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This article is written by Shankarlal Raheja, pursuing a Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from LawSikho.

Introduction 

In the scenario of a merger and acquisition of a company, the company that pays to take over the other company is known as the acquirer and the company being purchased/acquired is known as the target firm.

During the process of acquisition, a premium is referred to the figure that is a difference between the approximate real value of a company and the real-time price paid to acquire the company. So, basically acquisition premium shows us the increased cost of buying the targeted company during a Merger and Acquisition transaction. 

In the books of accounts, acquisition premium is also known as the ‘Goodwill’ of the company. Goodwill comprises of intangible assets like the value of the company’s brand, its customer base, good customer relations, or even the proprietary technology being acquired from the company being targeted. 

An acquirer can also take over a target company for a discount, which is less than its fair value in the market, when such a situation occurs, it is referred to it as negative goodwill. 

In 2018, Flipkart increased its funds from Softbank, eBay, Tencent, and Microsoft in order to compete with the rapidly growing Amazon in the Indian region. Walmart acquired 77% of Flipkart’s business by paying $18 billion. It is claimed by Walmart that only $5 billion in Flipkart’s assets were intangibles while $13.6 billion was goodwill which was a part of the its purchase price

Why is that the goodwill of the company is more than twice the actual price of Flipkart? 

That is because of the reputation and also the competition to acquire Flipkart in the market. 

Reasons for paying premium at the time of acquisition 

Value of control 

It is beneficial for the shareholders to have more control over a business. For this particular reason they would be willing to pay more than the investor, who only own a small proportion of the business and hence only has a little influence on the business. 

Advantages of having more control can be listed as follows:

  1. To execute the Merger & Acquisition;
  2. Having the authority on the decision of payment of dividends;
  3. Can easily influence strategies and heavily effect the long-term implementations;
  4. Having the power to choose the board of directors;
  5. Ability to hire and fire the CEO or key managerial personnel.

Value of its synergies

Whenever an acquirer is keen to purchase a company, it must first estimate the target companies’ fair value at the market rate. After determining such a value, the acquirer should then determine the potential synergies from the deal. 

A synergy can be defined as the combined value of two firms is more than the pre-merger value of both firms combined. 

For example: Firm A has a net value of Rs 10 crore, Firm B has a net value of Rs 10 Lakhs, then the merged firm has a net value of 10 crore 50 lakhs, and there is a 40lakhs worth of synergy for this merger 

Based on the two metrics mentioned above, the acquirer can determine the takeover premium. The premium should be paid only if the synergies created as the result of the deal exceed the takeover premium paid to the target company. However, the size of the premium also depends on other factors, such as the presence of other bidders, level of competition within the industry, and incentives of buyer and seller.  

Justification for payment of premium 

Initially, it does not make any sense as to why should the acquiring company is paying a price which is higher than what the target company is worth. But it worth noting the fact that the current price of the target company shows us what it is worth of in the eyes of the market or in point of view of the market. 

However, the acquiring company may value the target company much greater than the market does, maybe it looking for long term gains and often it is because of the strategic value that it may bring. 

There could be more than one reason for an acquiring company to pay a premium are as follows:

Synergy 

If by acquiring a company the net value of both the companies together is higher than the value of the pre-merged companies, then is certainly more advantageous than the thought of a mere premium for the acquisition. 

Generally, there are two types of synergies:

  1. Hard synergy: refers to the cost savings from economies scale
  2. Soft synergy: refers to the revenue increase from expanded market share, cross-selling and even increasing pricing power. 

Growth

It is a faster method to grow with the help of merger and acquisitions. It also helps in generating revenues at a faster pace. 

Market power

Two companies, if merged would conclude to fewer competitors in the industry and the focus can be shifted to maximising the profits. Combined companies have more ability to influence the market prices than an individual company. 

Hidden value

A target company, on its own, may be uncompetitive due to various reasons, such as poor management, lack of resources, or poor organizational structure. An acquiring company may have the belief that it can unlock hidden value through the reorganization of the target.

Unique capabilities

An acquirer may grow through M&A activity to pursue competitive advantages or obtain resources that it currently lacks, but that a target company may have. They can be specific competencies or resources, such as an advanced research and development (R&D) team, a strong sales team, or other unique talents.

Tax considerations

In some cases, it may be beneficial for a profitable acquirer to acquire or merge with a target company with large tax losses, where the acquirer can immediately lower its tax liability.

Diversification

Diversification can be considered from the viewpoint of a company as a portfolio of investments in other companies. Therefore, the variability of cash flows from the company can be reduced if the company is diversified to other industries.

Incentives

A merger or an acquisition can be used as a strategic tool to extend the market reach internationally to different countries and markets. Less regulation and more uniform accounting standards will make such a reason more common for M&A deals in the future.

A few examples of M&A  

Coca-Cola takeover the bottling plants

The Coca-cola company is an American multinational beverage company which produces non-alcoholic beverage concentrates and syrup. The company offers over 500 brands in more than 200 countries and territories. The Hindustan Coca-Cola Beverages (HCCB) has close to 24 bottling plants in India. The HCCB bottles close to 65% of the company’s total volume in India. Coca-Cola India is responsible for the supply of the concentrated syrup to all the bottlers and is responsible for marketing, strategy and the R&D. 

Coca-Cola currently owns close to 60% share of the market. In 1993, Coca-Cola acquired Parle beverage business which had thumbs-up, Citra and Gold spot. It inherited all the 55 parle bottlers as its franchisees. 

Currently the coca-cola works with 24 bottlers in India, including HCCB.  However, including its external bottling partners, Coca-cola has over 57 manufacturing units in India. 

In the year 2018-19, the HCCB had reported a net-profit of Rs.321.6 crore, while their revenue stood at close to Rs.9000crore. 

In the year 2018, the company agreed to buy British Coffee Chain Costa Coffee to grow beyond selling packaged beverages. 

Takeover of Land Rover and Jaguar by Tata Motors 

Tata acquired the Jaguar Land Rover in 2008, after a rigorous 9-month internal due diligence process before the acquisition. Tata Motors acquired Jaguar and land rover from Ford for $2.3 billion (approximately 12,000 crores), merging the two companies into a single company in 2013. 

Tata motors were however an Indian company that excelled in making cheap small cars such as the Indica and on the other hand they made trucks. What made tata motors acquire Jaguar and land rover from ford was the development of the product for a long-term goal, which has paid off with the global economy reviving and customers returning to the JLR showrooms. 

Tata motors invested in many green field and brownfield plants in England in order to manufacture the petrol and diesel engine parts and its products. 

JLR and a China based car maker Chery agreed to invest close to $2.78 Billion in a joint venture to manufacture JLR vehicles. To diversify the reach of the JLR, they even plan to set-up assembly units in China and even in India as well. 

JLR is setting up a joint venture in China, which would allow the company to manufacture the vehicles in China and eventually reducing the price up to 35%, which would hence, increase the market competition. JLR has also set up its manufacturing assembly units in Brazil, Italy, Slovakia and Nitra in order expand their reach.

Tata motors majorly focused on three areas of improvement- improving liquidity, Cost control and introducing new products. 

During 2009-2012, Jaguar was barely able to sell 50,000 units across the globe.  

After a load of R&D, Ratan Tata came up with more efficient engines and technology in no time. 

Soon after in 2013, the company clocked 77,000 sales that year. Jaguar almost tripled the sales in 2017 when compared to 2009. The carmaker sold close to 178601units in 2017. The JLR revenue topped by $34 Billion. 

FMCG brands to complete the basket of products

In 2020, The Indian FMCG market is valued at approximately $103.7 billion. It is the 4th largest sector in the Indian economy. It is said that in India, there are close to 800 million online users. 

India’s household and personal care is the leading segment accounting for 50% of the market share, healthcare accounts for 31% and food & beverages accounts for 19% of the market share. 

During the Financial year 2018-19, the FMCG sector witnessed a growth of around 14% of which a major part is attributed to growth in volume and consumption. 

A few examples of FMCG companies would be: Colgate- Palmolive, Dabur, Hindustan unilever, ITC etc. 

The key strategies companies keep in mind while merging and acquiring, these FMCG are: 

  1. Entry into a particular market: Wipro Customer care gained entry in south African market by acquiring Canway Corp. 
  2. Diversification of portfolio: Colgate made a debut in Indian Consumer brand section by acquiring Bombay Shaving Co. 
  3. Increase market share: Wipro Strengthened its position in the south east- Asian market by acquiring Splash Corp (largest philipino personal care company)
  4. Strategic synergies- Acquisition of Beardo by Marico. 
  5. Elimination of competition- Acquisition of Emami Cement by Nuvoco Vistas Corp. Ltd. 
  6. Distressed acquisition- Acquisition of Ruchi Soya Pvt Ltd by Patanjali Ayurved Ltd. 

 References


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