Mergers & Acquisitions

Synergy Analysis

sales forces and marketing materials of the acquirer and acquiree, in order to give
the appearance that the companies are operating separately; however, this also
means that any synergies from combining the sales functions of the businesses
cannot be pursued.

A variation on the concept of revenue synergies is when the acquirer purchases a
well-developed brand, with the intent of putting its own products within the
marketing umbrella of the acquired brand. Doing so would presumably equate to
greater customer acceptance of the rebranded products, which may translate into
higher unit sales or higher prices. However, a brand is created not just through long-
term marketing, but also with close attention to product quality, customer service,
and field support. If the acquirer attempts to force lower-grade goods into an
established brand, the likely outcome will be a weakening of the brand in the minds
of consumers, rather than increased sales. To make the brand extension concept
work, the acquirer must be willing to invest in upgrading the products it wants to
place within the brand, as well as the support of those products. This process can
take a considerable amount of time, which means that any synergies gained from
acquiring a brand may not be realized for several years.

A bright spot in the analysis of revenue synergies is that a larger combined
entity may have a better chance of winning government contracts. A government
may have purchasing rules that prevent it from awarding contracts to suppliers that
have revenues or assets below a certain threshold level. A business combination may
move a company above this level, which at least qualifies the organization to
compete. In reality, a business must still present proof of having experience
fulfilling larger government contracts, so it may take time before any additional
sales are obtained.

In summary, any gains to be had from revenue synergies can be hard to pin
down, and may never be realized at all. An acquirer should only plan for synergies
in this area if it has a history of achieving such gains with other acquisitions, and so
knows exactly which actions to take. Conversely, a company embarking on the
acquisition path for the first time will be uncertain of how to achieve revenue
synergies, and so should not assume that these gains can actually be achieved.

Synergy Analysis for Capital Expenditures

A synergy area that is not always considered is whether the capital expenditures of
the combined entities can be reduced below the level required for the businesses if
they were to be operated separately. This situation may arise when one of the two
businesses has recently made a large capital investment that results in excess
capacity, and which can accommodate the needs of the other business. If so, it may
also be possible to sell off some excess assets, in which case there may be some cash
to be gained from the acquisition.

While a reduced level of capital expenditure is a useful outcome of an acquisi-
tion, it is also a rare situation. More commonly, the target company has put itself up
for sale precisely because it does not have the cash reserves to meet its ongoing
fixed asset requirements. If this has been the case for some time, then the assets of

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the target company may be in a state of considerable disrepair. This means that the
acquirer is more likely to make a large (and immediate) investment in the acquiree,
just to keep operations functioning. Thus, the due diligence team is more likely to be
on the lookout for ancient equipment than for excess capacity that can be eliminated.

Another concern with capital expenditure analysis is the perceived need to
eliminate excess capacity. This is reasonable if the combined companies are not
subject to major swings in sales volume. However, a sharp cutback in production
facilities can also mean that the combined entity no longer has the ability to meet
surges in customer demand, which means that sales will be lost or at least delayed.

In short, the possibility of cutting back on total capital expenditures is a
tantalizing one, but can be difficult to achieve in practice without reducing the
overall capabilities of the combined business. If anything, the acquirer may find
itself burdened with an initial surge in capital spending.

The Synergies Table

Once all synergies have been analyzed, combine them into a table that shows the
amount of cash flow to be gained from each one over time. Doing so shows the
aggregate amount of synergies available to the acquirer, as well as any delays likely
to be experienced in achieving the synergies, and the costs associated with
implementing each one. A common occurrence is to see an initial cash expenditure
for some synergies, as the acquirer must make termination payments of various
kinds before ongoing savings can be achieved. A refinement of the table is to
include an estimated probability of success, so that a reader can readily discern the
perceived level of difficulty associated with each line item. A sample synergy table
is noted in the following exhibit.

Sample Synergies Table

Synergy Probability Quarter 1 Quarter 2 Quarter 3 Quarter 4
Staff reduction 100% -$250,000 $80,000 $80,000 $80,000
Close production line 80% -50,000 15,000 60,000
Sell excess equipment 60% 10,000 110,000
Eliminate advertising 100% -$240,000 75,000 75,000
Reduce inventory 50% 25,000 50,000
Process improvements 80% 25,000 30,000 35,000
$190,000 $250,000 $250,000

The exhibit only shows synergy-related cash flows for the first year following an
acquisition. In reality, this table should be extended for several additional years, so
that the full impact of all synergies can be seen. This is of particular importance if
some synergies are expected to require several years to fully attain.

Another option in setting up the table is to also note any impact on contribution
margins that result from implementation of the synergies. For example, terminating
the employment of selected salespeople will likely reduce the amount of sales, as
well as the contribution margin associated with those sales. By using this approach,
one can see the full impact on total cash flows of expense reductions. In some cases,

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the offsetting contribution margin declines may be so large that it does not make
sense to proceed with a proposed synergy project.

The concept of incorporating contribution margin effects can be taken a step
further. A truly rigorous analysis of synergies can include all of the following
factors:

• Projected contribution margin changes
• Projected expense changes
• Projected capital expenditure requirements
• Projected changes in working capital
• Projected financing costs
• Projected tax impact

EXAMPLE

The acquisition team for Colossal Furniture is delving into the details of synergies involving
its prospective acquisition of Shrimpy Designs (which manufactures furniture for thin
people). One item on the list is a projected increase in contribution margin of $2,000,000 that
is expected from offering Shrimpy products for sale in the showrooms of Colossal. The team
finds that several other issues should be incorporated into this analysis:

• Working capital. Colossal will have to maintain $200,000 of additional inventory in
order to support the sales growth, for which the related financing cost is $20,000 per
year.

• Support. Shrimpy’s customers typically demand a moderate amount of field support
related to furniture installations. This added cost will reduce the contribution margin
by 5%, or $100,000.

• Sales staff. There must be one additional salesperson on hand at each of the five
stores where the Shrimpy products will be offered, which will cost a total of
$150,000 per year.

• Tax rate. The company’s incremental tax rate is 35%.

Based on these additional considerations, the actual amount of net profit that Colossal is
likely to achieve is $1,124,500, which is almost half of the original estimate.

Synergy Analysis for Risk Reduction

Most of the discussion in this chapter has been about finding ways to improve the
cash flows from an acquisition. An additional area worth contemplating is the ability
to reduce the overall risk of the acquirer or the acquiree by engaging in an
acquisition. Here are several examples of risk reduction:

• Environmental liabilities. An old manufacturing business owns a number of
“smokestack” production facilities, and wants to reduce its exposure to pol-
lution-related lawsuits. Accordingly, it embarks on a campaign of selling off
the old facilities and acquiring new businesses that do not involve the crea-
tion of hazardous waste.

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• Key employee dependency. A company may have one person whose
knowledge and contacts are so crucial to the company that it would be una-
ble to function if that person were to leave. Engaging in an acquisition can
greatly increase the pool of people with a high level of knowledge and expe-
rience.

• Large customer dependency. A business may have a relatively small number
of large customers that provide the bulk of its revenue. If so, there is a risk
of being too dependent on these customers. If just one were to stop buying
from the company, the result could be a sudden and substantial decline in
profits. Buying another company that has a broader customer base can miti-
gate this risk.

• Technology. A company may have an aging set of patents for key technolo-
gy that it has been unable to improve upon with new research investments.
Once the patents expire, the company will be laid open to lower-priced
competition. An acquisition can bring access to a new set of patents and
research facilities that will improve the competitive position of the business.

In the presented cases, the acquirer is still interested in generating positive cash
flows – otherwise, it would be difficult to run the business over the long term.
However, the orientation of where those cash flows are generated shifts to different
types of businesses, thereby mitigating the existing risk profile of the acquirer and
the acquiree. In many cases, the risk profile of the acquiree is especially enhanced
by an acquisition, since acquirees tend to be smaller organizations that are more
likely to suffer from specific types of risks.

EXAMPLE

Meridian Company accumulates information about oil and gas leases, and rents this
information to the larger oil and gas exploration firms, which use it to bid on parcel leases
being offered by the government. The trouble that Meridian has experienced is that it takes
more than five years to develop a quality salesperson that has sufficient knowledge to sell the
company’s products to new customers. As a result, Meridian only has two salespeople who
can consistently generate sales.

The president of Meridian learns that a competitor, Baseline Brothers, is putting itself up for
sale. Baseline employs three quality salespeople who are experienced in selling similar
products to the ones sold by Meridian. The board of directors of Meridian decides to make an
offer for Baseline, with the intent of increasing the company’s pool of key salespeople and
thereby reducing its risk of a sales decline caused by a salesperson departure.

Synergy Secrecy

When the acquirer develops a list of synergies, it customarily does not share this
information with the target company (or any valuation information, for that matter).
The reason is that synergies may be the prime source of excess profits from an

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acquisition. The target company should have some idea of its own value, but not of
the additional value that it could bring to the acquirer through synergies.
Consequently, if the target were to obtain the acquirer’s list of synergies, it would
demand that a portion of the savings be handed over as part of the purchase price.
Thus, synergies should be a closely guarded secret.

It is entirely possible that an aggressive seller will develop its own list of
synergies, usually with optimistically-high savings for each item. This list is used to
justify a higher purchase price for the business, on the grounds that the acquirer is
expected to profit from the synergies. If this situation arises, the acquirer will likely
end up squabbling with the seller regarding the realism of the opportunities listed on
the seller’s synergies list. The negotiating position of the acquirer is to question all
presented synergies, since doing so may yield a lower purchase price for the
business. This is an interesting position for the acquirer to be in, since its negotiating
team may privately consider the presented list to be entirely reasonable, and possibly
even the source of synergies that its own team did not uncover.

The Cost of Synergies

The main focus of a drive to achieve synergies is the reduction of expenses. This can
have a major impact on both employees and suppliers. The employees of both the
acquirer and acquiree can expect layoffs, which can have a severe impact on the
local community if the business is a large local employer. This may be less of a
concern if a business has a small footprint in a local community, but can have a
bearing on the decision to implement a synergy project if the owners are directly
impacting the livelihoods of their neighbors. If there is significant social pressure,
and/or if the owners of the acquirer are interested in building a “good neighbor”
image, it is more likely that staff cutbacks will be achieved through attrition over a
number of years.

A similar impact may arise for suppliers. The acquirer may want to aggregate
purchases with a small number of suppliers, in which case some suppliers may
experience a sudden and catastrophic decline in sales. However, if the impacted
suppliers are located away from the home base of the company, there is less social
pressure to stop dealing with these suppliers. Consequently, it is much less likely
that supplier-related synergies will not be pursued.

Few organizations are willing to avoid synergy projects in order to relieve the
dislocation experienced by employees and suppliers. Instead, they are more inclined
to make larger employment or contract severance payments. By doing so, they are
still assured of achieving planned cost reductions over the long term, while at least
providing some short-term support to those being impacted.

Summary

In a situation where a canny seller is pushing for the maximum possible sale price,
the acquirer must rely upon the use of synergies to eventually earn a positive return
on its investment. If so, the proper quantification of synergies is critical. It is not

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sufficient to simply guesstimate a cost reduction or revenue gain for a set of
supposed synergies. Instead, the due diligence team should review possible
synergies in detail, questioning the ability of the acquirer to implement each one.
Once a set of reasonable synergy gains has been compiled, this information is
translated into an action plan, laying out exactly which steps must be taken, how
much will be saved, due dates, and who is responsible for each step. Only after this
action plan has been reviewed in detail and approved will the acquirer have a
reasonable understanding of the gains to be realized from synergies, and therefore
the maximum amount that it can afford to bid for the target company.

In addition, the board of directors (which must approve any acquisition deal)
should be particularly cognizant of the worst-case scenarios associated with a
synergy analysis, and the probabilities associated with those scenarios. If there is a
strong chance that lower synergy levels will be achieved, then the premium that the
board should be willing to pay should also be reduced. Otherwise, there is an
increased risk of achieving a reduced rate of return on the funds invested in an
acquisition.

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Chapter 8
Hostile Takeover Tactics

Introduction

Whenever possible, there is a strong preference for engaging in friendly takeovers,
since the cost tends to be lower and the in-place management team is more
cooperative. However, when an acquiring business sees a strong need for some
advantage held by another business, it may resort to a hostile takeover. This chapter
discusses the primary techniques for doing so – the tender offer and proxy fight, as
well as the less-used bear hug. We also cover a variety of takeover defenses that the
acquirer may encounter. We begin with an overview of the Williams Act, which
governs some aspects of hostile takeovers.

The Williams Act

The Williams Act is an amendment to the Securities Exchange Act of 1934. It
requires the disclosure of information related to tender offers or the possibility of
tender offers. A key provision of the Williams Act is that a shareholder must issue a
notification to the Securities and Exchange Commission (SEC) on Schedule 13D
when its holdings of the common stock of a target company reach five percent of the
total number of common shares outstanding. In that schedule, the shareholder
describes the number of shares owned, the source of funds to be used to pay for any
shares purchased, the reason for acquiring shares, the plans of the shareholder if it is
successful in gaining control over the business, and a number of lesser issues. The
filing must be completed within ten days of reaching the five percent plateau. The
shareholder must continue to provide updated versions of the schedule when there
are material changes to the information, which means that an acquirer is typically
issuing a stream of follow-on schedules to document changes in its share holdings.

The Act also prohibits the use of false, misleading, or incomplete statements in
relation to a tender offer, and gives the SEC authority to engage in enforcement
lawsuits.

Further, the Act requires that an acquirer keep any tender offer open for a
minimum of 20 business days. The acquirer is not allowed to purchase any tendered
shares during that time. Instead, it buys the shares at the stated offer price at the
termination of the tender offer period. There are three scenarios for buying shares
under a tender offer:

• Inadequate tender offer. If the number of shares tendered is less than the
target amount designated in the tender offer, the acquirer may elect to either
buy or not buy the shares.

Hostile Takeover Tactics

• Sufficient shares. If the number of shares tendered matches the target
amount designated in the tender offer, the acquirer must purchase all ten-
dered shares.

• Excessive shares. If the number of shares tendered exceeds the target
amount designated in the tender offer, the acquirer must purchase the target
amount, which means that shares will be purchased on a pro rata basis.

The Act allows shareholders to withdraw tendered shares at any time prior to the
completion date of a tender offer. This allows shareholders to evaluate bids from
other acquirers, and shift their shares to the tender offer giving them the best payout.
The procedure for doing so is to submit a withdrawal letter, along with a verified
signature.

If another party issues a tender offer while the first tender offer is still current,
the Act mandates that shareholders have at least 10 business days in which to
consider the new offer. This means that the duration of the first tender offer may be
extended to match the requirements of the Act.

EXAMPLE

High Noon Armaments issues a tender offer for Ninja Cutlery that terminates on August 31.
On August 27, a rival bidder issues a competing tender offer. There are five business days in
the period from August 27 to August 31, so High Noon extends its tender offer by five
business days to comply with the Williams Act.

There have been two key effects of the Act, which are:
• Higher payments. A considerable amount of information must be disclosed
along with a tender offer, and there is enough time for shareholders to con-
sider the offer, which tends to increase the amount paid for the shares of
target companies.
• Stronger defenses. There is a minimum waiting period before a tender offer
can be completed, which gives the management of the target company time
in which to mount a defense, if it chooses to do so.

Schedule TO

When any party makes a tender offer and accumulates more than five percent of a
class of the shares of a publicly-held business, it must file a Schedule TO (“Tender
Offer”) with the SEC, as well as send a copy to the target company’s executive
offices, and notify any exchanges on which the target company’s shares are traded.
The key items included in the schedule are as follows:

• Acquirer. Identify the entity making the offer.
• Financial statements. The acquirer must provide its financial statements

when the acquirer’s financial condition is material to the decision of a
stockholder to sell shares to the acquirer. There is no need to provide finan-

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cial statements when the offer is for cash, the offer is not subject to a financ-
ing condition, and the acquirer is a public reporting company.
• Purpose. Describe the purpose of the transaction.
• Shares owned. State the number of target company shares already owned by
the acquirer.
• Source of funds. State the source of funds or other consideration used to
make the stock purchases.
• Term sheet. Summarize the terms under which the acquirer is willing to
purchase shares. This includes the number of shares the acquirer is willing
to purchase, the expiration date of the tender offer, the procedures for ten-
dering and withdrawing shares, and the method of payment.

There are a number of other routine disclosures, but the main issues were noted in
the preceding bullet points.

Initial Share Acquisition

If an acquirer is planning a hostile takeover attempt of a publicly-held company, one
of its first steps is to begin accumulating shares in the target. By doing so, it can
purchase a small proportion of the target’s shares at a reasonable price, before the
market becomes aware of its intentions and begins to speculatively increase the
share price. Once the company makes its intentions public, it will have to purchase
the remaining shares at a much higher price, so this initial purchase reduces the
average cost of the entire acquisition transaction.

Tip: If the acquirer intends to take its time acquiring shares, it should keep any
purchased shares in the name of its brokerage firm, thereby concealing the identity
of the acquirer. See the next paragraph regarding disclosure of stock ownership.

The acquirer is required by law to disclose its holdings of a target company within
10 days of acquiring at least five percent of its stock. Thus, depending upon its
ability to acquire shares in the short term, an acquirer could reach the five percent
threshold and then keep acquiring shares for an additional 10 days before revealing
to the public its ownership interest in the target company.

Tip: If you reach the five percent ownership threshold on a Wednesday, you can
delay the disclosure of holdings for 12 days, since the 10th day of the allowed filing
period falls on a Saturday. You would then file on the next business day, which is a
Monday. This delay gives the acquirer more time to buy additional shares before the
investment community hears about the tender offer and ratchets up the share price.

The acquisition of an initial block of shares has the additional advantage of making a
potential white knight bidder think twice about making a bid, since it knows the
acquirer will become a hostile shareholder. A white knight is an entity that makes a

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friendly offer to acquire a business that is the subject of a hostile takeover attempt by
a third party.

Depending on the circumstances, an acquirer could decide to continue accumu-
lating stock until it buys a sufficient number of shares to gain control of the target
company, without using the other takeover techniques noted later in this chapter.
This approach may work if share ownership is not sufficiently concentrated in the
hands of those individuals or businesses that want the target company to remain
independent. However, once the investment community realizes that a large number
of shares are being bought, the share price will rise, which reduces the effectiveness
of this approach.

Tip: Once a hostile takeover attempt becomes public knowledge, arbitragers begin
to accumulate the shares of the target company, in hopes of realizing a gain when it
is bought by the acquirer. This presents an opportunity for the acquirer, which can
scoop up these large blocks of shares with just a few transactions (though possibly at
a high price). Arbitragers are willing to sell quickly (if the price is right), since the
alternative is to wait for a tender offer and regulatory approvals to be completed,
which delays their profit-taking on shares held.

The downside of this initial purchase is that the buyer may fail in its bid for the
target company, in which case it will likely sell the shares it has accumulated. The
market price may have changed by the time the buyer elects to sell the shares, and
the sale of a large number of shares will certainly exert downward pressure on the
stock price; this presents the risk of a loss on the transaction. Thus, if the acquirer
believes it will encounter a vigorous defense by the target company, it may be less
inclined to initially acquire shares.

Initial Communications

If the target company has a history of vigorously defending itself against buyout
offers, and has stated that it wants to remain independent, then there is little point in
engaging in any initial communications, even through third parties. Instead, you
probably want to prepare for a hostile takeover attempt in complete secrecy, so the
target does not have any additional time in which to mount its defenses. On the other
hand, there may be no information about a potential target’s stance on being
purchased. If so, a possibility is to have a third party, such as an attorney or
investment banker, contact the management of the target company. The objective of
this contact is to gain an idea of the response the acquirer would meet with if it were
to proceed with an offer. The third party may or may not reveal the identity of the
acquirer, depending upon the circumstances. Thus, the direction taken on initial
communications will vary by target.

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The Bear Hug

One approach to a hostile takeover is the bear hug; it is when the acquirer makes an
offer to buy the shares of the target company at a price that is clearly higher than
what the company is currently worth. The board of directors of the target company
has a fiduciary responsibility to obtain the best possible return for the shareholders
of the target business, so the board may essentially be forced to acquiesce and accept
the offer. Otherwise, the board may face lawsuits from shareholders. Another
advantage of the bear hug is that other potential bidders will very likely stay away,
since the price offered is so high that it would be uneconomical for them to top the
offer. Also, this approach is less time-consuming than a protracted takeover battle.
Yet another advantage is that the high price paid tends to mitigate hard feelings by
the employees of the target company, making them somewhat more likely to remain
as employees following the takeover.

If the board does not accept the bear hug offer, there is an implied threat that the
acquirer will then take the issue directly to the shareholders with a tender offer to
purchase their shares. Thus, the bear hug is essentially a two-step strategy: an initial
overwhelming offer to the board, followed by the same offer to the shareholders.

While there is a good chance that a bear hug strategy will work, the downside is
that it can be extremely expensive, so the acquirer has little chance of earning an
adequate return on its investment in the target. This approach is only needed for a
hostile takeover, since a friendly one can usually be achieved with a smaller
investment.

Tip: If a bear hug offer is issued, consider making the offer known to the public
shortly thereafter, perhaps through a press release. Doing so increases the pressure
applied by shareholders to the board of directors to accept the offer.

The Tender Offer

An acquirer may resort to a tender offer when it has made a friendly offer to
management that has been turned down. The acquirer uses a tender offer to go
around management and appeal directly to the shareholders. The SEC defines a
tender offer as follows:

“A tender offer is a broad solicitation by a company or a third party to purchase a
substantial percentage of a company’s … registered equity shares or units for a
limited period of time. The offer is at a fixed price, usually at a premium over the
current market price, and is customarily contingent on shareholders tendering a
fixed number of their shares or units.”

The particular advantage of a tender offer is that the acquirer is under no obligation
to buy any shares that have been put forward by shareholders until a stated total
number of shares have been tendered. This eliminates the initial need for large
amounts of cash to buy shares, and also keeps the acquirer from having to liquidate
its stock position in case the tender offer fails. The acquirer can include escape

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