What is M&A?

Mergers and acquistions (M&A) refers to the process by which two businesses come under common control. Whether we call it a "merger" or an "acquisition" often has more to do with public relations than legal considerations. A company's directors will feel small if their company is "acquired;" they'd prefer to announce that their company merged with an equal. It's less demeaning.

But in this section we'll be less sensitive of executive feelings. We'll use "acquiror" to refer to the company that's acquiring, and "target" to refer to the company being acquired.

There are several ways this can be done, but first let's discuss why.

Why merge?

There are a number of reasons companies merge. 

Synergies

Sometimes two companies working together create more value than they could apart. For example, if our bike shop merges with an outdoor equipment retailer, we'll likely have more customers passing through. They may come in for a bicycle but see some tents they like, increasing sales. In another example, two drug makers may merge to allow them to share equipment and researchers. Synergies refers to the extra value that is created from combining business that goes beyond the value of the businesses valued separately.

New Business Opportunities

A business may use M&A to enter new markets or product lines. For example, if our bike shop operates in the Midwest, we may acquire a retailer operating on the West Coast to grow quickly into that market. This type of M&A is especially useful where the new market has different legal rules or customs because we can instantly acquire the target's local expertise.

Increased Market Share

Some companies merge to increase market share. If I control 15% of the retail outdoor market, and I acquire a company with 10% of that market, I might expect to end up with around 25% of the market. This might allow me to negotiate lower costs with suppliers or to raise prices (antitrust rules may prohibit this, but are beyond the scope of this chapter). Less nefariously, the expanded volume may create economies of scale.

Economies of scale are per-unit cost savings created by producing more goods. For example, to create a pill that cures baldness we have to pay $10 million for the research, FDA approval and manfacturing facilities. If we do that to sell one pill, that single pill would cost about $10 million because we'd have to recoup all those costs from a single sale. But suppose we sell a million pills. If the pill costs $1 to make, then our total cost to create a million pills is about $11 million, so we could sell each pill for $11. That difference from $10 million per pill to $11 per pill is because of economies of scale.

If a merger increases a company's market share, it may be able to produce its product at a lower cost per unit, which allows it to produce the same quality product with less cost, which is good for everyone.

Assets

Some companies merge to get the assets of the target. This may be a new factory somewhere, but more often it's something less tangible. Tech companies, for example, often buy smaller companies as a way of acquiring the employees. Acquirors may be after customer lists, patents or a brand.

Private Equity

Private equity refers to equity investments in private companies, but the term is often used as a shorthand for private equity funds, in which investors pool their funds to purchase shares of a private company. There are a variety of strategies here, but the most common is to buy stock in a struggling company, fix it up and resell it. You can think of this as house flipping but for businesses. After purchasing a company they may reduce the number of employees, cut unprofitable segments or implement other measures to increase efficiency. Once the company is more efficient, the private equity company resells the business at a profit.

Premiums

Mergers are typically priced on a per-share basis. Consider taking a moment to look up a recent news story on a proposed merger. It will likely report an aggregate price for the deal and a per-share price. This per-share price will be higher than the market value of the share. That's because the acquiror needs to convince the target (either the board, the shareholders or both) to sell. The target wouldn't be willing to sell the shares for less than the shares are trading on the stock market. So the acquiror will need to add a premium so that the target agrees to the deal.

This premium is sometimes referred to as a merger premium or control premium. A control premium is the additional value of a share that comes from owning a controlling stake of the company. Recall that most shareholders have voting rights, but the voting rights are such a small fraction of the total votes that these voting rights don't have much value. In contrast, a shareholder with enough shares to control the vote gains a lot of extra value from the voting rights. This extra value is the control premium.

An asset sale is a merger method in which the acquiror purchases all or substantially all of the target's assets.

What You Get

With an asset sale, the acquiror gets whatever assets were sold. This is great because an acquiror can carve out specific assets, taking only the assets it wants. Better still, this allows the acquiror (in most circumstances) to not acquire the target's liabilities. They can remain with the seller (though the seller may push back on this idea). This makes some sense. If I buy your truck, I don't also buy your old parking tickets. There are a few exceptions to this rule, but we'll save those for your M&A class.

One downside of the asset sale is that you have to sell each asset. For a large transaction this can mean hundreds of pages listing out every desk, wrench or trash can changing hands. This can be tedious and create opportunities for clerical errors.

And all you get is the assets. The acquiror may need to register the deeds or apply for new permits. They'll also need to negotiate new contracts with suppliers or employees. This can be tedious, uncertain and expensive.

Asset sales bring some difficult tax consequences. For the seller, there can be negative tax consequences depending on how the asset sale is conducted, and this eats into the sales price. For the buyer, assets are purchased without any depreciation, so depreciation can be deducted in future tax years.

Approvals

On the buyer's side, the buyer's board must approve the sale (unless it has delegated this power to the officers). The buyer's shareholders need to approve the sale only if the company is paying for the assets by issuing stock that would trigger the NYSE rules discussed in the prior section. 

On the seller's side, asset sales require approval from the seller's board. That makes sense. Contracts are always consensual.

But asset sales may also require the approval of the seller's shareholders. This may surprise you. The board of directors typically has authority to manage the business, including the power to sell, lease, mortgage, or otherwise dispose of corporate assets without prior approval from its shareholders. But when a company sells all or substantially all of its assets, it's not managing the business, it's ending it. So both the DGCL and the MBCA require shareholder approval to sell “all or substantially all” corporate assets.

Determining what constitutes "substantially all" is tricky, and Delaware hasn't settled on a bright line rule but it considers the company's remaining assets, net worth, future revenues and earnings.

Under the MBCA, shareholder and board approval is required to dispose of assets when, as a result of the sale, the corporation would lack a “significant continuing business activity.” MBCA § 12.02.

A corporation lacks a “significant continuing business activity” if it retains less than 25% of its total assets and either (i) maintains less than 25% of its operating income (before income tax), or (ii) 25% of revenue from continuing operations. If the assets that the seller retains don't meet these tests, the shareholders must approve the sale. MBCA § 12.02.

Speed

Asset sales are not usually the fastest method of acquiring a business, but they are close. If the assets are not complicated an asset sale can be done relatively quickly. If they are complicated or require new permits, an asset sale may not be the best solution.

An acquiror may acquire the target by purchasing its shares. This can be done in the open market or through a tender offer.

Open Market Purchases

If the target is public, the acquiror may purchase the target's shares in the open market. The acquiror would put in an order with a broker just like you might if you were investing in a new company.

In earlier times, this could be done stealthily, giving the target quite a fright as it learned about a hostile acquiror and that the acquiror had already acquired a sizeable portion of the company.

Now, shareholders that acquire 5% or more of a company have five days to file a form with the SEC disclosing to the public their holdings and their intentions. If they intend to be passive investors, they file a Schedule 13-G. If they plan to make changes to the company, they file a Schedule 13-D. This puts the company on notice that a potential acquiror may be skulking about.

It also alerts other shareholders. Recall that shareholders expect to be paid a premium in a merger that's above the market price. Once everyone knows an acquiror is attempting an acquistion, shareholders will expect a premium, so the market price is likely to rise, making open market purchases more expensive.

Tender Offers

One solution to this problem is to do the public purchases all at once. A tender offer is a public offer to shareholders of the target corporation in which the prospective acquirer offers to purchase target company shares at a specified price to any shareholder that "tenders" their shares to the acquiror. The offer is made during a fixed period of time. The offer may be for all or only a portion of a class or classes of securities of the target corporation. Shareholders accept by “tendering” their shares, meaning they transfer them to an escrow agent to hold until the tender offer period has expired.

When a corporation makes a tender offer, it must leave the offer open for at least 20 days. During this period, the acquiror cannot make open market or private purchases of the target's stock. Exchange Act Rule 14e-5.

Two-Steps

Open market purchases and tender offers are not mutually exclusive. Typically an acquiror will precede the tender offer by purchasing 5% or more in the open market. This allows the acquiror to buy at a lower price before the market knows about the takeover attempt.

What You Get

An acquiror that uses a tender offer gets the shares tendered in the offering. This includes the economic rights and the voting control, which may be enough to replace the board with new directors that are friendly to the acquiror.

Approvals and Speed

On the buyer's side, a tender offers requires approval from the acquiring entity, which for a substantial acquisition is likely the board. If the acquiror plans to pay for the acquired shares by issuing stock, the acquiror's shareholders may need to approve the deal under the NYSE rules discussed above.

On the seller's side, the only approval required is each shareholder's decision to tender or to sell in the open market. This means that a tender offer can be hostile; you can do a tender offer even if the target board opposes the takeover. 

Still, most tender offers are friendly. Acquirors and targets use tender offers in friendly deals because they are typically the fastest way to acquire a company.

A statutory merger is a merger method in which two companies become one company by operation of law.

What You Get

With a statutory merger you get one company that continues as though nothing happened. This may sound trivial–it had that before the merger–but it means that all of its contracts stay in place, all of its permits are still issued and all of its relationships continue.

Process, Approvals & Speed

A statutory merger is executed in four steps: (1) drafting a plan of merger, which specifies the deal terms; (2) approval by the board of each company; (3) approval by the shareholders of each company; and (4) filing the articles of merger with the secretary of state.

Plan of Merger

The plan of merger, or merger agreement, details the merger consideration (i.e., what the acquiror will pay), the target's representations warranties (i.e., what the target promises is true about the target company), what preconditions apply for closing (e.g., regulatory approval) indemnifications and other deal devices. 

These terms are heavily negotiated, often late into the night before the announcement. When a tentative deal is done, it is given to the boards of each company for approval. But note that a merger agreement may be preconditioned on specific events and may be amended or rejected anytime before it is filed.  DGCL § 251(c); MBCA 11.04(b). 

Board Approval

The boards of each merging company must approve the merger agreement. DGCL § 251(c); MBCA 11.04(a) The default threshold is a majority of a meeting with a proper quorum. DGCL § 251(c); MBCA 11.04(e). Once the boards approve, they must recommend that the shareholders approve the merger. This recommendation, however, can be subject to certain exceptions–for example, the boards can change their mind even after the shareholders vote to approve.

Shareholder Approval

Next, the shareholders of each merging company vote on the merger. In Delaware, a majority of outstanding shares is required to approve a merger. DGCL 251. In MBCA states, a majority of a the shares present a meeting that has a proper quorum is required to approve of a merger. MBCA 11.04.

This step is unappealing because arranging shareholder meetings is costly and time-consuming and this delay adds uncertainty to the deal. This method is one of the longer methods for taking control. Long delays are troubling because you've fixed a price (in shares or cash) in the merger agreement, but the markets will continue to shift. If it shifts against you, the deal loses value.

On the other hand, this step is awesome because it doesn't require a unanimous vote. Contrast that with share purchases, which require each shareholder to consent to sell their shares. Here, if a majority of shareholders agree, it forces a complete merger.

Filing the Articles of Merger

Once the shareholders approve the plan of merger, the merger is completed by filing articles of merger with the state's secretary of state. Upon filing, the two companies will become one. The surviving corporation is the corporation designated in the articles of merger as surviving. It continues as though nothing happened with its contracts, permits and relationships in place.

Short-Form Mergers

To recap, a merger needs majority approval from both boards and both sets of shareholders. And holding shareholder meetings is costly and time-consuming. So what if the merger is with a shareholder that owns 90% of the target already? Does it make sense to spend time and money on a meeting where the outcome is predetermined?

A short-form merger is a merger in which the DGCL authorizes an acquiring stockholder to approve a merger without a shareholder vote if the acquiring stockholder owns 90% of each class of voting shares. This recognizes the futility of a meeting. These transactions are also referred to as freeze out or squeeze out mergers. 

To prevent a 90% shareholder from abusing this power, shareholders that are squeezed out through a short-form merger can ask a court to appraise the fair market value of the shares.

A proxy contest is a campaign to convince other shareholders to vote to replace the directors on the board. Recall that shareholders typically vote by designating a proxy to cast a vote on their behalf. It's called a proxy contest because the acquiror is competing with management to to obtain more proxy cards (i.e., votes).

What You Get

Following an aquisition, the directors of the target company are usually fired. They don't love this.

This provides incentives for directors to oppose takeovers. Recall that asset sales and statutory mergers both require approval by the target's board. A proxy contest is the last ditch effort around a board that's hostile.

If you successfully run a proxy contest, you replace the members of the board with directors who are more friendly to your vision for the company. This can allow you to begin negotiations on a merger agreement, a friendly tender offer or an asset sale.

Approvals

On the acquiror's side, shareholder approval is not needed to run a proxy contest. The board will likely authorize it, as this power is rarely delegated to officers.

On the target's side, the board's authorization isn't needed–the whole point is to remove the board from power. The shareholders must vote for your alternative slate of directors, which is a type of approval, but other than voting no approval is needed.

Speed & Defenses

Proxy contests are typically the slowest way to gain control of a company. Most public corporations limit shareholder action by written consent, which means you'll need to do the proxy contest at a meeting. The default rules do not allow most shareholders to call a special meeting, so you'll have to wait until the annual meeting. Annual meetings have limited windows to nominate directors, and if you've missed those, it could be more than a year before the next meeting in which you can vote on your nominees. And classified boards make it so that even if you win at the annual meeting, you might only be able to replace a third of the board per year, making it a multiyear process to get a majority.

Pre-Deal Preparations

The pre-deal preparations represent the incipient phase of any M&A transaction. Here, the acquiring company undertakes a comprehensive due diligence process to scrutinize the target company. This investigation encompasses a thorough assessment of the target's financial health, market position, legal standing, and potential risks. The aim is to unearth vital insights that are instrumental in determining the target's intrinsic value and compatibility with the acquiring entity.

Valuation

Before making an offer, the acquiror will attempt to value the target company using discounted cash flow analysis, comparable company analysis or asset-based valuation. As the deal progresses and the acquiror learns more about the target's business, it will adjust the valuation estimate.

Negotiation and Deal Structure

With preliminary valuation figures in hand, the acquiror approaches the target and the negotiation and deal structuring phase begins. In this stage, the parties negotiate to determine the terms of the deal. This encompasses aspects such as the purchase price, the method of payment (whether in cash, stock, or a mix), the post-merger management and ownership structure. M&A negotiations are intense, but also some of the most fun corporate lawyers have.

The Gap Between Signing and Closing

In M&A, there is a timing gap between the signing of the deal agreement and its formal “closing.” This gap will keep you busy. You'll work on regulatory filings, shareholder approvals and other closing conditions. The closing conditions work as a checklist for your deal.

While the attorneys work through the closing conditions, the business teams will work on integration planning. This is a delicate area with antitrust, so make sure you or another legal expert is aware of what they are doing.

Regulatory Approvals

Many deals require antitrust approval prior to closing. Larger deals may need filings in the U.S., China the E.U. and other jurisdictions. These usually take one to four months, but during the COVID pandemic some dragged on for over a year.

Not all deals are greeted with open arms and a welcoming spirit. Hostile takeovers represent a distinct category of acquisitions where the target company's management and board of directors actively resist the acquisition attempt by the acquiring company. These hostile takeovers can lead to tensions running high, both in the boardroom and in the courts.

To counter such aggressive acquisition tactics, target companies often employ a variety of defensive mechanisms known as "shark repellent" or "anti-takeover defenses." Shark repellent defenses thwart hostile takeover attempts. These defenses are designed to make it more challenging, costly, or unattractive for the aggressor to proceed with the takeover. Some common shark repellent strategies include:

• Poison Pills: Poison pills are one of the most well-known anti-takeover defenses. They allow existing shareholders to purchase additional shares at a substantial discount if an acquiring company accumulates a certain percentage of the target company's stock. This dilutes the aggressor's ownership stake and makes the takeover more expensive.
• Staggered or Classified Boards: In some companies, the board of directors is divided into multiple classes, with directors serving staggered terms. This makes it difficult for an aggressor to gain control of the entire board in a single election cycle, as only a portion of the board is up for reelection at any given time.
• Supermajority Voting Provisions: Supermajority voting provisions require a higher percentage of shareholder votes to approve certain actions, such as a merger or acquisition. This makes it more challenging for an acquiring company to garner the necessary support for the transaction

Setting a fixed price for an M&A deal is a common starting point, but it's often subject to various adjustments to ensure fairness and alignment between the parties involved. These adjustments can take several forms, all of which ultimately provide flexibility and risk-sharing opportunities. One such adjustment is related to working capital. Working capital is  a company's current assets less their current liabilities. Working capital adjustments are made to account for changes in the company's current assets and liabilities between the time of the initial price determination and the closing of the deal. 

If, for example, the seller retains a significant portion of accounts receivable or if there are unexpected fluctuations in inventory levels, a working capital adjustment might be necessary to reflect the true economic value of the business at the closing date. This mechanism helps both the buyer and seller ensure that they are paying or receiving the appropriate price for the company's financial health at the time of transfer.

Another common price mechanism in business transactions involves the use of earnouts. Earnouts are contingent payments that depend on the company achieving specific performance targets or milestones after the transaction is completed. These targets can be based on financial metrics like revenue, profitability, or other key performance indicators. 

Earnouts are often used when there is uncertainty about the company's future performance or when the parties have different views on its potential. They can align the interests of the buyer and seller by tying a portion of the purchase price to the company's post-acquisition performance, motivating the seller to contribute to the company's success during the transition period. 

If shareholders find themselves dissatisfied with the proposed price for their shares, they possess the recourse to approach a chancery court for an “appraisal.” This avenue allows shareholders to contest the valuation determined by the acquiring company, seeking a revised value that they believe more accurately reflects the worth of their shares in the context of the merger.

To ensure that the appraisal process remains a legitimate avenue for shareholders seeking fair valuation, there are certain qualifications in place. For one, shareholders must retain ownership of the shares throughout the merger process to be eligible for appraisal rights. Second, shareholders who have voted in favor of the merger are generally disqualified from pursuing appraisal, emphasizing that this avenue is intended for dissenting shareholders who hold reservations about the merger.

Furthermore, the appraisal remedy cannot be invoked when the shareholder is relinquishing shares in a publicly listed company to gain shares in another publicly listed company or the surviving entity. This stipulation is rooted in the underlying assumption that the financial markets are sufficiently liquid, enabling shareholders to easily sell their shares if they are dissatisfied with the terms of the merger.

The appraisal process is not available for transactions involving the purchase of assets. Instead, it is a mechanism primarily designed for situations involving corporations. Moreover, when it comes to entities like partnerships, limited liability companies, or limited partnerships (LPs), unanimity among the involved parties is typically required for significant decisions, rendering the appraisal route unavailable for these structures.

Questions

 1. You're a shareholder in a company that's about to be bought. What are appraisal rights, and when can you use them? 

2. Why might you want to use appraisal rights? 

3. Discuss the pros and cons of each M&A transaction  type: 

A) Asset Purchase 

B) Statutory Merger 

C) Proxy Contest

D) Tender Offer

4. Which of the following M&A methods can be hostile?​

A) Asset sale (all or substantially all assets)

B) Tender offer​

C) Statutory merger​

D) Any of the above (if you’re angry enough)

5. Which of the following M&A methods does not require a shareholder vote (assume A buys B with excess cash)?​

A) Asset sale (all or substantially all assets)​

B) Tender offer​

C) Statutory merger​

D) Proxy contest​

E) Any of the above (if you’re angry enough)

6. Which of the following M&A methods does not allow appraisal (assume Delaware law and no exceptional facts)?​

A) Asset sale (all or substantially all assets)​

B) Tender offer​

C) Statutory merger​

D) Proxy contest​

E) Exactly two of the above​

F) Exactly three of the above

7. What steps are required for a statutory merger?​

A) Approval by both boards​

B) Approval by shareholders at both merging entities​

C) Filing with the secretary of state​

D) All of the above​

E) Exactly two of the above

8. What’s one major advantage of an asset sale?​

A) It avoids a vote by the selling shareholders​

B) It allows the buyer to carve away the liabilities​

C) It is faster than a statutory merger or tender offer​

D) It can be done despite board opposition

9. Andi is interested in acquiring rights to a solid hydrogen energy technology developed by Miles. Money is no object, but Andi is concerned that Miles may have created environmental damage developing the product and would like to avoid the delays that litigation may cause. What M&A strategy would you recommend?

10. Clark is the CEO, sole board member and owner of 40% of Vacation Holdings. Clark would like Vacation to acquire the Jelly of the Month Company. At the price he’s offering, he’s confident the Jelly shareholders will approve, but he’s worried his cousin Eddie, a minor shareholder in Vacation Holdings, will misunderstand the deal and rally Vacation shareholders to oppose it. What structure would you recommend?

11. Pesto’s Pizzeria, Inc., would like to acquire Burger, Corp. Jimmy (the chair of Pesto’s) and Bob (chair of Burger Corp.) deeply hate each other, and Jimmy knows Bob would reject the deal even at a price other shareholders would jump at. What methods does Jimmy have available to acquire Burger, Corp.?

12. Executives at Romeo Inc. and Juliet Corp. are considering a business combination, though they are sure their major shareholders (Montague Investments and Capulet Holdings, respectively) will not approve. If the boards unanimously approve the plan of merger, can they avoid a shareholder vote?