A Merger or an Acquisition deal will be unsuccessful if the financial interests of both parties are not considered. If the deal fails to deliver at least the plausible benefits, then concerned stakeholders may disregard the deal.
Acquiring a company in case of an acquisition and the new firm in case of merger may issue shares, convertible bonds, or any other instrument in the decided ratio.
This article is the continuation of the previous article which laid the conceptual foundation of the topic.
Read Here, What is Merger and Acquisition (M&A)?
Mergers and Acquisitions – Financing & Valuations
In this article, we shall expand the horizon to the meaning of exchange ratio or swap ratio, forms or modes of financing a merger, and the most important, methods of valuation of firms in mergers and acquisitions.
Exchange Ratio / Swap ratio
It is the ratio in which shares or benefits of the new company are issued/exchanged to the shareholders of the existing company or the target company.
Let’s understand this clearly with help of an example:
Recently Vijaya Bank and Dena Bank was merged with Bank of Baroda. Where the Share Exchange ratio was 402:1,000 shares in the case of Vijaya bank.
It means that 402 shares of Bank of Baroda’s will be issued to the 1,000 shares held in Vijaya Bank. And 110: 1,000 was the Share exchange ratio in the case of Dena Bank. In simple words, 110 shares were issued to the shareholders of Dena Bank for 1,000 shares held by them.
Forms or Modes of Financing a Merger
The Mode of financing a merger depends on the liquidity, shareholding patterns, payment plans, future investment goals, etc. of the larger firm.
These are the various modes of financing normally vested by the companies:
A company with surplus cash reserves may resort to this straightforward method of financing the deal, based on the value of the firm.
Here, the beneficiaries will receive rewards directly. But in the future, it affects the liquidity position of the firm, leading to a cash crunch, and hence it is not preferred by the acquiring companies.
In the year 2020, Byju’s acquired White Hat Jr, an Edu tech company training students on developing apps for $ 300 million. It was a complete cash deal.
It is one of the most widely or popular used methods in business strategies. Here existing shareholders of the company will receive shares of the new company.
It enables shareholders to be owners in the new company and at the same time, it attracts capital gains for the transactions. The liquidity position of the issuing company remains unaffected in this mode of exchange.
The integration of Vodafone and Idea involved the exchange of shares between these companies. The swap ratio was 1:1.
Normally the blended mode of the cash offer and Equity shares financing is widely practiced. Even in the recent case of the acquisition of Akash Educational Services Ltd (AESL) by the Byju’s, we can witness it. It was a 70:30 Cash-Equity deal. $940 million in cash and remaining in the stock was agreed upon by the parties to the acquisition.
Convertible bonds or debentures
Sometimes if the firm is undertaking or investing in a project with a higher gestation period and high risk, then investors may not agree to Equity shares. Convertible bonds are one of the options available to the firm.
These bonds are converted to Equity shares in the future. Till then the holder receives periodical interest payments for his investment. After the conversion of bond/ debt to the shares, investors will enjoy ownership in the new firm.
It is an equity security that is used as collateral to secure a loan. This receives interest payments like other debt securities. Interest on the loan stock is deductible for tax purposes for the corporation.
The lender of the loan may retain the physical share certificates of the shares, till the loan is repaid. This may be converted to ordinary shares in the future at a predetermined conversion rate.
In this case, selling shareholders are directly or indirectly exchanging shares for loan stock in the other company.
In case of default of the loan, share prices may fall and affect the value of the investment.
Now, let’s move on to the next important topic.
Methods of Valuation of Companies
There are four models in valuing the business, which is discussed in detail as follows:
The Assets-based Valuation model
This valuation method requires data from the balance sheet. Asset values at the book price are considered for valuation purposes.
This method is suitable for industries with high fixed assets and production capabilities. As these are the earnings generator in the future. The quality of assets reflects the efficiency of the firm.
The undermining issue of this method is assets reflect the historical value and not the current value. Also, the lack of uniformity in the accounting practices and policies possess challenges in the valuation.
This method capitalizes the expected future earnings from the firm and NPV is ascertained using the appropriate capitalization rate, as the assumption is the value of the business is dependent on its revenue-generating capacity.
Projecting future earnings and selection of appropriate discount rates needs meticulous analysis. An investor gets a clear idea of possible risks and returns from the deal.
Over or underestimation of risk may falsify the future expectation leading to wrong selections or conclusions.
This method is applicable for firms generating stable returns and may not be suitable for start-ups, as they do not have a sufficient basis to project the future cash flows.
The market Valuation model
In this approach value of a business is arrived at by comparing it to similar business models in the industry. Sometimes the earlier transaction in the industry serves as a basis for the judgment.
This peer review or analysis of the recent similar transaction helps in ascertaining the accurate current value of the business. Business model, financials like profit margin, earnings, revenue, etc., and assets are the parameters considered in the study.
The price multiple is multiplied with the relevant financial metric to arrive at the appropriate value of the business. It could be a publicly listed company or a private company.
This could be an appropriate method to justify the value of the business with tax authorities, legal authorities, and strategic partnerships.
The method is applicable only if similar comparisons are available in the industry.
Discounted Cash-flow model
This method considers the projected future cash flows to ascertain the value of the business. As future cash flows are discounted to arrive at the present worth of the business and hence it is discounted cash flow model.
Usually, the cost of capital is used as the discount rate to ascertain the discounted cash flows. The present worth of the future cash flows indicates whether it is the right decision to invest in the business or not. If benefits are exceeding the investment, then it is time to grab the opportunity, as it is generating positive returns.
This method is appropriate if future returns are accurately predictable, otherwise, it may lead to wrong decisions.
Selection of the method to value the business depends upon the business model, industry of the business, financial metrics, etc. An accurate valuation is required to justify the swap ratio and benefits to be exchanged between parties to the deal.
Thorough industry, business, market, and financial analysis is essential in ascertaining the value of the business to mutually benefit the concerned stakeholders.