Mergers & Acquisitions

AccountingTools® Series

Mergers &
Acquisitions

A Comprehensive Guide

Third Edition

Steven M. Bragg, CPA

Mergers & Acquisitions

A Comprehensive Guide

Third Edition

Steven M. Bragg

Copyright © 2014 by AccountingTools, Inc. All rights reserved.

Published by AccountingTools, Inc., Centennial, Colorado.

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ISBN-13: 978-1-938910-51-7

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Table of Contents

Chapter 1 - Acquisition Strategy...........................................................................................1
The Sales Growth Strategy...................................................................................................1
The Geographic Growth Strategy ........................................................................................2
The Product Supplementation Strategy................................................................................2
The Full Service Strategy .....................................................................................................3
The Vertical Integration Strategy.........................................................................................4
The Adjacent Industry Strategy ............................................................................................4
The Diversification Strategy ................................................................................................5
The Market Window Strategy...............................................................................................6
The Blocking Strategy ..........................................................................................................6
The Bolt-on Strategy ............................................................................................................7
The Expertise Strategy .........................................................................................................8
The Low-Cost Strategy.........................................................................................................9
The Industry Roll-up Strategy ..............................................................................................9
The Size Consideration ......................................................................................................10
The Competitor Consideration...........................................................................................11
The Weak Link Consideration ............................................................................................12
The Ego Consideration ......................................................................................................12
The Failings of Acquisition Strategy..................................................................................13

Chapter 2 - The Acquisition Process...................................................................................15
The Acquirer’s Acquisition Process...................................................................................15
The Seller’s Acquisition Process........................................................................................20
The Bankrupt Seller Acquisition Process...........................................................................33
Reconciling the Acquisition Processes...............................................................................34

Chapter 3 - Regulatory Approval .......................................................................................37
Antitrust Laws ....................................................................................................................37
Hart-Scott-Rodino Act........................................................................................................37
Industry Concentration Concerns ......................................................................................40
The Failing Company Doctrine .........................................................................................43
The European Union Merger Regulation...........................................................................43

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Chapter 4 - Exit Planning ....................................................................................................45
Reasons for Selling.............................................................................................................45
Alternatives to Selling ........................................................................................................48
Clean Up the Business .......................................................................................................49
Timing of the Sale ..............................................................................................................60
Information Sharing...........................................................................................................61
Risks of a Failed Exit .........................................................................................................63

Chapter 5 - The Data Room.................................................................................................65
The Physical Data Room....................................................................................................65
The Electronic Data Room.................................................................................................66

Chapter 6 - Valuation of the Target....................................................................................69
Board of Directors Liability...............................................................................................69
Timing of the Deal..............................................................................................................70
Liquidation Value...............................................................................................................71
Real Estate Value ...............................................................................................................71
Relief-from-Royalty Method...............................................................................................72
Book Value .........................................................................................................................72
Enterprise Value ................................................................................................................74
Multiples Analysis ..............................................................................................................75
Discounted Cash Flows......................................................................................................78
Replication Value...............................................................................................................85
Comparison Analysis .........................................................................................................86
52-Week High.....................................................................................................................88
Influencer Price Point........................................................................................................89
The Initial Public Offering Valuation ................................................................................89
The Strategic Purchase ......................................................................................................90
Extraneous Valuation Factors ...........................................................................................90
The Control Premium.........................................................................................................91
The Earnout .......................................................................................................................91
The Valuation Floor and Ceiling .......................................................................................93
The Fairness Opinion.........................................................................................................95

Chapter 7 – Synergy Analysis..............................................................................................97

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The Need for Synergies ......................................................................................................97
Synergy Analysis for Expenses...........................................................................................98
Synergy Analysis for Revenue ..........................................................................................101
Synergy Analysis for Capital Expenditures......................................................................105
The Synergies Table .........................................................................................................106
Synergy Analysis for Risk Reduction................................................................................107
Synergy Secrecy ...............................................................................................................108
The Cost of Synergies.......................................................................................................109

Chapter 8 - Hostile Takeover Tactics ...............................................................................111
The Williams Act ..............................................................................................................111
Schedule TO .....................................................................................................................112
Initial Share Acquisition ..................................................................................................113
Initial Communications....................................................................................................114
The Bear Hug ...................................................................................................................115
The Tender Offer..............................................................................................................115
The Partial Tender Offer..................................................................................................118
The Partial Tender Offer..................................................................................................118
The Two-Tiered Tender Offer ..........................................................................................119
The Creeping Tender Offer ..............................................................................................120
The Mini-Tender Offer .....................................................................................................120
The Proxy Fight ...............................................................................................................121
Hostile Takeover Defenses ...............................................................................................122

Chapter 9 - Due Diligence ..................................................................................................130
Due Diligence Preparation ..............................................................................................131
Due Diligence Expectations.............................................................................................132
Due Diligence Cost ..........................................................................................................132
Target Company Overview ..............................................................................................133
Corporate Culture............................................................................................................135
Target Company Management.........................................................................................136
Employees ........................................................................................................................139
Employee Benefits ............................................................................................................142
Financial Results..............................................................................................................142

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Internal Reports ...............................................................................................................145
Revenue ............................................................................................................................146
Cost Structure ..................................................................................................................148
Intellectual Property ........................................................................................................149
Fixed Assets and Facilities...............................................................................................150
Liabilities .........................................................................................................................151
Equity ...............................................................................................................................153
Taxes ................................................................................................................................154
Accounting Policies..........................................................................................................156
Product Development.......................................................................................................158
Product Development.......................................................................................................158
Selling Activities...............................................................................................................159
Marketing Activities .........................................................................................................160
Production Operations.....................................................................................................161
Materials Management ....................................................................................................163
Information Technology...................................................................................................165
Treasury and Risk Management.......................................................................................167
Legal Issues......................................................................................................................168
Regulatory Compliance....................................................................................................170
Service Companies...........................................................................................................171
International Issues..........................................................................................................172
Due Diligence Results ......................................................................................................174
Indicators of a Strong Acquisition Candidate..................................................................176
Factors that Terminate a Deal.........................................................................................177

Chapter 10 - Payment Structure of the Acquisition ........................................................179
The Stock-for-Stock Exchange .........................................................................................179
The Exchange Ratio .........................................................................................................181
The Impact of Options, Warrants, and Convertible Securities.........................................182
Issues Impacting the Stock Payment Decision .................................................................183
Stock Payment Based on Fixed Share Count or Fixed Price ...........................................184
The Debt Payment............................................................................................................186
The Cash Payment ...........................................................................................................187

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The Acquisition Process

Contact Information

Gunarsson Investments is the Company’s exclusive investment banker, retained
to assist in the sale of the business. To review the Company’s offering memorandum, please

contact:

Arnold Gunarsson
Managing Partner
(303) 123-4567
[email protected]

Tip: Ensure that the information in the teaser letter is accurate, and verify that the
information it contains matches the numbers used in the follow-up offering
memorandum. Recipients have a way of finding and questioning disparities between
these documents.

The seller is not identified anywhere in the letter. Instead, the investment banker acts
as a front for the seller, issuing the letter and receiving any responses to it.

If a recipient of the letter is interested in receiving further information, the
banker has the recipient sign a confidentiality agreement and then sends the offering
memorandum, which is described next. The banker may question the recipient about
its reasons for requesting the offering memorandum, and may refuse to send any
further information if it seems possible that the recipient is simply fishing for
information, and has no real interest in an acquisition.

The Offering Memorandum

The offering memorandum is the primary tool that the seller uses to communicate
the value of the business to prospective bidders. It does not have to be a
comprehensive document, since bidders will also be expected to conduct due
diligence on the selling entity (see the Due Diligence chapter). Nonetheless, it needs
to communicate the reality of the company’s recent history, its products and
services, intellectual property, employee assets, and expected future results as
accurately as possible. Any glaring errors or falsehoods in the memorandum may
short-circuit the prospects for a sale, as well as damage the reputation of the
investment banker representing the seller. The key components of the offering
memorandum are:

• Investment summary. This addresses the key points of the remainder of the
offering memorandum, with the intent of giving the reader the general out-
lines of the company’s operations, financial results, and future prospects.

• Business overview. This is a broad overview of the business. As such, it may
contain many sub-sections, including the following:
o Company history
o Product offerings
o Current research and development efforts

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The Acquisition Process

o The markets in which the company competes
o Its ongoing sales and marketing activities
o Types of customers, possibly referencing any concentrations of

sales among the larger customers
o Major facilities
o Condensed biographies containing the positions, qualifications, and

achievements of the core management team
o The general number of employees in each functional area, possibly

also including their average tenure with the company and educa-
tional backgrounds
o Environmental issues and how the company has mitigated them
o Legal issues currently outstanding

Tip: It is acceptable to disguise the names of key customers, suppliers, and
employees in the offering memorandum, if it seems possible that a recipient could
use this information to harm the company in any way.

• Industry overview. This section describes the structure of the industry, the
major players within it, its historical rate of growth, and other pertinent in-
formation. If all bidders are expected to come from within the industry, this
section can be excluded.

• Products and services. This section contains a summary of each major
product or product line, their sales levels, gross margins, and related distri-
bution channels.

• Management. This section describes the qualifications of those key manag-
ers who are expected to remain with the business, and their roles within the
company.

• Financial overview. This section contains both historical and forward-
looking information for both the income statement and balance sheet. The
income statement should include a line item for earnings before interest,
taxes, depreciation, and amortization (EBITDA), since that gives a better
view of earnings from operations. The historical information should be for
the last five years, as well as the year-to-date information for the current
year. The amount of forward-looking financial information should encom-
pass at least the next three years. There may be some justification for re-
moving certain expenses from the income statement, such as excess owner
compensation, but it is better to state this information separately, so that
readers can see the untrammeled company results first, and then make their
own decisions about what the results could be following acquisition integra-
tion activities.

• Capitalization table. This summarizes the ownership of the business by
class of stock outstanding.

• Exhibits. There may be a small number of exhibits attached to the offering
memorandum to provide additional detailed information in a few key areas.

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The Acquisition Process

Examples of such exhibits are audited financial statements, itemizations of
historical product sales, and lists of patents owned.
• Other. It may be possible to spice up the offering memorandum with photos
of company facilities, products, and production lines, which may increase
the level of recipient interest in the company.

Tip: Subject the offering memorandum to an unusually high degree of examination.
This may call for reviews by the managers of every functional area in the company,
as well as the company’s attorneys, auditors, and investment banker, to ensure that
the information presented is accurate.

When a company sends an offering memorandum to a prospective bidder, it should
only do so after the other party has signed a confidentiality agreement in which it
also agrees not to solicit the company’s employees with job offers for at least the
next year. Since the offering memorandum contains crucial information about the
qualifications of the company’s senior management team, it could be used as a
recruiting tool.

After a week to ten days, all recipients of the offering memorandum are
contacted to see if they have any interest in buying the company. If so, they are
requested to submit an expression of interest in the company, with a stated price they
may be willing to pay, subject to additional due diligence in the business. There is
no standard format for an expression of interest, and could be as simple as a one-line
e-mail. A more detailed version could include:

• The total amount of consideration
• The form of that consideration
• Contact information for those assigned to the due diligence team
• The expected number of days to close the transaction

The seller then schedules the likeliest group of bidders for presentations by the
management team.

Presentations

The next step is for each bidder to send in a team for a tour of the facilities and a
management presentation. In most cases, it makes sense to have the presentations at
an off-site location, to preserve the confidentiality of the proceedings.

The meeting room should be well-prepped for the presentations. This means that
drinks and snacks should be served at the beginning of each meeting and
periodically refreshed during the meeting. The projector should be tested in advance,
as well as all other equipment needed for the presentation. To ensure that all details
are settled properly, someone from the presenting team should be on-site an hour
before the presentation is scheduled to begin.

Most presentations are made in a room having a standard boardroom configura-
tion, with a long table down the middle and the presentation screen at one end. If so,
the two teams generally sit across from each other. If the presentation is held in a

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The Acquisition Process

larger room where the tables are set up in a “U” configuration, the bidder’s team is
usually positioned across the bottom of the “U” so that they face the screen.

Tip: Try not to include too many managers in the presentation. Otherwise, a small
team from an interested party might feel overwhelmed by the large number of
people in the room.

If there is an investment banker, this person usually begins with welcoming
comments and then turns over the meeting to the owner or most senior manager
from the selling company. This person introduces his or her team, after which the
most senior person from the visiting group does the same. The management team
then begins its presentation.

The management presentation typically follows the general areas already
addressed in the offering memorandum. The presenters are those key members of
the management team whom prospective bidders will be most interested in meeting.
They should elaborate upon key aspects of the offering memorandum and take
questions from the audience.

The presentation team should give the best possible presentation. This means
formatting the PowerPoint presentation so that each slide is cogent and formatted in
a consistent manner. The entire team should run through the presentation several
times in advance, critiquing and adjusting the presentation. Also, prepare a list of
questions and pose them to the presenters during practice sessions. The investment
banker has seen many presentations, and so can play an important role in this review
process.

Tip: It is extremely important to keep the presentation as short as possible. A
lengthy, rambling talk does not impress attendees. Instead, keep presenters from
digressing, and encourage them to be brief in their expansions upon each bullet point
shown on the screen.

It makes sense to schedule the least likely bidders first, so that the presenters can
work through their presentation mistakes with this group and gradually refine it for
the later presentations with bidders more likely to buy the company. Where possible,
the bidder having stated the best offer should go last, when the presenters will have
already formulated a reply to every possible question, and will have arrived at the
most polished presentation.

Tip: Have someone record the amount of time taken on each slide and take down
audience comments, both during the review sessions and actual presentations. This
allows for continuing adjustments to the presentation.

Always provide the audience with copies of the PowerPoint presentation. By doing
so, they will spend less time taking notes and more time interacting with the
presenters.

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The Acquisition Process

Acquisition Story: One company of which the author was the CFO had run through
its management presentation numerous times, so that everyone knew how much time
they should spend on each slide. One manager decided that he needed to ensure his
employment with a bidder, and so spent 20 minutes describing his personal
background, despite a 30-second time budget for that item.

There may also be a plant tour. If the facilities of the seller comprise a key part of its
value, such as a manufacturing facility, then absolutely schedule a tour. However, if
the company is essentially a sea of cubicles, as is the case in many industries, it may
be better to preserve confidentiality and have either an abbreviated tour or none at
all.

If there is to be a plant tour, be sure to examine the tour area carefully at least a
week in advance. This gives enough time to spruce up the area before any tour
groups arrive. Consider a new coat of paint, moving out all trash and unused
equipment, and possibly paring back on the amount of inventory stored along the
route that the tour will take.

After the presentations have been completed, the seller or investment banker
contacts the meeting attendees to see if they are still interested in the company. If so,
they are sent access codes to use the company’s online data room (see the Data
Room chapter for more information). The company can monitor their usage of the
data room; continual accessing of information over several days is a good sign of
continuing interest.

The Auction Process

In many situations, the seller will opt for a selective auction, which is conducted
among a small number of prospective bidders who are most likely to have a strong
interest in acquiring the company, and in offering a reasonable price. There is some
chance that an outlier bidder will not be invited who might have offered more for the
business. However, having a short list of bidders involves less work interruption by
the seller’s management team, shortens the auction process somewhat, and may
improve the level of confidentiality.

Tip: Once the seller has selected the auction finalists, contact all other recipients of
the offering memorandum (and any other confidential materials) and ask them to
return the documents. This can preserve some degree of confidentiality.

If the management presentations and plant tours have gone well, it is now time to
solicit letters of intent (LOIs). It is better to solicit LOIs, rather than term sheets,
since term sheets are less specific (see the Acquisition Documents chapter).

Expect bidders to submit their LOIs at the last possible moment, or even
deliberately wait a day or two after the due date before making a submission.
Bidders do this because they are always suspicious that their offers will be shopped
to other participants. Consequently, it is not uncommon for a final submission date

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The Acquisition Process

to come and go with only a few LOIs trickling in; better offers may still be on their
way.

A brief review of the LOIs will not necessarily reveal a clear winner. Instead, it
may be necessary to create a matrix in which the various factors offered by each
bidder are enumerated. For example, one bidder may offer a higher price, but with
half of the payment structured as a five-year note, while another bidder is willing to
offer an all-cash deal but at a price 25% lower than the highest bid. The seller needs
to sort through these offers and evaluate each one. If there is an investment banker
involved, this person can offer valuable advice, especially based on any experience
he or she may have had with these bidders in the past. Nonetheless, the final
decision rests with the seller.

Tip: Never reveal to bidders the identities of other bidders. Not revealing this
information keeps bidders wondering if someone else is available to supplant them,
which tends to keep them from negotiating for an excessively low price.

Based on this decision, one bidder is selected, and negotiations over the exact terms
of the purchase agreement commence, using a purchase agreement template that is
provided by the seller. This can be an arduous process that does not always end in a
sale, so the other bidders should be politely put on hold.

Acquisition Story: In one situation where a subsidiary was being sold and its
president insisted on a generous employment contract with the buyer, the parent
company had to go to the fourth bidder among the finalists before it could obtain a
deal that incorporated this condition.

All aspects of the purchase agreement are open to negotiation, so settling upon a
mutually agreeable version can require a significant amount of work by the attorneys
representing both sides. One item that is likely to be reduced through these
negotiations is the price. For example, the seller may not want to escrow any part of
the purchase price, which the bidder will only agree to in exchange for a reduction in
the price. Or, the seller may want a certain legal structure for the deal that improves
its tax liability situation, which the bidder will only accommodate in exchange for a
price reduction. Another common scenario is that the bidder finds problems during
its due diligence investigation, and demands a compensatory price reduction. Thus,
the price stated in the LOI tends to be the maximum that the seller is ever likely to
see, with a variety of issues forcing it down to a lower level.

It is of some importance to not allow too long a period to elapse before complet-
ing a transaction with the designated high bidder, since negotiations may fail, and
the seller may need to turn to the next-highest bidder to conclude a deal. This can
also be a negotiating tactic by the bidder, to delay matters so long that the seller no
longer has any other interested parties. It will likely require 60 days to complete any
remaining due diligence, negotiate the terms of the agreement, and close the deal. If
the bidder extends this period past 90 days, the seller needs to start considering

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The Acquisition Process

shifting to the second-best bidder. Of course, no discussions with other bidders can
commence until the exclusivity period stated in the LOI has expired.

Tip: The seller should schedule a meeting immediately after the LOI exclusivity
period has terminated, to see if the selling process appears to be proceeding on
schedule, or if it should terminate discussions at once and move to the next-best
bidder.

During the negotiation of the purchase agreement, the attorneys for the two parties
take over and work their way through each draft of the document, summarizing
issues found and sending them back to their principals for direction. There will also
be some areas in which information is missing, requiring fast-tracked research to
find, verify, and incorporate it into the document. Also, due diligence has typically
not been completed by the time the purchase agreement is being drafted, so last-
minute items found in due diligence will have to be incorporated into the purchase
agreement. All of the iterations involved in this process result in spectacular legal
bills once the acquisition has been completed, but that is part of the acquisition
process.

There is a tendency for bidders to delve into due diligence issues long after all
substantive issues have been discovered. By doing so, they can continue to nibble
away at the price being offered. The seller can put a stop to this by being firm about
the targeted closing date, and persistently following the progress of the closing to
ensure that it is completed on time.

Acquisition Story: In one transaction, the buyer’s legal due diligence team kept
digging through inconsequential issues, and had already dragged out the planned due
diligence period by two weeks. The CEO of the seller finally called the president of
the buyer late one night and demanded payment by the following morning, or else
the deal was off. The money arrived as soon as the banks opened the next day.

Summary

Without question, the auction process is a slower method for selling a business, but
it tends to yield a higher price than if the seller were to engage with a single bidder.
The board of directors may insist on the auction approach, since it can prove to
investors that it engaged in all reasonable efforts to give them the highest possible
return on their investment in the business. As just noted, the downside of this higher
price is the longer period of time involved – typically 12 weeks to close a deal, with
some transactions requiring many additional weeks.

The Bankrupt Seller Acquisition Process

The preceding discussion of the auction process for the seller also applies when a
company is being sold while under bankruptcy protection, though there are some
differences in the process and in who makes decisions. Some issues are:

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The Acquisition Process

• Trustee. A bankruptcy trustee may be appointed by the bankruptcy court to
run the business. This person may elect to sell the business, if that outcome
is expected to yield the highest return to the company’s creditors.

• Investment banker. Given the poor financial condition of the seller, it is
more necessary than usual to hire an investment banker. A good one may
have so many contacts among potential buyers that it can consummate a sale
transaction much more quickly than would otherwise be the case.

• Bid deposit. Any entity entering a bid for a bankrupt company must pay a
deposit, which is based on a percentage of the bid they are submitting. The
entity will lose this deposit if it is awarded the sale and then cannot close the
deal.

• Notice of sale. If someone makes a bid for the company, notice of this bid
must be sent to other interested parties to ensure that the best price was ob-
tained for the creditors. Thus, an initial bidder is at risk of having its bid
topped by another party.

• Final approval. Instead of the seller approving the highest bid, the bank-
ruptcy court approves it.

• Subsequent apportionment of price. Though not of direct interest to the
acquirer, the price it pays must be apportioned among the various creditors
who are entitled to it – which may require one or more years to settle.

In addition to the preceding points, an overriding issue is speed – a bankrupt
business is probably losing customers, suppliers, and employees at a rapid rate, so it
is essential to sell it as quickly as possible. Entire transactions may be concluded in
as little as a few weeks or a month. The focus in these rapid sales is not necessarily
to obtain the best possible price, but rather to obtain a good offer, fast. Doing so
returns as much money as possible to the creditors before the underlying business
fails.

Reconciling the Acquisition Processes

This section addresses the key differences between the two main acquisition
processes described in this chapter, including such issues as price, timing, due
diligence, and control of the purchase agreement.

The most important difference in the two acquisition processes is price. A single
acquirer that approaches a target company is not being forced by an auction process
to pay the highest possible price, and so will not do so, unless it uses a pre-emptive
bid to keep anyone else from making a bid. Conversely, the auction process is more
likely to obtain a high bid, though some serial acquirers refuse to engage in auctions.

There is a difference in the time required to purchase a business under these
approaches. The auction process can be several months longer, since extra time is
required to locate and solicit potential bidders, as well as conduct presentations to
multiple companies, and possibly negotiate with several bidders. This can be a
problem for a motivated seller who needs cash immediately.

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The Acquisition Process

A significant difference between the two processes is that a serial acquirer is
likely dealing with sellers who have not prepared any information for them, whereas
sellers who have initiated the process will have audited financial statements and a
complete set of due diligence information posted into an electronic data room. This
difference can cause major delays in the acquisition process for the serial acquirer,
who may have to wait several months for a financial statement audit to be
completed. There may also be a number of documents requested for the due
diligence process that are missing (such as board minutes), and which may never be
found. Thus, the serial acquirer is faced with a more prolonged due diligence
exercise than a bidder taking part in an auction process.

Control of the purchase agreement is a subtle but important difference between
the two approaches. A serial acquirer that approaches other businesses about an
acquisition will insist on using its own purchase agreement and making any changes
to it, while the seller provides this document in an auction environment. It is up to
the party not controlling the purchase agreement to identify and negotiate changes to
any disagreeable provisions, so there is a negotiating advantage in controlling the
purchase agreement.

The acquisition process flows presented in this chapter are certainly different,
but their results tend to become more similar as they get closer to a purchase
agreement. In both cases, the acquirer sets a price that it is not certain will be
justified by the information that it uncovers during the due diligence process. Then,
as due diligence progresses, the operational and financial condition of the seller
becomes more certain, which tends to result in a continual series of incremental
reductions in the proposed purchase price. Thus, irrespective of the acquisition
process, the seller will be on the defensive during the last stage of an acquisition,
fighting to retain the proposed price. Even if the final price ends up being
substantially lower than the initial proposed price, the seller may still accept the
deal, because it has become committed to completing the sale.

A final note is that serial acquirers tend to avoid auction situations, since their
own search techniques and negotiation methods give them a different means for
acquiring businesses, and typically at lower prices than would be required in an
auction environment. Nonetheless, a serial acquirer may engage in an auction for a
particularly choice seller. Or, it may monitor the auction proceedings and swoop in
later if no one successfully completes a deal with the seller.

Summary

This chapter has outlined the acquisition process flow from the perspective of the
serial acquirer and the seller that uses an auction process. Each party uses its own
approach for a very good reason – the serial acquirer needs to initiate contact
continually with a large number of targets to achieve a much smaller number of
completed deals, while the seller prefers to contact a broad number of potential
bidders to ensure it itself of the best price. Despite their differing goals, both parties
use the same general technique – starting with a large number of potential
respondents and then winnowing down the field.

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