This article is written by R Sai Gayatri, from Post Graduate College of Law, Osmania University. This article deals with the valuation done in mergers and acquisitions. 

Introduction 

Mergers and Acquisitions in the corporate sector of India are increasing significantly day by day. The Indian corporations have taken the competition to the next level by acquiring foreign companies and allowing foreign investors to invest in India. In 1991, the economic liberalisation of India was initiated by the then Prime Minister P.V. Narasimha Rao and his finance minister Dr. Manmohan Singh encouraged mergers and acquisitions to a great extent. The Indian corporate sector is subject to cut-throat competition, as a result, mergers and acquisitions have become synonymous with tools that help in surviving the market. Corporate restructuring has often resulted positively due to an increase in the efficiency and sustainability of the companies or businesses. 

As a result of globalization, many foreign companies made their way towards the Indian corporate sector and the Indian companies proceeded to acquire foreign establishments. Since the corporate world has become so competitive, companies and businesses are more concerned about safeguarding their value in the market. Transactions of sale or purchase of any establishment demand a calculation of fair value to reassure the Regulators and stakeholders. Such calculation of fair value can be done through various methods. This article will explain the valuation done in mergers and acquisitions. 

Mergers

The Companies Act of 1956 did not define mergers, however, the Companies Act, 2013 provides an explanation of the term ‘merger’ rather than a definition. A merger is said to happen when two or more entities join hands to become a bigger entity. In a merger, the assets and liabilities of the entities involved are combined and the business activities carried out by them are considered as one. Mergers can be done due to various reasons such as to give effect to competition in the market, development of innovation and technology, accessing diversification, acquisition of assets, boosting financial capacity, etc.

Usually, when an entity merges with another entity it loses its identity and ceases to exist. The merged entities together will be considered as one in the market. For example, if “A” company and “B” company merge, they will be forming a bigger entity i.e, XYZ entity. Mergers take place due to various reasons and so there are various kinds of it.

Kinds of Mergers

Vertical Merger

In this kind of merger, the entities involved carry out their operations in different stages of production or industries. This is known as a vertical merger because the entities merge with an intention to match the demand and supply and reduce the transaction charges. This not only assures the involved companies to gain independence but also helps them become self-reliant. For example, when a company involved in manufacturing cars merges with a company that manufactures tyres or leather, such a merger will be considered as a vertical merger.

Horizontal Merger

In this kind of merger, the entities involved carry out the same kind of business at the same level in the market. Since they are in the same business and at the same level, it is known as a Horizontal Merger. The positive effect of this merger is that it brings in benefits like economies of scale and economies of scope. The negative effect of this merger is that it can lead to the creation of a monopoly in the market by the companies involved. The Competition Commission of India closely inspects horizontal mergers to avoid monopoly from being established in the market.

Triangular Merger

In this kind of merger, a target company and the subsidiary of the acquiring company get merged because of regulatory and tax-related reasons. A triangular merger is further classified into a forward merger and a backward merger. When a target entity gets merged into the subsidiary of the acquirer entity and such subsidiary continues to survive after the merger, it is known as a forward merger. However, when the subsidiary of the acquirer entity gets merged into the target entity and such target entity survives after the merger, it is known as a backward merger. 

Conglomerate Merger

In this kind of merger, the entities involved in the merger belong to two different industries. The aim of the entities in this kind of merger is to increase their debt receiving capacity, to efficiently make use of the financial resources and to increase the prices of their outstanding shares. For example, a jeweler company acquiring a petroleum company, an automobile company acquiring a textile company, etc. The main aim of the companies in this merger is to gain a larger size in the market. 

Congeneric Merger (Circular Merger) 

In this kind of merger, the companies belong to a common industry or an industry relating to the merging companies. However, the companies involved in this kind of merger do not have a common customer or supplier base, as a result, it is known as a congeneric merger. Companies engaging in a congeneric merger aim to expand their customer base through their means of distribution.

Cash Merger (Cash-out Merger)

In this kind of merger, when a company gets merged with another, the shareholders of the merging company are provided with cash as an alternative to the shares. A cash merger provides an easy way out to the shareholders who are willing to leave a particular company by selling their shares. 

Acquisitions

It is a known fact that in the ocean, the big fish eats the small fish. Likewise, in the corporate world, an entity that is big and powerful takes over the small entities to its comparison, this is known as acquisition or takeover.

In an acquisition, a target company’s share capital is purchased to have authority over the interests associated with its substantial or all shares, assets or liabilities. Where one company takes over another company and announces itself as the new owner, it is known as acquisition. Hence, no new company is formed in an acquisition. An acquisition is also done through a demerger. In a demerger, a big entity gets divided into small entities reflecting the opposite of the concept of a merger. An acquisition is usually carried out to increase the growth of an entity at a much faster rate. 

Importance of valuation in M&A

Irrespective of the purpose for which a merger or acquisition takes place, their main aim is to help entities expand their size and value in the market. After a merger or acquisition takes place, the value of the entities involved equals the sum of their independent values. However, it often happens that mergers and acquisitions tend to have a negative impact on the entities involved due to incorrect estimation of entity value. Though there are precise approaches and methodologies to estimate the value of an entity but when they are put to practical use it becomes a complex process. Therefore, it becomes significantly important to determine the right value of entities in mergers and acquisitions with the right approach and methods to avoid financial downfalls. 

Need for valuation

During mergers and acquisitions, the intended purpose of the valuation is identified so that the calculated value matches with the required purpose. Few instances where the valuation is done based on the purpose are:

• Corporate Restructuring;
• Calculating the consideration for the sale of business or acquisition;
• Liquidation of the company;
• Calculating the consideration for sale or purchase of equity stake;
• During family separation, there is a need to calculate the value of assets and businesses owned by such a family;
• The portfolio value of investments is calculated by the virtue of Private Equity Funds or Venture Funds; 
• Purchase or sale of intangible assets such as rights, patents, trademarks, copyrights, brands, etc;.
• For the purpose of getting listed on the Stock Exchange, calculating the fair value of the shares is required;
• Calculating the fair value of shares for providing Employee Stock Ownership Plan following the Employee Stock Ownership Plan guidelines.

Indian laws impacting valuation 

Valuation of entities is subject to the following Indian laws, authorities and actions – 

• Companies Act, 2013
• Foreign Exchange Management Act, 1999
• Securities Exchange Board of India and Stock Exchanges 
• Competition Commission of India 
• Stamp Duty
• Income Tax
• Takeover Regulations
• Indirect Tax 
• Accounting Standards 

Valuation approaches

To determine the value of a business, there are three different approaches i.e, Asset-based approach, Income approach and Market approach. Either a single approach or a combination of the three approaches can be employed while determining the value.

Asset-Based Approach

This approach states that the buyer shall not pay more value for the purchase of an asset where a similar asset of the same value could be bought. The asset-based approach focuses on the net asset value of an entity. The net asset value is determined by subtracting total liabilities from total assets. The said approach is employed for valuation in a going concern company as well as the company on a liquidation basis. This approach is also employed when a target company has tangible assets.

Income Approach

The income approach states that the value of the acquisition candidate must be worth the future benefit of its revenue channels, discounted to the current value post reflecting the investment risk and time value of money. Both net cash flow and dividends form income inflows while determining the value of the acquisition candidate. This estimation is known as economic income. Capitalization rate or discount rate is applied to the economic income for valuation. While the capitalization rate represents a particular period’s income channel, the discount rate represents the total return an investor expects to get based on the invested amount.

Market Approach

The market approach states that during the process of valuation the valuator must thoroughly search for such companies in the market that are similar to the acquisition candidate. A minority interest market value is provided in the market approach. The market approach helps the valuator to adjust multiple results acquired from a minority interest value to a control interest value. The relationship between the book value or an identified revenue stream and the gross purchase price is represented by the multiplier.

Methods of Valuation

Based on the above-mentioned approaches there are specific methods for estimating the value of an acquisition candidate.

Net Asset Method

This method comes under the asset-based approach. It determines the fair market value of every asset and liability on the date of valuation. In this method, the equity value is estimated based on adjusted assets minus the liabilities adjusted. Usually, the underperforming assets are brought by the acquiring company through this method.  

Excess earnings treasury method

This method comes under the asset and income-based approach. It differentiates among intangible assets and adjusted net tangible assets. The estimation of intangible value is done by capitalizing those earnings of the company that are more than the earnings relating to a reasonable return on the fair market value of its net assets. The total value of the company is calculated by combining the tangible net adjusted assets at fair market value with the intangible value as estimated above. The excess earnings treasury method makes use of the average returns on equity from similar companies or industry averages to estimate a reasonable return while determining the right capitalization rate.

Excess earnings reasonable rate method

This method comes under the asset and income-based approach. In this method, a reasonable rate of return is applied to the adjusted net assets. The estimation of intangible value is done by capitalizing those earnings of the company that are more than the earnings relating to a reasonable return on the fair market value of its net assets. To estimate the total value of the company, the intangible value is combined with the fair market value of the adjusted net assets.

Capitalization of earnings method

This method comes under the income approach. This method is used to determine the value of a profitable company when the investor aims to facilitate an annual return on investment over reasonable compensation of the owner. The future estimated earnings are determined and divided by a capitalization rate to obtain a value. In this method, no separation is done between the tangible and intangible assets. This method is not appropriate for capital-intensive companies.

Discounted Cash Flow (DCF) method

This method comes under the income approach. It is also known as the Discounted Earning Method (DEM). In this method, to determine the value of a company, its earnings are defined. The earnings here may refer to post-tax cash flow and cash flow from operations. In this method, the capitalization rate is used. The assumption in this method is that the total value of the company is estimated by determining the current value of the projected future earning and the current value of the terminal value. The valuator in this method must be satisfied that the projected earnings are backed by the assumptions of the management and constitute reasonable future earnings.

Price/Earnings ratio method

This method is a combination of income and market approach. In this method, market comparisons are used to estimate the multiple to be applied against post-tax earnings. A weighted average price/earnings ratio of similar publicly traded companies helps in capitalizing the future estimated net income (post-tax). The main problem in making market comparisons is finding publicly traded companies that are similar to the targeted company. This method is generally used to determine the value of large and diversified companies.

Dividend-paying capacity method

This method is a combination of income and market approach. It is usually employed to determine the value of large companies that pay dividends. A five-year weighted average of dividend yields of five similar companies helps in capitalizing the future estimated dividend to be paid or that can be paid. When the valuation of larger and diversified companies is required, this method is put to use.

Guideline method

This method is based on the market approach. It draws a qualitative and quantitative comparison between the targeted company and the public companies (guideline companies) that are similar to it. The evaluator must be satisfied that the public companies and the target company carry out similar functions, have similar products and services and are based in the same geographic location. The required adjustments to the financial statements of the public companies held for comparison must be made by the valuator.

Direct market data method

This method is based on the market approach. It uses the sales transactions of an entity to compare with the acquisition candidate. However, it is not an easy task to compare the sales transaction as they often get consummated due to favourable purchase terms, acquired synergies, etc. Therefore, the valuator is required to adjust the direct market data used for a premium or discount.

Rule of thumb method

This method is based on the market approach. It is derived from the direct market data method. A formula is determined based on industry-wide experiences in the marketplace. This formula is used to ascertain the relations between the sales price and the operational unit of measurement regarding a particular industry. The method does not include risks that have the materialistic capability to affect the value. However, this method provides an effective test to check whether the value estimates determined from other methods are appropriate or not.

Case laws on M&A valuation 

Shreya’s India (P.) Ltd. v. Samrat Industries (P.) Ltd.

This case dealt with the question of whether a valuation is required for a merger. In this case, an objection was raised by the Regional Director (RD) that no valuation report was filed and the exchange ratio for amalgamation was not estimated by an independent valuator analyst. The High Court of Rajasthan opined that no legal or factual aspect restrained the grant from being sanctioned for the amalgamation. As a result, the objection raised by the regional director was overruled by the said court.

Hindustan Lever Employees’ Union v. Hindustan Lever Ltd and Others

This case dealt with the question of whether a valuation method must be employed for a merger. There is no definite method prescribed for valuation in mergers. But, the High Court of Bombay in this case, accepted the ratio of 2:2:1 as income, market and asset-based approach upon which the valuation was done.

G.L. Sultania and Another v. SEBI

This case dealt with the valuation of infrequently traded shares. The Supreme Court of India stated that the valuator analyst must consider the laid down parameters as they are fundamental and necessary. In case the valuation report reveals the non-consideration of any of the said parameters, then the report shall be considered vitiated for such reason. However, such vitiation shall not prevent the valuator analyst from considering other relevant aspects according to the accepted principles of share valuation. 

Conclusion

Mergers and Acquisitions form a major part of the corporate sector. Every company in the market tries to establish itself over the other to gain maximum profits and brand value. Due to the high level of competition in the market, many companies opt for mergers or acquisitions. A merger takes place when two companies come together and form a new company. Where one company takes over another company and announces itself as the new owner, it is known as acquisition. The value of the company is determined based on the purpose for which it is getting merged or acquired. The valuation is done based on income, market and asset-based approaches. These approaches provide further methods of valuation that serve the purpose of the merger or acquisition. 

References 

• https://www.mondaq.com/india/maprivate-equity/266274/corporate-valuation 
• https://www.icsi.edu/media/portals/72/year%202017/presentation/MA-Valuation%20Aspect%20-%20Jyoti%20Bhatia%20-%20180217.pdf 
• https://corporatefinanceinstitute.com/resources/knowledge/valuation/valuation-methods/ 
• https://taxguru.in/company-law/calculation-fair-merger.html 
• http://accounting-financial-tax.com/2009/02/valuation-approaches-and-methodologies-of-acquisitions/