Module_4_Lecture_Notes-Deal_Structuring_and_Form_of_payment

Lecture Overview

Course: BUSI 4510Professor: Dr. Isaac OtchereFocus: M&A Deal Structuring Process and Form of Payment

Objectives:

• Understand the M&A deal structuring process and its implications in corporate finance.

• Learn the significance of different financing forms utilized in M&A transactions and how they impact shareholder value.

Deal Structuring Process

Definition: The M&A deal structuring process involves a comprehensive analysis and formulation of approaches to identify:

• The primary goals and motivations of the transaction parties, which could include growth, market access, cost efficiencies, etc.

• Potential alternatives to achieve these strategic goals, ensuring that various options are explored before decisions are made.

• Effective methods to share and mitigate risks associated with the transaction for all parties involved.

Key Criteria:

• The structuring must satisfy the primary objectives of both the buyer and the seller to facilitate a successful agreement.

• It must maintain acceptable levels of risk to ensure long-term sustainability and compliance with regulatory requirements.

Primary Components of Deal Structuring

Elements integral to the deal structuring process include:

• Acquisition Vehicles: These are the legal entities through which the target acquisition is conducted.

• Post-Closing Organization: Refers to how the entities will be organized and function after the completion of the transaction.

• Form of Payment: The manner in which the acquisition will be financed.

• Form of Acquisition: The legal framework within which the transaction takes place.

• Legal Form of Selling Entity: The type of entity that is being sold and its associated liabilities.

• Tax Considerations: Analyzing how taxes will affect the transaction structure and financial viability.

Acquisition Vehicles

Definition: Legal entities that are established or utilized for the purpose of acquiring a target business.Types:

1. Corporation: Provides limited liability to its owners, enhancing the ability to raise capital through equity markets.

2. Holding Company: Operates as a parent company to control other businesses while protecting its assets from liabilities.

3. Partnership: Offers flexibility in operations and taxation, allowing for a share of profits without incurring double taxation.

Post-Closing Organization

The structure adopted post-acquisition is contingent on the acquirer’s objectives:

• Strategies to facilitate quick integration into existing operations while minimizing risks to the owners and stakeholders.

• Consideration of corporate or divisional structures for immediate operational efficiency.

• Evaluation of a holding company structure if there is a need for earn-outs or when dealing with international targets.

• Utilization of partnership or joint ventures (JV) when future risk is perceived as high or uncertain due to variability in market conditions.

Form of Payment in M&A

Payment Options: Different methods through which transactions can be financed:

• Cash: Provides immediate liquidity but incurs immediate tax liability for the seller.

• Non-Cash Payments:

  • Common Equity: Might result in earnings per share (EPS) dilution and potential deferred tax implications.

  • Preferred Equity: Presents a lower risk for shareholder liquidation in times of financial distress.

  • Convertible Preferred Stock: A hybrid instrument that possesses characteristics of both common and preferred stock.

  • Debt: Lower risk during liquidation, but increases the leverage of the acquirer.

  • Real Property: Can provide potential tax benefits but may also entail complexities in valuation and integration.

  • Combination Payments: A bespoke structure addressing the needs of different stakeholders involved in the transaction.

Trends in Forms of Payment

The trends in payment methods are often reflective of broader economic cycles. For instance, high interest rates typically lead to an increase in stock financing as organizations seek to avoid debt. Cash-based transactions typically dominate smaller acquisitions due to straightforward financial implications, whereas transactions exceeding $25 billion typically see higher occurrences of stock financing.

Earnouts (Contingent Payouts)

Definition: A portion of the purchase price stipulated to be paid out based on the future financial performance of the acquired entity. Usage:

• Particularly valuable when there is a discrepancy between buyer and seller expectations regarding future performance projections.

• A mechanism to retain and motivate key managerial personnel from the target firm post-acquisition. Forms:

• Earnouts can be structured as payments contingent upon achieving certain performance thresholds or averages.

• These can allow for horizontal or lump-sum payments, depending on the performance metrics agreed upon.

Risks and Considerations with Earnouts

Although earnouts can align interests between buyers and sellers, they also shift certain risks:

• There is potential for poor performance outcomes leading to demotivated management if performance targets are not met.

• Managers might prioritize short-term results to meet targets, potentially at the expense of long-term growth and value creation.

When are Earnouts Commonly Used?

• Frequently seen in small or privately held firms.

• When the seller's access to information is limited, making valuation challenging.

• Situations where minimal integration is expected post-acquisition to mitigate complexity.

• Abnormal returns for bidders are often noted around the announcement dates of such deals.

Collar Agreements

Definition: These are risk management agreements that adjust the exchange ratio of the payment based on fluctuations in the bidder’s share price during the acquisition process.Preservation of Value: Helps to mitigate the perceptions of overpayment or underpayment of stock value at the time of merger completion.Types of Collar Agreements:

1. Fixed Exchange Collar: Maintains the agreed-upon exchange ratio provided that share prices remain within a predefined range.

2. Fixed Payment Collar: Ensures that target shareholders receive a specified dollar value under certain price conditions.

Value Effect of the Form of Payment

The choice of form of payment significantly influences shareholder returns:

• Short-Term Event Studies: Indicate that cash payments typically yield higher positive returns for target shareholders, whereas stock payments usually generate lower returns for the bidders.

• Long-Run Studies: Suggest that, in terms of excess returns over a prolonged period, cash deals consistently outperform stock-based transactions.

Factors Impacting Form of Payment Choices

• Buyer and seller perspectives on investment strategies and valuations.

• The likelihood of competing bids may also determine how payment structures are designed.

• Consideration of tax implications and potential control fluctuations during negotiations.

• Transaction costs related to executing cash payment versus stock options.

• The effects of asymmetric information can significantly affect payment decision-making in the marketplace.

Summary of Deal Structuring

The primary focus is on satisfying the key objectives of both parties involved and effectively sharing risks through the deal components, which include acquisition vehicles, payment forms, legal structures, and tax implications. An understanding of the prevailing economic conditions is critical as they play a significant role in determining the most viable form of payment, ultimately impacting future benefits for all shareholders involved.

Key Takeaways

• Strategic choices made in one deal area have the potential to influence other facets of the deal.

• Aligning all components of the deal structure is crucial for achieving optimal performance and minimizing conflicts.