Acquisition

What Is Acquisition?

An acquisition is a corporate action in which one company, known as the acquiring company, purchases the majority, or even all, of the shares or assets of another company, the target company. This grants the acquiring company control over the target company, its operations, and its assets. Acquisitions are a fundamental strategy within corporate finance for growth, market expansion, diversification, and gaining competitive advantages. Unlike a merger, where two companies typically combine to form a new entity, in an acquisition, the acquired company often ceases to exist as an independent entity, or it becomes a subsidiary of the acquirer.

History and Origin

The concept of companies acquiring others dates back centuries, evolving alongside the development of corporate structures and financial markets. Early acquisitions were often driven by a desire for raw materials, expanding geographical reach, or eliminating competition within nascent industries. Significant periods of acquisition activity, often referred to as "merger waves," have historically coincided with economic booms, technological advancements, or deregulation. For instance, the late 19th and early 20th centuries saw large-scale consolidations in industries like steel and oil, as companies sought to achieve economies of scale and control supply chains. More recently, cross-border mergers and acquisitions activities have sharply increased, partly as a result of financial liberalization policies and regional agreements, with data from the U.S. Bureau of Economic Analysis (BEA) providing comprehensive information on new foreign direct investment in the United States, which includes the acquisition of U.S. business enterprises by foreign investors.⁷,⁶ The strategic logic behind many of these deals, and the outcomes, are frequently topics of discussion in financial forums such as The New York Times' DealBook Summit.⁵,⁴

Key Takeaways

• An acquisition involves one company purchasing another, leading to the acquirer gaining control.
• Acquisitions are a core strategy in corporate finance for growth and market expansion.
• The process typically involves thorough due diligence and complex valuation analyses.
• Acquisitions aim to generate synergy and enhance shareholder value, though success is not guaranteed.

Formula and Calculation

While there isn't a single formula for "acquisition" itself, determining the fair price and value of a target company is central to the acquisition process. Companies employ various valuation methods to arrive at an offer price. Common approaches include:

1. Discounted Cash Flow (DCF) Analysis: This method projects the target company's future free cash flows and discounts them back to their present value using a discount rate, typically the Weighted Average Cost of Capital (WACC).

   $$PV = \sum_{t=1}^{n} \frac{FCF_t}{(1+WACC)^t} + \frac{TV}{(1+WACC)^n}$$

   Where:

   • (PV) = Present Value
   • (FCF_t) = Free Cash Flow in year t
   • (WACC) = Weighted Average Cost of Capital (Discount Rate)
   • (n) = Number of years in the projection period
   • (TV) = Terminal Value (value of cash flows beyond the projection period)

2. Comparable Company Analysis (Comps): This involves valuing the target company by comparing it to similar publicly traded companies or recent transactions, using multiples such as Price-to-Earnings (P/E), Enterprise Value-to-EBITDA (EV/EBITDA), or Price-to-Sales.

3. Precedent Transactions Analysis: This method examines the multiples paid in historical acquisitions of similar companies to determine a reasonable valuation for the target.

The final acquisition price often reflects intense negotiations between the acquiring and target companies, influenced by these valuation models, market conditions, and strategic considerations.

Interpreting the Acquisition

An acquisition's success is not merely measured by the completion of the deal but by the realization of its intended strategic and financial objectives, primarily the creation of value for the acquiring firm's shareholders. Successful acquisitions are typically those where the acquiring company effectively integrates the target's operations, culture, and employees, leading to expected synergy gains. Conversely, failure to achieve these objectives, often due to poor post-merger integration or overpayment, can lead to significant financial write-downs and a decrease in shareholder value. The market often reacts to acquisition announcements, with the stock prices of both the acquirer and the target reflecting investor sentiment regarding the potential for value creation or destruction.

Hypothetical Example

Imagine "Tech Innovations Inc." (the acquiring company), a leading software firm, identifies "Code Wizards Ltd." (the target company), a smaller but highly innovative startup specializing in artificial intelligence for cybersecurity, as a valuable strategic fit. Tech Innovations Inc. believes that acquiring Code Wizards will allow them to quickly expand into the cybersecurity market and integrate cutting-edge AI technology into their existing products, creating significant synergy.

Tech Innovations Inc. initiates a due diligence process to scrutinize Code Wizards' financials, intellectual property, contracts, and talent. After extensive valuation analysis, Tech Innovations offers to buy all outstanding shares of Code Wizards Ltd. for $200 million, a price that includes a premium over Code Wizards' current market value. Code Wizards' shareholders, seeing the strong strategic rationale and favorable offer, approve the acquisition. Post-acquisition, Code Wizards operates as a wholly-owned subsidiary of Tech Innovations, with its team integrated into Tech Innovations' R&D department.

Practical Applications

Acquisitions are widely used across various sectors of the economy for a multitude of strategic reasons. In the financial markets, they are central to the growth strategies of large corporations, often leading to industry consolidation. For instance, a pharmaceutical company might acquire a smaller biotech firm to gain access to a promising new drug pipeline, while a tech giant might acquire a startup for its innovative technology or user base. Private equity firms frequently engage in acquisitions, buying companies, improving their operations, and eventually selling them for a profit.

Acquisitions also play a significant role in market dynamics, influencing competition and regulatory oversight. Regulators, such as the Federal Trade Commission (FTC) and the Department of Justice (DOJ) in the U.S., closely scrutinize large acquisitions for potential antitrust issues to ensure fair competition. Beyond corporate strategy, understanding acquisitions is crucial for investors assessing the long-term prospects of companies. For individuals, an acquisition of a company they hold shares in could result in a cash payout or an exchange of shares, impacting their capital gains obligations. Despite their potential for growth, a significant number of acquisitions face challenges, with some studies suggesting that historically, a high percentage of deals have failed to create value, although recent research indicates a rising success rate for mergers and acquisitions.³

Limitations and Criticisms

Despite their strategic appeal, acquisitions are not without significant limitations and criticisms. A notable concern is the high failure rate often associated with achieving expected synergies and creating long-term shareholder value. Common reasons for failure include overpaying for the target, inadequate due diligence, and, most critically, poor post-acquisition integration, particularly regarding cultural clashes and employee retention. A 2023 analysis found that poor integration was cited by over 60% of executives as a primary cause of deal failure.²

Furthermore, acquisitions can introduce considerable risk management challenges. The acquiring company takes on the target's liabilities, including financial debt, legal issues, and unforeseen operational problems. There can also be resistance from the target company's management or shareholders, leading to a hostile takeover scenario, which can be costly and disruptive. Critics also point to the potential for acquisitions to reduce market competition, leading to monopolistic practices and less innovation, thereby attracting regulatory scrutiny. The OECD, for instance, highlights the increasing complexity and challenges of managing parallel regulatory reviews for cross-border mergers, which can become burdensome and costly.¹

Acquisition vs. Merger

The terms "acquisition" and "merger" are often used interchangeably, but they represent distinct corporate actions. The primary difference lies in the legal and operational outcome.

• An acquisition occurs when one company buys another company and establishes itself as the clear owner. The acquired company usually integrates into the acquiring company, often losing its separate identity or operating as a subsidiary. This is often seen as a dominant company taking over a smaller one. For example, a large technology firm buying a startup would be an acquisition, which can take the form of an asset purchase or a stock purchase.

• A merger, on the other hand, involves two companies of roughly similar size agreeing to combine their operations and form a new, single entity. In a merger, both original companies cease to exist as independent entities, and a new corporate name is often established, signifying a partnership of equals. The goal is to pool resources and capabilities to create a stronger competitive presence.

While the end result of both can be a larger, consolidated entity, the legal structure and power dynamics distinguish an acquisition from a merger.

FAQs

What are the main types of acquisition?

Acquisitions can be categorized in several ways, including horizontal (buying a competitor), vertical (buying a supplier or distributor), and conglomerate (buying a company in an unrelated industry). They can also be classified by payment method, such as cash, stock, or a combination, and by the nature of the transaction, like an asset purchase or a stock purchase.

Why do companies pursue acquisitions?

Companies pursue acquisitions for various strategic reasons, including expanding market share, gaining access to new technologies or markets, achieving economies of scale, diversifying product offerings, eliminating competition, or acquiring key talent. The ultimate goal is typically to enhance shareholder value and improve competitive positioning.

What is the role of due diligence in an acquisition?

Due diligence is a critical step in the acquisition process where the acquiring company thoroughly investigates the target company's financial, legal, operational, and strategic aspects. This extensive review helps the acquirer understand the target's true value, identify potential risks and liabilities, and verify all relevant information before committing to the deal.

Can an acquisition be hostile?

Yes, an acquisition can be hostile if the acquiring company attempts to take over the target company against the wishes of its management or board of directors. This often involves the acquirer making a direct appeal to the target's shareholders, bypassing the existing management. Such situations are known as hostile takeovers.