Strategic mergers can be an effective strategy to enhance shareholder value in an increasingly competitive operating environment. However, there are several issues and complexities in merging two entities, including determining a merger ratio, performing proper due diligence (financial, as well as legal and regulatory), and determining the impact of synergies on a post-merger value.
When two private companies decide to merge, an exchange ratio must be determined since there is no public market or readily observable price. As a result, the merger partners must determine the values of both entities to calculate the merger ratio. It is oftentimes beneficial to mutually retain an independent financial advisor (as opposed to each party retaining a financial advisor, which often leads to biased analyses) to assist in the valuations to ensure neither party is disadvantaged (especially if one of the entities will be assuming a minority role).
The first step in determining a merger ratio should be an independent look at the value of each entity on a stand-alone basis. As with any valuation, this can be done using the traditional approaches to valuation (i.e., an income approach, market approach, and asset approach, if applicable). Each merger party is likely to have differing financial projection assumptions, discount rates, and applicable earnings multiples due to their respective profiles for growth, risk, and profitability. The determination of appropriate discount rates and market multiples should account for factors such as differences in size, geography, product breadth, and end markets. When performing the due diligence, certain off balance sheet liabilities and contingent liabilities such as pending lawsuits, warranty issues, regulatory issues, and retirement obligations (among others) should also be considered as they could have an adverse effect on value.
Synergies can provide immediate cost savings and efficiency gains for a combined entity. For example, revenue can be increased through cross selling efforts, gross profits can be improved through increased raw material buying power, and the size of the combined entity can impact credit worthiness thereby lowering its cost of capital. As a result of the synergies, the question becomes how to allocate the synergies between the two entities for determination of the merger ratio. Since a synergy requires contributions by both merger entities, the allocation of synergies depends upon how unique the resources are that are being brought into the combined entity. If only one of the entities has unique resources and assets necessary to realize the expected synergies, that entity and its shareholders should logically receive a larger share of the synergy benefits. If one of the firm’s strengths are not unique and could be offered by other firms, the bargaining power shifts to the other entity in negotiations. A qualified valuation can assist in the exercise of allocating synergies and determining the impact on a merger ratio by putting together reasonable and supportable assumptions.
Successful mergers can create significant additional value for the shareholders of the merger parties. However, mergers of private entities tend to be complex and require a significant amount of due diligence in order to be performed and negotiated correctly. The process of determining a reasonable and supportable merger ratio can be greatly eased through the use of a qualified valuation professional.