Mergers and Acquisitions

Updated on April 10, 2024
Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What is a Mergers and Acquisitions?

Mergers and acquisitions (M&A) are collaborations between two or more firms. In a merger, two or more companies functioning at the same level combine to create a new business entity. In an acquisition, a larger organization buys a smaller business entity for expansion. The collaboration between merger and acquisition companies is to eliminate competition, improve operations, or gain a larger market share.

Mergers and Acquisitions

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Mergers and Acquisitions (wallstreetmojo.com)

A company that aims to take over another business is called the acquirer. The firm that is being purchased by the acquirer is called the target. Valuation is a crucial aspect of M&As—it dictates negotiation and selling price. The dealings take place either through a stock purchase or asset buyoutsBuyoutsA buyout is a process of acquiring a controlling interest in a company, either via out-and-out purchase or through the purchase of controlling equity interest. The underlying principle is that the acquirer believes that the target company’s assets are undervalued.read more.

Key Takeaways

  • Mergers and acquisitions (M&A) are the two forms of strategic collaboration between two or more firms—one large business entity is formed.
  • M&As improve the quality of companies’ performance by reducing redundant operations, accelerating growth, and acquiring new skills and technology.
  • Growing industries reach a point of excess capacity—new entrants increase—supply rises, and prices fall. Thus, companies merge or acquire to get rid of the excess supply. This way price gets rectified.

Mergers and Acquisitions Explained

Mergers and acquisitions (M&A) are strategic alliancesStrategic AlliancesA strategic alliance is a type of agreement between two companies to reap the mutual benefits of a specific project, in which both agree to share resources and thus result in synergy to execute the project, resulting in a higher profit margin.read more between two or more companies. In mergers, companies join hands to create a new firm by pooling their assets and resources. In acquisitionsAcquisitionsAcquisition refers to the strategic move of one company buying another company by acquiring major stakes of the firm. Usually, companies acquire an existing business to share its customer base, operations and market presence. It is one of the popular ways of business expansion.read more, however, one organization buys more than 51% shares of the other business entityBusiness EntityThe business entity concept declares that a business stands independently from its owner, and hence the two should be treated as separate entities when recording transactions. Therefore, all business transactions (income, expenses, assets, liabilities, and equity) must be kept separate from the owner’s account to ensure accurate accounting records.read more.

Mergers and Acquisitions Explanation

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Mergers and Acquisitions (wallstreetmojo.com)

They are carried out for various reasons that are allowed under the mergers and acquisitions law. Its other benefits include elimination of excess workforce, growth acceleration, technology, and the procurement of new talent. By merging or acquiring firms, companies overcome competition, attain economies of scaleEconomies Of ScaleEconomies of scale are the cost advantage a business achieves due to large-scale production and higher efficiency. read more, acquire a monopolyMonopolyMonopoly is the “one-&-only” seller of a good or service in the market & it faces no competition from any other entity. Generally, it is controlled or monitored by the Government to safeguard the customers’ interests. read more, and multiply profits.

The disadvantages cannot be overlooked either. It involves a significant level of risk—acquisitions are expensive. Such changes in ownership can adversely impact a firms’ stock prices. Cultural difference is a huge hurdle—newly formed teams always take time to work smoothly. The overvaluation of a target firm can result in huge losses. In M&As, many employees lose their jobs—due to the duplicity of roles.

Financial Modeling & Valuation Courses Bundle (25+ Hours Video Series)

–>> If you want to learn Financial Modeling & Valuation professionally , then do check this ​Financial Modeling & Valuation Course Bundle​ (25+ hours of video tutorials with step by step McDonald’s Financial Model). Unlock the art of financial modeling and valuation with a comprehensive course covering McDonald’s forecast methodologies, advanced valuation techniques, and financial statements.

What is Mergers and Acquisitions? Video with Explanation

 

Types

Let us understand the different types of mergers and acquisition companies through the discussion below. This discussion will help us understand all possible combinations of transactions that can be processed in this domain.

Types of Mergers and Acquisitions

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Mergers and Acquisitions (wallstreetmojo.com)

The various forms of acquisition are as follows:

Examples

Let us understand the mergers and acquisitions law with the help of a couple of examples.

Example #1

XYZ Ltd. is a market leader in manufacturing stationary. Their revenue for the previous assessment year crossed $250 million, which was only a marginal 3% increase from the year before.

After research and analysis, it was found that a new company, A1 Ltd which entered the market only three years ago, was posing a serious threat to their sales by producing innovative products at a reasonable process. A1’s net worth was $25 million.

Therefore, the top management of XYZ decided to acquire A1 under friendly conditions and eliminate their future threat and competition.

After negotiations and considerations, the deal was finalized at $50 million. XYZ’s sales increased by a staggering 35% due to the addition of innovative products in its product portfolio and its existing essential products.

Example #2

On February 28, 2022, Zip Co (ASX: Z1P) signed a merger agreement with its US competitor Sezzle. In this collaboration, Sezzle shareholders Shareholders A shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company's total shares.read morewill receive 0.98 Zip shares for every share of Sezzle common stock. Also, Zip shareholders will get 78% stocks of the new entity.

Also, on February 28, 2022, Toronto-Dominion Bank Group (TD.TO) took over the First Horizon Corp (FHN.N) by paying $13.4 billion in cash. Toronto-Dominion Bank holds the second-highest market value in Canada. The group aims to expand into south-eastern parts of the US—outside the domestic boundaries of Canada.

Process

Let us understand the process that is to be followed according to the mergers and acquisition law through the step-by-step explanation below.

Mergers and Acquisitions Process

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Mergers and Acquisitions (wallstreetmojo.com)

  1. Self-assessment: In this phase, the acquiring company reviews the need for mergers and acquisitions. It analyzes strengths, weaknesses, opportunities, and threats. A specific M&A strategy is strategized.
  2. Search and Screen: The acquirer identifies potential target businesses that can be purchased at low prices.
  3. Investigate and Evaluate: Then, the acquirer conducts a detailed analysis and valuation of the identified business—due diligence.
  4. Negotiate and Acquire: A representative of the acquirer negotiates with the target firm to finalize the deal.
  5. Post-merger Integration: If the merger or acquisition succeeds, both companies make a formal announcement.

Valuation

Let us understand how two companies deciding to collaborate for business decide the value of their companies. The valuation of mergers and acquisition companies play a vital role in the agreement and the terms as nobody would like to pay extra for a company that is not worth the costs incurred and vice versa.

  1. Discounted Cash Flow: DCF DCF Discounted cash flow analysis is a method of analyzing the present value of a company, investment, or cash flow by adjusting future cash flows to the time value of money. This analysis assesses the present fair value of assets, projects, or companies by taking into account many factors such as inflation, risk, and cost of capital, as well as analyzing the company's future performance.read moreis computed by deducting the capital expenditureCapital ExpenditureCapex or Capital Expenditure is the expense of the company's total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year.read more and change in working capitalWorking CapitalWorking capital is the amount available to a company for day-to-day expenses. It's a measure of a company's liquidity, efficiency, and financial health, and it's calculated using a simple formula: "current assets (accounts receivables, cash, inventories of unfinished goods and raw materials) MINUS current liabilities (accounts payable, debt due in one year)"read more from the sum of net incomeNet IncomeNet income for individuals and businesses refers to the amount of money left after subtracting direct and indirect expenses, taxes, and other deductions from their gross income. The income statement typically mentions it as the last line item, reflecting the profits made by an entity.read more and depreciationDepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. read more. It thus interprets the firm’s current value using future cash flowsCash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more.
  2. Enterprise Value to Sales Ratio: EV/Sales ratio evaluates the enterprise valueEnterprise ValueEnterprise value (EV) is the corporate valuation of a company, determined by using market capitalization and total debt.read more as a multiple of the revenue generated by the company.
  3. Price to Earnings Ratio: The P/E ratioP/E RatioThe price to earnings (PE) ratio measures the relative value of the corporate stocks, i.e., whether it is undervalued or overvalued. It is calculated as the proportion of the current price per share to the earnings per share. read more determines the price an acquirer plans to offer. It is represented as a multiple of the target firm’s earningsEarningsEarnings are usually defined as the net income of the company obtained after reducing the cost of sales, operating expenses, interest, and taxes from all the sales revenue for a specific time period. In the case of an individual, it comprises wages or salaries or other payments.read more.
  4. Replacement Cost: The acquirer determines the replacement costReplacement CostReplacement Cost is the capital amount required to replace the current asset with a similar one at the present market rate. Usually, assets replacement occurs when their repair & maintenance charges surge beyond a reasonable level. read more of a target firm by identifying a competing target available at the same price.
M&A valuation

Benefits

Let us understand the benefits of mergers and acquisition companies collaborating with one another in detail through the explanation below.

  • When two companies join hands, their size of operation increases and they have better chances of acquiring raw materials at a lower cost since the quantity of purchase is likely to rise.
  • Since both companies can combine their workforce, the overall cost of their labor might go down significantly.
  • With databases of two companies, it becomes easier to expand sales geographically as well as each of their connections would help them introduce their partnership to a larger audience.
  • The biggest advantage of such collaboration is that these companies can grow to an extent with a larger market share in their domain.

Limitations

Despite the benefits mentioned above, there are certain factors from the mergers and acquisition law and other management-related factors that prove to be a limitation for all parties involved. Let us understand them through the points below.

  • Firstly, carrying out a merger procedure according to the laws can significantly increase legal costs for both companies.
  • There is a great chance of mismanagement of resources as M&A can be time-consuming and a tedious process. Generally, corporations appoint one executive to overlook the procedures and processes on their behalf to ensure daily routine is not affected. However, it often turns out otherwise.
  • The coordination and understanding between the management of two companies can clash due to varying ideologies.

Merger Vs. Acquisition

While both these terms are used interchangeably, there are noticeable differences. Let us understand the differences between mergers and acquisition companies through the comparison below.  

BasisMergerAcquisition
MeaningTwo or more firms combine their assets and resources to form a single business unit.One giant company takes over a small business entity by purchasing its stocks or assets.
Firm SizeBoth merging companies have similar size and scale of operationThe acquirer is larger than the target—in size and scale of operation
Type of DecisionMutualFriendly or hostile
Formation of New FirmYesNo
PowerEqual power to the involved partiesAcquirer holds the power
Legal ProcedureLengthyComparatively quick

Frequently Asked Questions (FAQs)

What is the difference between mergers and acquisitions?

A merger is a collaboration of two or more business entities of the same size—forming one large organization for sharing their resources, ideas, technology, and assets. On the other hand, an acquisition refers to a large firm buying a small firm—to get hold of its assets and resources.

Why do mergers and acquisitions fail?

Most Mu0026As fail due to poor due diligence, leading to an improper valuation of target firms. The other significant cause is the absence of strategic planning. Moreover, the collaborating organizations may have cultural differences. Sometimes, target companies have hidden debts.

How do mergers and acquisitions work?

First, the acquirers analyze target firms. It is followed by the target firm’s valuation and due diligence. Then, the acquirer negotiates the value, along with terms and conditions. Finally, the new business entity is restructured to integrate a collaboration of assets, resources, talent, and technology.

Guide to Mergers and Acquisitions (M&A). We explain Mergers and Acquisitions, meaning, examples, processes, requirements, along with M&A companies. You may learn more about M&A from the following articles –