Corporate RestructuringModule - 1IntroductionWith Indian corporate houses showing sustained growth over the last decade, many have shown an interestin growing globally by choosing to acquire or merge with other companies outside India. One such examplewould be the acquisition of Britain’s Corus by Tata an Indian conglomerate by way of a leveraged buy-out.The Tatas also acquired Jaguar and Land Rover in a significant cross border transaction. Whereas bothtransactions involved the acquisition of assets in a foreign jurisdiction, both transactions were alsogoverned by Indian domestic law.Whether a merger or an acquisition is that of an Indian entity or it is an Indian entity acquiring a foreignentity, such a transaction would be governed by Indian domestic law. In the sections which follow, we touchup on different laws with a view to educate the reader of the broader areas of law which would be ofsignificance. Mergers and acquisitions are methods by which distinct businesses may combine. Jointventures are another way for two businesses to work together to achieve growth as partners in progress,though a joint venture is more of a contractual arrangement between two or more businesses.Corporate Restructuring Classifications A. MERGERS AND AMALGAMATIONS.The term ‘merger’ is not defined under the Companies Act, 1956 (the ‘Companies Act’), the Income TaxAct, 1961 (the ‘ITA’) or any other Indian law. Simply put, a merger is a combination of two or more distinctentities into one; the desired effect being not just the accumulation of assets and liabilities of the distinctentities, but to achieve several other benefits such as, economies of scale, acquisition of cutting edgetechnologies, obtaining access into sectors / markets with established players etc. Generally, in a merger, themerging entities would cease to be in existence and would merge into a single surviving entity.Very often, the two expressions "merger" and "amalgamation" are used synonymously. But there is, in fact, adifference. Merger generally refers to a circumstance in which the assets and liabilities of a company(merging company) are vested in another company (the merged company). The merging entity loses itsidentity and its shareholders become shareholders of the merged company. On the other hand, anamalgamation is an arrangement, whereby the assets and liabilities of two or more companies (amalgamatingcompanies) become vested in another company (the amalgamated company). The amalgamating companies
all lose their identity and emerge as the amalgamated company; though in certain transaction structures theamalgamated company may or may not be one of the original companies. The shareholders of theamalgamating companies become shareholders of the amalgamated company.While the Companies Act does not define a merger or amalgamation, Sections 390 to 394 of the CompaniesAct deal with the analogous concept of schemes of arrangement or compromise between a company, itshareholders and/or its creditors. A merger of a company ‘A’ with another company ‘B’ would involve twoschemes of arrangements, one between A and its shareholders and the other between B and its shareholders.Mergers may be of several types, depending on the requirements of the merging entities:Horizontal Mergers. Also referred to as a ‘horizontal integration’, this kind of merger takes place betweenentities engaged in competing businesses which are at the same stage of the industrial process.2 A horizontalmerger takes a company a step closer towards monopoly by eliminating a competitor and establishing astronger presence in the market. The other benefits of this form of merger are the advantages of economies ofscale and economies of scope.Vertical Mergers. Vertical mergers refer to the combination of two entities at different stages of theindustrial or production process. For example, the merger of a company engaged in the construction businesswith a company engaged in production of brick or steel would lead to vertical integration. Companies standto gain on account of lower transaction costs and synchronization of demand and supply. Moreover, verticalintegration helps a company move towards greater independence and self-sufficiency. The downside of avertical merger involves large investments in technology in order to compete effectively.Congeneric Mergers. These are mergers between entities engaged in the same general industry andsomewhat interrelated, but having no common customer-supplier relationship. A company uses this type ofmerger in order to use the resulting ability to use the same sales and distribution channels to reach thecustomers of both businesses.3Conglomerate Mergers. A conglomerate merger is a merger between two entities in unrelated industries.The principal reason for a conglomerate merger is utilization of financial resources, enlargement of debtcapacity, and increase in the value of outstanding shares by increased leverage and earnings per share, and bylowering the average cost of capital.4 A merger with a diverse business also helps the company to foray intovaried businesses without having to incur large start-up costs normally associated with a new business.Cash Merger. In a typical merger, the merged entity combines the assets of the two companies and grantsthe shareholders of each original company shares in the new company based on the relative valuations of thetwo original companies. However, in the case of a ‘cash merger’, also known as a ‘cash-out merger’, the
shareholders of one entity receive cash in place of shares in the merged entity. This is a common practice incases where the shareholders of one of the merging entities do not want to be a part of the merged entity.Triangular Merger. A triangular merger is often resorted to for regulatory and tax reasons. As the namesuggests, it is a tripartite arrangement in which the target merges with a subsidiary of the acquirer. Based onwhich entity is the survivor after such merger, a triangular merger may be forward (when the target mergesinto the subsidiary and the subsidiary survives), or reverse (when the subsidiary merges into the target and thetarget survives).B. ACQUISITIONS.An acquisition or takeover is the purchase by one company of controlling interest in the share capital, or allor substantially all of the assets and/or liabilities, of another company. A takeover may be friendly or hostile,depending on the offerer company’s approach, and may be effected through agreements between the offererand the majority shareholders, purchase of shares from the open market, or by making an offer for acquisitionof the offeree’s shares to the entire body of shareholders.Friendly takeover. Also commonly referred to as ‘negotiated takeover’, a friendly takeover involves anacquisition of the target company through negotiations between the existing promoters and prospectiveinvestors. This kind of takeover is resorted to further some common objectives of both the parties.Hostile Takeover. A hostile takeover can happen by way of any of the following actions: if the board rejectstheoffer, but the bidder continues to pursue it or the bidder makes the offer without informing the boardbeforehand. The acquisition of one company (called the target company) by another (called the acquirer) thatis accomplished not by coming to an agreement with the target companys management, but by going directlyto the company’s shareholders or fighting to replace management in order to get the acquisition approved. Ahostile takeover can be accomplished through either a tender offer or a proxy fight.Leveraged Buyouts. These are a form of takeovers where the acquisition is funded by borrowed money.Oftenthe assets of the target company are used as collateral for the loan. This is a common structure when acquirerswish to make large acquisitions without having to commit too much capital, and hope to make the acquiredbusiness service the debt so raised.Bailout Takeovers. Another form of takeover is a ‘bail out takeover’ in which a profit making companyacquires a sick company. This kind of takeover is usually pursuant to a scheme ofreconstruction/rehabilitation with the approval of lender banks/financial institutions. One of the primary
motives for a profit making company to acquire a sick/loss making company would be to set off of the lossesof the sick company against the profits of the acquirer, thereby reducing the tax payable by the acquirer. Thiswould be true in the case of a merger between such companies as well.C. STRATEGIC ALLIANCEA partnership with another business in which you combine efforts in business efforts in a business effortinvolving anything from getting a better price for goods by buying bulk together, to seeking businesstogether, with each of you providing part of the product. The basic idea behind alliances is to minimize riskwhile maximising your leverage.D. JOINT VENTURES.A joint venture is the coming together of two or more businesses for a specific purpose, which may or maynot be for a limited duration. The purpose of the joint venture may be for the entry of the joint venture partiesinto a new business, or the entry into a new market, which requires the specific skills, expertise, or theinvestment of each of the joint venture parties. The execution of a joint venture agreement setting out therights and obligations of each of the parties is usually a norm for most joint ventures. The joint ventureparties may also incorporate a new company which will engage in the proposed business. In such a case, thebyelaws of the joint venture company would incorporate the agreement between the joint venture parties.E. DEMERGERS.A demerger is the opposite of a merger, involving the splitting up of one entity into two or more entities. Anentity which has more than one business, may decide to ‘hive off’ or ‘spin off’ one of its businesses into anew entity. The shareholders of the original entity would generally receive shares of the new entity. If one ofthe businesses of a company is financially sick and the other business is financially sound, the sick businessmay be demerged from the company. This facilitates the restructuring or sale of the sick business, withoutaffecting the assets of the healthy business. Conversely, a demerger may also be undertaken for situating alucrative business in a separate entity. A demerger, may be completed through a court process under theMerger Provisions, but could also be structured in a manner to avoid attracting the Merger Provisions.The terms "demerger", "spin-off" and "spin-out" are sometimes used to indicate a situation where onecompany splits into two, generating a second company which may or may not become separately listed on astock exchange.F. DIVESTITURESA Divestiture is the sale of part of a company to a third party. Assets, product lines, subsidiaries, or divisionsare sold for cash or securities or some combination thereof. The buyers are typically other corporations or,increasingly, investor groups together with the current managers of the divested operation.
Reasons : Dismantling Conglomerates Restructuring activity Adding Value by selling into a better fit Large additional investment required Harvesting Past investments successfully Discarding Unwanted Business divisionsG. LEVERAGED BUYOUTS (LBO)A leveraged Buyout or “Bootstrap” transaction occurs when a financial sponsor gains control of a majorityof a target company’s equity through the use of borrowed money or debt. A LBO is essentially a strategyinvolving the acquisition of another company using a significant amount of borrowed money (bonds or loans)to meet the cost of acquisition. Often, the assets of the company being acquired are used as collateral for theloans in addition to the assets of the company.H. EMPLOYEE STOCK OPTION PLAN (ESOP)ESO plans are allows employees can buy company’s stock after certain length of employment or they canbuy share at any time. Some corporations have policies to compensate employees with company’s sharesinstead of other monetary benefits. This will increase the accountability and commitment of employee withhis work and organizational growth. At the same time accumulation of shares to employees hands alsoweakens the power of top management.I. SELL-OFFSA sell-off, also known as a divestiture, is the outright sale of a company subsidiary. Normally, sell-offs are donebecause the subsidiary doesnt fit into the parent companys core strategy. The market may be undervaluing thecombined businesses due to a lack of synergy between the parent and subsidiary. As a result, management and theboard decide that the subsidiary is better off under different ownership.J. EQUITY CARVE-OUTS More and more companies are using equity carve-outs to boost shareholder value.A parent firm makes a subsidiary public through an initial public offering (IPO) of shares, amounting to a partialsell-off. A new publicly-listed company is created, but the parent keeps a controlling stake in the newly tradedsubsidiary
K. SPINOFFS A spinoff occurs when a subsidiary becomes an independent entity. The parent firm distributes shares of thesubsidiary to its shareholders through a stock dividend. Since this transaction is a dividend distribution, no cash isgenerated. Thus, spinoffs are unlikely to be used when a firm needs to finance growth or deals. Like the carve-out,the subsidiary becomes a separate legal entity with a distinct management and board.KE Merger & AcquisitionBasic ConceptsMergers and acquisitions represent the ultimate in change for a business. No other event is more difficult,challenging, or chaotic as a merger and acquisition. It is imperative that everyone involved in the processhas a clear understanding of how the process works. Hopefully this short course will provide you with abetter appreciation of what is involved. You might be asking yourself, why do I need to learn the merger andacquisition (M & A) process?Well for starters, mergers and acquisitions are now a normal way of life within the business world. In todaysglobal, competitive environment, mergers are sometimes the only means for long-term survival. In othercases, such as Cisco Systems, mergers are a strategic component for generating long-term growth.Additionally, many entrepreneurs no longer build companies for the long-term; they build companies for theshort-term, hoping to sell the company for huge profits. In her book The Art of Merger and AcquisitionIntegration, Alexandra Reed Lajoux puts it best: Virtually every major company in the United States todayhas experienced a major acquisition at some point in history.M & A DefinedWhen we use the term "merger", we are referring to the merging of two companies where one new companywill continue to exist. The term "acquisition" refers to the acquisition of assets by one company from anothercompany. In an acquisition, both companies may continue to exist. However, throughout this course we willloosely refer to mergers and acquisitions ( M & A ) as a business transaction where one company acquiresanother company. The acquiring company will remain in business and the acquired company (which we willsometimes call the Target Company) will be integrated into the acquiring company and thus, the acquiredcompany ceases to exist after the merger.
Distinction between Mergers and AcquisitionsAlthough they are often uttered in the same breath and used as though they were synonymous, the terms mergerand acquisition mean slightly different things.When one company takes over another and clearly established itself as the new owner, the purchase is called anacquisition. From a legal point of view, the target company ceases to exist, the buyer "swallows" the business andthe buyers stock continues to be traded.In the pure sense of the term, a merger happens when two firms, often of about the same size, agree to go forwardas a single new company rather than remain separately owned and operated. This kind of action is more preciselyreferred to as a "merger of equals." Both companies stocks are surrendered and new company stock is issued in itsplace. For example, both Daimler-Benz and Chrysler ceased to exist when the two firms merged, and a newcompany, DaimlerChrysler, was created.In practice, however, actual mergers of equals dont happen very often. Usually, one company will buy anotherand, as part of the deals terms, simply allow the acquired firm to proclaim that the action is a merger of equals,even if its technically an acquisition. Being bought out often carries negative connotations, therefore, bydescribing the deal as a merger,Merger Theories Differential efficiency theory. Inefficient management theory. Synergy. Pure diversification. Strategic realignment to changing environment. Hubris hypothesis
Differential efficiency theory. According to this theory if the management of firm A is more efficient than the firm B and if the firm A acquires firm B, the efficiency of firm B is likely to be brought up to the level of the firm A. The theory implies that some firms operate below their potential and as a result have below average efficiency. Such firms are most vulnerable to acquisition by other more efficient firms in the same industry. This is because firms with greater efficiency would be able to identify firms with good potential but operating at lower efficiency. According to this theory, some firms operate below their potential and consequently have low efficiency. Such firms are likely to be acquired by other, more efficient firms in the same industry. This is because, firms with greater efficiency would be able to identify firms with good potential operating at lower efficiency. They would also have the managerial ability to improve the latter’s performance. However, a difficulty would arise when the acquiring firm overestimates its impact on improving the performance of the acquired firm. This may result in the acquirer paying too much for the acquired firm. Alternatively, the acquirer may not be able to improve the acquired firm’s performance up to the level of the acquisition value given to it. The managerial synergy hypothesis is an extension of the differential efficiency theory. It states that a firm, whose management team has greater competency than is required by the current tasks in the firm, may seek to employ the surplus resources by acquiring and improving the efficiency of a firm, which is less efficient due to lack of adequate
managerial resources. Thus, the merger will create a synergy, since the surplus managerial resources of the acquirer combine with the non-managerial organizational capital of the firm. When these surplus resources are indivisible and cannot be released, a merger enables them to be optimally utilized. Even if the firm has no opportunity to expand within its industry, it can diversify and enter into new areas. However, since it does not possess the relevant skills related to that business, it will attempt to gain a ‘toehold entry’ by acquiring a firm in that industry, which has organizational capital alongwith inadequate managerial capabilities. Inefficient management theory. This is similar to the concept of managerial efficiency but it is different in that inefficient management means that the management of one company simply is not performing upto its potential. Inefficient management theory simply represents that is incompetent in the complete sense. Synergy. Synergy refers to the type of reactions that occur when two substances or factors combine to produce a greater effect together than that which the sum of the two operating independently could account for. The ability of a combination of two firms to be more profitable than the two firms individually. There are two types of synergy: Financial synergy.
Operating synergy. Pure diversification. Diversification provides numerous benefits to managers, employees, owners of the firms and to the firm itself. Diversification through mergers is commonly preferred to diversification through internal growth, given that the firm may lack internal resources or capabilities requires. Strategic realignment to changing environment. It suggests that the firms use the strategy of M&As as ways to rapidly adjust to changes in their external environments. When a company has an opportunity of growth available only for a limited period of time slow internal growth may not be sufficient. Hubris hypothesis Hubris hypothesis implies that manager’s look for acquisition of firms for their own potential motives and that the economic gains are not the only motivation for the acquisitions. This theory is particularly evident in case of competitive tender offer to acquire a target. The urge to win the game often results in the winners curse refers to the ironic hypothesis that states that
the firm which overestimates the value of the target mostly wins the contest.Module - IIValuing synergy in M&A deals AEvery merger has its own unique reasons why the combining of two companies is a good business decision.The underlying principle behind mergers and acquisitions ( M & A ) is simple: 2 + 2 = 5. The value ofCompany A is $ 2 billion and the value of Company B is $ 2 billion, but when we merge the two companiestogether, we have a total value of $ 5 billion. The joining or merging of the two companies creates additionalvalue which we call "synergy" value.Synergy value can take three forms:
1. Revenues: By combining the two companies, we will realize higher revenues then if the two companiesoperate separately.2. Expenses: By combining the two companies, we will realize lower expenses then if the two companiesoperate separately.3. Cost of Capital: By combining the two companies, we will experience a lower overall cost of capital.Why Mergers?- MotivesThe dominant rationale used to explain M&A activity is that acquiring firms seek improved financial performance. Thefollowing 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 brokers customers, while the broker can sign up the banks 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 targets 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. 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. Vertical integration: Vertical integration occurs when an upstream and downstream firm merges (or one acquires the other). There are several reasons for this to occur. One reason is to internalize an externality problem. A common example of such an externality is double marginalization. Double marginalization occurs when both the upstream and downstream firms have monopoly power and each
firm reduces output from the competitive level to the monopoly level, creating two deadweight losses. Following a merger, the vertically integrated firm can collect one deadweight loss by setting the downstream firms output to the competitive level. This increases profits and consumer surplus. A merger that creates a vertically integrated firm can be profitable. Hiring: some companies use acquisitions as an alternative to the normal hiring process. This is especially common 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. Absorption of similar businesses under single management: similar portfolio invested by two different mutual funds 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. However, on average and across the most commonly studied variables, acquiring firms financialperformance does not positively change as a function of their acquisition activity.  Therefore, additionalmotives 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.Objectives in a M&A transaction? An opportunity for achieving faster growth Obtaining tax concessions Eliminating competition Achieving diversification with minimum cost Improving corporate image and business value Gaining access to management or technical talentObjective for Companies to offer themselves for sale? Declining earnings and profitability To raise funds for more promising lines of business Desire to maximize growth Give itself the benefit of image of larger company Lack of adequate management or technical skills
For the most part, the biggest source of synergy value is lower expenses. Many mergers are driven by theneed to cut costs. Cost savings often come from the elimination of redundant services, such as HumanResources, Accounting, Information Technology, etc. However, the best mergers seem to have strategicreasons for the business combination.These strategic reasons include:Positioning - Taking advantage of future opportunities that can be exploited when the two companiesare combined. For example, a telecommunications company might improve its position for the future if itwere to own a broad band service company. Companies need to position themselves to take advantage ofemerging trends in the marketplace.Gap Filling - One company may have a major weakness (such as poor distribution) whereas the othercompany has some significant strength. By combining the two companies, each company fills-in strategicgaps that are essential for long-term survival.Organizational Competencies - Acquiring human resources and intellectual capital can help improveinnovative thinking and development within the company.Broader Market Access - Acquiring a foreign company can give a company quick access to emergingglobal markets.Mergers can also be driven by basic business reasons, such as:Bargain Purchase - It may be cheaper to acquire another company then to invest internally. Forexample, suppose a company is considering expansion of fabrication facilities. Another company has verysimilar facilities that are idle. It may be cheaper to just acquire the company with the unused facilities then togo out and build new facilities on your own.Diversification - It may be necessary to smooth-out earnings and achieve more consistent long-termgrowth and profitability. This is particularly true for companies in very mature industries where future growthis unlikely. It should be noted that traditional financial management does not always support diversificationthrough mergers and acquisitions. It is widely held that investors are in the best position to diversify, not themanagement of companies since managing a steel company is not the same as running a softwarecompany.Short Term Growth - Management may be under pressure to turnaround sluggish growth andprofitability. Consequently, a merger and acquisition is made to boost poor performance.
Undervalued Target - The Target Company may be undervalued and thus, it represents a goodinvestment. Some mergers are executed for "financial" reasons and not strategic reasons. For example,Kohlberg Kravis & Roberts acquires poor performing companies and replaces the management team inhopes of increasing depressed values.The Overall ProcessThe Merger & Acquisition Process can be broken down into five phases:Phase 1 - Pre Acquisition Review: The first step is to assess your own situation and determine if a mergerand acquisition strategy should be implemented. If a company expects difficulty in the future when it comesto maintaining core competencies, market share, return on capital, or other key performance drivers, then amerger and acquisition (M & A) program may be necessary.Phase 2 - Search & Screen Targets: The second phase within the M & A Process is to search for possibletakeover candidates. Target companies must fulfill a set of criteria so that the Target Company is a goodstrategic fit with the acquiring company. For example, the targets drivers of performance should complimentthe acquiring company. Compatibility and fit should be assessed across a range of criteria - relative size,type of business, capital structure, organizational strengths, core competencies, market channels, etc. It isworth noting that the search and screening process is performed in-house by the Acquiring Company.Reliance on outside investment firms is kept to a minimum since the preliminary stages of M & A must behighly guarded and independent.Phase 3 - Investigate & Value the Target: The third phase of M & A is to perform a more detail analysis ofthe target company. You want to confirm that the Target Company is truly a good fit with the acquiringcompany. This will require a more thorough review of operations, strategies, financials, and other aspects ofthe Target Company. This detail review is called "due diligence." Specifically, Phase I Due Diligence isinitiated once a target company has been selected. The main objective is to identify various synergy valuesthat can be realized through an M & A of the Target Company. Investment Bankers now enter into the M & Aprocess to assist with this evaluation.Phase 4 - Acquire through Negotiation: Now that we have selected our target company, its time to start theprocess of negotiating a M & A. We need to develop a negotiation plan based on several key questions:How much resistance will we encounter from the Target Company?What are the benefits of the M & A for the Target Company?What will be our bidding strategy?How much do we offer in the first round of bidding?The most common approach to acquiring another company is for both companies to reach agreementconcerning the M & A; i.e. a negotiated merger will take place. This negotiated arrangement is sometimes
called a "bear hug." The negotiated merger or bear hug is the preferred approach to a M & A since havingboth sides agree to the deal will go a long way to making the M & A work.Phase 5 - Post Merger Integration: If all goes well, the two companies will announce an agreement to mergethe two companies. The deal is finalized in a formal merger and acquisition agreement. This leads us to thefifth and final phase within the M & A Process, the integration of the two companies. Every company isdifferent - differences in culture, differences in information systems, differences in strategies, etc. As a result,the Post Merger Integration Phase is the most difficult phase within the M & A Process. Now all of a suddenwe have to bring these two companies together and make the whole thing work. This requires extensiveplanning and design throughout the entire organization.The integration process can take place at three levels:1. Full: All functional areas (operations, marketing, finance, human resources, etc.) will be merged into onenew company. The new company will use the "best practices" between the two companies.2. Moderate: Certain key functions or processes (such as production) will be merged together. Strategicdecisions will be centralized within one company, but day to day operating decisions will remainautonomous.3. Minimal: Only selected personnel will be merged together in order to reduce redundancies. Both strategicand operating decisions will remain decentralized and autonomous. As mentioned at the start of this course,mergers and acquisitions are extremely difficult. Expected synergy values may not be realized andtherefore, the merger is considered a failure.Some of the reasons behind failed mergers are:Poor strategic fit - The two companies have strategies and objectives that are too different and theyconflict with one another.Cultural and Social Differences - It has been said that most problems can be traced to "peopleproblems." If the two companies have wide differences in cultures, then synergy values can be very elusive.Incomplete and Inadequate Due Diligence - Due diligence is the "watchdog" within the M& A Process.If you fail to let the watchdog do his job, you are in for some serious problems within the M & A Process.
Poorly Managed Integration - The integration of two companies requires a very high levelof quality management. In the words of one CEO, "give me some people who know the drill." Integration isoften poorly managed with little planning and design. As a result, implementation fails.Paying too Much - In todays merger frenzy world, it is not unusual for the acquiring company to pay apremium for the Target Company. Premiums are paid based on expectations of synergies. However, ifsynergies are not realized, then the premium paid to acquire the target is never recouped.Overly Optimistic - If the acquiring company is too optimistic in its projections about the TargetCompany, then bad decisions will be made within the M & A Process. An overly optimistic forecast orconclusion about a critical issue can lead to a failed merger.M & A Valuation approachesValuation of Target CompanyThe principal incentive for a merger is that the business value of the combined business is expected to begreater than the sum of the independent business values of the merging entities. The difference between thecombined value and the sum of the values of individual companies is the synergy gain attributable to theM&A transaction. Hence,Value of acquirer + Stand alone value of Target + Value of Synergy = Combined Value.There is also a cost attached to an acquisition. The cost of acquisition is the price premium paid over themarket value plus other costs of integration. Therefore, the net gain is the value of synergy minus premiumpaid.SupposeVA = Rs. 200 (Merging Company, or Acquirer)VB = Rs. 50 (Merging Company, or Target)VAB = Rs. 300 (Merged or Amalgamated Entity)Therefore,Synergy = VAB – ( VA + VB ) = Rs. 50. If the premium paid for this merger is Rs. 20, Net gain from mergerof A and B will be Rs. 30 (i.e. Rs. 50 – Rs. 20). It is this 30, because of which companies merge or acquire.One of the essential steps in M&A is the valuation of the Target Company. Analysts use a wide range ofmodels in practice for measuring the value of the Target firm. These models often make very differentassumptions about pricing, but they do share some common characteristics and can be classified in broader
terms. There are several advantages to such a classification: it is easier to understand where individualmodels fit into the bigger picture, why they provide different results and where they have fundamentalerrors in logic.There are only three approaches to value a business or business interest. However, there are numeroustechniques within each one of the approaches that the analysts may consider in performing a valuation. TheApproaches and Techniques are as follows: - 1. Income ApproachThe Income Approach is one of three major groups of methodologies, called valuation approaches, used byappraisers. It is particularly common in commercial real estate appraisal and in business appraisal. Thefundamental math is similar to the methods used for financial valuation, securities analysis, or bond pricing.However, there are some significant and important modifications when used in real estate or businessvaluation.Under this approach two primary used methods to value a business interest include:a) Discounted Cash flow methodb) Capitalized Cash flow methodEach of these methods depends on the present value of an enterprise’s future cash flows.Discounted Cash flow TechniqueThe Discounted Cash flow valuation is based upon the notion that the value of an asset is the present value ofthe expected cash flows on that asset, discounted at a rate that reflects the riskiness of those cash flows. Thenature of the cash flows will depend upon the asset, dividends for an equity share, coupons and redemptionvalue for bonds and the post tax cash flows for a project. The Steps involved in valuation under this methodare as under:FCFE Technique (Free Cash Flow From Equity)The Capitalized Cash flow technique of income approach is the abbreviated version of Discounted Cash flowtechnique where the growth rate (g) and the discount rate (k) are assumed to remain constant in perpetuity.This model is represented as under:Value of Firm = Net Cash flow in year one ( k – g )
2. Market ApproachThe origin of market approach of business valuation is established in the economic rationale ofcompetition. It states that in case of a free market, the demand and supply effects direct the value of businessproperties to a particular balance. The purchasers are not ready to pay higher amounts for the business andthe vendors are not ready to receive any amount, which is lower in comparison to the value of acorresponding commercial entity. It is the value of a firm by performing a comparison between the firmsconcerned with organizations in the similar location, of equal volume or operating in the similar sector.It has a large number of resemblances with the comparable sales technique, which is generally utilized in caseof real estate estimation. The market value of shares of companies that are traded publicly and are involved inidentical commercial activities may be a logical signal of the value of commercial operation. In this case thecompany shares are bought and sold in an open and free market. This process allows purposeful comparisonof the market value of shares.The problem exists in distinguishing public companies, which are adequately corresponding to the companyconcerned for this intention. In addition, in case of a private company, the liquidity of the equity is lower (putdifferently, its shares are difficult to trade) in comparison to a public company. The value is regarded assomewhat lesser in comparison to that a market-based valuation will render.E.g. - Suppose a company operating in the same industry as ABC with comparable size and other situationshas been sold at Rs. 500 crores in last week provides a good measurement for valuation of business.Considering the circumstances, 10 value of the business of ABC should be around Rs. 500 crores undermarket approach. 3. Assets ApproachThe first step in using the assets approach is to obtain a Balance Sheet as close as possible to the valuationdate. Each recorded asset including intangible assets must be identified, examined and adjusted to fair marketvalue. Now all liabilities are to be subtracted, again at fair market value, from the value of assets derived asabove to reach at the fair market value of equity of the business. It is important to note here that anyunrecorded assets or liabilities should also be considered while arriving at the value of business by the assetsapproach.
Net Asset Value ApproachNet asset value (NAV) is a term used to describe the value of an entitys assets less the value of its liabilities.The term is most commonly used in relation to open-ended or mutual funds due to the fact that shares of suchfunds are redeemed at their net asset value.Economic Value Added (EVA) ApproachEconomic Value Added or EVA is an estimate of economic profit, which can be determined, among otherways, by making corrective adjustments to GAAP accounting, including deducting the opportunity cost ofequity capital. EVA is similar to Residual Income (RI), although under some definitions there may be minortechnical differences between EVA and RI (for example, adjustments that might be made to NOPAT before itis suitable for the formula below).Market Value Added Approach (MVA)Market Value Added (MVA) is the difference between the current market value of a firm and the capitalcontributed by investors. If MVA is positive, the firm has added value. If it is negative, the firm hasdestroyed value. The amount of value added needs to be greater than the firms investors could have achievedinvesting in the market portfolio, adjusted for the leverage (beta coefficient) of the firm relative to the market.The formula for MVA is:MVA = V – KWhere:MVA is market value added, V is the market value of the firm, including the value of the firms equity anddebt K is the capital invested in the firm The higher the MVA the better it is. A high MVA indicates thecompany has created substantial wealth for the shareholders. A negative MVA means that the value ofmanagements actions and investments are less than the value of the capital contributed to the company by thecapital market (or that wealth and value have been destroyed).Legal and Regulatory ConsiderationsIntroductionWhen one company decides to acquire another company, a series of negotiations will take place betweenthe two companies. The acquiring company will have a well-developed negotiating strategy and plan in
place. If the Target Company believes a merger is possible, the two companies will enter into a "Letter ofIntent."The Letter of Intent outlines the terms for future negotiations and commits the Target Company to givingserious consideration to the merger. A Letter of Intent also gives the acquiring company the green light tomove into Phase II Due Diligence. The Letter of Intent attempts to answer several issues concerning theproposed merger:1. How will the acquisition price be determined?2. What exactly are we acquiring? Is it physical assets, is it a controlling interest in the target, is it intellectualcapital, etc.?3. How will the merger transaction be designed? Will it be an outright purchase of assets? Will it be anexchange of stock?4. What is the form of payment? Will the acquiring company issue stock, pay cash, issue notes, or use acombination of stock, cash, and/or notes?5. Will the acquiring company setup an escrow account and deposit part of the purchase price? Will theescrow account cover unrecorded liabilities discovered from due diligence?6. What is the estimated time frame for the merger? What law firms will be responsible for creating the M &A Agreement?7. Will there be any adjustment to the final purchase price due to anticipated losses or events prior to theclosing of the merger?M &M & A AgreementM & A AgreementAs the negotiations continue, both companies will conduct extensive Phase II Due Diligence in an effort toidentify issues that must be resolved for a successful merger. If significant issues can be resolved and bothcompanies are convinced that a merger will be beneficial, then a formal merger and acquisition agreementwill be formulated. The basic outline for the M & A Agreement is rooted in the Letter of Intent. However,Phase II Due Diligence will uncover several additional issues not covered in the Letter of Intent.Consequently, the M & A Agreement can be very lengthy based on the issues exposed through Phase IIDue Diligence. Additionally, both companies need to agree on the integration process. For example, aTransition Service Agreement is executed to cover certain types of services, such as payroll.The Target Company continues to handle payroll up through a certain date and once the integration processis complete, the acquiring company takes over payroll responsibilities. The Transition Service Agreementwill specify the types of services, timeframes, and fees associated with the integration process.IndemnificationAnother important element within the M & A Agreement is indemnification. The M & A Agreement will specifythe nature and extent to which each company can recover damages should a misrepresentation or breach ofcontract occur. A "basket" provision will stipulate that damages are not due until the indemnification amount
has reached a certain threshold. If the basket amount is exceeded, the indemnification amount becomespayable at either the basket amount or an amount more than the basket amount. The seller (TargetCompany) will insist on having a ceiling for basket amounts within the M & A Agreement.Since both sides may not agree on indemnification, it is a good idea to include a provision on how disputeswill be resolved (such as binding arbitration). Finally, indemnification provisions may include a "right of selloff" for the buyer since the buyer has deposited part of the purchase price into an escrow account. The Rightto Sell Off allows the buyer (acquiring company) to offset any indemnification claims against amountsdeferred within the purchase price of the merger. If the purchase price has been paid, then legal action maybe necessary to resolve the indemnification.Accounting For M & AOne last item that we should discuss is the application of accounting principles to mergers and acquisitions.Currently, there are two methods that are used to account for mergers and acquisitions (M & A):Purchase: The M & A is viewed prospectively (restate everything and look forward) by treating thetransaction as a purchase. Assets of the Target Company are restated to fair market value and thedifference between the price paid and the fair market values are posted to the Balance Sheet as goodwill.Pooling of Interest: The M & A is viewed historically (refer back to existing values) by combining the bookvalues of both companies. There is no recognition of goodwill. It should be noted that Pooling of Interestapplies to M & As that involve stock only. In the good old days when physical assets were important; thePurchase Method was the leading method for M & A accounting. However, as the importance of intellectualcapital and other intangibles has grown, the Pooling of Interest Method is now the dominant method forM & A accounting. However, therein lies the problem. Because intangibles have become so important tobusinesses, the failure to recognize these assets from an M & A can seriously distort the financialstatements. As a result, the Financial Accounting Standards Board has proposed the elimination of thePooling of Interest Method. If Pooling is phased out, then it will become much more important to properlyarrive at fair market values for the targets assets.Module – IIISEBI Takeover CodeSECURITIES AND EXCHANGE BOARD OF INDIA. Takeover CodeIf an acquisition is contemplated by way of issue of new shares 20, or the acquisition of existing shares, of aListed company, to or by an acquirer, the provisions of the Takeover Code may be applicable. Under theTakeover Code, an acquirer, along with persons acting in concert. cannot acquire shares or voting rights which (taken together with shares or voting rights, if any, held byhim and by persons acting in concert), entitle such acquirer to exercise 15% or more of the shares or voting
rights in the target, who has acquired, 15% or more but less than 55% of the shares or voting rights in the target, cannotacquire, either by himself or through persons acting in concert who holds 55% or more but less than 75% of the shares or voting rights in the target, cannot acquireeither by himself or through persons acting in concert, any additional shares or voting rights therein who holds 75% of the shares or voting rights in the target, cannot acquire either by himself or throughpersons acting in concert, any additional shares or voting rights therein. unless the acquirer makes a public announcement to acquire the shares or voting rights of the target inaccordance with the provisions of the Takeover Code. The term ‘acquisition’ would include both, directacquisition in an Indian listed company as well as indirect acquisition of an Indian listed company by virtueof acquisition of companies, whether listed or unlisted, whether in India or abroad. Further, the aforesaidlimit of 5% acquisition is calculated aggregating all purchases, without netting of sales.However, vide a recent amendment, any person holding 55% or more (but less than 75%) shares is permittedto further increase his shareholding by not more than 5% in the target without making a public announcementif the acquisition is through open market purchase in normal segment on the stock exchange but not throughbulk deal /block deal/ negotiated deal/ preferential allotment or the increase in the shareholding or votingrights of the acquirer is pursuant to a buyback of shares by the target.Though there were certain ambiguities as to the period during which the 5% limit can be exhausted, SEBI hasclarified that the 5% limit shall be applicable during the lifetime of the target without any limitation as tofinancial year or otherwise. However, just like the acquisition of 5% up to 55%, the acquisition is calculatedaggregating all purchases, without netting of sales.The SEBI may also require valuation of such infrequently traded shares by an independent valuer.Mode of payment of offer price. The offer price may be paid in cash, by issue, exchange or transfer of shares(Other than preference shares) of the acquirer, if the acquirer is a listed entity, by issue, exchange or transferof secured instruments of the acquirer with a minimum ‘A’ grade rating from a credit rating agency registeredwith the SEBI, or a combination of all of the aboveNon-compete payments. Payments made to persons other than the target company under any non-competeagreement exceeding 25% of the offer price arrived at as per the requirements mentioned above, must beadded to the offer price.
Pricing for indirect acquisition or control. The offer price for indirect acquisition or control shall bedetermined with reference to the date of the public announcement for the parent company and the date of thepublic announcement for acquisition of shares of the target company, whichever is higher, in accordance withrequirements set out above. If the acquirer intends to dispose of / encumber the assets in the target company, except in the ordinarycourse of business, then he must make such a disclosure in the public announcement or in the letter of offer tothe shareholders, failing which, the acquirer cannot dispose of or encumber the assets of the target companyfor a period of 2 years from the date of closure of the public offerRestrictions on the target company.After the public announcement is made by the acquirer, the targetcompany is also subject to certain restrictions. The target company cannot then (a) sell, transfer, encumber orotherwise dispose off or enter into an agreement for sale, transfer, encumbrance or for disposal of assets,except in the ordinary course of business of the target company and its subsidiaries, (b) issue or allot anysecurities carrying voting rights during the offer period, except for any subsisting obligations, and (c) enterinto any material contracts.The following acquisitions / transfers would be exempt from the key provisions of the Takeover Code: acquisition pursuant to a public issue; acquisition by a shareholder pursuant to a rights issue to the extent of his entitlement and subject tocertain other restrictions; inter-se transfer of shares amongst:o qualifying Indian promoters and foreign collaborators who are shareholders,o qualifying promoter, provided that the parties have been holding shares in the target company for aperiod of at least three years prior to the proposed acquisition,o the acquirer and PAC, where the transfer of shares takes place three years after the date of closure ofthe public offer made by them under the Takeover Code and the transfer is at a price not exceeding125% of the price determined as per the Takeover Code (as mentioned above); acquisition of shares in the ordinary course of business by (a) banks and public financial institutions aspledgees, (b) the International Finance Corporation, Asian Development Bank, International Bank forReconstruction and Development, Commonwealth Development Corporation and such other internationalfinancial institutions; acquisition of shares by a person in exchange of shares received under a public offer made under theTakeover Code;
acquisition of shares by way of transmission on succession or inheritance; transfer of shares from venture capital funds or foreign venture capital investors registered with the SEBIto promoters of a venture capital undertaking or to a venture capital undertaking, pursuant to anagreement between such venture capital fund or foreign venture capital investors, with such promoters orventure capital undertaking; change in control by takeover of management of the borrower target company by the secured creditor orby restoration of management to the said target company by the said secured creditor in terms of theSecuritization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002; acquisition of shares in companies whose shares are not listed on any stock exchange, unless it results inthe acquisition shares/voting rights/control of a company listed in India; and acquisition of shares in terms of guidelines or regulations regarding delisting of securities framed by theSEBI.Financing M&A DealsMergers are generally differentiated from acquisitions partly by the way in which they are financed and partlyby the relative size of the companies. Various methods of financing an M&A deal exist:CashPayment by cash. Such transactions are usually termed acquisitions rather than mergers because theshareholders of the target company are removed from the picture and the target comes under the (indirect)control of the bidders shareholders.StockPayment in the form of the acquiring companys stock, issued to the shareholders of the acquired company ata given ratio proportional to the valuation of the latter.Financing optionsThere are some elements to think about when choosing the form of payment. When submitting an offer, theacquiring firm should consider other potential bidders and think strategically. The form of payment might bedecisive for the seller. With pure cash deals, there is no doubt on the real value of the bid (withoutconsidering an eventual earn out). The contingency of the share payment is indeed removed. Thus, a cashoffer preempts competitors better than securities. Taxes are a second element to consider and should be
evaluated with the counsel of competent tax and accounting advisers. Third, with a share deal the buyer’scapital structure might be affected and the control of the buyer modified.If the issuance of shares is necessary, shareholders of the acquiring company might prevent such capitalincrease at the general meeting of shareholders. The risk is removed with a cash transaction. Then, thebalance sheet of the buyer will be modified and the decision maker should take into account the effects on thereported financial results. For example, in a pure cash deal (financed from the company’s current account),liquidity ratios might decrease. On the other hand, in a pure stock for stock transaction (financed from theissuance of new shares), the company might show lower profitability ratios (e.g. ROA). However, economicdilution must prevail towards accounting dilution when making the choice. The form of payment andfinancing options are tightly linked. If the buyer pays cash, there are three main financing options: Cash on hand: it consumes financial slack (excess cash or unused debt capacity) and may decreasedebt rating. There are no major transaction costs. It consumes financial slack, may decrease debt rating and increase cost of debt. Transaction costs include underwriting or closing costs of 1% to 3% of the face value. Issue of stock: it increases financial slack, may improve debt rating and reduce cost of debt. Transaction costs include fees for preparation of a proxy statement, an extraordinary shareholder meeting and registration.If the buyer pays with stock, the financing possibilities are: Issue of stock (same effects and transaction costs as described above). Shares in treasury: it increases financial slack (if they don’t have to be repurchased on the market), may improve debt rating and reduce cost of debt. Transaction costs include brokerage fees if shares are repurchased in the market otherwise there are no major costs.In general, stock will create financial flexibility. Transaction costs must also be considered but tend to have agreater impact on the payment decision for larger transactions. Finally, paying cash or with shares is a way tosignal value to the other party, e.g.: buyers tend to offer stock when they believe their shares are overvaluedand cash when undervalued.Specialist M&A advisory firmsAlthough at present the majority of M&A advice is provided by full-service investment banks, recent yearshave seen a rise in the prominence of specialist M&A advisers, who only provide M&A advice (and notfinancing). These companies are sometimes referred to as Transition companies, assisting businesses oftenreferred to as "companies in transition." To perform these services in the US, an advisor must be a licensedbroker dealer, and subject to SEC (FINRA) regulation. More information on M&A advisory firms is providedat corporate advisory
DEBT RESTRUCTURINGDebt restructuring is a process that allows a private or public company facing cash flow problems and financialdistress, to reduce and renegotiate its delinquent debts in order to improve or restore liquidity and rehabilitate so that itcan continue its operations.A debt restructuring is usually less expensive and a preferable alternative to bankruptcy. The main costs associatedwith a business debt restructuring are the time and effort to negotiate with bankers, creditors, vendors and taxauthorities. Debt restructurings typically involve a reduction of debt and an extension of payment termsDefinition of Debt RestructuringA method used by companies with outstanding debt obligations to alter the terms of the debtagreements in order to achieve some advantage.Companies use debt restructuring to avoid default on existing debt or to take advantage of a lower interestrate. A company will often issue callable bonds to allow them to readily restructure debt in the future. Theexisting debt is called and then replaced with new debt at a lower interest rate. Companies can alsorestructure their debt by altering the terms and provisions of the existing debt issue.Related termsReplacement of old debt by new debt when not under financial distress is referred to as RefinancingDebt consolidation entails taking out one loan to pay off many others. This is often done to secure a lower interestrate, secure a fixed interest rate or for the convenience of servicing only one loanShare Buyback (or) Share RepurchaseA program by which a company buys back its own shares from the marketplace, reducing the number ofoutstanding shares. Share repurchase is usually an indication that the companys management thinks theshares are undervalued. The company can buy shares directly from the market or offer its shareholder theoption to tender their shares directly to the company at a fixed price.Because a share repurchase reduces the number of shares outstanding (i.e. supply), it increases earnings pershare and tends to elevate the market value of the remaining shares. When a company does repurchase shares,it will usually say something along the lines of, "We find no better investment than our own company."
1. Shareholders may be presented with a tender offer whereby they have the option to submit (or tender) a portion or all of theirshares within a certain time frame and at a premium to the current market price. This premium compensates investors for tenderingtheir shares rather than holding on to them.2. Companies buy back shares on the open market over an extended period of time.Share RepurchaseAlternative to the payment of cash dividends, the company may purchase the shares back. Purchase of sharesoutstanding can be done through the secondary market Stock Exchange. Shares purchased are included intreasury stock account. Theoretically, the value of the company before and after the purchase of shares will bethe same again.The Advantages of Stock Repurchases • Buying back shares could save on taxes. • Announcement of buy-back could be considered a positive signal by investors, because Stock repurchases often driven by the motivation of managers who assume that the undervalued stock price (lower than they should). • Payment of dividends is usually done with a stable pattern. • Shareholders have the option to Stock Repurchases. When need cash, they can sell the shares they acquire. Conversely, if do not need cash, or evading taxes, they can invest back into the company stock. • In some specific situations, Stock Repurchases done selectivelyThe Disadvantages of Stock Repurchases • The shareholders may have different preferences between cash dividends and Stock Repurchases (profits derived from capital gains). Cash dividends tend to be ‘unreliable’ because it gives a clear income (cash received), and relatively stable. • The Company may pay the repurchase price is too high, to the detriment of current shareholders (who still holds the shares). • Shareholders who sell their shares may not know exactly the implications and the Stock Repurchases program effects. If it turns out to feel aggrieved, they can sue the company.•Merits of Share RepurchaseReduce takeover chances:B u yi n g b a c k s t o c k u s e s u p e x c e s s c a s h . T h e r e t u r n s o n e x c e s s c a s h i n m o n e y m a r k e ta c c o u n t s c a n d r a g d o w n o v e r a l l company performance. Cash rich companies are also very attractive
takeover t a r g e t s . B u yi n g b a c k s t o c k a l l o w s t h e c o m p a n y t o e a r n a b e t t e r r e t u r n o nexcess cash and keep itself from becoming a takeover target.•Increase ROE:Buying back stock can increase the return on equity (ROE). T h i s e f f e c t i s g r e a t e r t h e m o r eu n d e r v a l u e d t h e s h a r e s a r e w h e n t h e y a r e repurchased. If shares are undervalued, this may be themost profitable course of action for the company.• Psychological Effect:W h e n a c o m p a n y p u r c h a s e s i t s o w n s t o c k i t i s essentially telling the marke t t h a t t h e y t h i n k t h a t t h e c o m p a n y’ s s t o c k i s undervalued. This can have a psychological effecton the market.•Buying back stock allows a company to pass on extra cash to shareholders without raising thedividend. If the cash is temporary in nature it may prove more beneficial to pass on value toshareholders through buybacks rather than raising the dividend.• Excellent Tool for Financial Reengineering:In the case of profit making, h i g h d i v i d e n d -p a y i n g c o m p a n i e s w h o s e s h a r e p r i c e s a r e l a n g u i s h i n g , buybacks can actually boosttheir bottom lines since dividends attract taxes. A b u y b a c k a n d t h e s u b s e q u e n t n e u t r a l i s a t i o n o fs h a r e s c a n r e d u c e d i v i d e n d outflows, and if the opportunity cost of funds used is lower than thedividend savings, the company can laugh all the way to the bank.• Tax Implication:E x e m p t i o n i s a v a i l a b l e o n l y i f t h e s h a r e s a r e s o l d o n a recognised stock exchange andif securities transaction tax (STT) on the sale h a s b e e n p a i d . I n a b u yb a c k s c h e m e ,n e i t h e r d o e s t h e s a l e t a k e p l a c e o n a recognised exchange nor is the STT paid. So, you will haveto pay income tax on your long-term capital gain on the buyback after deducting the acquisition cost of yourshares plus the benefit of indexation from the year of purchase to the year of buyback. On the resultantgain, the tax would be 20 per cent plus the applicable surcharge, if any, plus 2 per cent education cess.You may also work out the tax at 10 per cent of the gain without considering indexation. Your taxliability will be limited to the lower of the two calculations.•Stock buybacks also raise the demand for the stock on the open market. This point is ratherself explanatory as the company is competing against other investors to purchase shares of its ownstock.
Demerits of Share Repurchase:• Sending Negative Signals:A buyback announcement can send a negative signal i n t h e s e s i t u a t i o n s . A t yp i c a l e x a m p l e i st h e H P c a s e : F r o m N o v e m b e r 1 9 9 8 through October 2000, the computer giant Hewlett-Packard spent $8.2 billion to buy back 128 million of its shares. The aim was to make opportunisticpurchases of HP stock at attractive prices—in other words, at prices they felt undervalued thecompany. Instead of signalling good operating prospects to the market, the buyback signal wascompletely drowned out more powerful contradictory signalsabout the company’s future which are an aborted acquisition, a protracted businessr e s t r u c t u r i n g , s l i p p i n g f i n a n c i a l r e s u l t s , a n d a d e c a y i n t h e g e n e r a l profitability of keymarkets. By last January, HP’s shares were trading at around half the average $64 per share paid torepurchase the stock.•Backfire:Buybacks can also backfire for a company competing in a high-growth industry because they may beread as an admission that the company has few i m p o r t a n t n e w o p p o r t u n i t i e s o n w h i c h t oo t h e r w i s e s p e n d i t s m o n e y . I n s u c h cases, long-term investors will respond to a buybackannouncement by selling the company’s sharesThe share buyback scheme might become a big disadvantage to the company when itp a ys t o o m u c h f o r i t s o w n s h a r e s . I n d e e d , i t i s f o o l i s h t o b u y i n a n overpriced market.Instead, the company should put the money into assets that can be easily converted back into cash. Thisway, when the market swings the other way and is trading below its true value, shares of the companycan be bought back at a discount, ensuring current shareholders receive maximum benefit. Strictly,acompany should repurchase its shares only when its stock is trading below its expected valueand when no better investment opportunities are available.PROVISIONS / CONDITIONS RELATING TO BUYBACK.The restrictions were imposed to restrict the companies from using the stock markets as short term moneyprovider apart from protecting interests of small investors. Sec 77A: Power of a company to purchase its ownsecurities. Section 77A was introduced by the Companies (Amendment) Act, 1999, pursuant to the report of
the working group which was set up to suggest reforms to the Companies Act. Section 77A(2) of theCompanies Act, 1956:1)Authorised by Articles of Association and a Special Res olution2)Buyback should be equal to or less than 25%of the total paid upc a p i t a l a n d f r e e reserves3)Shares to be bought back should be fully paid up4)Debt Equity ratio should not exceed 2:1 post buyback5)Notice of meeting to the shareholders should have all the details necessary6)Buyback of shares listed on any recognised stock exchange should be in accordance withSEBI guidelines7)Explanatory statement stating the following should be prepared-a)A full and complete disclosure of all material facts;b ) T h e n e c e s s i t y f o r t h e b u y- b a c kc)The class of security intended to be purchased under the buy-back;d)The amount to be invested under the buy-back; ande ) T h e t i m e l i m i t f o r c o m p l e t i o n o f b u y- b a c k8)A declaration of solvency has to be filed with SEBI and Registrar Of Companies9)Completion of the buyback should be within 12 months10) The shares bought back should be extinguished and physically destroyed;11) The company should not make any further issue of securities within 2 years, except bonus,conversion of warrants, etc.DETERMINATION OF SWAP RATIO M&A DEALS
Definition of Swap RatioThe ratio in which an acquiring company will offer its own shares in exchange for the target companysshares during a merger or acquisition. To calculate the swap ratio, companies analyze financialratios such as book value, earnings per share, profits after tax and dividends paid, as well as otherfactors, such as the reasons for the merger or acquisition.For example, if a company offers a swap ratio of 1:1.5, it will provide one share of its own company forevery 1.5 shares of the company being acquired.This can also be applied as a debt/equity swap, when a company wants investors to trade their bondswith the company being acquired for the acquiring companys own shares.Swap Ratio (or Exchange Ratio)The shareholders of the amalgamating company are given the shares of the amalgamated company inexchange for the shares held by them in the amalgamating company. For example when TOMCO wasemerged with Hindustan Lever Limited, shareholders of TOMCO were given the shares of Hindustan LeverLimited in the ratio of 2:15; that means 2 shares of Hindustan lever Limited were given in lieu of 15 shares ofTOMCO . How is the exchange ratio determined? The commonly used bases for establishing the exchangeratio are: earnings per share, market price per share, and book value per share.Earnings per share: Suppose the earnings per share of the acquiring firm are Rs 5.00 and the earnings pershare of the target firm Rs 2.00. An exchange ratio based on earnings per share will be 0.4 that is (2/5). Thismeans 2 shares of the acquiring firms will be exchanged for 5 shares of the target firm.While earnings per share reflect prime facie the earnings power, there are some problems in an exchangeratio based solely on current earnings per share of the merging companies because it fails to take into accountthe following:* The difference in the growth rates of earnings of the two companies* The gains in earnings arising out of merger* The differential risks associated with the earnings of the two companies
Moreover, there is the measurement problem of defining the normal level of current earnings. The currentearnings per share may be influenced by certain transient factors like a windfall profit, or an abnormal laborproblem, or a large tax relief. Finally, how can earnings per share, when they are negative, be used?Market Price per share: The exchange ratio may be based on the relative market prices of the shares of theacquiring firm and the target firm. For example, if the acquiring firm’s equity share sells for Rs 50 and thetarget firm’s equity share sells for Rs 10 the exchange ratio based on the market price is 0.2 that is (10/50).This means that 1 share of the acquiring firm will be exchanged for 5 shares of the target firm.When the shares of the acquiring firm and the target firm are actively traded in a competitive market, marketprices have considerable merit. They reflect current earnings, growth prospects and risk characteristics. Whenthe trading is meagre market prices, however, may not be very reliable. In the extreme case market pricesmay not be available if the shares are not traded. Another problem with market prices is that they may bemanipulated by those who have a vested interest.Book value per share: The relative book values of the two firms may be used to determine the exchangerate. For example, if the book value per share of the acquiring company is Rs 25 and the book value per shareof the target company is Rs 15, the book value based exchange ratio is 0.6 =(15/25).The proponents of book value contend that it provides a very objectives basis. This however is notconvincing argument because book values are influenced by accounting policies which reflect subjectivejudgments. There are still serious objections against the use of the book value.1. Book values do not reflect changes in purchasing power of money.2. Book values often are highly different from true economic valuesSHARE BUYBACK IN REGULATED INDUSTRIESThe regulation is applicable to buyback of shares or other specified securities of a company listed on a StockExchange. The buyback of shares can’t take place for delisting of shares from the Stock Exchange.When the company is buying back shares it can’t buy back through negotiated deals with any person orthrough spot transactions or through any private arrangement.Special Regulation
In case the Offer size is greater than 25% of its Equity share capital & free reserves, the company cango ahead with the buy back only if a special resolution is passed at the general meeting. When the notice isbeing sent to the shareholders an Explanatory Statement must be annexed to the notice containing variousdisclosures T h e c o m p a n y c a n a l s o c o m p a n y c a n g o a h e a d w i t h t h e b u y b a c k o n l yif a specialresolution is through the postalballot route as per The Companies (Passing of theResolution by Postal Ballot) Rules, 2001.“Postal Ballot” includes voting by share holders by postalor electronic mode instead of voting personally by presenting for transacting businesses in ageneral meeting of the company,Method for sending notice:(a) The company may issue notices either,-(i) Under Registered PostAcknowledgement Due; or (ii) Under certificate of posting;and( b ) W i t h a n a d v e r t i s e m e n t p u b l i s h e d i n a l e a d i n g E n g l i s h N e w s p a p e r a n di n o n e vernacular Newspaper circulating in the State in which the registeredo f f i c e o f t h e company is situated, about having despatched the ballot papers.”Explanatory StatementThe company needs to make the following disclosures in the statement1. The date of the Board meeting at which the proposal for buy back was approved by the BOD.2. The necessity for the buy back3. The company may specify one reason to be adopted for buy-back so that the shareholdersauthorize the BOD for the same.4. The maximum amount required under the buy back and the sources of funds fr om which thebuy back would be financed.5. The basis of arriving at the buy-back price.6. The number of securities that the company proposes to buy back.7. a. The aggregate shareholding of the promoter and of the directors of the promoters, as on thedate of the notice convening the General Meeting.b. Aggregate number of shares purchased or sold by such persons during a period of six monthspreceding the date of the Board Meetingc. The maximum and minimum price at which purchases and sales were made along with therelevant dates.8. Intention of the promoters and persons in control of the company to tender their shares forbuy-back indicating the number of shares and details of acquisition with dates and price.
9. A confirmation that there are no defaults subsisting in repayment of deposits, redemption ofdebentures or preference shares or repayment of term loans to any financial institutions or banks.10. A confirmation that the BOD has made a full enquiry into the affairs and prospects of the company andis of the opinion.a. that there will be no grounds on which the company could be found unable to pay its debts;b.The company during that year, the company will be able to meet its liabilities as and when theyfall due and will not be rendered insolvent within a period of one year from that General Meeting date ; andc. In forming their opinion for the above purposes, the directors have taken into account theliabilities as if the company were being wound up under the provisions of the Companies Act, 1956Who Is Merchant Banker?A merchant banker, according to SEBI (Merchant Bankers) Regulations, 1992 “is a person who is engaged in the business of issue management either by making arrangements regardingselling, buying or subscribing to securities as manager, consultant, advisor or rendering corporate advisoryservices in relation to such issue management”Merchant bankers render services to meet the needs of trade, industry and also investors by performing asintermediary, consultant and a liaison. Merchant banking is a service oriented industry specializing ininvestment and financial decision making, assisting in making corporate strategies, assessing capital needsandhelping in procuring the equity and debt funds for corporate sectors and ultimately helping in establishingfavourable economic environment.SWEAT EQUITY & CORPORATE PERFORMANCE
What is Sweat Equity?Sweat equity is a partys contribution to a project in the form of effort -- as opposed to financial equity, which is acontribution in the form of capital. In a partnership, some partners may contribute to the firm only capital and othersonly sweat equityContribution to a project or enterprise in the form of effort and toil. Sweat equity is the ownershipinterest, or increase in value, that is created as a direct result of hard work by the owner(s). It is thepreferred mode of building equity for cash-strapped entrepreneurs in their start-up ventures, since theymay be unable to contribute much financial capital to their enterprise. In the context of real estate,sweat equity refers to value-enhancing improvements made by homeowners themselves to theirproperties. The term is probably derived from the fact that such equity is considered to be generatedfrom the "sweat of ones brow."For example, consider an entrepreneur who has invested $100,000 in her start-up. After a year ofdeveloping the business and getting it off the ground, she sells a 25% stake to an angel investor for$500,000. This gives the business a valuation of $2 million (i.e. $500,000/0.25), of which theentrepreneurs share is $1.5 million. Subtracting her initial investment of $100,000, the sweat equityshe has built up is $1.4 million.Valuation of sweat equity can become a contentious issue when there are multiple owners in anenterprise, especially when they are performing different functions. To avoid disputes and complicationsat a later stage, it may be advisable to arrive at an understanding of how sweat equity will be valued atthe outset or initial stage itself.Employee Stock Option (ESOP) and Sweat Equity (SE) are new tools, which are in use by a lot ofmultinational companies and consulting companies coming to India and engaging the real brain ofIndian professionals who are offered ESOP/SE by such companies as an incentive to them. Inabsence of any set law or precedent about its legality, taxation and accounting, a great deal ofconfusion is prevailing and an attempt is made to resolve the same.Why ESOP or SE ?The employee stock option plan is a good management tool for retention of human talent andguarding against poaching of staff of a running organisa-tion by a rival company.
When a company is newly formed or starts a new line of business, the company engages the bestexecutives and employees available, who bring in their IPR (Intellectual Property Rights) and know-how, skill and expertise with them, which make a value addition for the company. Certain keyprofessionals would like to invest in the company’s capital and would like to risk their owncontribution to the capital of the company along with their own IPR, know-how, skill and expertise.Such employees would like to be a strategic part of the promoter group and would like to makevalue addition to their capital invested in the company. Such an employee is awardedwith Sweat Equity as an incentive to join the company.As the company grows, the management would like to see that all its core management teamremains with them and further, such core management team is given additional incentive as areward for the efforts put in by them in managing the company. Such employees are offered ESOPat a price which is less than the real value of the share.Employee Stock Ownership Plan (ESOP)An employee stock ownership plan (ESOP) is a defined contribution plan that provides a companys workers with an ownership interest in the company. In an ESOP, companies provide their employees with stock ownership, typically at no cost to the employees. Shares are given to employees and are held in the ESOP trust until the employee retires or leaves the company, or earlier diversification opportunities arise.USES OF AN ESOPA Readily Available Market for Controlling ShareholdersFrequently, controlling shareholders desire to sell a part of their shares in order to diversity their holdings, orto provide liquidity for investment or estate planning purposes. Usually, however, there is no market for thesale of a minority interest in a closely-held company.A great deal of flexibility is available in structuring sales to the ESOP. If a shareholder desires immediateliquidity, the plan may obtain a bank loan and purchase the shares for cash. If a shareholder does not needimmediate liquidity, he may defer the tax on the sale by selling his shares to the trust on an instalment salebasis, or by selling only a portion of his shares to the trust on a year-by-year basis.
A Readily Available Market for Minority Shareholders and Outside InvestorsThe ESOP also provides a readily available market for the minority shareholders and other “outside”investors who desire to realize their gain or to liquidate a part or all of their investment for reinvestment inother companies. If the ESOP acquires at least 30% ownership, a minority shareholder may also elect tax-freerollover treatment under §1042 of the Internal Revenue Code.A Tax-Advantaged Alternative to Sale or MergerPurchase of an owner’s stock by an ESOP will almost always be more beneficial to the owner than sale ormerger. For example, in the case of a sale, the seller will incur an income tax, will lose control, will usuallylose his salary and fringe benefits, and will seldom be able to keep any retained equity. In comparison, therewill be no tax to the seller if he sells stock to the ESOP under the tax-free rollover provision of the 1984 TaxReform Act. In addition, under an ESOP, the seller can keep control, can continue to receive his salary andfringe benefits, and can keep as much or as little of the stock as he desires.An Effective Tool for Increasing Cash Flow and Net WorthA company can reduce its corporate income taxes and increase its cash flow and net worth by simply issuingtreasury stock or newly issued stock to an ESOP in any amount up to 25% of eligible annual payroll. Usingthis approach, a company may drastically reduce or even eliminate its corporate tax liability. The cash flowimpact can be dramatic. If the contribution to the ESOP is made in lieu of cash contributions to a profitsharing plan, the cash flow savings are even more dramatic. Of course, the owners must consider that thesecontributions of stock will result in some dilution of their ownership interest.A Superior Employee Incentive DeviceAn Employee Stock Ownership Plan is designed to provide employees with the incentive of a “piece of theaction,” and to enable employees to share in the capital growth of the company. Employee stock ownershipgives employees a direct and vested interest in the success of their company, enables employees to share inthe profits of their own labor, and creates an identity of interest between management and labor.As an employee incentive device, the ESOP is usually superior to other incentive plans. In an ordinary profitsharing plan, for example, the funds are invested in stocks of unrelated companies, and the incentive effectsare minimal. In an ESOP, on the other hand, the employees acquire an ownership interest in their owncompany, and the incentive element is maximized.The ESOP is a flexible plan that can be used either in lieu of or in combination with other employee benefitsplans. Because of its many advantages, the ESOP is becoming an increasingly popular form of employeebenefit. The ESOP is particularly advantageous for companies whose rapid growth has required the
reinvestment of profits, resulting in a shortage of cash available for employee benefits. A collateral benefit isthat the ESOP often serves to diminish employee interest in unionization.A New Way to Finance Debt ReductionCompanies frequently find it necessary to borrow money in order to finance corporate growth. Onedisadvantage of debt financing is that repayment of the loan principal is not a deductible expense. An ESOPcan be used to mitigate this problem by having the company issue newly issued stock or treasury stock to anESOP. The resulting tax savings can then be applied against the principal payments so that tax-deductibledollars are used to pay part, or all, of the loan principal.How the Plan is DesignedAn ESOP is a plan qualified by the Internal Revenue Service as an equity-based deferred compensation plan.As such, it is in the same family as profit sharing plans and stock bonus plans.An ESOP, however, differs from a profit sharing plan in that an ESOP is required to invest primarily inemployer securities, while a profit sharing plan is usually prohibited from investing primarily in employersecurities.An ESOP also differs from profit sharing plans and from stock bonus plans in that an ESOP is permitted andauthorized to engage in leveraged purchases of company stock. Consequently, an ESOP required differentaccounting procedures and a different method of allocating stocks and other investments among theemployees than other types of plans. For this reason, the plan should be designed by an ESOP specialist inorder to avoid Internal Revenue Service difficulties.The ESOP, like a profit sharing plan, must cover all non-union employees who are at least age 21 and haveone year of service. An ESOP may either include or exclude union employees. In practical effect, shareownership under the plan is usually proportionate to the relative salaries of the participants in the plan.How do Stock Purchase Plans work?Under a typical Stock Purchase Plan, employees are given an option to purchase their employers stockgenerally at a discounted price at the end of an offering period. Prior to each offering period, eligibleemployees indicate if they wish to participate in the plan.If the employee wishes to participate, he/she indicates the percentage or dollar amount ofcompensation to be deducted from their payroll throughout the offering period. The percentage ordollar amount employees are allowed to contribute varies by plan, however, the IRS limits the totalpurchase to $25,000 annually.Under most stock purchase plans, the purchase price is set at a discount from the fair market value.While some plans provide that the discount is applied to the value on the stock on the purchase date
(e.g., 85% of the fair market value on that date), it is more common to apply the discount to the valueof the stock on the first or last day of the offering period, whichever is lower.Most plans allow employees to increase or decrease their payroll deduction percentage at any timeduring the offering period. Each plan is unique, your plan materials will detail how a specific planworks.TopTwo Types of Employee Stock Purchase PlansThere are two types of Employee Stock Purchase Plans, classified by their tax status:Qualified Employee Stock Purchase Plans (Section 423)Qualified Employee Stock Purchase Plans meet conditions described by Section 423 of the InternalRevenue Code. There is special tax treatment for shares that are held for more than a year. A qualifiedplan must meet the following requirements: • Only employees of the company (or its parent or subsidiary corporations) may participate in the plan • The purchase plan must be approved by the shareholders of the company within the 12 months before it is adopted by the board. • Any employee owning more than 5% of the company stock may not participate in the plan • All eligible employees must be allowed to participate in the plan, although certain categories of employees may be excluded (e.g. employees employed less than two years) • All employees must enjoy the same rights and privileges under the plan, expect that the amount of stock that may be purchased may be based on compensation differences • The purchase price may not be less than the lesser of 85% of the fair market value of the stock 1) at the beginning of the offering period, or 2) on the purchase date • The maximum offering period cannot exceed 27 months unless the purchase price is based solely on the fair market value at time of purchase, in which case the offering period may be as long as 5 years • An employee may not purchase more than $25,000 worth of stock (based on fair market value on the first day of the offering period) for each calendar year in which the offering period is in effectNon-Qualified Employee Stock Purchase PlansNon-Section 423 Employee Stock Purchase Plans are simple payroll deduction plans that allowemployees to purchase company stock, sometimes at a discount. There is no special tax treatment ofany proceeds, and the plan is not necessarily available to all employees.