INTRODUCTION TO BUSINESS COMBINATIONS CHAPTER ONE

1. INTRODUCTION TO BUSINESS COMBINATIONSCHAPTER ONE

2. Advantages of Business Combinations Over Internal Expansion • Rapid expansion • Provide established, experienced management group • Various economies of scale • Some tax advantages

3. 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

4. When does a business combination occur? • When one entity (acquiror) acquires control over another entity (acquiree)

5. 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

6. Horizontal Combination permits acquiror to: • Increase sales by entering new product markets • Increase production capacity • Expand into new geographic regions

7. Vertical Combination permits acquiror to: • Have a guaranteed source of production inputs • Have a guaranteed market for production outputs

8. Conglomerate Combination permits acquiror to: • Diversify asset base • Reduce income volatility • Reduce the likelihood of antitrust challenges by the government

9. 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

10. 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

11. Defensive Measures • Strategies used by an acquiree to thwart attempts at hostile takeovers

12. 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

13. 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

14. 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

15. Common ways to attain control of an entity • Type I Exchange: Acquiror purchases acquiree’s net assets • Type II Exchange: Acquiror purchases acquiree’s voting common stock

16. 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

17. 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

18. Type II - Asset for Stock Exchange • Acquiree assets and liabilities remain on acquiree’s 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

19. Type II - Stock for Stock Exchange • Acquiree assets and liabilities remain on acquiree’s 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

20. Business Combination Forms • Statutory merger • Statutory consolidation • Stock acquisition

21. 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

22. 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

23. Stock Acquisition • Neither entity ceases to exist • Acquiror purchases stock of acquiree • Parent-subsidiary relationship created • Consolidated financial statements are required

24. 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

25. Contingent Consideration • Contingent consideration clauses are negotiated because of disagreements about prediction of: • Acquiree future earnings • Value of acquiror resources given to acqiuree

26. 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

27. 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

28. 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

29. 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

30. 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

31. 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