MERGERS, ACQUISITIONS, AND DIVESTITURE
External growth occurs when a business purchases the existing assets of another entity through a merger. One is often required to appraise the suitability of a potential merger as well as participate in negotiations. Besides the growth aspect, a merger may reduce risk through diversification. The three common ways of joining two or more companies are a merger, consolidation, or a holding company.
In a merger, two or more companies are combined into one, where only the acquiring company retains its identity. Generally, the larger of the two companies is the acquirer. A merger is a business combination in which the acquiring firm absorbs a second firm, and the acquiring firm remains in business as a combination of the two merged firms. The acquiring firm usually maintains its name and identity. Mergers are legally straightforward because there is usually a single bidder and payment is made primarily with stock. The shareholders of each merging firm involved are required to vote to approve the merger. However, merger of the operations of two firms may ultimately result from an acquisition of stock.
With a consolidation, two or more companies combine to create a new company. None of the consolidation firms legally survive. For example, companies A and B give all their assets, liabilities, and stock to the new company, C, in return for C’s stock, bonds, or cash.
A holding company possesses voting control of one or more other companies. The holding company comprises a group of businesses, each operating as a separate entity. By possessing more than 50% of the voting rights through common stock, the holding company has effective control of another company with a smaller percent of ownership.
Depending on the intent of the combination, there are three common ways in which businesses get together so as to obtain advantages in their markets. They are:
- Vertical merger: This occurs when a company combines with a supplier or customer.
An example is when a wholesaler combines with retailers.
- Horizontal merger: This occurs when two companies in a similar business combine. An example is the combining of two airlines.
- Conglomerate merger: This occurs when two companies in unrelated industries combine, such as where an electronics company joins with an insurance company.
Divestiture (Restructuring Plan)
Divestiture involves the partial or complete conversion, disposition and reallocation of people, money, inventories, plants, equipment and products. It is the process of eliminating a portion of the enterprise for subsequent use of the freed resources for some other purpose. A divestment may involve a manufacturing, marketing, research or other business function.
A business segment may be subject to divestiture if they:
- Do not produce an acceptable return on invested capital.
- Do not generate sufficient cash flow.
- Fit in with the overall corporate strategy.
- Are unrelated to their primary lines of business.
- Fail to meet management goals for growth in profits, sales or in other respects.
- The worth of the pieces is greater than that of the whole.
Objectives and Types of Divestitures
The usual objectives behind divestiture are to reposition the company in a market, raise cash, and to reduce losses.
There are four primary types of divestitures:
(a) Sale of an operating unit to another firm
(b) Discharge of the managers of the unit being divested
(c) Setting up the business to be divested as a separate corporation and then giving (or “spinning off”) its stock to the divesting firm’s stockholders on a pro rata basis
(d) Outright liquidation of assets
Planning for divestitures, as for acquisitions, should be related to the company’s overall objectives and long-range plans. Typically, this process requires that management:
- Review existing operations — identify those lines that either do not relate to primary product areas or do not meet internal financial and operating goals. Special strengths and weaknesses should be inventoried. These might include, for example, the existence (or absence) of special marketing, distribution, or product facilities that might be more valuable to another company
- Calculate each operating unit’s historical and projected return on investment (historical and current value) and profit contributions.
- Determine what units are to be divested — using the information obtained in the steps above, study high-priority divestiture possibilities. Focus on (a) the attractiveness and value to others vs. the arguments for retention, (b) corrective action that might be taken and (c) the current value to the company. Only then should a decision be made about which units, if any, to divest.
- Identify logical acquirers — Identify companies, groups, or individuals for whom the particular strengths of a unit to be divested would be of most value as well as the weaknesses that would be of least concern. Consideration should also be given to selling a unit to management through a leveraged buyout or to employees through an Employee Stock Ownership Plan (ESOP).
The use of these techniques allows employees to become owners of the divested unit and thereby helps ensure their continued employment.
Valuation and Appraisal in Divestiture
There are basically four groups of methods of valuation or appraisal: (1) asset valuation methods, (2) sales and income methods, (3) market comparison methods, and (4) discounted cash flow methods.
- Asset valuation methods
Asset valuation methods are based on the asset value of a business segment. Four popular methods are described below.
Adjusted Net Book Value
One of the most conservative methods of valuation is the adjusted net book value, because it determines the value based on historical (book) value and not on market value. This can be adjusted to compensate for this shortage by adding in such items as favorable lease arrangements, and other intangible items such as customer lists, patents, and goodwill.
Another method is the replacement cost technique. It asks, “What would it cost to purchase the division’s assets new?” This method will give a higher division value than the adjusted net book value method and is therefore good for adjusting the book value to account for new costs. This figure can also be used as a basis for determining the liquidation value of the division’s assets.
The most reasonable value comes from adjusting the replacement value for depreciation and obsolescence of equipment.
The liquidation value is also a conservative estimate of a division’s value since it does not consider the division’s ongoing earning power. The liquidation value does provide the seller with a bottom line figure as to how low the price can be. The liquidation value is determined by estimating the cash value of assets assuming that they are to be sold in a short period of time. All the liabilities, real and estimated, are then deducted from the cash that was raised to determine the net liquidation value. Liquidation value can be determined based on fire sale prices or on a longer-term sales price. Obviously, the fire sale value would be lower.
Secured Loan Value
The secured loan value technique is based on the borrowing power of the division’s assets. Banks will usually lend up to 90% of the value of accounts receivable and anywhere from 10-60% on the value of inventory depending on the quantity of the inventory in the conversion process.
- Sales and income factors
Using sales and/or income figures as the basis for valuation can be made in two different ways.
Price-Earnings (P-E) Ratios
The P-E ratio for publicly held companies is known and therefore valuation is made easy. The division’s value can be determined by multiplying the P-E ratio by the expected earnings for the division. This will give a derived price that all suitors can readily understand. The earnings can be estimated from quarterly or annual reports published by the company.
For privately held companies, however, it is difficult to determine a P-E ratio as the stock of the company is not traded and the earnings are rarely disclosed. However, the earnings can be estimated and an industry average P-E ratio can be used in the calculation to estimate the private company’s sales value.
Sales or earnings multiples
There are many rules of thumb that can be used when estimating a division’s value based on a multiple of sales or earnings. For example, insurance agencies sell for 200% of annual commissions or liquor stores sell for 10 times monthly sales. Another example would be radio stations selling for 8 times earnings or cash flow. These rules are fast and dirty and may result in a completely erroneous estimate of a division’s value. Most business brokers will know these rule of thumb values to assist management in estimating the value of a division.
- Market based comparisons
Every day that a public company is traded on the stock market a new value is assigned to it by the traders. Thus, the stock price can be compared to equivalent companies, in terms of products, size of operations, and average P-E ratios. From these P-E ratios, an estimated sales price can be estimated as described earlier.
In the case of private companies, it is difficult for the buyer to determine the earnings of the company. However, they can compare the company to other companies that are publicly traded. Comparison to publicly traded companies is necessary as the sales price is typically disclosed in the sale or acquisition announcement.
- Discounted cash flow analysis
Another method of determining value of a business segment is to use discounted cash flow (DCF) analysis. This bases the value of the segment on the current value of its projected cash flow. In theory, this method should result in a division’s value being equal to that determined by one of the P-E ratio calculations, since both reflect the current worth of the company’s earnings. In actuality, discounted cash flow is basing the value of the company on actual forecasted cash flows whereas the stock market is basing the stock price on other things including the markets perception of the company and its potential cash flow.
Due to the difficulty in predicting the NCFs and also in knowing what kinds of prices will be offered for the divestment candidate, the divestment’s net present value is normally uncertain.