No one was surprised in 2006 when Disney, the undisputed leaders in animated films, acquired newcomer Pixar for a staggering $7.4billion. The strategy was obvious to even the least interested observer. The creation of a single company would help the businesses cement and protect their position in the animated film industry.
Mergers and acquisitions are excellent strategies to generate growth. In many cases, the goal is often to create a sustainable competitive advantage or protect market share. However, pursuing a merger or acquisition does have its risks, especially if the deal is overpriced and heavily debt funded. Despite these risks, it is clear that merger and acquisition activity is increasing, especially in challenging sectors such as retail.
There’s no doubt that many retailers in Australia are experiencing some challenging conditions. The value of the Australian dollar and relative ease with which consumers can buy over the internet coupled with reduced consumer spending have made business difficult. Consequently, many businesses are facing increased financial pressure and the immediate need to manage costs and increase efficiencies. One of the ways in which business can do this is to merge with a similar business and share back office platforms and systems. The value of doing so can be easily seen in Dymocks’ acquisition of Healthy Habits a couple of years ago. At first glance bookstores and sandwich bars have little in common, but on closer evaluation, the opportunity to share common back office systems was an obvious incentive.
Exploiting economies of scale can help companies reduce their fixed cost base and increase profit margins. It may also enable greater efficiencies in meeting consumer demands, marketing and distribution costs or the introduction and cross utilisation of products. The Fosters Group is a good example. In the early 1990s, Fosters’ strategy was to diversify its product offering into wine. It quickly acquired Mildara Blass, Rothbury and Beringer Wine Estates in a few short years. Its intent was to become a global premium-branded beverage company. Obviously, some mergers are more successful than others. In an apparent reversal of its long-held strategy, Fosters has been de-merging its wine operations after years of underperformance. Just last year, Fosters sold off non-essential wine brands and in May 2011 spun off its wine division into a separately listed company.
Partner selection
Undoubtedly, one of the most critical issues facing businesses considering a merger is to find the right partner. Whether the merger involves small or large businesses, the partners’ objectives, ethos, way of doing business and expectations need to be aligned. Prospective partners need to agree on all aspects of the proposed merger and conduct an early assessment of the regulatory and legal hurdles. The latter is especially important to avoid unnecessary costs and time.
Each party involved in a merger or acquisition need to undertake proper due diligence. This involves a thorough assessment of the others business; its structure, financial results, management, systems, contracts and debts just to name a few. As a general rule, the more due diligence, the greater the probability the merger or acquisition won’t be derailed for some unforeseen reason.
Quite often, it is beneficial for businesses seeking to merge or acquire to seek assistance from brokers or agencies. These third parties can often find the most appropriate partner through their broad networks and general knowledge of the business community and their clients’ needs.
Legal structure
There are a number of ways in which an acquisition can take place:
- Acquisition of shares. Here, the purchaser acquires shares in the target company. One of the risks in this approach is that the purchaser “inherits” the target company’s past – including all of its liabilities. The purchaser cannot decide on which assets it wishes to purchase or which liabilities it wishes to assume.
- Acquisition of the business or of business assets. Here, the purchaser selects the assets it wishes to acquire. As such, it will not be burdened with having to accept the target company’s liabilities. However, the purchaser needs to ensure that the assets it acquires are not encumbered by a mortgage or some other security interest.
One of the most important issues in this type of acquisition is to ensure the title in the relevant assets is properly transferred. This includes intellectual property assets such as trademarks and any other materials related to the brand.
Although merger and acquisition activity has increased over the last few years, valuing a specific opportunity has become more challenging in that time due to the uncertain economic and financial circumstances. Consequently, it is critically important purchasers clearly understand the form of payment and financing options available. Prudent purchasers will seek appropriate professional advice when valuing the target company’s assets and business.
Earn outs
In today’s markets, purchasers are generally more cautious about acquiring businesses. One of the most obvious points of concern is the degree of gearing the purchasers are generally willing to accept.
Earn-outs provide a method of mitigating some degree of risk. Here, the seller’s ability to receive payments as a result of the transaction is directly linked to the businesses performance. If the business reaches or exceeds certain targets then the seller’s payments are paid in accordance with the sales agreement. If the business fails to achieve the target performance level, then some reduction (also contained in the sales agreement) in the amount to be paid is made.
In the earn-out scenario, each party has some degree of risk. The purchaser may not be able to get the seller to agree to the earn-out conditions. The seller has to ensure the purchaser does not deliberately fail to meet the target performance. More often than not, the seller remains in close contact with the business, often in an advisory or even executive role.
Earn-outs can reduce a purchaser’s initial payment and to a certain extent at least, provide some security that the business will continue to perform. In effect, the purchaser minimises the risk of over-paying for future revenues and profits.
For the seller, agreeing to an earn-out may result in a higher effect sales price than an outright and immediate sale. However, sellers should generally be cautious about performance-based earn-outs. It is a case of balancing the upfront payments with the risk associated with the ongoing performance of the business. Ideally, the seller should obtain a substantial up-front payment and have limited exposure to the ongoing performance of the business. The rationale for this is that if a substantial portion of the purchase price was linked to post-settlement performance, the purchaser has a heightened interest in manipulating the businesses’ performance to minimise the payments to the seller.
Earn-outs pose risks for both the purchaser and the seller. Parties which enter into such arrangements should ensure that appropriate conditions are included in the sales agreement so that the performance potential of the business is protected.
Every business owner should have a clear exit strategy to extract the maximum value from the business upon exit. Whether or not the maximisation of value comes from merging or acquiring another business, exit strategies should be well planned in advance. This will help avoid the potential for poor decision making when under pressure.
It is critical that shareholders have an agreed and well-documented exit strategy. Shareholders often have very different and conflicting views which often only come to light as an offer to merge or be acquired is laid on the table. It is essential that every business has a well drafted shareholders agreement covering the principles to be applied in the event the business is engaged in a merger or acquisition.
As with most business issues, obtaining high quality professional advice early can often help the business and its owners avoid conflict and confusion when critical opportunities become apparent.
– Marwan Kojok, Executive Partner, DCS Lawyers.
