Strategic mergers during an economic downturn can position the combined company (“NewCo”) as a stronger entity as the global economy improves. Existing shareholders of each company do not have to sell out at a historically low point of the business cycle and, thus, can potentially recover more value in the recovery stage by capitalizing on the consequent synergies. The complexities of merging two entities can be a daunting task, beginning with the determination of the merger exchange ratio. To illustrate the concept of how this ratio is determined, imagine two companies (Company A and Company Z) have decided to pursue a merger. Company A is worth $50 and Company Z is worth $50, so the total value of the NewCo (before consideration of any merger synergies, discussed below) is $100. In this case, the merger exchange ratio would be 50/50 – i.e., Company A’s shareholders would own 50% of NewCo after the merger, and Company Z’s shareholders would also own 50%. However, if Company A were worth $40 and Company Z $60, the ratio would be 40/60 (and so on and so forth).
When two public companies decide to merge, the process of determining the merger ratio is often quite simple – after all, their “value” is readily apparent by looking at the current trading price of each company’s publicly traded stock (once again leaving aside, for now, any premium given one company or the other for the expected value of any post-merger synergies). However, when two privately held companies decide to merge, the process of establishing the exchange ratio is not quite so simple. Because the price of a private company’s stock is not readily observable, a value for each merger partner must be independently established in order to calculate the ratio. A financial advisor can help bridge the gap between the two entities and aid the process to ensure neither party is disadvantaged, especially if one of the entities will be assuming a minority role in NewCo. The balance of this article will discuss the different roles a financial advisor (or advisors) may play in this process, as well as some of the valuation issues that should be considered in due course.
Role of the Financial Advisor
There are several ways in which a financial advisor can work with the respective merger parties to assist them in establishing the exchange ratio. The first, and most obvious, is for each party to hire its own financial advisor to value their respective company, with the two parties then exchanging those valuations and using them to attempt to negotiate the ratio. While it may appeal to a business owner to have their own advisor to serve as an “advocate” for their specific interests in the deal, there is one primary drawback to this arrangement. Specifically, it virtually guarantees that there will be significant inconsistencies in the manner in which the financial advisors approach the two valuations – e.g., the information that is utilized, the valuation methodologies that are employed, the standard of value that is followed, etc. One way in which this issue can be mitigated to some extent is for the two parties to jointly hire a third, independent financial advisor to review the two previously issued valuations for consistency, accuracy, and reasonableness. This third firm can then make recommendations (either binding or non-binding) as to its view of the two valuations, and the appropriate exchange ratio for the proposed merger.
Of course, the introduction of a third financial advisor adds another layer of cost into the process, and, to the extent that this firm’s recommendations are not binding on the two parties, may not achieve the desired result of addressing the questions raised in the first place by the initial valuations. There is, however, a third option that is not often considered by the parties to a potential merger. Specifically, the parties could jointly retain a single financial advisor with the responsibility to simultaneously value both companies involved in the merger. The advantages to this approach are threefold. First, because the advisor is jointly retained by the two parties, it is not beholden to the agenda of either party, and can prepare its analysis without bias or undue influence. Second, the use of a single financial advisor ensures greater consistency and comparability of the two valuations. And third, because the cost of retaining the financial advisor is shared between the two parties, the overall execution costs of the transaction can be kept to a minimum.
Common Valuation Issues to Consider
There are numerous valuation issues to consider when determining the proper merger ratio. The first step in the valuation is determining the value of the two entities on a stand-alone basis. The focus of the valuation should center on the traditional approaches to valuation such as an Income Approach (i.e., discounted cash flow method) or Market Approach (i.e., a market multiple analysis). An asset approach may not be as applicable due to differences in asset utilization and profitability. Ultimately, the methodologies that are utilized to value each company should be determined based upon the prevailing facts and circumstances surrounding each company.
The entities are likely to have differing financial projection assumptions, discount rates, and applicable earnings multiples due to their respective profiles for growth, risk, and profitability. A financial advisor should also consider differences in geography, products and end markets. For example, one company may have significant operations in Europe, which is a more mature and (some may argue) competitive market; whereas, China is a higher growth region with less developed capital markets and greater potential volatility and risk. Additionally, end markets can also affect the growth and profitability levels of the entities (e.g., OEM vs. aftermarket).
When performing the valuation, certain off balance sheet liabilities and contingent liabilities should also be considered as they could have an adverse effect on value (i.e., pending lawsuits, warranty issues, regulatory issues). One category of liabilities that should be closely analyzed (and which may not be entirely transparent) is any post-retirement obligations. Many times, both companies will have their own employee benefit plans. During the pre-merger due diligence phase, both firms need to disclose all relative information relating to their employee benefit plans and decide to either terminate one plan in favor of the other or merge the two plans together in the NewCo. Any unfunded liabilities or payments required by the firms should be taken into account in the merger ratio.
Another important issue surrounding the development of the merger ratio is the issue of minority versus controlling interests. Many times a company will consider taking a minority interest in NewCo in order to benefit from the expected increase in value due to synergies and the increased scale in operations. Thus, by giving up control of their own business, there may be added value for taking a minority interest in NewCo. These issues must be considered when evaluating any potential compensation to the (post-merger) minority partner for giving up this control. While they are beyond the scope of this article, these issues are generally handled in concert with corporate governance provisions and pre-arranged liquidity options (e.g., put and call rights).
As noted, some of the most common problems encountered in attempting to set the exchange ratio are simple inconsistencies in the way the valuations for each party are performed. Thus, whether there are two (or more) financial advisors involved, or a single financial advisor that is valuing both companies, it may make sense for the parties to come to an up-front agreement on as many (as possible) of the processes, procedures, and methodologies that will govern the valuation process. This may range from something as simple as agreeing to a standard data request to provide to both parties (to ensure that each party is submitting a similar type and quantity of data, and in a similar level of detail); to creating a standardized “template” for the financial projections that each party will submit; to even agreeing on which publicly traded guideline companies will be utilized in a market approach analysis. Obviously, the individual assumptions (for growth, risk, profitability, etc.) underlying the valuation of each company will be fact-specific and will be left to the discretion of the financial advisor(s), taking into account the information they have received, their conversations with the respective management teams, and their own independent research. However, the more items that the parties can agree to up front regarding valuation templates, processes, etc., the lesser the likelihood that differences in approach will become an issue that will endanger the process at a later stage.
Post-Merger Synergies & Their Impact on Value
Combining operations can provide immediate cost savings and efficiency gains for NewCo. Redundant assets can be liquidated to generate cash or pay off debts to strengthen the combined balance sheet, and sales can be increased through cross selling of products and services. Gross profits can be improved through vertical integration and better capacity utilization. The increased size of NewCo can impact credit ratings, and can have a positive impact on the combined cost of capital, making it more economical to borrow capital to finance growth. The credit rating may also be impacted by the possibility that the earnings and cash flow of NewCo may become more stable and predictable, allowing it to borrow more and at better terms, than the merger parties could have done as individual entities. Ideally, the merger will also produce a stronger management team and talent pool. Therefore, one question that may arise when performing the valuations is how to value these synergies and how to allocate the synergies between the two entities.
Valuing synergy requires assumptions about future cash flows and growth. Thus, the value of the synergy can be estimated by forecasting the higher cash flows from existing assets as a result of cost savings and economies of scale, higher expected growth rates due to leverage in the companies’ end markets, and the lower expected cost of capital. Synergies are unlikely to be realized immediately after the merger, but rather during the subsequent years as NewCo consolidates operations. Since the value of the synergies is the present value of the additional cash flows that are created, the longer it takes for the synergies to develop, the lesser their value. To approximate the value of the synergies, it is necessary to estimate the value of the combined firm with no synergy by adding together the separate values previously determined for each firm, then building the effects of synergy into the expected growth rates and cash flows and revaluing the combined firm with synergies. The difference between the value of the combined firm with synergy and the value of the combined firm without synergy provides a value for synergy.
If synergy can create significant value under the right conditions in a merger, the next question becomes one of determining how this incremental value should be shared between the acquiring firm and the target firm’s stockholders. Since synergy requires resources, talent, and assets to be contributed by both the acquiring and target firms for its existence, the acquiring company’s share of the synergy will depend upon how unique the attributes it brings to the mix are. If only the acquiring firm has the unique resources and assets necessary to realize the expected synergies, it should reasonably receive a larger share of the synergy benefits. If the acquiring firm’s strengths are not unique and could be offered by other firms as well, the bargaining power shifts to the target firm, and its stockholders should arguably receive the bulk of the benefits.
Other Factors to Consider
Companies considering a merger should also consider the potential pitfalls to completing a successful merger, such as anti-trust concerns and competitive issues if the deal fails. A merger between competitors reduces the number of participants in the market and, thus, may be subject to anti-trust review. Proper due diligence with counsel prior to a merger is also important to avoid potential information-sharing issues, such as the requirement to open up a company’s financials and strategies to competitors, if the deal falls through.
The primary reason for completing a merger is to enhance cash flows leading to added shareholder value. In a private company, shareholders are unable to achieve liquidity as easily as their public company counterparts; thus, during the due diligence phase, discussions of an exit strategy should be had in order to maximize shareholder value upon exit. For example, if NewCo is private, management needs to consider if the company would be an attractive IPO or acquisition candidate or, if the company is already publicly traded, could it garner a higher multiple post-merger.
Conclusion
In the end, thorough due diligence and consideration of the factors cited herein are vital to completing a successful merger. A well-executed merger can create significant additional value for the shareholders of the merger parties. However, many mergers are complex, and the process of understanding and negotiating the terms of a deal can be eased by utilizing a valuation professional to help establish a reasonable (and supportable) exchange ratio between the two parties.
