Types of Mergers

Mergers appear in three forms, based on the competitive relationships between the merging
parties. In a horizontal merger, one firm acquires another firm that produces and sells an
identical or similar product in the same geographic area and thereby eliminates competition
between the two firms. In a Vertical Merger, one firm acquires either a customer or a supplier.
Conglomerate mergers encompass all other acquisitions, including pure conglomerate
transactions where the merging parties have no evident relationship

Corporate Merger Procedures

State statutes establish procedures to accomplish corporate mergers. Generally, the board of
directors for each corporation must initially pass a resolution adopting a plan of merger that
specifies the names of the corporations that are involved, the name of the proposed merged
company, the manner of converting shares of both corporations, and any other legal provision to
which the corporations agree. Each corporation notifies all of its shareholders that a meeting will
be held to approve the merger. If the proper number of shareholders approves the plan, the
directors sign the papers and file them with the state. The Secretary of State issues a certificate of
merger to authorize the new corporation.

Some statutes permit the directors to abandon the plan at any point up to the filing of the final
papers. States with the most liberal corporation laws permit a surviving corporation to absorb
another company by merger without submitting the plan to its shareholders for approval unless
otherwise required in its certificate of incorporation.

Statutes often provide that corporations that are formed in two different states must follow the
rules in their respective states for a merger to be effective. Some corporation statutes require the
surviving corporation to purchase the shares of stockholders who voted against the merger.

Competitive Concerns
Horizontal, vertical, and conglomerate mergers each raise distinctive competitive concerns.

Horizontal Mergers Horizontal mergers raise three basic competitive problems. The first is the
elimination of competition between the merging firms, which, depending on their size, could be
significant. The second is that the unification of the merging firms' operations might create
substantial market power and might enable the merged entity to raise prices by reducing output
unilaterally. The third problem is that, by increasing concentration in the relevant market, the
transaction might strengthen the ability of the market's remaining participants to coordinate their
pricing and output decisions. The fear is not that the entities will engage in secret collaboration
but that the reduction in the number of industry members will enhance tacit coordination of
behavior.

Vertical Mergers Vertical mergers take two basic forms: forward Integration, by which a firm
buys a customer, and backward integration, by which a firm acquires a supplier. Replacing
market exchanges with internal transfers can offer at least two major benefits. First, the vertical
merger internalizes all transactions between a manufacturer and its supplier or dealer, thus
converting a potentially adversarial relationship into something more like a partnership. Second,
internalization can give management more effective ways to monitor and improve performance.

Vertical integration by merger does not reduce the total number of economic entities operating at
one level of the market, but it might change patterns of industry behavior. Whether a forward or
backward integration, the newly acquired firm may decide to deal only with the acquiring firm,
thereby altering competition among the acquiring firm's suppliers, customers, or competitors.
Suppliers may lose a market for their goods; retail outlets may be deprived of supplies; or
competitors may find that both supplies and outlets are blocked. These possibilities raise the
concern that vertical integration will foreclose competitors by limiting their access to sources of
supply or to customers. Vertical mergers also may be anticompetitive because their entrenched
market power may impede new businesses from entering the market.

Conglomerate Mergers Conglomerate transactions take many forms, ranging from short-term
joint ventures to complete mergers. Whether a conglomerate merger is pure, geographical, or a
product-line extension, it involves firms that operate in separate markets. Therefore, a
conglomerate transaction ordinarily has no direct effect on competition. There is no reduction or
other change in the number of firms in either the acquiring or acquired firm's market.

Conglomerate mergers can supply a market or "demand" for firms, thus giving entrepreneurs
liquidity at an open market price and with a key inducement to form new enterprises. The threat
of takeover might force existing managers to increase efficiency in competitive markets.
Conglomerate mergers also provide opportunities for firms to reduce capital costs and overhead
and to achieve other efficiencies.

Conglomerate mergers, however, may lessen future competition by eliminating the possibility
that the acquiring firm would have entered the acquired firm's market independently. A
conglomerate merger also may convert a large firm into a dominant one with a decisive
competitive advantage, or otherwise make it difficult for other companies to enter the market.
This type of merger also may reduce the number of smaller firms and may increase the merged
firm's political power, thereby impairing the social and political goals of retaining independent
decision-making centers, guaranteeing small business opportunities, and preserving democratic
processes.

Varieties of Mergers From the perspective of business structures, there is a whole host of
different mergers. Here are a few types, distinguished by the relationship between the two
companies that are merging:
 Horizontal merger - Two companies that are in direct competition and share the same
product lines and markets.
 Vertical merger - A customer and company or a supplier and company. Think of a cone
supplier merging with an ice cream maker.
 Market-extension merger - Two companies that sell the same products in different
markets.
 Product-extension merger - Two companies selling different but related products in the
same market.
 Conglomeration - Two companies that have no common business areas. There are two
types of mergers that are distinguished by how the merger is financed. Each has certain
implications for the companies involved and for investors:
o Purchase Mergers - As the name suggests, this kind of merger occurs when one
company purchases another. The purchase is made with cash or through the issue of some
kind of debt instrument; the sale is taxable. Acquiring companies often prefer this type of
merger because it can provide them with a tax benefit. Acquired assets can be written-up to
the actual purchase price, and the difference between the book value and the purchase
price of the assets can depreciate annually, reducing taxes payable by the acquiring
company. We will discuss this further in part four of this tutorial.
o Consolidation Mergers - With this merger, a brand new company is formed and both
companies are bought and combined under the new entity. The tax terms are the same as
those of a purchase merger.

Valuation Matters
Investors in a company that is aiming to take over another one must determine whether the
purchase will be beneficial to them. In order to do so, they must ask themselves how much
the company being acquired is really worth.
Naturally, both sides of an M&A deal will have different ideas about the worth of a target
company: its seller will tend to value the company at as high of a price as possible, while
the buyer will try to get the lowest price that he can. There are, however, many legitimate
ways to value companies. The most common method is to look at comparable companies in
an industry, but deal makers employ a variety of other methods and tools when assessing a
target company. Here are just a few of them:
1. Comparative Ratios - The following are two examples of the many comparative metrics
on which acquiring companies may base their offers:
o Price-Earnings Ratio (P/E Ratio) - With the use of this ratio, an acquiring company makes
an offer that is a multiple of the earnings of the target company. Looking at the P/E for all
the stocks within the same industry group will give the acquiring company good guidance
for what the target's P/E multiple should be.
o Enterprise-Value-to-Sales Ratio (EV/Sales) - With this ratio, the acquiring company
makes an offer as a multiple of the revenues, again, while being aware of the price-to-sales
ratio of other companies in the industry.
2. Replacement Cost - In a few cases, acquisitions are based on the cost of replacing the
target company. For simplicity's sake, suppose the value of a company is simply the sum of
all its equipment and staffing costs. The acquiring company can literally order the target to
sell at that price, or it will create a competitor for the same cost. Naturally, it takes a long
time to assemble good management, acquire property and get the right equipment. This
method of establishing a price certainly wouldn't make much sense in a service industry
where the key assets - people and ideas - are hard to value and develop.

3. Discounted Cash Flow (DCF) - A key valuation tool in M&A, discounted cash flow
analysis determines a company's current value according to its estimated future cash flows.
Forecasted free cash flows (operating profit + depreciation + amortization of goodwill –
capital expenditures – cash taxes - change in working capital) are discounted to a present
value using the company's weighted average costs of capital (WACC). Admittedly, DCF is
tricky to get right, but few tools can rival this valuation method.

Motives behind M&A

The dominant rationale used to explain M&A activity is that acquiring firms seek improved
financial performance. The following motives are considered to improve financial performance:

 Economy of scale: This refers to the fact that the combined company can often reduce its fixed
costs by removing duplicate departments or operations, lowering the costs of the company
relative to the same revenue stream, thus increasing profit margins.
 Economy of scope: This refers to the efficiencies primarily associated with demand-side changes,
such as increasing or decreasing the scope of marketing and distribution, of different types of
products.
 Increased revenue or market share: This assumes that the buyer will be absorbing a major
competitor and thus increase its market power (by capturing increased market share) to set
prices.
 Cross-selling: For example, a bank buying a stock broker could then sell its banking products to
the stock broker's customers, while the broker can sign up the bank's customers for brokerage
accounts. Or, a manufacturer can acquire and sell complementary products.
 Synergy: For example, managerial economies such as the increased opportunity of managerial
specialization. Another example are purchasing economies due to increased order size and
associated bulk-buying discounts.
 Taxation: A profitable company can buy a loss maker to use the target's loss as their advantage
by reducing their tax liability. In the United States and many other countries, rules are in place
to limit the ability of profitable companies to "shop" for loss making companies, limiting the tax
 motive of an acquiring company. Tax minimization strategies include purchasing assets of a non-
performing company and reducing current tax liability under the Tanner-White PLLC Troubled
Asset Recovery Plan.
 Geographical or other diversification: This is designed to smooth the earnings results of a
company, which over the long term smoothens the stock price of a company, giving
conservative investors more confidence in investing in the company. However, this does not
always deliver value to shareholders (see below).
 Resource transfer: resources are unevenly distributed across firms (Barney, 1991) and the
interaction of target and acquiring firm resources can create value through either overcoming
information asymmetry or by combining scarce resources.[5]
 Vertical integration: Vertical integration occurs when an upstream and downstream firm merge
(or one acquires the other). There are several reasons for this to occur. One reason is to
internalise an externality problem. A common example is of such an externality is double
marginalization. Double marginalization occurs when both the upstream and downstream firms
have monopoly power, each firm reduces output from the competitive level to the monopoly
level, creating two deadweight losses. By merging the vertically integrated firm can collect one
deadweight loss by setting the downstream firm's output to the competitive level. This increases
profits and consumer surplus. A merger that creates a vertically integrated firm can be
profitable.[6]
 "Acq-hire": An "acq-hire" (or acquisition-by-hire) may occur especially when the target is a small
private company or is in the startup phase. In this case, the acquiring company simply hires the
staff of the target private company, thereby acquiring its talent (if that is its main asset and
appeal). The target private company simply dissolves and little legal issues are involved. Acq-
hires have become a very popular type of transaction in recent years. [7]
 Absorption of similar businesses under single management: similar portfolio invested by two
different mutual funds (Ahsan Raza Khan, 2009) namely united money market fund and united
growth and income fund, caused the management to absorb united money market fund into
united growth and income fund.</ref>

However, on average and across the most commonly studied variables, acquiring firms' financial
performance does not positively change as a function of their acquisition activity.[8] Therefore,
additional motives for merger and acquisition that may not add shareholder value include:

 Diversification: While this may hedge a company against a downturn in an individual industry it
fails to deliver value, since it is possible for individual shareholders to achieve the same hedge
by diversifying their portfolios at a much lower cost than those associated with a merger. (In his
book One Up on Wall Street, Peter Lynch memorably termed this "diworseification".)
 Manager's hubris: manager's overconfidence about expected synergies from M&A which results
in overpayment for the target company.
 Empire-building: Managers have larger companies to manage and hence more power.
 Manager's compensation: In the past, certain executive management teams had their payout
based on the total amount of profit of the company, instead of the profit per share, which
would give the team a perverse incentive to buy companies to increase the total profit while
decreasing the profit per share (which hurts the owners of the company, the shareholders);
although some empirical studies show that compensation is linked to profitability rather than
mere profits of the company.
Economic Rationale for Mergers and Acquisitions
Increased Market Power: Market power is the ability of a firm to alter the market price of a good or
service. In perfectly competitive markets, market participants have no market power. A firm with market
power can raise prices without losing its customers to competitors

Overcoming Entry Barriers: A barrier of entry is defined as an obstruction that makes it difficult for a
company to enter into an industry.

Read more at Suite101: How to Overcome Barriers of Entry: Strategies for Small Entrepreneurs to
Penetrate New Markets | Suite101.com http://www.suite101.com/content/how-to-overcome-barriers-
of-entry-a47625#ixzz1LIm1Ctg3

If a merger will substantially increase concentration to the point where a competition agency is concerned about
possible anticompetitive effects, entry barriers matter because competition will not be reduced if new firms would enter
easily, quickly and significantly.

Avoiding the Cost of New Product Development: The thrill is indescribable – your new product, after a
huge investment in dollars and effort, takes off like a
rocket.
Wow.
Such successful new products bring dramatic benefits:
♦ Rapid company growth
♦ Increased sales and stature with customers
♦ Higher margins and
Increased Speed to Market
Lower Risk
Increased Diversification
Reshaping the Firm's Competitive Scope