Mergers & Acquisitions

A Guide to Understanding These Common Corporate Practices

Mergers and Acquisitions present a complex financial situation in which a variety of factors must be considered in the outcomes. Most important, are factors of agency costs, compensation, and the CEO and board’s responsibilities to stakeholders. Creating contingency plans is vital to mergers and acquisitions (M&A).

Agency Cost

M&A’s are complex financial situations which require the involvement of different parties. This creates a situation in which the cost to the principal in the acquisition can grow and sometimes outweigh the benefit of the merger. There competing stakeholders in the M&A which can cause this issue:

Most mergers and acquisitions involve at least four parties with competing interests — acquiring firm shareholders, acquiring firm management, target firm shareholders, and target firm management (Moeller, 2001).

It is for this reason that agency cost must be monitored in order that situations such as conflicts of interest and neglect of fiduciary responsibility do not occur. This problem is controlled through compensation management.

Compensation

All parties involved in the M&A must be compensated and this presents a complicated negotiation process as the various stakeholders will vie to achieve the best compensation or cost possible. Compensation is a difficult area due to the fact that target firm’s are trying to achieve the best possible price in friendly takeovers or trying to limit the damage that may be incurred to the company during a hostile takeover. Because managers in a firm being acquired typically lose their job in M&A this can present agency risk in which the target firm may increase compensation demands during these transactions. As well, the target shareholders will attempt to obtain the highest price for their interest which can have a direct impact on the cost of the M&A. For this reason, agents involved in the M&A must maintain the fiduciary requirements to shareholders as well as outlining contingency plans for divestment.

Fiduciary Requirements

There is a legal duty to the shareholders of a firm which the directors must maintain during an M&A. This fiduciary responsibility is explicit under most state laws which is described as a duty of care:

The duty of care requires that directors be informed and exercise appropriate diligence and good faith as they make business decisions and otherwise fulfill their general oversight responsibilities. When reviewing plans to sell a company unit or to buy or merge with another company, the board must exercise proper oversight of management, especially with respect to issues of strategy and compliance with legal obligations such as mandatory disclosures (Lajoux, 2015).

This means that the board must analyze opportunities and risks appropriately as well as looking at the alignment of strategies within the merger. Short term profits can damage companies in the long term if this is the deciding factor for carrying out an M&A. Most importantly this type of consideration must be made on both sides fo the M&A. The target and acquiring companies must decide how the combination will impact both boards. This is an important consideration because it directly impacts the success of the merger:

…among the mergers of Fortune 500 companies, most directors on the acquiring board (83%) stay on, while only about one-third of directors from the target board (34% of the inside directors and 29% of the outside directors) continue to serve after the merger. The study also shows that for acquiring company boards, outside directors who sit on more than one other outside board have a higher chance of remaining members (Lajoux, 2015).

The risk involved in M&As can be high. As a result of this risk there are other methods of expansion which may be more beneficial and less expensive. For example, strategic alliances and joint ventures offer companies a means of entering new markets or gaining market share without risking large amounts of capital or loss of brand. Joint ventures are a popular option because they reduce the risk and cost of other forms of market entry such as M&A. Normally, a foreign firm will possess a superior technology or competence such as how to deal with foreign governments or manufacturing technology. This allows the firms to share knowledge while bath are able to leverage the new market.

Strategic alliances are also a less costly option than the M&A. This allows firms to create working relationships but they maintain their separate brands and operations. This works well in many instances such as expanding selling channels are product lines.

The problem with both joint ventures and strategic alliances is that they allow firms to remain separate which can actually harm one of the firms if operations are studied or one firm becomes competitive with the other. There is no guarantee that these relationships will work and can cost one firm business to another.

As a result of these considerations for mergers and acquisitions, contingency planning must be defined in terms of possible outcomes. Contingency planning should consider the fiduciary responsibilities as it must maintain ethical and legal responsibilities entailed in the M&A process (Lajoux, 2015). If agency cost and risk is becoming too high, there must be a contingency plan for divestment. This is a difficult area because in many cases the acquiring firm may have already spent a large amount of money in the M&A process.

Tax Inversion M&A

A tax inversion M&A occurs when a company acquires a foreign firm for the purpose of establishing a legal entity in a country with decreased corporate taxes. This occurs most often with American companies moving their operations to foreign countries. Relocating a company is expensive and complicated but this strategy can be highly beneficial saving the corporation a tremendous amount of money in the long run.

One of the primary motivations for the tax inversion M&A is the fact that US corporate tax is extremely high, approximately 35% is amongst the highest globally (Hall, 2014). Once an inversion is complete the company will begin increasing shareholder wealth due to the lower cost of operation.

Taxable Vs Tax-Free Transactions

The tax inversion M&A is complicated by the taxing of the purchase and sale. This is an important factor because the sale must be made in a manner that either makes it a taxable or tax-free purchase (Hall, 2014). The manner in which this is determined is by the method of purchase. In a purchase in which stock or assets are used and the company must reorganize the loss whereas in a tax fee purchase there is no reorganization of loss (Hall, 2014).

Stock and Inversion

Initially, tax inversion M&As can be positive for investors. The tax inversion is inviting because it means that the firm will be saving money in the long run and this increases the stock’s value since the company can afford to pay higher dividends. In many instances this can incur an increase of more than 25% of the stock’s value. Typically, this trend in M&As is the standard but it can occur that the M&A inversion loses value depending on the situation. For example, moving a corporation to a foreign country can damage brand. There are also industry considerations as some industries do not benefit from this in the way that other industries benefit. For example, pharmaceutical companies benefit from this inversion because the laws in other countries are typically less stringent on their operations so there is a larger benefit than just corporate tax. However, clothing industries have not benefitted because they compete for labor in foreign entities and this creates price schemes that are often damaging to profits.

Conclusions

The tax inversion M&A is typically a beneficial maneuver for companies. While the cost for completing the transaction is high, the benefit can offset this cost quickly through savings. Perhaps the largest benefit is the fact that the company can increase its benefit to shareholders which makes it more appealing to investors in the long run.

References

Hall, J. (2014). Corporate Inversion: Tax strategies for the 21st Century . Online: Amazon.

Lajoux, A. R. (2015, September 7). Role of the Board in M&A. Retrieved from Harvard Law School: https://corpgov.law.harvard.edu/2015/09/07/role-of-the-board-in-ma/

Moeller, T. (2001, July). Who’s Cheating Whom in Mergers and Acquisitions? How Managerial Preferences Influence Attitude, Target Choice and Payoffs ∗. (R. University, Producer) Retrieved from Thomas Moeller: http://www.thomasmoeller.net/thomasmoeller/research_files/Merger_Theory.pdf