INTRODUCTION TO BUSINESS

COMBINATIONS

CHAPTER ONE
 Advantages of Business
Combinations Over Internal
Expansion

Rapid expansion
Provide established, experienced management
group
Various economies of scale
Some tax advantages
 Advantages of Business
Combinations as Compared to
Internal Expansion

Total supply of goods unchanged

Increase market share
May provide guaranteed raw materials or product
markets
Reduce income volatility
 When does a business combination
occur?
When one entity (acquiror) acquires
control over another entity
(acquiree)
 Types of Business Combinations

Horizontal: acquisition of a competitor

Vertical: acquisition of a supplier or consumer
Conglomerate: acquisition of an company in an
unrelated industry
 Horizontal Combination permits
acquiror to:

Increase sales by entering new product markets

Increase production capacity
Expand into new geographic regions
Vertical Combination permits acquiror
to:

Have a guaranteed source of production inputs

Have a guaranteed market for production outputs

 Conglomerate Combination permits
acquiror to:
Diversify asset base

Reduce income volatility

Reduce the likelihood of antitrust challenges by

the government
 Legal Restrictions on Business
Combinations
Sherman Act (1890): allows break up monopolies
after they occur
Clayton Act (1917): proposed combinations
stopped if free trade will be hindered
Hart-Scott Rodino Amendment (1976): Federal
Trade Commission notified of proposed
combination potential impact to be assessed
 Friendly versus Hostile Takeovers

Friendly: both management groups favor the

combination and encourage stockholder approval

Hostile: acquiree management opposes the

combination and acquiree stockholders are
discouraged by acquiree management from
selling stock to acquiror
 Defensive Measures

Strategies used by an acquiree to

thwart attempts at hostile takeovers
 Defensive Measures include:

Greenmail: premium to the acquiror to sell

acquiree stock back to the company
White Knight: friendly replacement for acquiror
Poison Pill: issuance of preferred, convertible
into common stock of unwanted acquiror
 Defensive Measures (continued)

Sale of Crown Jewels: sale of key assets,

distributing proceeds to stockholders
Scorched Earth: broad based sale of assets,
distributing proceeds to stockholders
Fatman: acquiree buys poorly performing assets
Staggered board of director terms
 Defensive Measures (continued)

Supermajority vote requirement for business

combination
Golden Parachutes: additional compensation for
top executives if there is a change in control
Packman: acquiree makes a bid to purchase
acquiror
Common ways to attain control of an
entity

Type I Exchange: Acquiror purchases acquirees

net assets

Type II Exchange: Acquiror purchases acquirees

voting common stock
 Type I - Asset for Asset Exchange
Acquiree assets and liabilities are transferred to
acquiror financial records
Acquiree corporation becomes a skeleton
containing cash and/or receivables from acquiror
Stockholders of both corporations are unchanged
Acquiror capitalization remains unchanged
 Type I - Stock for Asset Exchange
Acquiree assets and liabilities are transferred to
acquiror financial records
Acquiree corporation becomes a skeleton
containing acquiror stock
Acquiree stockholders unchanged, but acquiror
stockholder list includes acquiree corporation
Acquiror capitalization increases by amount of
stock issued
 Type II - Asset for Stock Exchange

Acquiree assets and liabilities remain on

acquirees financial records
Acquiror stockholders remain unchanged while
acquiree stockholders sell their shares for assets
New owner of acquiree is the acquiror corporation
as an entity
Acquiror capitalization does not change
 Type II - Stock for Stock Exchange
Acquiree assets and liabilities remain on
acquirees financial records
Acquiree stockholders become stockholders of
acquiror but give up ownership of acquiree entity
New owner of acquiree is the acquiror corporation
as an entity
Acquiror capitalization increases by the value of
stock issued
 Business Combination Forms

Statutory merger
Statutory consolidation
Stock acquisition
 Statutory Merger

One entity continues but the other ceases to exist

Steps
Acquiree stock purchased by acquiror
Acquiree declares a 100% liquidating dividend
Acquiree corporate charter is cancelled
 Statutory Consolidation
Both entities cease to exist - new entity is created

Steps:
New corporation is formed
New corporation acquires stock of acquiror and
acquiree in stock for stock exchange
Acquiror and acquiree declare 100% liquidating
dividend
Acquiror and acquiree corporate charters cancelled
 Stock Acquisition

Neither entity ceases to exist

Acquiror purchases stock of acquiree

Parent-subsidiary relationship created
Consolidated financial statements are required
 Substance Versus Form

Form of combination may vary while exchange

value (substance) is the same
Table 1: exchange (of $5,000,000 of value) may be
structured in any of the legal forms discussed
Exception: Some legal forms have unequal tax
implications
 Contingent Consideration

Contingent consideration clauses are negotiated

because of disagreements about prediction of:
Acquiree future earnings
Value of acquiror resources given to acqiuree
 Contingent Consideration
Disagreements
Expected future earnings disagreements
Future earnings targets set
If acquiree meets targets, additional resources
transferred to acquiree stockholders
Investment account increases on acquiror
books
 Contingent Consideration
Disagreements (continued)

Disagreements regarding value of acquiror

securities given
Future minimum acquiror stock price set
If minimum stock value not met, additional
shares issued to acquiree stockholders
Acquiror adjusts Additional PIC not Investment
 Business Combinations and Tax
Considerations
Combination may be nontaxable or tax deferred if
it qualifies as a reorganization. To qualify:
Acquisition accomplished with assets or stock
Structured as a statutory merger, statutory
consolidation, or stock acquisition
Must meet other reorganization criteria
 Three Types of Reorganizations

Type A:
Only 50% of consideration must be in stock
Acquiror liable for all known and contingent
acquiree liabilities
Statutory merger or consolidation must be
approved by shareholders of both entities
Types of Reorganizations (continued)

Type B:
Stock for stock exchange
Acquiror must own at least 80% of acquiree
Any acquisition of acquiree stock prior to
reorganization for consideration other than
stock may disqualify firms
Types of Reorganizations (continued)
Type C Features:
Acquiror may gain possession of acquiree
assets through contract
Acquiror is not liable for acquiree liabilities
Voting common stock must be issued for 100%
of consideration of acquiree
Acquiree must distribute stock to shareholders
and terminate operations