.Thesedatamustbecollectedonallsig-
nificantcompetitorsinthefirm’schosenmarkets.
Thisframeworkmaybemodifiedtoincludeotherfactorsthatdeter-
mineactualindustryprofitabilityandcashflow,suchastheseverityofgov-
ernmentregulationortheimpactofglobalinfluencessuchasfluctuating
exchangerates.Laborcostsmayalsobeincluded.Althoughtheyrepresent
arelativelysmallpercentageoftotalexpensesinmanyareasofmanufac-
turing,theyfrequentlyconstitutethelargestexpenseinthenonmanufac-
turingsector.Withthemanufacturingsectorinmostindustrializednations
continuingitslong-termdeclineasapercentageofthetotaleconomy,the
analysisshouldalsoincludefactorsaffectingthebargainingpoweroflabor.
Profiling the Firm
Withinthetargetedmarket,apotentialtargetfirmshouldbeidentified
basedonselectioncriteriasuchassize,marketshare,reputation,growth,
andsoon.Thepotentialbuyershouldthenattempttoprofilethatfirm.
Forpubliclytradedfirms,obtainingthenecessaryinformationisrelatively
easy.Publiclytradedfirmsmustsubmitauditedfinancialstatementsto
theSecuritiesandExchangeCommission(SEC),oftenaremonitoredby
securitiesanalysts,maybetopicsofdiscussioninthepopularpress,and
haveexecutiveswhotalkpubliclyaboutthefirm.Obtaininginformation
onprivatelyownedfirmsismuchmorechallenging,requiringexcellent
detectivework.Wherepossible,itmayinvolvetalkingtothefirm’scus-
tomers,suppliers,andcurrentorformeremployeesandreviewingtrade
pressarticlesandspeechesbythefirm’smanagement.
Often,potentialacquirerspaybusinessbrokersorinvestmentbankers
tovalueprivatefirmsbasedonwhatwaspaidinrecenttransactions
4Walmartprovidesanextremeexampleofrelativebargainingpower.Giventheubiquityofthe
chain’sstores,mostsuppliersofretailproductswouldliketohavetheirproductsdisplayedon
Walmart’sstoreshelvesnationwide.TheabilityofWalmarttoattractmillionsofcustomerseach
weekgivesthefirmahugeadvantageinnegotiatingthepricesitpaysitssuppliers.
 Mergers and Acquisitions Basics
involvingsimilarbusinesses.Althoughsuchestimatesareuseful,theinfor-
mationformanybusinessessimplyisnotavailable.Consequently,the
potentialbuyermustpiecetogetheravailabledatatoreconstructthefirm’s
financialstatementstothedegreepossible.Thefinancialstatementsofsimi-
larpubliclytradedfirmsmaybeausefulstartingpoint;whilethese“proxy”
publicfirmsareoftenmuchlargerthanthetargetprivatefirm,therela-
tionshipsamongvariousfinancialvariablesmaybesimilar.Forexample,
theanalystcancomputetheratiotosalesofcostofsales;sales,general,and
administrativeexpenses;assets;capitalspending;accountsreceivable;inven-
tory;andsoon.Suchratiosmaybeappliedtoestimatesofrevenueforthe
targetfirmtoapproximateitsfinancialstatements.However,theanalyst
shouldadjustforpossibledifferencesinoperatingefficiency,recognizing
thatthelargerproxyfirmmaybemoreefficientthanthesmallerfirm.5
Revenueorsomemeasureofsizesuchasunitsalesofthetargetfirm
oftencanbeobtainedfromnewspaperaccounts,speeches,orinterviews.
Thetarget’sestimatedrevenuecanbemultipliedbythefinancialratiosfor
theproxyfirm.6
Therearemanypossiblesourcesofinformation.Theyincludecomput-
erizeddatabasesanddirectoryservicessuchasStandard&Poor’sCorporate
Register,theThomas Register,andDun&Bradstreet’sMillion Dollar Directory,
whichcanbeusedtoidentifyqualifiedcandidates.Potentialacquirersmay
alsoquerytheirlaw,banking,andaccountingfirmstoidentifycandidates.
Investmentbanks,brokers,andprivateequityfirmscanbefertilesources
ofcandidates,althoughtheyarelikelytorequireanadvisoryorfinder’sfee.
TheInternetmakesresearchmucheasierthaninthepast,puttingconsider-
ableinformationattheanalyst’sfingertips.ServicessuchasGoogleFinance,
Yahoo!Finance,Hoover’s,orEDGAROnlineenableresearcherstogather
dataquicklyaboutcompetitorsandcustomers,andprovideeasyaccesstoa
varietyofpublicdocumentsfiledwiththeSEC.Exhibit1-2providesalist-
ingofcommonlyusedsourcesofinformationthatcanbehighlyusefulin
conductingasearchforprospectiveacquisitioncandidatesaswellasforper-
formingduediligence.
5Consequently,theproxyfirm’scostofsalesasapercentofsalesratioshouldbeincreasedbeforeitis
multipliedbythesmallertargetfirm’srevenuetoreflectitspotentiallyloweroperatingefficiency.
6Therefore,iftheproxyfirm’scostofsalesandassetsasapercentofsalesare60percentand
40percent,respectively,multiplyingtheseratiosbythetarget’sestimatedannualsalesof$40million
resultsinestimatesofthetargetfirm’scostofsalesandassetsof$24millionand$16million,
respectively.
Introduction to Negotiating Mergers and Acquisitions 
EXHIBIT 1-2 Information Sources on Individual Companies
SEC Filings (Public Companies Only)
0-K: Provides detailed information on a company’s annual operations, business
conditions, competitors, market conditions, legal proceedings, risk factors in
holding the stock, and other related information.
0-Q: Updates investors about the company’s operations each quarter.
S-: Filed when a company wants to register new stock. Can contain information
about the company’s operating history and business risks.
S-: Filed when a company is completing a material transaction such as a merger
or acquisition. Provides substantial detail underlying the terms and conditions
of the transaction, the events surrounding the transaction, and justification for
the merger or acquisition.
-K: Filed when a company faces a “material event” such as a merger.
Schedule A: A proxy statement. Gives details about the annual meeting and
biographies of company officials and directors including stock ownership and pay.
Websites
www.capitaliq.com
www.factset.com
www.sec.gov
www.edgar-online.com
www.freeedgar.com
www.quicken.com
www.hooversonline.com
www.aol.com
finance.yahoo.com
www.bizbuysell.com
www.dialog.com
www.lexisnexis.com
www.mergernetwork.com
www.mergers.net
www.washingtonresearchers.com
www.twst.com
www.worldm-anetwork.com
www.onesource.com
google.com/finance
Organizations
Value Line Investment Survey: Information on public companies
Directory of Corporate Affiliations: Corporate affiliations
(Continued)
0 Mergers and Acquisitions Basics
EXHIBIT 1-2 (Continued)
Lexis/Nexis: Database of general business and legal information
Thomas Register: Organizes firms by products and services
Frost & Sullivan: Industry research
Findex.com: Financial information
Competitive Intelligence Professionals: Information about industries
Dialog Corporation: Industry databases
Ward’s Business Directory of U.S. Private and Public Companies
Predicasts: Provides databases through libraries
Business Periodicals Index: Business and technical article index
Dun & Bradstreet Directories: Information about private and public companies
Dun & Bradstreet Million Dollar Directory: Specific data on large U.S. corporations
Experian: Information about private and public companies
Nelson’s Directory of Investment Research: Wall Street research reports
Standard & Poor’s Publications: Industry surveys and corporate records
Harris Infosource: Information about manufacturing companies
Hoover’s Handbook of Private Companies: Information on large private firms
Washington Researchers: Information on public and private firms, markets, and
industries
The Wall Street Journal Transcripts: Wall Street research reports
Directory of Corporate Affiliations (Published by Lexis-Nexis Group)
Estimating the Price Range of an Initial Offer
Priortomakingcontactwiththetargetfirm,youshouldhaveanideaof
whatthatthefirmmaybeworth.Again,thesellermayrefusetoprovide
thenecessaryproprietaryinformationwithoutsomeindicationofvalue
fromthebuyer.Howcanarangeofvaluesbedetermined?
Transactions in Which Synergy Is Believed to Exist
Fortransactionsinwhichthereispotentialsynergybetweentheacquirer
andtargetfirms,theinitialofferpriceforthetargetfirmliesbetweenthe
minimumandmaximumofferprices.Inapurchaseofstocktransaction,
theminimumofferpricemaybedefinedasthetarget’sstandaloneorpres-
entvalue(PV )oritscurrentmarketvalue(MV )(i.e.,thetarget’scurrent
T T
stockpricetimesitssharesoutstanding).Presentvalueisthecurrentvalueof
afirmbasedonitsexpectedfuturecashflows,theriskassociatedwiththose
cashflows,andfinancialratesofreturnonalternativeinvestmentsexhibiting
similarrisk.Thestandalonevalueisthepriceabusinesswouldcommandif