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Published by igodigital, 2017-04-14 12:04:27

Mergers & Acquisitions

A Comprehensive Guide

Keywords: merger,acquisition,comprehensive,guide

Due Diligence

restrictions can severely impact the amount of cash that an acquirer might
expect to extract from an acquisition transaction.
• Non-operating results. Identify all non-operating transactions that arose
during the review period, and strip them out of the financial results to see
how the core operations of the business performed. This includes extraordi-
nary income and expenses, proceeds from insurance claims and legal settle-
ments, gains or losses on asset sales, and so forth.
• Expenses categorized as non-operational. A company may shift expenses
into a non-operational expense category, such as extraordinary expenses, in
order to make its earnings from operations look more impressive. Be sure to
examine all expenses claimed to be non-operational, and reclassify them as
operational, if necessary.
• One-time events. See if there were any operational events that are unlikely to
occur again, and strip them out of the results of operations. This is a com-
mon problem for one-time sales to large customers, such as the sale of a
large number of software licenses to the federal government. This is a par-
ticular problem, because target companies have an annoying habit of putting
themselves up for sale immediately after such sales, on the assumption that
buyers will assume a continuing sales level in the future, and accordingly
pay a higher price for the business.
• Adjusting entries. Examine the financial statements for unusual adjusting
entries that have been used to prop up the results of the business, such as
accrued revenue, expenses shifted into a prepaid expenses account, or liabil-
ities that were not accrued.

Acquisition Story: The author once reviewed the financial statements of a software
development company as part of a due diligence investigation, and found an unusual
$1 million asset on its balance sheet for internally developed software. The
company’s management team had decided that its latest product was worth $1
million, so it recorded the asset; doing so also changed its equity balance from a
negative to a positive number.

• Restructuring charges. The target may have created an expense accrual for
restructuring charges, which is essentially the pre-recognition of expenses
that do not happen until a future accounting period. This is a warning flag
that managers are reducing expenses in future periods, possibly to spruce up
profits in anticipation of a sale.

• Disclosures. Audited financial statements should include a set of disclosures
on various topics. Review these disclosures in detail, since they can reveal a
great deal more information about a company than is shown in its income
statement and balance sheet.

• Public filings. If a company is publicly-held, it must file the Form 10-K
annual report, Form 10-Q quarterly report, and a variety of other issues on
the Form 8-K. All of these reports are available on the website of the Securi-

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Due Diligence

ties and Exchange Commission, which is www.sec.gov. These documents
are a treasure trove of information, and describe the results of a business in
great detail.
• Management letters. After an audit has been completed, the auditors
sometimes compile a set of recommendations into a management letter,
which they distribute to the CEO and audit committee. Any such letters
issued for the past few years are worth reading, since they contain sugges-
tions to rectify deficiencies found in the company’s practices.
• Margin analysis. Nearly every viable business has one product, product line,
or business segment that generates outsized profits in comparison to the rest
of the company. The team needs to find this “golden goose,” to ensure that
the acquirer does not take any steps following the acquisition that will inter-
fere with its flow of profits. Conversely, this analysis may also reveal a
number of other aspects of the business that consistently lose money. In
short, margin analysis can be used in entirely different ways – to bolster
profitable parts of the business and restructure or even shut down money-
losing operations.

Tip: When calculating profitability for any portion of a company, it is generally best
not to allocate overhead to it, unless the overhead is generated by that portion of the
company. Otherwise, the resulting profits will be distorted, and not reveal the true
profitability of the underlying operations.

Near the end of the due diligence investigation, adjust the reported results of the
company for any synergies found, resulting in pro forma financial statements that
reveal what its financial results would have been for the past year if the acquisition
had taken place at the beginning of the year. Pro forma financial statements are the
complete set of financial statements issued by an entity, incorporating assumptions
or hypothetical conditions about events that may have occurred in the past or which
may occur in the future. If there is some concern about the ability to implement
certain synergies, then prepare pro forma statements based on best case, most likely,
and worst case scenarios.

After constructing the pro forma financial statements, also develop a one-year
cash flow forecast for the business, incorporating the best estimates of revenues and
changes caused by synergies. This information is needed to ensure that the target
will begin generating sufficient cash flows to make it worthwhile to proceed with the
acquisition.

Internal Reports

A potentially useful source of information for the team can be the internal reports
used by the management group – not necessarily because of what they contain, but
because of what they do not contain. In particular, see if there is a reporting system
in place that shows the contribution margin associated with each sales territory,
store, product line, and/or product. Contribution margin is the margin that results

145

Due Diligence

when variable production costs are subtracted from revenue. If the company does
not have this information, it means there may be an opportunity for the acquirer to
conduct a margin analysis and prune away unproductive parts of the business,
thereby generating an immediate improvement in cash flow.

Revenue

One of the most important due diligence areas is the future revenue stream, since
this is the foundation upon which most acquirers construct their expectations for a
business. As you will see from the following list, the revenue topic is comprised of
many issues. They are:

• Backlog. Ascertain the total amount of backlog, by month, for at least the
past year. This may reveal an increasing or decreasing backlog trend, which
is a strong indicator of near-term revenue levels. Also, divide the total back-
log amount into the average amount of monthly sales to arrive at the months
of sales in backlog metric; this is a useful leading indicator of future reve-
nues.

• Fulfillment issues. Is the company having any issues fulfilling its obligations
under some of the backlogged orders? This may relate to supply chain prob-
lems, production bottlenecks, or unusually strict customer approval proce-
dures. To what extent do these issues reduce the size of the backlog? Could
these problems expand to other orders within the backlog? If so, the backlog
may not represent as much short-term revenue as would normally be the
case.

• Recurring revenue stream. A key value driver in a business is its recurring
revenue stream. Determine the amount of baseline revenue that can be ex-
pected to arise on an ongoing basis. Also, consider whether this revenue is
based on subscriptions that lock buyers into longer-term purchases, or are
one-time purchases that happen to occur with considerable regularity.

• After-market sales. Investigate the profitability of after-market sales, which
involve the sale of replacement parts, upgrades, field service, maintenance,
and so forth. These sales can be enormously profitable, and in some cases
may exceed the total profits of the product lines upon which they are found-
ed. Also, does it appear that there is room for expansion of this line of busi-
ness? Given the high profit levels, an acquirer could generate easy profits by
expanding these types of sales.

• Customer changes. In the past three years, what changes have there been
among the company’s top ten customers for each product line? The intent of
this analysis is to see if there is a net decline or increase in larger customers,
which is an indicator of the general trend of sales.

• Available regions/channels. Are there any likely geographic regions or
distribution channels that the company has not yet entered? Attempt to
quantify the sales and margins likely to result from entry into these areas.
The result of this analysis is an estimation of the future growth potential of
the company, given its current set of product and service offerings.

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• Pricing philosophy. How does the company set prices? Does it add a
percentage profit to its costs, or charge based on the value of the underlying
product, or set its prices based on those of competing products? Does it po-
sition its prices somewhat low, to follow a value strategy, or somewhat high,
to follow a premium pricing strategy? If the team suspects that a different
pricing strategy could translate into higher profits, this could impact the
discussion of possible synergies.

• Pricing rigidity. Is there a history of how customers have reacted to price
increases in the past? Is it reasonable to expect the company to pass through
cost increases to its customers? Is there a competitor whose lower prices
might attract customers in the event of a price increase?

• Pricing variations. Is the sales staff allowed to diverge from stated prices? If
so, is there a standard policy for it? Is there evidence of significant depar-
tures from standard pricing, and if so, how prevalent is it? These issues may
be acceptable, if they are necessary to retain larger customer orders. Howev-
er, continual departures from standard prices are indicative of either exces-
sively high standard prices or poor pricing discipline among the sales staff.

• Estimating. Does the company have an estimating department that derives
prices for customized services or products? If so, examine the model for
soundness, and investigate whether the company has persistently lost money
on incorrect estimates in the past.

• Contract terminations. If revenues are derived from customer contracts,
obtain copies of the larger contracts and determine the remaining stream of
payments related to them, when they expire, and the likelihood of obtaining
follow-on contracts. Contract-based revenue has more value if there is a
long history of contract renewals.

• Accounts receivable. Review the most recent accounts receivable aging
report to see if there are any customer invoices that are overdue by unusual-
ly long periods of time, and find out the reasons why. If substantial, these
receivables may reduce the valuation that the acquirer assigns to the compa-
ny.

• Product life. Though subjective, make an estimation of the likely remaining
lifespan of each product. This may be based on historical records for previ-
ous products. Product life is a particularly important topic if a product might
be considered part of a fad, or subject to sudden changes in fashion.

• Franchises. If the company is in the franchising business, what is the annual
turnover of franchise ownership? What is the growth rate in franchise own-
ership? What has been the trend line of average franchise fees per franchise
for the past five years? This line of inquiry is intended to give some perspec-
tive on the likelihood of future changes in revenues.

Most of the avenues of investigation in this section are designed to use sales and
backlog information from the recent past to extrapolate what revenues might look
like in the future. This is an extremely inexact science, and could yield spectacularly
incorrect results. Consequently, the team needs to call upon its sources of

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information not just in the company, but also for the industry as a whole, to make its
best estimates of future revenues.

Cost Structure

A key area of concern is the cost structure of the company. This requires more than a
quick glance through the income statement. Instead, the team should consider the
following types of analysis to obtain a better understanding of how the business
operates:

• Target costing. Does the company have a system in place for managing the
cost of its products while they are still in development? This is an excellent
sign that the company is capable of avoiding excessive cost overruns on its
products, and so can achieve reasonable profitability levels. If such a system
is in place, investigate whether the design team includes members of the
marketing, purchasing, and industrial engineering departments, so that it is
creating products most likely to meet customer requirements, incorporate
low-cost components, and be designed for optimal manufacturing processes.

• Expense trends. Load the company’s income statements for the past five
years into a spreadsheet and create trend lines from this information as a
percentage of sales, to see how expenses are trending. If there are unusual
cost increases, ascertain the reasons for them.

Tip: Verify that all intercompany revenues and expenses between the subsidiaries of
the target company have been stripped out. Otherwise, they skew the results shown
in the financial statements.

• Core expenses. In addition to the expense trends just noted, investigate any
declines in expenses in areas where the company should be spending in
order to have a sustainable business. In particular, look for declines in
equipment maintenance, advertising, and research and development. An
even larger red flag is when these expenses have declined in just the past
year, which indicates that senior management deliberately elected to cut
expenses in order to improve the company’ reported cash flow for a pro-
spective sale.

• Retainer fees. Look for periodic retainer fees paid to legal, accounting, and
consulting firms for any number of services. Many of these can be eliminat-
ed, if the acquirer is already paying its own group of experts. Some of the
fees may also be made to outsiders who are friends or family, in exchange
for no discernible services. These fees can be a rich source of synergy sav-
ings.

• Questionable expenses. Review certain expense accounts for questionable
expenditures. These typically relate to such items as personal expenses
charged through the company, reimbursing employees for medical deduc-
tions, or excessive travel costs. The team can find this information in the
travel and entertainment, consulting, supplies, and benefits expense ac-

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counts. At a more detailed level, some of this information can be found in
employee expense reports. This is useful information, not only for learning
about the extent of favoritism and nepotism in a business, but also because it
represents a potential future expense savings.
• Loans to employees. Determine the amount of any loans extended to
employees. It is acceptable if these are small payroll advances for a short
period of time. However, if they are long-term loans under which little or no
repayment has been made, treat them as expenses that reduce the profits of
the company, and which therefore reduce the valuation of the business.
• Fixed assets. A key part of the cost structure of a business is its fixed assets.
If there have been few fixed asset replacements in recent years, it indicates a
lack of attention to the future competitiveness of the business. If a reduced
level of investment is evident, then the acquirer should reduce the valuation
of the company by the amount of extra investment it will have to make to
bring the fixed asset base back up to a reasonably operable level.
• Breakeven point. Calculate the sales level at which the business breaks even.
This is a function of the amount of fixed expenses that the business incurs
each month. A smaller amount of fixed expenses translates into a lower
breakeven point, which makes it less likely that the company will incur loss-
es at lower revenue levels.

Intellectual Property

In some industries, the majority of the price paid for a business is based on its
intellectual property (IP). This asset is usually not listed on a company’s balance
sheet, so the due diligence team needs to conduct a considerable amount of
investigation to determine what types of IP are owned by the business, and what it
might be worth. Consider the following due diligence tasks:

• Patents. Does the company have any valuable patents? It is extremely
difficult for a due diligence team to have sufficient technical knowledge to
sort through the various patents owned by a company, and figure out which
ones are truly valuable. It will likely require either an outside expert or the
services of the acquirer’s own R&D department to make this determination.

• Patent ownership. Verify that all patents are owned by the company. If not,
they are probably owned by an employee who licenses use of the patent to
the company. The latter situation provides no value to the business, and
presents the risk that the patent owner could retract usage rights. A related
issue is whether anyone has filed suit regarding ownership of the intellectual
property. If the case being made is reasonable, the acquirer must evaluate
whether the resulting loss of intellectual property could have a notable im-
pact on the value of the business.

• Trademarks. Has the company registered its trademarks? If not, see if
someone else is using them, and whether they have trademarks or have ap-
plied for them. In the latter case, the company may need to rebrand itself
and/or its products.

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Due Diligence

• Licensing income. Determine the size of any licensing income that the
company generates by licensing its patents to third parties. If there is little or
no licensing income, this could be an opportunity for the acquirer to absorb
the patents into its own patent portfolio and aggressively market them to
third parties.

• Licensing expense. A company may have licensed critical intellectual
property from another party. If so, evaluate the time period left on the li-
censing agreement, as well as the ability of the licensor to retract permission
to use the license in the future.

Fixed Assets and Facilities

Fixed assets and facilities can be an enormously important topic in an asset-intensive
industry, or only of passing interest in more service-oriented businesses. The
following list assumes that the target company is in the former situation:

• Valuation. The net book value of fixed assets as recorded in a company’s
accounting records has nothing to do with what they are actually worth if
they were to be sold on the open market. If the acquirer intends to sell any of
these assets, the team should obtain a rough estimate of their value. This
may call for the services of a third-party appraiser. If the acquirer elects to
proceed with the acquisition, an appraisal will also be useful for assigning
part of the purchase price to the fixed assets in the accounting records.

• Equipment and facilities for sale. If the company has been trying to sell its
equipment or facilities for some time, compare their condition and price to
the market rate (which may require the services of an appraiser). The inves-
tigation will likely reveal that these assets are worth considerably less than
their net book value. This may impact the acquirer’s valuation of the busi-
ness.

• Inspection. Trace the fixed asset register to the fixed asset balance appearing
in the company’s general ledger to verify that it is complete, and then trace a
selection of the items on the register to the actual fixed assets. The point of
this inspection is to prove the existence of the most essential and/or valuable
fixed assets.

• Bottlenecks. If the company has its own manufacturing facilities, have a
production expert examine them to determine if there is a bottleneck, and
the extent to which it may be impacting the profitability of the business. The
acquirer may be able to alter the production configuration or outsource some
manufacturing, thereby increasing the profitability of the business.

• Utilization. Conduct a review of the more expensive fixed assets to see if
any are no longer in use. If such assets exist and they are not needed to sup-
port peak production periods, then note these items as being potentially
available for sale. In the case of facilities, someone from the team should
visit each one to determine the level of utilization. This is particularly im-
portant for warehouse space, some of which may be eliminated through the
reduction of inventory and other assets.

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Due Diligence

• Replacement rate. Review the company’s fixed asset replacement history
for the past five years. Has it replaced assets at a consistent rate, or is it fall-
ing behind? If there is a declining investment in fixed assets, this issue
should attract detailed attention from the team. In a worst-case scenario, the
team may conclude that the existing fixed assets need complete replacement
in the near future, which impacts the price the acquirer will pay for the ac-
quisition.

• Maintenance. Have an experienced maintenance person examine the
machinery in the production area, as well as their associated maintenance
records, to see if maintenance levels have been adequate. In addition, inves-
tigate the presence of a preventive maintenance program. If maintenance
levels appear to have been inadequate, the team should estimate the cost
required to bring maintenance levels up to the acquirer’s standards. The
same issues apply to any buildings owned by the company.

Acquisition Story: The author was investigating the fixed asset records of a
software company, and found that a number of burial plots at nearby cemeteries
were listed. Upon further investigation, we found that the owner’s husband thought
that burial plots were a good investment, and had been purchasing them with
company money.

• Square footage. Divide the number of employees in an administrative
facility by its total square footage to determine the square feet per person. If
the result is a larger number than the acquirer has in its facilities, there may
be an opportunity to eliminate some facility space or put it to some other
use.

• Title records. Verify that the company has clear title to all property owned.
• Third party ownership. Is there any equipment in the company’s facilities

that is owned by a third party? These items may be removed by the owner in
the event of a change in control.

Liabilities

When reviewing the liabilities noted in this section, be sure to examine the payment
schedules and acceleration clauses associated with them. The acquirer does not want
to be surprised by a near-term balloon payment on a debt, or the acceleration of
payments that were triggered by a change in control of the business. The issues to
examine are:

• Accounts payable. Review the most recent aged accounts payable report to
see if there are any overdue payables, and find out why they have not been
paid.

• Leases. Determine if any equipment leases have bargain purchase clauses
that allow the company to buy assets at the end of the lease period for be-

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low-market prices (such as $1). If so, make note of them so the acquirer can
take advantage of the purchase clauses when their exercise dates arrive.
• Debt. Review the debt agreements associated with outstanding debt and see
if there are any clauses that accelerate payment in the event of a change in
control of the business. Also, there may be personal guarantees on debt that
must be removed before the current owners will consent to sell the business.
In addition, verify that the company is complying with any covenants in-
cluded in the debt agreements. In all likelihood, the acquirer will need to pay
off all debt as part of the acquisition, or arrange for replacement debt
agreements with the current or other lenders.

Tip: Investigate the outstanding debt of the target company as early in the due
diligence process as possible. The reason is that the target company’s lenders may
have the right to accelerate payment when there is a change in control. If the
acquirer cannot pay off these loans at once, then it may be necessary to enter into
protracted negotiations to give the lenders sufficient collateral and guarantees to
convince them to let their debt remain outstanding.

• Debts to related parties. Have managers, owners, or shareholders loaned
money to the company? What are the terms of these agreements, and do
they contain any clauses under which the other party can convert the debt
into the company’s common stock? These debts will likely need to be paid
off as part of the acquisition.

• Bonds. If the company has issued bonds, obtain the documents used to
create them, as well as a list of holders. This is particularly important if the
bonds are convertible into the company’s common stock, since this may
potentially alter the ownership of the business.

• Factoring. Review any factoring arrangements with lenders. Factoring is the
sale of receivables to a finance company. Under the arrangement, the cus-
tomer is notified that it should now remit payments to the factor. The factor
assumes collection risk. These arrangements typically carry high interest
rates, so the acquirer will probably want to terminate them in favor of other
types of financing.

• Warranties. Examine customer claims records that resulted in the replace-
ment or repair of products during the past year to determine if there are
product flaws that could result in significant expenditures in the future. Al-
so, compare warranty-related expenses to revenues over the past year, and
extrapolate that forward, based on future sales estimates, to determine the
likely amount of future warranty expenses. If warranty costs appear to be
high, then compare the warranty terms to those offered elsewhere in the
industry, to see if the terms are excessively generous.

• Earnouts. If the company has acquired other businesses in the past, does it
have any potential earnout liabilities to the shareholders of the acquired

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Payment Structure of the Acquisition

As the example shows, the impact of contingent shares is entirely on the
shareholders of the seller, since they obtain fewer acquirer shares in the stock-for-
stock exchange. Contingent shares have no impact on the acquirer, since it is still
issuing the same number of shares.

Issues Impacting the Stock Payment Decision

An acquirer is more inclined to offer stock-for-stock deals when it believes its stock
price is unusually high. During these times, it can offer fewer shares to pay for an
acquisition. Conversely, if it feels that the market is assigning it an unusually low
share price, it will be less inclined to pay with stock, for it must issue more shares.
The seller is placed in the reverse situation if it believes the acquirer’s stock to be
selling at too high a level, since there is a higher risk that the share price will
subsequently decline, and along with it the effective price paid to the seller.

EXAMPLE

The market is currently assigning a high $20 share price to the stock of High Noon
Armaments, well above its usual $12 trading price. Within the past year, its stock has traded
as low as $10 per share. High Noon is contemplating the purchase of a competitor for
$8,000,000. If it were to pay with stock, it would only issue 400,000 shares at the current
stock price. The number of shares would usually be 666,667 shares at the normal trading
price, or 800,000 at the lowest trading price.

If the acquirer believes that it has obtained a good (i.e., low) price for an acquisition,
it will be less inclined to pay with its own stock. If it were to do so, the price of the
stock should increase, and the shareholders of the seller would share in that increase.
In such a situation, the acquirer should be more interested in buying for cash; doing
so means that all share price increases will accrue to the benefit of existing
shareholders.

Note: If a canny seller feels that the stock price of the acquirer will increase as a
result of the acquisition, and it was paid in cash, then it can use the cash to buy the
shares of the acquirer. However, this will result in a short-term gain that is taxable at
a higher tax rate, unless the shareholder wants to hold the shares for an extended
period of time.

EXAMPLE

High Noon Armaments makes a low-ball offer for Black Powder Weaponry, which is
currently having cash flow problems. The price is $6,000,000, and High Noon believes that
the actual value of Black Powder is closer to $10,000,000. High Noon currently has
2,000,000 shares of common stock outstanding, at a market price of $12 per share, which
gives the company a total market valuation of $24,000,000. High Noon could pay with
500,000 shares of its stock (calculated as $6,000,000 price ÷ $12 per share). However, High

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Payment Structure of the Acquisition

Noon must consider the impact on its current shareholders if the market later increases the
price of its stock to reflect the full value of the Black Powder deal. The impact is noted in the
following table:

Deal Structure Stock Price Calculation
Pay in cash
($24,000,000 current valuation + $10,000,000 incremental valuation -
Pay in stock $6,000,000 cash)

÷ 2,000,000 shares = $14.00/share

($24,000,000 current valuation + $10,000,000 incremental valuation)
÷ (2,000,000 existing shares + 500,000 new shares) = $13.60/share

Thus, paying with stock for the Black Powder acquisition reduces the eventual price per
share that the original High Noon shareholders would realize by $0.40.

If the seller drives an extremely hard bargain, where there is little room for the
acquirer to earn a profit from the transaction, the acquirer should be more inclined to
offer stock as part of the deal structure. By doing so, the seller’s shareholders take
on some of the risk that the value of the shares with which they are paid will decline
in value.

Tip: When the acquirer has plenty of cash available, but chooses to offer mostly its
own stock as payment, this is a signal that it expects to have problems achieving
sufficient synergies to make the deal worthwhile, and so is shifting some of the risk
of failure to the seller. Thus, if the value of the combined companies is less than
expected, the market price of the acquirer’s stock will decline, which reduces the
amount that the shareholders of the seller will realize.

Stock Payment Based on Fixed Share Count or Fixed Price

There are two ways in which a stock-for-stock deal can be structured. They are:
• Fixed share count. Under this method, the exact number of shares to be paid
is incorporated into the purchase agreement. This introduces some risk to
the seller, in that the market value of the acquirer’s shares could change in
the days leading up to the purchase date. However, it also gives the seller a
fixed percentage of ownership in the acquirer, irrespective of changes in the
stock price.
• Fixed price. Under this method, the total price to be paid is incorporated into
the purchase agreement. The actual payment is based on the market price of
the acquirer’s stock on the effective date of the agreement. This method
reduces the risk to the seller that the value of the underlying shares will de-
cline in the days leading up to the acquisition.

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Payment Structure of the Acquisition

The problem with stock price variability and its impact on the purchase price is
sometimes resolved through the use of a collar agreement. A collar agreement is a
clause within a stock-for-stock purchase transaction, where the number of shares
paid to the shareholders of the seller will be adjusted if the market price of the
acquirer’s shares trade above or below certain predetermined levels, which are
usually 10-20% above and below the midpoint stock price. The agreement may also
allow either party to terminate the acquisition arrangement if stock prices fluctuate
beyond specific price points.

There are several variations on the collar concept. In a fixed-price collar, the
price is fixed within the collar boundaries. For example, the price might be set at
$10.00 per share, within a share price range of $9.00 to $11.00. In this case, the
width of the collar is $2.00. If the price of the acquirer’s stock moves outside of the
collar, then the price is based on an exchange ratio. In this situation, the seller
benefits from gaining more shares if the acquirer’s stock price falls below the lower
collar, while the acquirer benefits from issuing fewer shares if its share price
increases above the higher collar. Thus, the price is fixed within the collar and
variable outside of the collar. The fixed-price collar works well when the seller
wants to be sure of obtaining a specific valuation amount.

In a fixed-exchange collar, the exchange ratio is locked between the collar
boundaries. This means that the acquirer is setting a fixed number of shares that will
be paid within the boundaries of the collar. Outside of the upper and lower
boundaries of the collar, the price is fixed. In this situation, the acquirer keeps from
having to issue more of its own shares if its share price plummets below the lower
collar, while the seller benefits from an increase in the share price of the acquirer
above the upper collar. Thus, the price is variable within the collar and fixed outside
of the collar. The fixed-exchange collar works well when:

• The acquirer wants to preserve for itself any upside potential in its stock price
• The seller wants to establish a floor on the value of the consideration it

receives

Tip: If an acquirer is engaged in a bidding war for a target company, it can modify
its bid to include a collar agreement. This reduces the risk for the seller, and so
makes the acquirer’s bid more valuable.

The collar agreement is particularly important in two situations:
• Volatility. Stock prices in some industries are unusually volatile, making it
difficult to pin down a price to use for the exchange ratio.
• Time to close. If regulatory approval is required, it will lengthen the time
required to close the purchase transaction. This means there is some risk that
the acquirer’s share price will gradually drift away from the amount at
which the exchange ratio was first calculated. For these longer closing
transactions, it is customary to adopt fairly wide collars.

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In short, the collar agreement is useful for preserving the value of the compensation
that the seller receives, at least for the time period covered by the collar agreement.

The Debt Payment

The acquirer may include debt in the structure of its deal to buy the acquiree. This
can be beneficial to the seller’s shareholders, since they do not pay income taxes
until they receive the debt payments.

The seller should not accept this form of payment unless it is very certain of the
financial condition of the acquirer. Otherwise, if the acquirer were to enter
bankruptcy, the seller’s shareholders would simply be categorized among other
creditors to be paid out of any remaining assets. The seller can mitigate this risk to
some extent by placing the holders of the debt in the most senior position of all debt
holders. However, most companies already have assigned senior debt positions to
other lenders, so the shareholders are instead placed in a junior debt position. The
seller could place a lien on the assets of the acquiree, but the seller will have no
control over those assets once the purchase agreement is finalized; this means that
the acquirer could sell off the assets and use the proceeds, or simply let the
equipment run down over time without proper maintenance, leaving little for the
seller’s shareholders to recover.

Tip: A common acquirer ploy is to offer a large proportion of cash and a smaller
amount of debt that is either unsecured or very junior to other debt. If the debt is
considered to be speculative in any way, the seller should essentially ignore it for
purposes of evaluating the offer, and instead focus on the cash component of the
deal.

Even if the seller is certain of the financial condition of the acquirer, accepting debt
means that the shareholders will have no access to cash until the debt payments
begin. This can be a problem if the shareholders previously received dividends or
other distributions from the target company, and are no longer receiving that cash
flow. Also, now that they are debt holders, rather than shareholders, they have no
ability to vote for a new board of directors, and so have no control over the business
that owes them money.

Tip: If the interest rate on a note is at the market rate, the seller may be able to sell
the debt to another party at its face value. However, there may be a discount related
to the perceived creditworthiness of the acquirer.

Payment in debt also means that the acquirer is in a position to profit from 100% of
any stock appreciation caused by the acquisition, while the seller is locked into a
fixed payment plan.

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Payment Structure of the Acquisition

Tip: If it appears that a significant proportion of the purchase price will be paid in
the form of debt, the seller should insist on convertible debt. This means that the
seller’s shareholders can switch to stock if there is a surge in the price of the
acquirer’s stock, which allows them to share in the appreciation of the stock.

The acquirer is more likely to offer debt, if only because it can then conserve its
cash. The use of debt may be the only alternative when it is difficult for the acquirer
to obtain credit from lenders. It is an especially useful tool when the acquirer can
force the seller to accept a junior debt position behind its other lenders, thereby
effectively placing the seller’s shareholders in a position not much better than that of
its general creditors.

In short, despite the favorable tax impact of debt payments, this is the worst
alternative for the seller. On the flip side of the deal, it is usually the best alternative
for the seller. Thus, the two sides are quite likely to dicker over the presence of debt
in a deal, the terms associated with the debt, and its convertibility into the acquirer’s
stock.

The Cash Payment

The form of payment generally preferred by shareholders is cash. It is particularly
appreciated by shareholders who are unable to sell their stock by other means, which
is the case for most privately-held companies. In addition, they no longer have to
worry about the future performance of their company impacting the amount that
they will be paid. The degree to which cash is preferred is indicated by the extent to
which sellers are generally willing to accept a smaller amount of cash rather than a
larger payment in stock or debt. However, a cash payment also means that the
selling shareholders must pay income taxes on any gains immediately.

From the perspective of the acquirer, a cash payment presents both pluses and
minuses. One advantage is that, in a competitive bidding situation, the bid of the
buyer willing to pay cash is more likely to be accepted by the seller. Also, not
paying in stock means that any future upside performance generated by the
acquisition accrues solely to the existing shareholders of the acquirer – the
shareholders of the acquiree are taking cash instead, so they are blocked from the
gains.

The main disadvantage of paying with cash is the availability of cash to the
acquirer. If the purchase will use up the bulk of its cash on hand, and the borrowing
environment is difficult, the acquirer could place itself in a tenuous financial
position. However, using cash places greater financial discipline on an acquirer, who
may therefore be more prudent in setting an offer price than a company that is
willing to pay with vast amounts of stock.

A possible point of contention is the tax effect of a cash payment. The seller’s
shareholders must immediately pay income taxes on any gain resulting from a cash
transaction, so they may want additional compensation to pay for the taxes. The
acquirer typically resists this pressure, on the grounds that cash is a scarce

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