One of the more exciting parts of the Finance space is M&A. This is where you may often find heavyweight investment banks battling it out to complete ever bigger deals. But what is the M&A, and how does a deal work?
We clearly have two parts to M&A – the mergers, and the acquisitions. We will more often see acquisitions, for reasons I will explain later, but the two are pretty similar transactions.
A merger involves two companies agreeing to merge, and become one company, often under a new name, or a name that is a combination of the two original names. An acquisition, on the other hand, involves one company (acquirer) purchasing another (target) company. The business of the target company is then absorbed into that of the acquirer. The end result in either case is two companies becoming one.
The first question to address then, is why such a transaction would be undertaken? For mergers, often they are undertaken to provide a wider range of business opportunities or market coverage, or to reduce redundant work by both companies in order to make the companies more profitable. An acquisition usually has many of the same goals, however one party is more aggressively pursuing the deal, and therefore becomes a purchaser.
How does one buy a company?
When you purchase a company, there are two options for payment – cash or stock. A cash payment is straightforward – a certain amount of cash is given for each share outstanding of the company you are purchasing. You effectively buy all of the shares available, and therefore own the company.
However, an alternative is to issue a certain number of your own shares for each outstanding target share. This effectively converts the shares of the target company into shares of the acquirer. The amount of shares issued is determined by the ratio between the stock prices of the companies, and the final purchase price.
These two approaches can also be combined – creating a cash/stock deal. Considerations for which way to go include borrowing that would be required – a Leveraged Buy Out will usually be performed using borrowed cash, which a company that has loan covenants restricting more borrowing may lean more toward a stock purchase.
The mechanics of how to pay for the company essentially comes down to a range of factors that are more complex than this article is trying to get at.
How much do you pay for a company?
Due to the scale of some of the transactions in the market, it is impossible to fully understand how they work unless you are one of the people working on the deal. However, there are some general ideas which can be understood. Note: This discussion is focused on publicly traded companies, not privately held companies.
When a deal is put in place, a purchase price must be determined. This is done in a number of ways, but the general idea is that you use the Enterprise Value of the company. This enterprise value the market value of equity, plus the market value of debt, less any cash.
EV = Market Cap + Debt – Cash
The reason for this, is that in order to own a company, you must own the stock. However, when you own the stock, you must now also pay back any debt that the company has, so this increases the purchase price of the company. However, any cash that the company has on its books will be transferred to the purchaser, and can be used the pay down that debt.
As is quite obvious, the amount that is offered by the acquirer is usually higher than the market cap of the business. This is known as a premium. There are several ways of determining the price that should be paid for a company, but the main ones will involve some kind of comps analysis or discounted cash flow analysis.
To determine whether a deal is worth going through with, and what price will make it work, an M&A model must be built.
The first step to the M&A model is to make assumptions about different costs or parts of the deal. Some major assumptions that must be made may include, but are not limited to:
- Current share price and number of shares outstanding of the buyer
- Current valuation information of the seller
- Expected purchase price and premium
- Portion of consideration arising from cash
- Portion of consideration arising from stock
- M&A transaction fees
- Financing fees from new equity/debt issues
- Expected interest rates on new debt
The next thing that must be built is a sources and uses of funds table. Essentially what this does is breaks down where money for the deal is coming from, and what it is being used for. Importantly, the sources of funds must always equal the uses of funds.
At the end of the day, the thing that shareholders will be interested in is whether they will earn more or less from their investment after the deal takes place. This is determined through the earnings per share. While the process for adjusting the balance sheet and income statements for the combined company can be quite complex, and definitely warrants its own blog post, the basic idea is that if EPS goes up, then the deal is accretive. However, if the EPS goes down, the deal is dilutive. A deal that is accretive is perferable for obvious reason.
While there are many, many technical details that affect M&A transactions, and many investment bankers make entire careers out of handling such deals, the basics of the deals almost always remain the same as outlined above. A good way to get comfortable with M&A analysis is to read different reports on M&A deals that are posted in the news, which will begin to lead to understanding of how the deals take place.
If you want to read more on the subject, go read the following book.Investment Banking, Second Edition: Valuation, Leveraged Buyouts, and Mergers & Acquisitions