Chapter 5 Implementation: Search through Closing

Phases 3 through 10

A man that is very good at making excuses is probably good at nothing else.

—Ben Franklin

Inside M&A: bank of america acquires merrill lynch

Against the backdrop of the Lehman Brothers' Chapter 11 bankruptcy filing, Bank of America (BofA) CEO Kenneth Lewis announced on September 15, 2008, that the bank had reached agreement to acquire mega–retail broker and investment bank Merrill Lynch. Hammered out in a few days, investors expressed concern that BofA's swift action on the all-stock $50 billion transaction would saddle the firm with billions of dollars in problem assets by pushing BofA's share price down by 21%.

BofA saw the takeover of Merrill as an important step toward achieving its long-held vision of becoming the number 1 provider of financial services in its domestic market. The firm's business strategy was to focus its efforts on the U.S. market by expanding its product offering and geographic coverage. The firm implemented its business strategy by acquiring selected financial services companies to fill gaps in its product offering and geographic coverage. The existence of a clear and measurable vision for the future enabled BofA to make acquisitions as the opportunity arose.

Since 2001, the firm completed a series of acquisitions valued at more than $150 billion. The firm acquired FleetBoston Financial, greatly expanding its network of branches on the East Coast, and LaSalle Bank to improve its coverage in the Midwest. The acquisitions of credit card–issuing powerhouse MBNA, U.S. Trust (a major private wealth manager), and Countrywide (the nation's largest residential mortgage loan company) were made to broaden the firm's financial services offering.

The acquisition of Merrill makes BofA the country's largest provider of wealth management services to go with its current status as the nation's largest branch banking network and the largest issuer of small business, home equity, credit card, and residential mortgage loans. The deal creates the largest domestic retail brokerage and puts the bank among the top five largest global investment banks. Merrill also owns 45% of the profitable asset manager BlackRock Inc., worth an estimated $10 billion. BofA expects its retail network to help sell Merrill and BlackRock's investment products to BofA customers.

The hurried takeover encouraged by the U.S. Treasury and Federal Reserve did not allow for proper due diligence. The extent of the troubled assets on Merrill's books was largely unknown. While the losses at Merrill proved to be stunning in the short run—$15 billion alone in the fourth quarter of 2008—the acquisition by Bank of America averted the possible demise of Merrill Lynch. By the end of the first quarter of 2009, the U.S. government had injected $45 billion in loans and capital into BofA in an effort to offset some of the asset write-offs associated with the acquisition. Later that year, Lewis announced his retirement from the bank.

Mortgage loan losses and foreclosures continued to mount throughout 2010, with a disproportionately large amount of such losses attributable to the acquisition of the Countrywide mortgage loan portfolio. While BofA's vision and strategy may still prove to be sound, the rushed execution of the Merrill acquisition, coupled with problems surfacing from other acquisitions, could hobble the financial performance of BofA for years to come.

Chapter overview

This chapter starts with the presumption that a firm has developed a viable business plan that requires an acquisition to realize the firm's strategic direction. Whereas Chapter 4 addressed the creation of business and acquisition plans (Phases 1 and 2), this chapter focuses on Phases 3 through 10 of the acquisition process, including search, screening, first contact, negotiation, integration planning, closing, integration implementation, and evaluation. The negotiation phase is the most complex aspect of the acquisition process, involving refining the preliminary valuation, deal structuring, due diligence, and developing a financing plan. It is in the negotiation phase that all elements of the purchase price are determined.

A review of this chapter (including the practice questions) is contained in the file folder entitled Student Study Guide on the companion site for this book (www.elsevierdirect.com/companions/9780123854858). The companion site also contains a comprehensive acquirer due-diligence question list, redacted agreements of purchase and sale for stock and asset purchases, and a Learning Interactions Library, which gives students the opportunity to test their knowledge of this chapter in a “real-time” environment.

Phase 3: the search process

The first step in searching for potential acquisition candidates is to establish a relatively small number of primary screening or selection criteria. These should include the industry and size of the transaction, which is best defined in terms of the maximum purchase price a firm is willing to pay. This can be expressed as a maximum price-to-earnings, book, cash flow, or revenue ratio, or as a maximum purchase price stated in terms of dollars. It also may be appropriate to add a geographic restriction to the selection criteria.

Consider a private acute-care hospital holding company that wants to buy a skilled nursing facility within 50 miles of its largest hospital in Allegheny County, Pennsylvania. Management believes it cannot afford to pay more than $45 million for the facility. Its primary selection criteria could include an industry (skilled nursing), location (Allegheny County), and maximum price (five times cash flow, not to exceed $45 million).

Similarly, a Texas-based manufacturer of patio furniture with manufacturing operations in the southwestern United States seeks to expand its sales in California. The company decides to seek a patio furniture manufacturer that it can purchase for no more than $100 million. Its primary selection criteria could include an industry (outdoor furniture), a location (California, Arizona, and Nevada), and a maximum purchase price (15 times after-tax earnings, not to exceed $100 million).

The next target selection step is to develop a search strategy that employs the selection criteria. This typically involves using computerized databases and directory services such as Disclosure, Dun & Bradstreet, Standard & Poor's Corporate Register, and Capital IQ to identify qualified candidates. Firms also may query their law, banking, and accounting firms to identify other candidates. Investment banks, brokers, and leveraged buyout firms are also fertile sources of potential candidates, although they are likely to require an advisory or finder's fee.

The Internet makes research much easier than in the past; today, analysts have much more information at their fingertips than ever before. Such services as Google Finance, Yahoo! Finance, Hoover's, and EDGAR Online enable researchers to quickly obtain data about competitors and customers. These sites provide easy access to a variety of public documents filed with the Securities and Exchange Commission. Exhibit 5.1 provides a comprehensive listing of alternative information sources.

Exhibit 5.1 Sources of Information on Individual Companies

SEC Filings (Public Companies Only)

10-K: Provides detailed information on a company's annual operations, business conditions, competitors, market conditions, legal proceedings, risk factors in holding the stock, and other related information.

10-Q: Updates investors about a company's operations each quarter.

S-1: Filed when a company wants to register new stock. Can contain information about the company's operating history and business risks.

S-2: Filed when a company is completing a material transaction, such as a merger or acquisition. Provides substantial detail underlying the terms and conditions of the transaction, the events surrounding the transaction, and justification for the merger or acquisition.

8-K: Filed when a company faces a “material event,” such as a merger.

Schedule 14A: A proxy statement. Gives details about the annual meeting and biographies of company officials and directors, including stock ownership and pay.

Organizations

Value Line Investment Survey: Information on public companies

Directory of Corporate Affiliations: Corporate affiliations

Lexis/Nexis: Database of general business and legal information

Thomas Register: Organizes firms by products and services

Frost & Sullivan: Industry research

Findex.com: Financial information

Competitive Intelligence Professionals: Information about industries

Dialog Corporation: Industry databases

Wards Business Directory of U.S. and public companies

Predicasts: Provides databases through libraries

Business Periodicals Index: Business and technical article index

Dun & Bradstreet Directories: Information about private and public companies

Experian: Information about private and public companies

Nelson's Directory of Investment Research: Wall Street Research Reports

Standard & Poor's Publications: Industry surveys and corporate records

Harris Infosource: Information about manufacturing companies

Hoover's Handbook of Private Companies: Information on large private firms

Washington Researchers: Information on public and private firms, markets, and industries

The Wall Street Journal Transcripts: Wall Street research reports

Directory of Corporate Affiliations (published by Lexis-Nexis Group)

If confidentiality is not an issue, a firm may seek to advertise its interest in acquiring a particular type of firm in The Wall Street Journal or trade press. While this may generate substantial interest, it is less likely to generate high-quality prospects. Rather, it will probably result in a lot of responses from those interested in getting a free valuation of their own company or from brokers claiming that their clients fit the buyer's criteria as a ruse to convince you that you need the broker's services.1

Finding reliable information about privately owned firms is a major problem. Sources such as Dun & Bradstreet or Experian may only provide fragmentary data. Publicly available information may offer additional details. For example, surveys by trade associations or the U.S. Census Bureau often include industry-specific average sales per employee. A private firm's sales can be estimated by multiplying this figure by an estimate of the firm's workforce, which may be obtained by searching the firm's product literature, website, or trade show speeches, or even by counting the number of cars in the parking lot during each shift. Obtaining data on privately owned firms will be discussed in more detail in Chapter 10.

Increasingly the number of companies—even midsize firms—are moving investment banking “in-house.” Rather than use brokers or so-called “finders”² as part of their acquisition process, they are identifying potential targets, doing valuation, and performing due diligence on their own. This reflects efforts to save on investment banking fees, which can easily be more than $5 million plus expenses on a $500 million transaction.³

Phase 4: the screening process

The screening process is a refinement of the initial search process. It begins by pruning the initial list of potential candidates created using the primary criteria discussed earlier. Because relatively few primary criteria are used, the initial list may be lengthy. It can be shortened using secondary selection criteria, but care should be taken to limit the number of these criteria. An excessively long list of selection criteria will severely limit the number of candidates that pass the screening process. The following selection criteria should be quantifiable whenever possible.

Market Segment: The search process involves the specification of the target industry and perhaps results in a lengthy list of acquisition candidates. The list can be shortened by identifying a target segment within the industry. For example, a steel fabricated products company may decide to diversify into the aluminum fabricated products industry. Whereas the primary search criterion might have been firms in the aluminum flat-rolled products industry, a secondary criterion could stipulate a segmenting of the market to identify only those companies that manufacture aluminum tubular products.

Product Line: The product line criterion identifies a specific product line within the target market segment. For example, the same steel fabrication company may decide to focus its search on companies manufacturing aluminum tubular products used for lawn and patio furniture.

Profitability: The profitability criterion should be defined in terms of the percentage return on sales, assets, or total investment. This allows a more accurate comparison among candidates of different sizes. A firm with after-tax earnings of $5 million on sales of $100 million may be less attractive than a firm earning $3 million on sales of $50 million because the latter firm may be more efficient.

Degree of Leverage: Debt-to-equity or debt-to-total-capital ratios are used to measure the level of leverage or indebtedness. The acquiring company may not want to purchase a company whose heavy debt burden may cause the combined company's leverage ratios to jeopardize its credit rating.

Market Share: The acquiring firm may be interested only in firms that are number 1 or 2 in market share in the targeted industry, or in firms whose market share is some multiple (e.g., 2 × the next largest competitor). Firms that have substantially greater market share than their competitors often are able to achieve lower-cost positions than their competitors because of economies of scale and experience curve effects.

Cultural Compatibility: While cultural compatibility between the acquirer and the target may be more difficult to quantify than other measures, public statements about the target's vision for the future and its governance practices, as well as its reputation as a responsible corporate citizen within its industry, will provide some subjective measure. Insights can be gained by examining employee demographics, such as the approximate average age and diversity of the workforce, and how long the potential target has been in business. America Online's 2001 acquisition of Time Warner highlighted how difficult it can be to integrate a young, heterogeneous employee population with a much older, more homogeneous group. Also, as a much newer firm, AOL had a much less structured management style than was found in Time Warner's more staid environment. Finally, an acquirer needs to determine whether it can adapt to the challenges of dealing with foreign firms, such as different languages and customs.

Phase 5: first contact

Using both the primary and secondary selection criteria makes it possible to bring the search to a close and begin the next part of the acquisition planning process. This begins with contacting the selected target company. For each target firm, it is necessary to develop an approach strategy in which the potential acquirer develops a profile of each firm to be contacted in order to be able to outline the reasons the target firm should consider an acquisition proposal. Such reasons could include the need for capital, a desire by the owner to “cash out,” and succession planning issues (see Chapter 10).

Research efforts should extend beyond publicly available information and include interviews with customers, suppliers, ex-employees, and trade associations in an effort to better understand the strengths, weaknesses, and objectives of potential target firms. Insights into management, ownership, performance, and business plans help provide a compelling rationale for the proposed acquisition and heighten the prospect of obtaining the target firm's interest.

The approach for initiating contact with a target company depends on the size of the company, whether the target is publicly or privately held, and the acquirer's time frame for completing a transaction. The latter can be extremely important. If time permits, there is no substitute for developing a personal relationship with the sellers—especially if theirs is a privately held firm. Developing a rapport often makes it possible to acquire a company that is not thought to be for sale.

Personal relationships must be formed only at the highest levels within a privately held target firm. Founders or their heirs often have a strong paternalistic view of their businesses, whether they are large or small. Such firms often have great flexibility in negotiating a deal that “feels right,” rather than simply holding out for the highest possible price. In contrast, personal relationships can only go so far in negotiating with a public company that has a fiduciary responsibility to its shareholders to get the best price. If time is a critical factor, acquirers may not have the luxury of developing close personal relationships with the seller. Under these circumstances, a more expeditious approach must be taken.

For small companies with which the buyer has no direct contacts, it may only be necessary to initiate contact through a vaguely worded letter expressing interest in a joint venture or marketing alliance. During the follow-up telephone call, be prepared to discuss a range of options with the seller.

Preparation before the first telephone contact is essential. If possible, script your comments. Get to the point quickly but indirectly. Identify yourself, your company, and its strengths. Demonstrate your understanding of the contact's business and how an informal partnership could make sense. Be able to explain the benefits of your proposal to the contact—quickly and succinctly. If the opportunity arises, propose a range of options, including an acquisition. Listen carefully to the contact's reaction. If the contact is willing to entertain the notion of an acquisition, request a face-to-face meeting.⁴

Whenever possible, use an intermediary to make contact, generally at the highest level possible in the target firm's organization. In some instances, the appropriate contact is the most senior manager, but it could be a disaffected large shareholder. Intermediaries include members of the acquirer's board of directors or the firm's outside legal counsel, accounting firm, lender, broker/finder, or investment banker. Intermediaries can be less intimidating than if you take a direct approach.

For publicly traded companies, contact also should be made through an intermediary at the highest level possible. Discretion is extremely important because of the target's concern about being “put into play”—that is, when circumstances suggest that it may be an attractive investment opportunity for other firms. Even rumors of an acquisition can have substantial, adverse consequences for the target. Current or potential customers may express concern about the uncertainty associated with a change of ownership.

Such a change could imply variation in product or service quality, reliability, and the level of service provided under product warranty or maintenance contracts. Suppliers worry about possible disruptions in their production schedules as the transition to the new owner takes place. Employees worry about possible layoffs or changes in compensation. Competitors will do what they can to fan these concerns in an effort to persuade current customers to switch and potential customers to defer buying decisions; key employees will be encouraged to defect to the competition. Shareholders may experience a dizzying ride as arbitrageurs, buying on the rumor, bid up the price of the stock, only to bail out if denial of the rumor appears credible.

Discussing Value

Neither the buyer nor the seller has any incentive to be the first to provide an estimate of value. It is difficult to back away from a number put on the table by either party should new information emerge. Getting a range may be the best that you can do. Discussing values for recent acquisitions of similar businesses is one way to get a range. Another is to agree to a formula for calculating the purchase price. For example, the purchase price may be defined in terms of a price to current year earnings multiple. This enables both of the parties to proceed to performing due diligence to reach a consensus on the actual current year's earnings for the target firm.

Preliminary Legal Documents

Typically, and early on, parties to M&A transactions negotiate a confidentiality agreement, term sheet, and letter of intent.

Confidentiality Agreement

All parties to the deal are likely to want a confidentiality agreement (also called a nondisclosure agreement), which is generally mutually binding—that is, it covers all parties to the transaction. In negotiating the confidentiality agreement, the buyer requests as much audited historical data and supplemental information as the seller is willing to provide. The prudent seller requests similar information about the buyer to assess the buyer's financial credibility. It is important for the seller to determine the buyer's credibility early in the process so as not to waste time with a potential buyer incapable of raising the financing to complete the transaction. The agreement should cover only information that is not publicly available and should have a reasonable expiration date. Note that the confidentiality agreement can be negotiated independently or as part of the term sheet or letter of intent.

Term Sheet

A term sheet outlines the primary terms with the seller and is often used as the basis for a more detailed letter of intent. It may not be necessary to involve lawyers and accountants at this stage. It is the last point before the parties to the potential transaction start incurring significant legal, accounting, and consulting expenses.

A standard term sheet is typically two to four pages long and stipulates the total consideration or purchase price (often as a range), what is being acquired (i.e., assets or stock), limitations on the use of proprietary data, a no-shop provision that prevents the seller from sharing the terms of the buyer's proposal with other potential buyers with the hope of instigating an auction environment, and a termination date. Many transactions skip the term sheet and go directly to negotiating a letter of intent.

Letter of Intent

Unlike the confidentiality agreement, not all parties to the transaction may want a Letter of Intent (LOI). While the LOI can be useful in identifying areas of agreement and disagreement early in the process, the rights of all parties to the transaction, and certain protective provisions, it may delay the signing of a definitive purchase agreement and may also result in some legal risk to either the buyer or the seller if the deal is not consummated. Public companies that sign a letter of intent for a transaction that is likely to have a “material” impact on the buyer or seller may need to announce the LOI publicly to comply with securities law.

The LOI formally stipulates the reason for the agreement and major terms and conditions. It also indicates the responsibilities of both parties while the agreement is in force, a reasonable expiration date, and how all fees associated with the transaction will be paid. Major terms and conditions include a brief outline of the structure of the transaction, which may entail the payment of cash or stock for certain assets and the assumption of certain target company liabilities. The letter may also specify certain conditions, such as an agreement that selected personnel of the target will not compete with the combined companies for some period should they leave. Another condition may indicate that a certain portion of the purchase price will be allocated to the noncompete agreement.⁵ The LOI also may place a portion of the purchase price in escrow.

The proposed purchase price may be expressed as a specific dollar figure, as a range, or as a multiple of some measure of value, such as operating earnings or cash flow. The LOI also specifies the types of data to be exchanged and the duration and extent of the initial due diligence. The LOI usually will terminate if the buyer and the seller do not reach an agreement by a certain date. Legal, consulting, and asset transfer fees (i.e., payments made to governmental entities when ownership changes hands) may be paid for by the buyer or seller, or they may be shared.

Depending on how it is written, the LOI may or may not be legally binding. A well-written LOI usually contains language limiting the extent to which the agreement binds the two parties. Price or other provisions are generally subject to closing conditions, such as the buyer having full access to all of the seller's books and records; having completed due diligence; obtaining financing; and having received approval from boards of directors, stockholders, and regulatory bodies. Other standard conditions include requiring signed employment contracts for key target firm executives and the completion of all necessary M&A documents. Failure to satisfy any of these conditions will invalidate the agreement.

A well-written LOI should also describe the due diligence process in some detail. It should stipulate how the potential buyer should access the potential seller's premises, the frequency and duration of such access, and how intrusive such activities should be. The LOI should indicate how the buyer should meet and discuss the deal with the seller's employees, customers, and suppliers. Sometimes the provisions of a standard confidentiality agreement are negotiated as part of the LOI. The letter of intent becomes the governing document for the deal that the potential acquirer can show to prospective financing sources.

The LOI may create legal liabilities if one of the parties is later accused of not negotiating in “good faith.” This is the basis for many lawsuits filed when transactions are undertaken but not completed as a result of disagreements that emerge during lengthy and often heated negotiations.

In recent years, some letters of intent have included go-shop provisions, which allow the seller to continue to solicit higher bids for several months. However, if the seller accepts another bid, the seller must pay a breakup fee to the bidder with whom it has a signed agreement.

Phase 6: negotiation

The negotiation phase often is the most complex aspect of the acquisition process. It is interactive and iterative. Activities unfold concurrently. It is during this phase that the actual purchase price paid for the acquired business is determined, and often it will be quite different from the initial valuation of the target company, which was probably made before due diligence and with only limited, publicly available information.

In this section, the emphasis is on negotiation in the context of problem-solving or interest-based bargaining, in which parties look at their underlying interests rather than simply stating positions and making demands. In most successful negotiations, parties to the transaction search jointly for solutions to problems. All parties must be willing to make concessions that satisfy their own needs, as well as the highest-priority needs of the others involved in the negotiation.

The negotiation phase consists of four iterative activities that may begin at different times but tend to overlap (Figure 5.1). Due diligence starts as soon as the target is willing to allow it to begin and, if permitted, runs throughout the negotiation process. Another activity is refining the preliminary valuation based on new information uncovered as part of due diligence, enabling the buyer to better understand the value of the target. A third activity is deal structuring, which involves meeting the needs of both parties by addressing issues of risk and reward. The final activity entails a financing plan, which provides a reality check for the buyer by defining the maximum amount the buyer can reasonably expect to finance and, in turn, pay for the target company. Each of these activities is detailed next.

Figure 5.1 Viewing negotiation as a process.

Refining Valuation

The starting point for negotiation is to update the preliminary target company valuation based on new information. A buyer requests and reviews at least three to five years of historical financial data. While it is highly desirable to examine data that have been audited in accordance with Generally Accepted Accounting Principals, such data may not be available for small, privately owned companies. The historical data should be normalized, or adjusted for nonrecurring gains, losses, or expenses. Nonrecurring gains or losses can result from the sale of land, equipment, product lines, patents, software, or copyrights. Nonrecurring expenses include severance payments, employee signing bonuses, and settlements of litigation. These adjustments allow the buyer to smooth out irregularities and better understand the dynamics of the business. Once the data have been normalized, each major expense category should be expressed as a percentage of revenue. By observing year-to-year changes in these ratios, sustainable trends in the data are more discernible.

Deal Structuring

In purely financial terms, deal structuring involves the allocation of cash-flow streams (with respect to amount and timing), the allocation of risk, and, therefore, the allocation of value between different parties to the transaction. However, because of the human element involved in negotiation, deal structuring must also be a process of identifying and satisfying as many of the highest-priority objectives of the parties involved in the transaction as possible, subject to their tolerance for risk. The process begins with each party determining its own initial negotiating position, potential risks, options for managing risk, levels of tolerance for risk, and conditions under which either party will “walk away” from the negotiations. (These elements of negotiation are discussed in more detail in Appendix A at the end of this chapter.)

In practice, deal structuring is about understanding potential sources of disagreement—from simple arguments over basic facts to substantially more complex issues, such as the form of payment and legal, accounting, and tax structures. It also requires understanding the potential conflicts of interest that can influence the outcome of discussions. For example, when a portion of the purchase price depends on the long-term performance of the acquired business, its management—often the former owner—may not behave in a manner that serves the acquirer's best interests.

Decisions made throughout the deal-structuring process influence various attributes of the deal, including how ownership is determined, how assets are transferred, how ownership is protected (i.e., governance), and how risk is apportioned among parties to the transaction. Other attributes include the type, number, and complexity of the documents required for closing; the types of approvals required; and the time needed to complete the transaction. These decisions also will influence how the combined companies will be managed, the amount and timing of resources committed, and the magnitude and timing of current and future tax liabilities.⁶

Given its complexity, the deal-structuring process should be viewed as comprising a number of interdependent components. At a minimum, these include the acquisition vehicle, postclosing organization, legal form of the selling entity, form of payment, form of acquisition, and tax and accounting considerations. The acquisition vehicle refers to the legal structure (e.g., corporation or partnership) used to acquire the target company. The postclosing organization is the organizational and legal framework (e.g., corporation or partnership) used to manage the combined businesses following the completion of the transaction. The legal form of the selling entity refers to whether the seller is a C or Subchapter S Corporation, a limited liability company, or a partnership.

The form of payment may consist of cash, common stock, debt, or some combination. Some portion of the payment may be deferred or be dependent on the future performance of the acquired entity. The form of acquisition reflects what is being acquired (e.g., stock or assets) and how ownership will be transferred. As a general rule, a transaction is taxable if the remuneration paid to the target company's shareholders is primarily something other than the acquirer's stock, and it is nontaxable (i.e., tax deferred) if what they receive is largely acquirer stock.

Finally, accounting considerations refer to the potential impact of financial reporting requirements on the earnings volatility of business combinations, due to the need to periodically revalue acquired assets to their fair market value as new information becomes available. Fair market value is what a willing buyer and seller, having access to the same information, would pay for an asset.⁷

Conducting Due Diligence

Due diligence is an exhaustive review of records and facilities and typically continues throughout the negotiation phase. Although some degree of protection is achieved through a well-written contract, legal documents should never be viewed as a substitute for conducting formal due diligence. Table 5.1 lists convenient online sources of information that are helpful in conducting due diligence. A detailed preliminary acquirer due diligence question list is provided on the companion site to this book. While due diligence is most often associated with buyers, both sellers and lenders will also conduct due diligence.⁸

Table 5.1. Convenient Information Sources for Conducting Due Diligence

Web Address	Content
Securities and Exchange Commission	Financial Information/Security Law Violations
– www.sec.gov – http://www.sec.gov/litigation.shtml	– Public filings for almost 10 years available through the EDGAR database – Enforcement actions
U.S. Patent Office	Intellectual Property Rights Information
– www.uspto.gov – www.uspto.gov/patft/index.html	– Search patent database – Database if you have patent number
Federal Communications Commission	Regulates Various Commercial Practices
– www.fcc.gov – http://www.fcc.gov/searchtools.html	– General information – Access to database of individuals sanctioned for illegal marketing practices
U.S. and States Attorneys General Offices	Information on Criminal Activities
– http://www.naag.org/ag/full_ag_table.php	– Listing of states attorneys general
National Association of Securities Dealers	Regulates Securities Industry
– www.nasdr.com – http://www.nasdr.com	– Information on investment bankers – Database
Better Business Bureau (BBB)	Compiles Consumer Complaints
– http://search.bbb.org/search.html	– Database
Paid Services	Information On
– U.S. Search (www.ussearch.com) – KnowX (www.knowx.com)	– Criminal Violations – Liens/bankruptcies – Credit history – Litigation

The acquirer typically attempts to protect itself through due diligence, extensive representations and warranties (i.e., claims and promises made by the seller), or some combination of the two. In some instances, buyers and sellers may agree to an abbreviated due diligence period on the theory that the buyer can be protected in a well-written purchase agreement in which the seller is required to make certain representations and warrant that they are true. These could include the seller's acknowledgment that it owns all assets listed in the agreement “free and clear” of any liens, with a mechanism for compensating the buyer for any material loss (defined in the contract) should the representation be breached (i.e., found not to be true). Relying on reps and warranties as a substitute for a thorough due diligence is rarely a good idea.

An expensive and exhausting process, due diligence is, by its nature, highly intrusive, and it places considerable demands on managers' time and attention. Frequently, the buyer wants as much time as necessary to complete due diligence, while the seller will want to limit the length and scope as much as possible.

Due diligence rarely works to the advantage of the seller because a long and detailed due diligence is likely to uncover items the buyer will use as a reason to lower the purchase price. Consequently, sellers may seek to terminate due diligence before the buyer feels it is appropriate.⁹ If the target firm succeeds in reducing the amount of information disclosed to the target firm, it can expect to be required to make more representations and warranties as to the accuracy of its claims and promises in the purchase and sale agreement.¹⁰

The Components of Due Diligence

Three primary reviews comprise due diligence; they are of equal importance and often occur concurrently. The strategic and operational review conducted by senior operations and marketing management asks questions that focus on the seller's management team, operations, and sales and marketing strategies. The financial review directed by financial and accounting personnel focuses on the accuracy, timeliness, and completeness of the seller's financial statements.

A legal review, which is conducted by the buyer's legal counsel, deals with corporate records, financial matters, management and employee issues, tangible and intangible assets of the seller, and material contracts and obligations of the seller, such as litigation and claims. A rigorous due diligence requires the creation of comprehensive checklists. The interview process provides invaluable sources of information. By asking the same questions of a number of key managers, the acquirer is able to validate the accuracy of its conclusions.

Buyer Due Diligence

Buyers use due diligence to validate assumptions underlying valuation. The primary objectives of buyer's due diligence are to identify and confirm sources of value or synergy and mitigate real or potential liability by looking for fatal flaws that reduce value. Table 5.2 categorizes potential sources of value from synergy that may be uncovered or confirmed during due diligence and the impact these may have on operating performance.

Table 5.2. Identifying Potential Sources of Value

Potential Source of Value	Examples	Potential Impact
Operating Synergy
• Eliminating functional overlap • Productivity improvement • Purchasing discounts • Working capital management • Facilities management – Economies of scale – Economies of scope • Organizational realignment	• Reduce duplicate overhead positions • Increased output per employee • Volume discounts on material purchases • Reduced days in receivables due to improved collection of accounts receivable • Fewer days in inventory due to improved inventory turns • Increased production in underutilized facilities • Data centers, R&D functions, call centers, and so on, support multiple product lines/operations • Reduce the number of layers of management	• Improved margins • Same • Same • Improved return on total assets • Same • Improved return on total assets • Same • Improved communication • Reduced bureaucratic inertia
Financial Synergy
• Increased borrowing capacity • Increased leverage	• Target has little debt and many unencumbered assets • Access to lower–cost source of funds	• Increased access to financing • Lower cost of capital
Marketing/Product Synergy
• Access to new distribution channels • Cross-selling opportunities • Research and development • Product development	• Increased sales opportunities • Selling acquirer products to target customers and vice versa • Cross-fertilization of ideas • Increased advertising budget	• Increased revenue • Same • More innovation • Improved market share
Control
• Opportunity identification • More proactive management style	• Acquirer sees opportunities not seen by target's management • More decisive decision making	• New growth opportunities • Improved financial returns

Seller Due Diligence

Although the bulk of due diligence is performed by the buyer on the seller, the prudent seller should also perform due diligence on the buyer and on its own personnel and operations. By investigating the buyer, the seller can determine whether the buyer has the financial wherewithal to finance the purchase. As part of its internal due diligence, a seller often requires its managers to sign affidavits attesting (to the “best of their knowledge”) to the truthfulness of what is being represented in the contract that pertains to their areas of responsibility. In doing so, the seller hopes to mitigate liability stemming from inaccuracies in the seller's representations and warranties made in the definitive agreement of purchase and sale.

Lender Due Diligence

If the acquirer is borrowing to buy a target firm, the lender(s) will want to perform their own due diligence independent of the buyer's effort. Multiple lender due diligences, often performed concurrently, can be quite burdensome to the target firm's management and employees, and the seller should agree to these disruptive activities only if confident that the transaction will be consummated within a reasonable period.

Developing the Financing Plan

The last of the four negotiation phase activities is to develop the balance sheet, income, and cash-flow statements for the combined firms. Unlike the financial projections of cash flow made to value the target, these statements should include the expected cost of financing the transaction. Developing the financing plan is a key input in determining the purchase price because it places a limitation on the amount the buyer can offer the seller. The financing plan is appended to the acquirer's business and acquisition plans and is used to obtain financing for the transaction. No matter the size of the transaction, lenders and investors will want to see a coherent analysis of why the proposed transaction is a good investment opportunity. How transactions are financed is discussed in more detail in Chapter 13.

Defining the Purchase Price

The three commonly used definitions of purchase price are total consideration, total purchase price/enterprise value, and net purchase price. Each serves a different purpose.

Total Consideration

In the purchase agreement, the total consideration consists of cash (C), stock (S), new debt issues (D), or some combination of all three. It is a term commonly used in legal documents to reflect the different types of remuneration received by target company shareholders. Note that the remuneration can include both financial and nonfinancial assets, such as real estate. Nonfinancial compensation sometimes is referred to as payment in kind. The debt counted in the total consideration is what the target company shareholders receive as payment for their stock, along with any cash or acquiring company stock.

Each component of the total consideration may be viewed in present value terms; therefore, the total consideration is itself expressed in present value terms (PV_TC). The present value of cash is its face value. The stock component of the total consideration is the present value (PV_S) of future dividends or net cash flows or the acquiring firm's stock price per share times the number of shares to be exchanged for each outstanding share of the seller's stock. New debt issued by the acquiring company as part of the compensation paid to shareholders can be expressed as the present value (PV_ND) of the cumulative interest payments plus principal discounted at some appropriate market rate of interest (see Chapter 7).

Total Purchase Price/Enterprise Value

The total purchase price (PV_TPP) or enterprise value of the target firm consists of the total consideration (PV_TC) plus the market value of the target firm's debt (PV_AD) assumed by the acquiring company. The enterprise value is sometimes expressed as the total purchase price plus net debt. Net debt includes the market value of debt assumed by the acquirer less cash and marketable securities on the books of the target firm.

The enterprise value of the firm often is quoted in the media as the purchase price because it is most visible to those who are not familiar with the details. It is important to analysts and shareholders alike, because it approximates the total investment made by the acquiring firm. It is an approximation because it does not necessarily measure liabilities the acquirer is assuming that are not visible on the target firm's balance sheet. Nor does it reflect the potential for recovering a portion of the total consideration paid to target company shareholders by selling undervalued or redundant assets.

Net Purchase Price

The net purchase price (PV_NPP) is the total purchase price plus other assumed liabilities (PV_OAL)¹¹ less the proceeds from the sale of discretionary or redundant target assets (PV_DA)¹² that are on or off the balance sheet. PV_OAL are those assumed liabilities not fully reflected on the target firm's balance sheet or in the estimation of the economic value of the target firm.

The net purchase price is the most comprehensive measure of the actual price paid for the target firm. It includes all known cash obligations assumed by the acquirer as well as any portion of the purchase price that is recovered through the sale of assets. The various definitions of price can be summarized as follows:

Total consideration = PV_TC = C + PV_S + PV_ND

Total purchase price or enterprise value = PV_TPP = PV_TC + PV_AD

Net purchase price = PV_NPP = PV_TPP + PV_OAL – PV_DA = (C + PV_S + PV_ND + PV_AD) + PV_OAL – PV_DA

Although the total consideration is most important to the target company's shareholders as a measure of what they receive in exchange for their stock, the acquirer's shareholders often focus on the total purchase price/enterprise value as the actual amount paid for the target firm. However, the total purchase price tends to ignore other adjustments that should be made to determine actual or pending “out-of-pocket” cash spent by the acquirer. The net purchase price reflects adjustments to the total purchase price and is a much better indicator of whether the acquirer overpaid for the target firm. The application of the various definitions of the purchase price is addressed in more detail in Chapter 9.

Phase 7: developing the integration plan

Part of the premerger integration planning process involves the preclosing due diligence activity. One of the responsibilities of the due diligence team is to identify ways in which assets, processes, and other resources can be combined to realize cost savings, productivity improvements, or other perceived synergies. This information is also essential for refining the valuation process by enabling planners to understand better the necessary sequencing of events and the resulting pace at which the expected synergies may be realized.

Contract-Related Issues

Integration planning also involves addressing human resource, as well as customer and supplier issues that overlap the change of ownership. These are transitional issues to resolve as part of the purchase agreement, and it is critical that the seller's responsibilities be negotiated before closing to make the actual transition as smooth as possible. Also, a cooperative effort is most likely made prior to closing. For example, the agreement may stipulate how target company employees will be paid and how their benefit claims will be processed.¹³

A prudent buyer will want to include assurances in the purchase agreement to limit its postclosing risk. Most seller representations and warranties made to the buyer refer to the past and present condition of the seller's business. They pertain to items such as the ownership of securities; real and intellectual property; current levels of receivables, inventory, and debt; and pending lawsuits, worker disability, customer warranty claims; and an assurance that the target's accounting practices are in accordance with Generally Accepted Accounting Principles.

Although “reps and warranties” apply primarily to the past and current state of the seller's business, they do have ramifications for the future. For example, if a seller claims there are no lawsuits pending and a lawsuit is filed shortly after closing, the buyer may seek to recover damages from the seller.

The buyer also may insist that certain conditions be satisfied before closing can take place. Common conditions include employment contracts, agreements not to compete, financing, and regulatory and shareholder approval. Finally, the buyer will want to make the final closing contingent on receiving approval from the appropriate regulatory agencies and shareholders of both companies before any money changes hands.

Earning Trust

Decisions made before closing affect postclosing integration activity.¹⁴ Successfully integrating firms requires getting employees in both firms to work toward achieving common objectives. This comes about through building credibility and trust, not through superficial slogans, pep talks, and empty promises. Trust comes from cooperation, keeping commitments, and experiencing success.

Choosing the Integration Manager and Other Critical Decisions

The buyer should designate an integration manager who possesses excellent interpersonal and project management skills. During the integration phase, interpersonal skills are frequently more important than professional and technical skills. The buyer must also determine what is critical to continuing the acquired company's success during the first 12 to 24 months after the closing. Critical activities include identifying key managers, vendors, and customers, and determining what is needed to retain them as valued assets.

Preclosing integration planning activities should also determine the operating norms or standards required for continued operation of the businesses: executive compensation, labor contracts, billing procedures, product delivery times, and quality metrics. Finally, there must be a communication plan for all stakeholders that can be implemented immediately following closing.¹⁵ Chapter 6 describes in detail the way in which the integration plan is implemented.

Phase 8: closing

In the closing phase of the acquisition process, you obtain all necessary shareholder, regulatory, and third-party consents (e.g., customer and vendor contracts) and also complete the definitive purchase agreement. Like all other phases, this activity benefits from significant planning at the outset if it is to go smoothly, but this is often impractical because so many activities tend to converge on the closing date.

Assigning Customer and Vendor Contracts

In a purchase of assets, many customer and vendor contracts cannot be assigned to the buyer without receiving written approval from the other parties. While this may be largely a formality, both vendors and customers may view it as an opportunity to attempt to negotiate more favorable terms. Licenses must be approved by the licensor, which can be a major impediment to a timely closing if not properly planned. For example, a major software vendor demanded a substantial increase in royalty payments before agreeing to transfer the software license to the buyer. The vendor knew that the software was critical for the ongoing operation of the target company's data center. From the buyer's perspective, the exorbitant increase in the fee had an adverse impact on the economics of the transaction and nearly caused the deal to collapse.

Gaining the Necessary Approvals

The buyer's legal counsel is responsible for ensuring that the transaction is in full compliance with securities, antitrust, and state corporation laws. Significant planning before closing is again crucial to minimizing roadblocks that a target company may place before the buyer. Great care must be exercised to ensure that all filings required by law have been made with the Federal Trade Commission and the Department of Justice. Finally, many transactions require approval by the acquirer and target company shareholders.

Completing the Acquisition/Merger Agreement

The acquisition/merger agreement is the cornerstone of the closing documents. It indicates all of the rights and obligations of the parties both before and after the closing. This agreement also may be referred to as the purchase agreement or, more formally, as the definitive agreement of purchase and sale; its length depends on the complexity of the transaction.

Deal Provisions

In an asset or stock purchase, this section of the agreement defines the consideration or form of payment and how it will be paid and the specific assets or shares to be acquired. In a merger, this section of the agreement defines the number (or fraction) of acquirer shares to be exchanged for each target share.

Price

The purchase price or total consideration may be fixed at the time of closing, subject to future adjustment, or it may be contingent on future performance. In asset transactions, it is common to exclude cash on the target's balance sheet from the transaction; the price paid for noncurrent assets, such as plant and intangible assets, will be fixed, but the price for current assets will depend on their levels at closing following an audit.

Allocation of Price

The buyer typically has an incentive to allocate as much of the purchase price as possible to depreciable assets, such as fixed assets, customer lists, and noncompete agreements, which will enable the buyer to depreciate or amortize these upwardly revised assets and reduce future taxable income. However, such an allocation may constitute taxable income to the seller. Both parties should agree on how the purchase price should be allocated to the various assets acquired in an asset transaction before closing. This eliminates the chance that the parties involved will take conflicting positions for tax reporting purposes.

Payment Mechanism

Payment may be made at closing by wire transfer or cashier's check, or the buyer may defer the payment of a portion of the purchase price by issuing a promissory note to the seller. The buyer may agree to put the unpaid portion of the purchase price in escrow or through a holdback allowance, thereby facilitating the settlement of claims that might be made in the future.¹⁶

Assumption of Liabilities

The seller retains those liabilities not assumed by the buyer. In instances such as environmental liabilities, unpaid taxes, and inadequately funded pension obligations, the courts may go after the buyer and seller. In contrast, the buyer assumes all known and unknown liabilities in a merger or purchase of shares.

Representations and Warranties

The reps and warranties should provide for full disclosure of all information that is germane to the transaction, typically covering the areas of greatest concern to both parties. Areas commonly covered include financial statements, corporate organization and good standing, capitalization, absence of undisclosed liabilities, current litigation, contracts, title to assets, taxes and tax returns, no violation of laws or regulations, employee benefit plans, labor issues, and insurance coverage.

Covenants

Covenants are agreements by the parties about actions they agree to take or refrain from taking between signing the definitive agreement and the closing. For example, the seller may be required to continue conducting business in the usual and customary manner. The seller often will be required to seek approval for all expenditures that may be considered out of the ordinary, such as one-time dividend payments or sizeable increases in management compensation.

Closing Conditions

The satisfaction of negotiated conditions determines whether a party to the agreement must go forward and consummate the deal. These conditions could include the continued accuracy of the seller's reps and warranties and the extent to which the seller is living up to its obligations under the covenants. Other examples include obtaining all necessary legal opinions, the execution of other agreements (e.g., promissory notes), and the absence of any “material adverse change” in the condition of the target company.

The effects of material adverse change clauses (MACs) in agreements of purchase and sale became very visible during the disruption in the financial markets in 2008. Many firms that had signed M&A contracts looked for a way out. The most common challenge in negotiating such clauses is defining what constitutes materiality—for example, is it a 20% reduction in earnings or sales? Because of the inherent ambiguity, the contract language is usually vague, and it is this very ambiguity that has enabled so many acquirers to withdraw from contracts. Lenders, too, use these clauses to withdraw financing (see the following).

Indemnification

In effect, indemnification is the reimbursement of the other party for a loss incurred following closing for which they were not responsible. The definitive agreement requires the seller to indemnify or absolve the buyer of liability in the event of misrepresentations or breaches of warranties or covenants. Similarly, the buyer usually agrees to indemnify the seller. Both parties generally want to limit the period during which the indemnity clauses remain in force.¹⁷

Financing Contingencies

Most well-written agreements of purchase and sale contain a financing contingency. The buyer is not subject to the terms of the contract if the buyer cannot obtain adequate funding to complete the transaction. Breakup fees can be particularly useful to ensure that the buyer will attempt as aggressively as possible to obtain financing. In some instances, the seller may require the buyer to put a nonrefundable deposit in escrow to be forfeited if the buyer is unable to obtain financing to complete the transaction.

Lenders, too, exercise financial contingencies, invoking material adverse change clauses to back out of lending commitments. For example, concerned that they would have to discount such loans when they were resold, Morgan Stanley and UBS balked at commitments to fund the purchase of Reddy Ice Holdings and Genesco in late 2007. Similarly, that same year Lehman and J.P. Morgan were part of a group of banks that helped force Home Depot to take $1.8 billion less for its construction supply business.¹⁹

Phase 9: implementing postclosing integration

The postclosing integration activity is widely viewed as among the most important phases of the acquisition process. Postclosing integration is discussed in considerable detail in Chapter 6. What follows is a discussion of those activities required immediately following closing. Such activities generally fall into five categories, which are discussed in the next sections.

Communication Plans

Implementing an effective communication plan immediately after the closing is crucial for retaining employees of the acquired firm and maintaining or boosting morale and productivity. The plan should address employee, customer, and vendor concerns. The message always should be honest and consistent. Employees need to understand how their compensation, including benefits, might change under the new ownership. Employees may find a loss of specific benefits palatable if they are perceived as offset by improvements in other benefits or working conditions. Customers want reassurance that there will be no deterioration in product or service quality or delivery time during the transition from old to new ownership. Vendors also are very interested in understanding how the change in ownership will affect their sales to the new firm.

Whenever possible, communication is best done on a face-to-face basis. Senior officers of the acquiring company can be sent to address employee groups (on site, if possible). Senior officers also should contact key customers (preferably in person or at least by telephone) to provide the needed reassurances. Meeting reasonable requests for information from employees, customers, and vendors immediately following closing with complete candor will contribute greatly to the sense of trust among stakeholders that is necessary for the ultimate success of the acquisition.

Employee Retention

Retaining middle-level managers should be a top priority during this phase of the acquisition process. Frequently, senior managers of the target company that the buyer chooses to retain are asked to sign employment agreements as a condition of closing. Without these signed agreements, the buyer would not have completed the transaction. Although senior managers provide overall direction for the firm, middle-level managers execute the day-to-day operations. Plans should be in place to minimize the loss of such people. Bonuses, stock options, and enhanced sales commission schedules are commonly put in place to keep such managers.

Satisfying Cash-Flow Requirements

Invariably, operating cash-flow requirements are higher than expected. Conversations with middle-level managers following closing often reveal areas in which maintenance expenditures have been deferred. Receivables previously thought to be collectable may have to be written off. Production may be disrupted as employees of the acquired firm find it difficult to adapt to new practices introduced by the acquiring company's management or if inventory levels are inadequate to maintain desired customer delivery times. Finally, more customers than had been anticipated may be lost to competitors that use the change in ownership as an opportunity to woo them away with various types of incentives.

Employing Best Practices

An important motivation for takeovers is to realize specific operating synergies, which result in improved operating efficiency, product quality, customer service, and on-time delivery. The parties in a transaction are likely to excel in different areas. An excellent way for the combined companies to take advantage of their individual strengths is to use the “best practices” of both. However, in some areas, neither company may be employing what its customers believe to be the best practices in the industry. In these circumstances, management should look beyond its own operations to accept the practices of other companies in the same or other industries.

Cultural Issues

Corporate cultures reflect the set of beliefs and behaviors of the management and employees of a corporation. Some corporations are very paternalistic, and others are very “bottom-line” oriented. Some empower employees, whereas others believe in highly centralized control. Some promote problem solving within a team environment; others encourage individual performance. Inevitably, different corporate cultures impede postacquisition integration efforts. The key to success is taking the time to explain to all of the new firm's employees what behaviors are expected and why and to tell managers that they should “walk the talk.”

Phase 10: conducting a postclosing evaluation

The primary reasons for conducting a postclosing evaluation of all of the acquisitions are to determine whether the acquisition is meeting expectations, to determine corrective actions if necessary, and to identify what was done well and what should be done better during future acquisitions.

Do Not Change Performance Benchmarks

Once the acquisition appears to be operating normally, evaluate the actual performance against that projected in the acquisition plan. Success should be defined in terms of actual to planned performance. Too often, management simply ignores the performance targets in the acquisition plan and accepts less than plan performance to justify the acquisition. This may be appropriate if circumstances beyond the firm's control cause a change in the operating environment. Examples include a recession, which slows the growth in revenue, or changing regulations, which preclude the introduction of a new product.

Ask the Difficult Questions

The types of questions asked should vary, depending on the time elapsed since the closing. After six months, what has the buyer learned about the business? Were the original valuation assumptions reasonable? If not, what did the buyer not understand about the target company and why? What did the buyer do well? What should have been done differently? What can be done to ensure that the same mistakes are not made in future acquisitions? After 12 months, is the business meeting expectations? If not, what can be done to put the business back on track? Is the cost of fixing the business offset by expected returns? Are the right people in place to manage the business for the long term? After 24 months, does the acquired business still appear attractive? If not, should it be divested? If yes, when and to whom?

Learn from Mistakes

It always pays to take the time to identify lessons learned from each transaction. This is often a neglected exercise and results in firms repeating the same mistakes. This occurs even in the most highly acquisitive firms because those involved in the acquisition process may change from one acquisition to another. Lessons learned in an acquisition completed by the management of one of the firm's product lines may not be readily communicated to those about to undertake acquisitions in other parts of the company. Highly acquisitive companies can benefit greatly by dedicating certain legal, human resource, marketing, financial, and business development resources to support acquisitions made throughout the company.

Some things to remember

The acquisition process consists of 10 identifiable phases. During the first phase, the business plan defines the overall direction of the business. If an acquisition is believed necessary to implement the firm's business strategy, an acquisition plan, developed during the second phase, defines the key objectives, available resources, and management preferences for completing an acquisition. The next phase consists of the search for appropriate acquisition candidates. To initiate this phase, selection criteria need to be developed. The screening phase is a refinement of the search phase and entails applying more criteria to reduce the list of candidates that surfaced during the search process.

How the potential acquirer initiates first contact depends on the urgency of completing a transaction, the size of the target, and the availability of intermediaries with highly placed contacts within the target firm. The negotiation phase consists of refining valuation, structuring the deal, conducting due diligence, and developing a financing plan. Integration planning is a highly important aspect of the acquisition process that must be done before closing. The closing phase includes wading through the logistical quagmire of getting all the necessary third-party consents and regulatory and shareholder approvals. The postclosing integration phase entails communicating effectively with all stakeholders, retaining key employees, and identifying and resolving immediate cash-flow needs. The postclosing evaluation phase is the most commonly overlooked phase because many firms stop short of formally questioning how effective they were in managing the acquisition process.

Discussion Questions

5.1 What resources are commonly used to conduct a search for potential acquisition targets?

5.2 Identify at least three criteria that might be used to select a manufacturing firm as a potential acquisition candidate. A financial services firm? A high-technology firm?

5.3 Identify alternative ways to make “first contact” with a potential acquisition target. Why is confidentiality important? Under what circumstances might a potential acquirer make its intentions public?

5.4 What are the advantages and disadvantages of a letter of intent?

5.5 How do the various activities undertaken concurrently as part of the negotiation phase affect the determination of the purchase price?

5.6 What are the differences between total consideration, total purchase price/enterprise value, and net purchase price? How are these different concepts used?

5.7 What is the purpose of the buyer and seller in performing due diligence?

5.8 What is the purpose of a financing plan? In what sense is it a “reality check”?

5.9 Why is preclosing integration planning important?

5.10 What key activities make up a typical closing?

5.11 In a rush to complete its purchase of health software producer HBO, McKesson did not perform adequate due diligence but rather relied on representations and warranties in the agreement of sale and purchase. Within six months following closing, McKesson announced that it would have to reduce revenue by $327 million and net income by $191.5 million for the preceding three fiscal years to correct for accounting irregularities. The company's stock fell by 48%. If HBO's financial statements had been declared to be in accordance with GAAP, would McKesson have been justified in believing that HBO's revenue and profit figures were 100% accurate? Explain your answer.

5.12 Find a transaction currently in the news. Speculate as to what criteria the buyer may have employed to identify the target company as an attractive takeover candidate. Be specific.

5.13 In mid-2008, Fresenius, a German manufacturer of dialysis equipment, acquired APP Pharmaceuticals for $4.6 billion. The deal includes an earn-out, under which Fresenius will pay as much as $970 million if APP reaches certain future financial targets. What is the purpose of the earn-out? How does it affect the buyer and seller?

5.14 Material adverse change clauses (MACs) are a means for the parties to the contract to determine who will bear the risk of adverse events that occur between the signing of an agreement and the closing. MACs are frequently not stated in dollar terms. How might MACs affect the negotiating strategies of the parties to the agreement during the period between signing and closing?

5.15 Despite disturbing discoveries during due diligence, Mattel acquired The Learning Company (TLC), a leading developer of software for toys, in a stock-for-stock transaction valued at $3.5 billion. Mattel had determined that TLC's receivables were overstated, a $50 million licensing deal had been prematurely put on the balance sheet, and TLC's brands were becoming outdated. TLC also had substantially exaggerated the amount of money put into research and development for new software products. Nevertheless, driven by the appeal of rapidly becoming a big player in the children's software market, Mattel closed on the transaction even though aware that TLC's cash flows were overstated. After restructuring charges associated with the acquisition, Mattel's consolidated net loss was $82.4 million on sales of $5.5 billion. Mattel's stock fell by more than 35% to end the year at about $14 per share. What could Mattel have done to better protect its interests?

Answers to these Chapter Discussion Questions are available in the Online Instructor's Manual for instructors using this book.

Chapter business cases

Case Study 5.1

Oracle's Efforts to Consolidate the Software Industry

Oracle 's completion of its $7.4 billion takeover of Sun Microsystems on January 28, 2010, illustrated how in somewhat more than five years the firm has been able to dramatically realign its focus. Once viewed as the premier provider of proprietary database and middleware services (accounting for about three-fourths of the firm's revenue), Oracle is now seen as a leader in enterprise resource planning, customer relationship management, and supply chain management software applications. The purpose of this case study is to show how industry-wide trends, coupled with increasing recognition within Oracle of its own limitations, compelled the firm to radically restructure its operations.

In the past, the corporate computing market was characterized by IBM selling customers systems that included most of the hardware and software in a single package. Later, minicomputer manufacturers pursued a similar strategy in which they would build all of the crucial pieces of a large system, including its chips, main software, and networking technology. The traditional model was upended by the rise of more powerful and standardized computers based on readily available chips from Intel and an innovative software market. Customers could choose the technology they preferred (i.e., “best of breed”) and assemble those products in their own data centers. Prices of hardware and software declined under intensifying competitive pressure as more and more software firms entered the fray.

Although the enterprise software market grew rapidly in the 1990s, by the early 2000s, market growth showed signs of slowing. This market consists primarily of large Fortune 500 firms with multiple operations across many countries. Such computing environments tend to be highly complex and require multiple software applications that must work together on multiple hardware systems.

In recent years, users of information technology have sought ways to reduce the complexity of getting disparate software applications to work together. Although some buyers still prefer to purchase the “best of breed” software, many are moving to purchase suites of applications that are compatible. However, while customers seeking to simplify their IT operations are better able to choose from a wider array of products from firms such as Oracle and SAP, they are finding that they are increasingly locked into a single vendor.

Oracle, an industry leader, sought to bring about what its CEO Larry Ellison believed was needed industry consolidation. Oracle's big move into enterprise applications came with its 2004 $10.3 billion purchase of PeopleSoft. From there, Oracle proceeded to acquire 55 firms, with more than one-half focused on strengthening the firm's software applications business. Revenues have almost doubled since then to $23 billion in 2009, and they have continued to grow through the 2008–2009 recession. Oracle's intensifying focus on business applications software largely reflected the slowing growth of its database product line, which accounts for more than three-fourths of the company's sales.

Oracle, like most of the successful software firms, generates substantial and sustainable cash flow as a result of the way in which business software is sold. Customers buy licenses to obtain the right to utilize a vendor's software and periodically renew the license in order to receive upgrades. Healthy cash flow minimized the need for Oracle to borrow. Consequently, it was able to sustain its acquisitions by borrowing and paying cash for companies rather than to issue stock and avoid diluting existing shareholders.

Oracle has experience in streamlining other firms' supply chains and in reducing costs. For most software firms, the largest single cost is the cost of sales. Consequently, in acquiring other software firms, Oracle attempted to add other firms' revenue streams while reducing costs by pruning unprofitable products and redundant overhead during the integration of the acquired firms.

For example, since acquiring Sun, Oracle has rationalized and consolidated Sun's manufacturing operations and substantially reduced the number of products the firm offers. Fewer products will mean less administrative and support overhead. Furthermore, Oracle has introduced a “build to order” mentality rather than a “build to inventory” marketing approach. With a focus on “build to order,” hardware is manufactured only when orders are received rather than for inventory in anticipation of future orders. By aligning production with actual orders, Oracle is able to reduce substantially the cost of carrying inventory; however, it does run the risk of lost sales from customers who need their orders satisfied immediately. Oracle has also pared down the number of suppliers in order to realize savings from volume purchase discounts. While lowering its cost position in this manner, Oracle has sought to distinguish itself from its competitors by being known as a full-service provider of integrated software solutions.

Prior to the Sun acquisition, Oracle's primary competitor in the enterprise software market was SAP. However, the acquisition of Sun's vast hardware business pits Oracle for the first time against Hewlett-Packard, IBM, Dell Computer, and Cisco Systems, all of which have made acquisitions of software services companies in recent years, moving well beyond their traditional specialties in computers or networking equipment. In 2009, Cisco Systems diversified from its networking roots and began selling computer servers, a move that brought them into competition with HP, Dell, and IBM. Traditionally, Cisco had teamed with hardware vendors HP, Dell, and IBM. HP countered Cisco by investing more in its existing networking products and acquiring 3Com, also a networking company for $2.7 billion in November 2009. HP also bought EDS in 2008 for $13.8 billion in an effort to sell more equipment and services to customers often served by IBM. The individual firm seems to be pursuing a “me too” strategy in which they can claim to their customers that they and they alone have all the capabilities to be an end-to-end service provider. Which firm is most successful in the long run may well be the one that successfully integrates its acquisitions the best.

Investors' concern about Oracle's strategy is that the frequent acquisitions make it difficult to measure how well the company is growing. With many of the acquisitions falling in the $5 million to $100 million range, relatively few of Oracle's acquisitions have been viewed as material for financial reporting purposes. Consequently, Oracle is not obligated to provide pro forma financial data about these acquisitions, and investors have found it difficult to ascertain the extent to which Oracle has grown organically (i.e., grown the revenue resulting from prior acquisitions) versus simply by acquiring new revenue streams. Ironically, in the short run, Oracle's acquisition binge has resulted in increased complexity as each new acquisition means more products must be integrated.

Discussion Questions

1. How would you characterize the Oracle business strategy (i.e., cost leadership, differentiation, niche, or a combination of all three)? Explain your answer.

2. Conduct an external and internal analysis of Oracle. Briefly describe those factors that influenced the development of Oracle's business strategy. Be specific.

3. In what way do you think the Oracle strategy was targeting key competitors? Be specific.

4. What other benefits for Oracle and for the remaining competitors such as SAP do you see from further industry consolidation? Be specific.

Answers to these questions are found in the Online Instructor's Manual available for instructors using this book.

Case Study 5.2

Exxon Mobil Buys XTO Energy in a Bet on Natural Gas

Exxon Mobil Corporation has stated publicly that it is committed to being the world's premier petroleum and petrochemical company and that the firm's primary focus in the coming decades will likely remain on its core businesses of oil and gas exploration and production, refining, and chemicals. According to the firm, there appears to be “a pretty bright future” for drilling in previously untapped shales—such as the natural gas–rich Barnett Shale of North Texas and the Haynesville Shale in northwest Louisiana and East Texas—as a result of technological advances in horizontal drilling and hydraulic fracturing. No single energy source available currently solves the dual challenge of meeting growing energy needs while reducing CO₂ emissions. The firm seeks a set of solutions ranging from producing hydrocarbons more effectively to using them more efficiently to improving existing alternatives and developing policies that encourage long-term planning and investments.20

Traditionally, energy companies have extracted natural gas by drilling vertical wells into pockets of methane that are often trapped above oil deposits. With this newer technology in use for the last 20 years, energy companies now drill horizontal wells and fracture them with high-pressure water, a practice known as “fracking.” That technique has enabled energy firms to release natural gas trapped in the vast shale oil fields in the United States, as well as to recover gas and oil from fields previously thought to have been depleted. The natural gas and oil recovered in this manner are often referred to as “unconventional energy resources.”

In an effort to bolster its position in the development of unconventional natural gas and oil, Exxon announced on December 14, 2009, that it had reached an agreement to buy XTO Energy in an all-stock deal valued at $31 billion. The deal also included Exxon's assumption of $10 billion in XTO's current debt. Exxon agreed to issue 0.7098 of a share of common stock for each share of XTO common stock. This represented a 25% premium to XTO shareholders at the time of the announcement. XTO shares jumped 15% to $47.86, while Exxon's fell by 4.3% to $69.69. The deal values XTO's natural gas reserves at $2.96 per thousand cubic feet of proven reserves, in line with recent deals. This price is about one-half of the NYMEX natural gas futures price at that time.

Known as a wildcat or an independent energy producer, the 23-year-old XTO competed aggressively with other independent drillers in the natural gas business, which had boomed with the onset of horizontal drilling and well fracturing to extract energy from older oil fields. However, independent energy producers like XTO typically lack the financial resources required to unlock unconventional gas reserves, unlike the large multinational energy firms like Exxon.

The geographic overlap between the proven reserves of the two firms was significant, with both Exxon and XTO having a presence in the states of Colorado, Louisiana, Texas, North Dakota, Pennsylvania, New York, Ohio, and Arkansas. The two firms' combined proven reserves are the equivalent of 45 trillion cubic feet of gas and include shale gas, coal bed methane, and shale oil. These reserves also complement Exxon's U.S. and international holdings.

Exxon is the global leader in oil and gas extraction and the largest publicly traded firm in terms of market value. Given its size, it is difficult to achieve rapid future earnings growth organically through reinvestment of free cash flow. Consequently, mega-firms such as Exxon often turn to large acquisitions to offer their shareholders significant future earnings growth.

Given the long lead time required to add to proven reserves and the huge capital requirements to do so, energy companies by necessity must have exceedingly long-term planning and investment horizons. Acquiring XTO is a bet on the future of natural gas. Moreover, XTO has substantial technical expertise in recovering unconventional natural gas resources, which complement Exxon's global resource base, advanced R&D, proven operational capabilities, global scale, and financial capacity.

In the five-year period ending in 2008, the U.S. Energy Information Administration estimates, the U.S. total proven natural gas reserves increased by 30% to 245 trillion cubic feet, or the equivalent of 41 billion barrels of oil. Unconventional natural gas is projected by the EIA to meet most of the nation's domestic natural gas demand by 2030, representing a substantial change in the overall energy consumption pattern in the United States. At current consumption rates, the nation can count on natural gas for nearly a century. In addition to its abundance, natural gas is the cleanest burning of the fossil fuels.

A sizeable purchase price premium, the opportunity to share in any upside appreciation in Exxon's share price, and the tax-free nature^* of the transaction convinced XTO shareholders to approve the deal. Exxon's commitment to manage XTO on a stand-alone basis as a wholly-owned subsidiary in which a number of former XTO managers would be retained garnered senior management support.

Discussion Questions

1. What was the total purchase price/enterprise value of the transaction?

2. Why did Exxon Mobil's shares decline and XTO Energy's shares rise substantially immediately following the announcement of the takeover?

3. What do you think Exxon Mobil believes are its core skills? Based on your answer to this question, would you characterize this transaction as a related or unrelated acquisition? Explain your answer.

4. Identify what you believe are the key environmental trends that encouraged Exxon Mobil to acquire XTO Energy.

5. How would you describe Exxon Mobil's long-term objectives, business strategy, and implementation strategy? What alternative implementation strategies could Exxon have pursued? Why do you believe it chose an acquisition strategy? What are the key risks involved in Exxon Mobil's takeover of XTO Energy?

Answers to these case study discussion questions are found in the Online Instructor's Manual available to instructors using this book.

Appendix A Thoughts on Negotiating Dynamics

Negotiating is essentially a process in which two or more parties that represent different interests attempt to achieve a consensus on a particular issue. It is useful to start a negotiation by determining any areas of disagreement, which can be done by having all of the parties review the facts pertaining to the deal at the beginning. Generally, parties reach agreement on most facts relatively easily.

From there, it is easy to identify areas in dispute. Good negotiators make concessions on issues that are not considered deal breakers—anything to which a party cannot agree without making the deal unacceptable—but only if they receive something in return. If deal breakers occur, they must be the highest priority in a negotiation and must be resolved if a negotiated settlement is to be reached.

The easiest areas of disagreement should be resolved first. By the time only a few remain, all of the parties to the negotiation have invested a great deal of money, time, and emotional commitment in the process and will be looking forward to resolving any remaining issues quickly.

Sound planning is the key to successful negotiation. Prior to negotiating, each party should determine its own goals (i.e., highest-priority needs) and prioritize those goals. Is money the major issue, or is it more about gaining control? Each party should also make an effort to identify the other party's goals and priorities based on public statements and actions, as well as information uncovered during due diligence. With clearly identified goals, each party can develop strategies for achieving those goals. Each party needs to recognize that allowances must be made so other parties can achieve—or at least believe they have achieved—their primary goals.

All moves in a negotiation should be supported by the most objective rationale possible; a well-reasoned and well-structured proposal is difficult to counter. The first move of any negotiation can set the tone for the entire process.

A reasonable offer is more likely to appeal to the other side and is more likely to elicit a reasonable counteroffer. Skilled negotiators often employ a series of techniques to reach consensus. For example, negotiators may try to determine the minimum outcome that the other party will accept and then to adjust its demands accordingly, without giving up its highest-priority objectives.

Traditional negotiating has been referred to as the “win–lose” approach, based on the assumption that one's gain is necessarily another's loss. This is true when only one issue is at stake. For example, if a seller accepts a lower cash purchase price, and if cash is a high-priority concern to the buyer and the seller, the buyer gains at the seller's expense.

“Win–win” negotiations, in contrast, presume there are outcomes in which both parties to a negotiation gain; these are negotiations that involve multiple related issues. In a win–win negotiation, one party can concede what it believes to be a relatively low-priority item in exchange for the other party's acceptance of something else that is highly important.

When it comes to issues of money, it can be important to reach agreement first on a formula or a framework for determining what both parties believe is a fair value. This may require intense discussion. A formula might be that the purchase price will be some multiple of earnings or cash flow; a framework might consist of a series of steps, such as the extent of due diligence, to be allowed before a purchase price is proposed. The formula or framework can help avoid the thorny issue of how much to offer at the outset and enables negotiators to proceed to the data collection or due diligence stage (DePamphilis, 2010a).

Appendix B Legal Due Diligence Preliminary Information Request

The due diligence question list, found in the file folder entitled “Acquirer Due Diligence Question List” on the companion site to this book, applies mainly to transactions involving large public companies. For smaller, privately owned target firms, the list may be substantially more focused. Normally, the length and complexity of a “due diligence question list” submitted by the acquiring firm to the target firm's management team is determined through negotiation. The management of the target firm normally would view a lengthy list as both intrusive and costly to complete. Consequently, the target firm's management often will try to narrow both the number and breadth of the questions included in the initial request for information. The request for such a list often is included as part of the letter of intent signed by the acquirer and target firms. Note that all references to the company in the due diligence question list refer to the target.

¹ It is important to respond in writing if you receive a solicitation from a broker or finder, particularly if you reject their services. If at a later date you acquire the firm they claim to have represented, the broker or finder may sue your firm for compensation.

² A broker has a fiduciary responsibility to either the potential buyer or the potential seller and is not permitted to represent both parties. Compensation is paid by the client to the broker. A finder is someone who introduces both parties but represents neither party. The finder has no fiduciary responsibility to either party and is compensated by one or both parties. If you choose to use a broker or finder, make sure the fees and terms are clearly stipulated in writing. Keep a written record of all telephone conversations and meetings with the finder or broker. These may be used in court at a later date if the broker or finder sues for fees that may be in dispute.

³ Actual fee formulas are most often based on the purchase price. The so-called Lehman formula was at one time a commonly used fee structure in which broker or finder fees would be equal to 5% of the first $1 million of the purchase price, 4% of the second, 3% of the third, 2% of the fourth, and 1% of the remainder. Today, this formula is often ignored in favor of a negotiated fee structure consisting of a basic fee (or retainer) paid regardless of whether the deal is consummated, an additional closing fee paid on closing, and an “extraordinary” fee paid under unusual circumstances that may delay the eventual closing, such as gaining antitrust approval or achieving a hostile takeover. Fees vary widely, but 1% of the total purchase price plus reimbursement of expenses is often considered reasonable.

⁴ To ensure confidentiality, choose a meeting place that provides sufficient privacy. Create a written agenda for the meeting after soliciting input from all participants. The meeting should start with a review of your company and your perspective on the outlook for the industry. Encourage the potential target firm to provide information on its own operations and its outlook for the industry. Look for areas of consensus.

⁵ Such an allocation of the purchase price is in the interests of the buyer because the amount of the allocation can be amortized over the life of the agreement. As such, it can be taken as a tax-deductible expense. However, it may constitute taxable income for the seller.

⁶ McCarthy, 1998

⁷ For a more detailed discussion of how to structure M&A transactions, see M&A Negotiations and Deal Structuring—All You Need to Know by Donald M. DePamphilis (2010b).

⁸ For a detailed discussion of the due diligence process and best practices, see Selim (2003).

⁹ One way sellers try to limit due diligence is to sequester the acquirer's team in a data room. Typically, this is a conference room filled with file cabinets and boxes of documents requested by the buyer's due diligence team. Formal presentations by the seller's key managers are given in the often cramped conditions of the data room. In other instances, the potential buyer may have limited access to information on a password-protected website, also called a virtual data room.

¹⁰ A buyer is well advised to rely more on an on-site review of facilities and records and personnel interviews than on a seller's contract obligations. Should a seller declare bankruptcy, disappear, or move assets to offshore accounts, receiving remuneration for breach of contract may be impossible.

¹¹ If all the target firm's balance sheet reserves reflected accurately all known future obligations and there were no significant potential off-balance sheet liabilities, there would be no need to adjust the purchase price for assumed liabilities other than for short- and long-term debt assumed by the acquiring company. Earnings would accurately reflect the expected impact of known liabilities. Operating cash flows, which reflect both earnings and changes in balance sheet items, would also accurately reflect future liabilities. In practice, reserves are often inadequate to satisfy pending claims. This is particularly true if the selling company attempts to improve current earnings performance by understating reserves. Common examples include underfunded or underreserved employee pension and healthcare obligations and uncollectable receivables, as well as underaccrued vacation and holidays, bonuses, and deferred compensation, such as employee stock options. To the extent that such factors represent a future use of cash, the present value of their future impact, to the extent possible, should be estimated.

¹² Discretionary assets are undervalued or redundant assets that can be used by the buyer to recover some portion of the purchase price. Such assets include land valued at its historical cost on the balance sheet or equipment whose resale value exceeds its fully depreciated value. Other examples include cash balances in excess of normal working capital needs and product lines or operating units considered nonstrategic by the buyer. The sale of discretionary assets is not considered in the calculation of the economic value of the target firm because economic value is determined by future operating cash flows before consideration is given to how the transaction will be financed.

¹³ Systems must be in place to ensure that employees of the acquired company continue to be paid without disruption. If the number of employees is small, this may be accommodated easily by loading the acquirer's payroll computer system with the necessary salary and personal information before closing or by having a third-party payroll processor perform these services. For larger operations or where employees are dispersed geographically, the target's employees may continue to be paid for a specific period using the target's existing payroll system. As for benefits, employee healthcare or disability claims tend to escalate just before a transaction closes, and studies show that employees, whether they leave or stay with the new firm, file more disability claims for longer periods after downsizing (The Wall Street Journal, November 21, 1996). The sharp increase in such expenses can pose an unexpected financial burden for the acquirer if the responsibility for paying such claims has not been addressed in the merger agreement. For example, the agreement may read that all claims incurred within a specific number of days before closing but not submitted by employees for processing until after closing will be reimbursed by the seller after the closing. Alternatively, such claims may be paid from an escrow account containing a portion of the purchase price set aside to cover these types of expenses.

¹⁴ Benefits packages, employment contracts, and retention bonuses to keep key employees typically are negotiated before the closing. Contractual covenants and conditions also affect integration. Earnouts, which are payments made to the seller based on the acquired business achieving certain profit or revenue targets, and deferred purchase price payments, which involve placing some portion of the purchase price in escrow until certain contractual conditions have been realized, can limit the buyer's ability to integrate the target effectively into the acquirer's operations.

¹⁵ Porter and Wood, 1998

¹⁶ The escrow account involves the buyer putting a portion of the purchase price in an account held by a third party, while the holdback allowance generally does not.

¹⁷ At least one full year of operation and a full audit are necessary to identify claims. Some claims (e.g., environmental) extend beyond the survival period of the indemnity clause. Usually, neither party can submit claims to the other until some minimum threshold, expressed in terms of the number or dollar size of claims, has been exceeded.

¹⁸ Sherman, 2006

¹⁹ Although only the tenth largest transaction of 2007 in terms of price, the Home Depot deal became one of the most important by midyear as among the first of the large, highly leveraged transactions to be renegotiated following the collapse of the subprime mortgage market in late summer.

²⁰ Rex Tillerson, ExxonMobil CEO, 2009 ExxonMobil Annual Report.

^* When target firm shareholders receive primarily acquirer shares for their shares, the transaction is deemed to be tax free in that no taxes are due until the acquirer shares are sold. See Chapter 12 for more details on tax-free transactions.

Chapter 5

Implementation: Search through Closing

Inside M&A: bank of america acquires merrill lynch

Chapter overview

Phase 3: the search process

Phase 4: the screening process

Phase 5: first contact

Discussing Value

Preliminary Legal Documents

Confidentiality Agreement

Term Sheet

Letter of Intent

Phase 6: negotiation

Refining Valuation

Deal Structuring

Conducting Due Diligence

The Components of Due Diligence

Buyer Due Diligence

Seller Due Diligence

Lender Due Diligence

Developing the Financing Plan

Defining the Purchase Price

Total Consideration

Total Purchase Price/Enterprise Value

Net Purchase Price

Phase 7: developing the integration plan

Contract-Related Issues

Earning Trust

Choosing the Integration Manager and Other Critical Decisions

Phase 8: closing

Assigning Customer and Vendor Contracts

Gaining the Necessary Approvals

Completing the Acquisition/Merger Agreement

Deal Provisions

Price

Allocation of Price

Payment Mechanism

Assumption of Liabilities

Representations and Warranties

Covenants

Closing Conditions

Indemnification

Other Closing Documents

Financing Contingencies

Phase 9: implementing postclosing integration

Communication Plans

Employee Retention

Satisfying Cash-Flow Requirements

Employing Best Practices

Cultural Issues

Phase 10: conducting a postclosing evaluation

Do Not Change Performance Benchmarks

Ask the Difficult Questions

Learn from Mistakes

Some things to remember

Chapter business cases