Strategic planning customarily involves reallocation of cash flows from low-yielding to higher-yielding investments.  This process takes place at different levels in large and small companies.  The board of director develops enterprise strategy and determines the businesses on which the company will expend its cash flows.  The strategy may be to expand the enterprise by making a major horizontal acquisition of a primary competitor of similar size.  On the other hand, the board may decide to contract by selling off major lines and reallocating cash flows into entirely new and higher-yielding business

Corporate strategy involves consolidation under common management groups with strategic business units which have common operating elements in terms of technology, marketing, geographic location, etc.

Strategic units are formed via group strategy.  Cash flows among group members are reallocated to maximize Iong-term return.  Groups also seek new investment opportunities appropriate for the group.  In many large corporations, each group may control its own M&A activity independent of headquarters.

Group strategy involves the assembly under one operating group of strategic business units which have common attributes.  Within each group, cash flows are allocated and reallocated to the individual business units or into new internal or external investments.

Business unit strategy deals with assembling under common management product lines that have certain commonalities, i.e. usually manufacturing or marketing.  Cash flows are reinvested in the most promising units after comparing the potential return from acquiring new product lines or start-ups.

The board may appoint a corporate strategy policy group whose initial task is to prepare a corporate strategy guide.  The guide should assign responsibilities in the corporate planning hierarchy.  It should define the level at which M&A search and screening activity will occur, the reports which should be prepared and the decision-making methods for structuring, financing, pricing, and post-acquisition operations.  Any acquisition investment should be compared against the cost of obtaining the same results from an internal development program, i.e. creating the same operation internally.

The board of directors sets the general strategy.  Directors ensure that managers make M&A decisions within the framework of a plan.  Without the structure, managers could waste time and money in undertaking pre-acquisition analyses of projects that do not fit the company's long-term strategy.


DUTIES OF BOARD OF DIRECTORS

Internal Project Development
Internal projects often fail because the company is not able to eliminate the proposed target as a competitor so that market shares are lower;  there are no earnings during the build-up period;  and the discount rate applied to the future earnings stream is higher due to the risks associated with new internal ventures.

Self-Funded Acquisitions
Some acquisitions may be partially self funded.  For example, in some acquisitions, the cost of acquiring a company through horizontal integration can be recovered in a short period because of efficiencies created by inventory reduction and elimination of staff and management duplication.

Product-line Strategy
Product-line strategy deals with product life cycles, supplementing or replacing mature or aging products with new products.  Functional strategy deals with alternative manufacturing methods of changing materials or techniques.  It should include plant relocation, i.e. finding lower labor rates or rents, better amenities, proximity to raw materials, etc.

Examples of Transformation of Companies
There are many examples of U.S. companies which have transformed themselves from historic commerce into modern enterprises.  For instance, American Can Company transformed from a can manufacturer into a financial services company.

STRUCTURING TRANSACTIONS
There are 3 basic forms used in business acquisitions: 
A.  the purchase of the assets of a business; 
B.  the purchase of the stock of the target business;  and 
C.  a statutory merger of the buyer of an affiliate with the target. 
These forms can in some cases be combined;  for example, certain assets of the business may be purchased separately from the stock of the company which owns the remainder of the assets.  A merger may take place immediately following the asset purchase.  If two corporation are owned by one seller, it is possible to purchase the assets of one corporation and the stock of another.

Asset Purchase
The buyer will receive all of the assets used in the business from the seller.  These may include equipment, inventory and real estate as well as intangible assets such as leases, patents, trademarks and contract rights.  The selling company may sell all or only part of its assets.  Specific documents are used to transfer assets, such as deeds, bills of sale and assignments.

An asset transaction is required when the sale involves only part of the business owned by the selling corporation.  If a product line is sold and it has not operated as a subsidiary corporation with its own books and records. 
In some cases an asset deal is selected due to its special advantages.  If a seller will realize taxable gain from the sale, the buyer generally will obtain significant tax savings from structuring the deal as an asset deal by stepping up the asset tax basis to the purchase price.  As a matter of law, the buyer generally assumes only the liabilities which it specifically agrees to assume.

There are a variety of tax concerns and other disadvantages to asset sales which need to be considered.

Stock Purchase
The seller transfers its shares in the target company to the buyer in exchange for an agreed upon consideration.  In most cases, the buyer will purchase all of the shares of the target.  However, when a shareholder who is a key manager and will remain active as an employee post-acquisition, he may retain shares.

A stock transaction is employed if the tax costs and other problems of an asset purchase make the latter undesirable.  Also, a stock purchase may be required if an asset transfer requires the consent of third parties which may be costly and difficult.

Sellers typically prefer a stock deal because the buyer will acquire the business subject to all of its liabilities.  Buyers will seek indemnities against undisclosed liabilities.

Mergers
A merger is a transaction in which one corporation is incorporated into another and the surviving corporation succeeds to all of the assets and liabilities of the merged corporation.  There are no separate transfers of the assets or liabilities.  The transfer occurs by operation of law when the merger papers are filed with the appropriate State authorities.

In a reverse merger, the buyer is incorporated into the target and the buyer’s shareholders receive stock in the target and the target’s shareholders receive the purchase price.  In a forward merger, the target merges into the buyer and the target shareholders exchange their stock for the purchase price.  A subsidiary merger is a merger in which the buyer corporation incorporates an acquisition subsidiary which merges with the target. 

A reverse subsidiary merger in which the acquisition subsidiary merges into the target is popular because of its simplicity.

The board of directors of each corporation must adopt a resolution approving the agreement of merger.  Also, the shareholders owning a majority of the stock must approve the transaction.

Sale of Corporate Division
The sale of a corporate division presents different problems from those that occur when the entire corporate business or businesses are sold.  For example, a trade name may be used with products sold by another division, and license transfers may be more complicated when a division is bought and sold.  Assets, liabilities, and obligations that were integrated with other divisions may be difficult to separate. The role of executives whose work extended across divisional lines must be sorted out. And the sale or transfer of a corporate division on a tax-free basis may be difficult.

Leveraged Buyout
A leveraged buyout, or LBO, is an acquisition transaction in which the purchaser uses financing provided by others to effect the purchase.  The buyer then uses earnings from the acquired business to service and repay the debt.  The attraction of this form of financing is that the buyer commits a relatively small amount of its own resources to the acquisition, relying instead on the assets acquired from the selling corporation.

TAXATION
In any merger or acquisition, there are a wide variety of tax issues which must be considered as part of the negotiation and structuring of the transaction.  These issues affect valuation and pricing and the structure.  For example, mergers and acquisitions may be completely tax-free, partially tax free or entirely taxable to the seller.  Each party will have divergent views on how to structure the transaction from a tax standpoint, depending on their non-tax strategic objectives and their respective tax and financial positions.  In some cases, the tax consequences may be a driving force in the transaction and in others, the tax issues may be secondary.  Other tax issues need to be reviewed, such as the tax basis of the assets acquired, the impact of imputed interest rules and the tax aspects of any deferred consideration and/or incentive compensation to the seller.

Net Operating Losses
The buyer will likely want to preserve net operating and other losses of the acquired corporation to reduce federal income tax liability. The Tax Reform Act of 1986 and the Revenue Act of 1987, however, substantially limited the carryover of such losses after an acquisition. IRC §§382-384. One of the principal goals of these provisions is to limit net operating loss and other relevant carryovers to the annual income that the loss corporation’s business would have produced had its assets been sold on the acquisition date at fair market value and the proceeds invested in high-grade securities.

In general, if ownership of a loss corporation changes more than 50-percent over a three-year period, whether because of a tax-free reorganization or a taxable stock purchase (no carryover is available, in any event, if assets are purchased), earnings in any later year against which the net operating loss and other carryovers may be used are limited to the fair market value of the loss corporation’s stock immediately before the ownership change multiplied by the “long-term tax-exempt rate” (published by the Treasury Department on a periodic basis). IRC §§382-384.

NEGOTIATIONS AND PRICING
International and domestic M & A transactions utilize traditional valuation methods.  However, international transactions require some adjustments.  Valuation is the process by which the target company[s fair market value is determined.  Fair market value is often not the sole determinate of the purchase price in the context of acquisitions.  Fair market value in theory recognizes only arm’s length factors and assumes both parties are well informed and equally motivated to complete the transaction.  However, in fact, different buyers may be willing to pay more or less than the fair market value due to variables such as business synergies, the need to bolster a floundering business or the desire by the buyer or the target to diversify in international markets.  Target companies may demand a premium price if management is not highly motivated to pass control.

The parties’ respective motivations and bargaining strength may influence the actual price substantially.  Practitioners typically employ comparable company analysis, discounted cash flow, asset analysis and control premium information.  In international transactions, the questions of multiples and market-book value rations are more complex. 

The criteria for pricing include the following factors:

Voting rights of each class of shares and the % ownership to be purchased.
The target’s history and management, the nature of the business, strengths and weaknesses and type of business.
The target’s financial condition, historical, current and projected;  analysis of assets, liabilities, capital and net worth.
Historical operating results, including earnings.
The target’s prospects, the overall state of the economy and the target’s industry.
Appraisals of publicly traded shares of companies for comparative purposes, financial performance of the comparables, discounted cash flow, asset valuation, payback analysis and several other factors.
Other recently closed M & A transactions in comparable industries.
The marketability of the target’s securities.
Control premium.
The strategic value of the target.

The above criteria are traditionally used in pricing analysis.  In the real world, some elements will be considered more important than others will.  Typically, buyers will at least consider all of the relevant factors, even though the ultimate pricing may not be affected by some elements.

The buyer must undertake a thorough due diligence investigation of the target.  If the target is taking the buyer’s shares or notes, the target will investigate the buyer. 

The process will require a review of the origin of the target;  the main company milestones;  the process by which new products are developed;  details about the target’s manufacturing processes and labor situation;  details regarding the target’s sales and marketing efforts;  the target’s current and projected competitive position;  details regarding the target’s senior management;  review of the target’s historical and projected financial statements;  and review of the target’s future strategies and projects.

EXPRESSING THE PURCHASE PRICE
After the parties agree on the price, they must express it properly and consider the effect on the price, if any, of any significant change in profits and losses between the signing and closing.  The parties may agree that the price is a fixed amount or an amount determined by a formula.  A fixed amount is specified as a total dollar amount, which may be payable in cash or a combination of cash and securities.  The non-cash portion of the price will  often be in the form of subordinated promissory notes, preferred stock, or, if the buyer is a public company, common stock of the buyer. 
Where the price is determined by a formula, it is commonly based on book value or stockholders’ equity from a balance sheet prepared as of the closing date, subject to adjustments.  Another approach is to fix a price and permit the buyer to receive a credit against the price for any excess earnings or pay an increased amount equal to losses realized by the business after a specific date.  This may be provided as an adjustment for changes in working capital i.e. the difference between cash and current assets against current liabilities on the closing date.

If a substantial time period will elapse between signing the agreement and the closing, the buyer will want protection against changes in the value of the target during the interim.  A book value formula may protect by detecting any sales of assets or other changes in operations from the ordinary course of business.

The parties may agree that the share value is established as the market price as of the date that agreement is signed.  However, because the market price may be significantly higher or lower on the closing date, the parties may agree to use the market price on the closing date.  Another method is to use the average price at closing for a number of days prior to the closing.  Another method is to apply the price of the stock over the past year and place a maximum and minimum (collar) on the stock price irrespective of the trading price on the closing date.  There are a number of other variations of these approaches.

In transactions involving public companies buyers may use a combination of cash and securities.  For tax reasons, a deal may provide for fixed percentages of cash and stock.  The agreement may allocate the cash and securities proportionately or the target’s shareholders may be given the option to elect between all cash and all securities or any combination.

An earnout is a method of compensating a seller based on the future earnings of a company.  It is the contingent portion of the purchase price.  A common earnout provides for additional payments to the seller if the earnings exceed agreed-upon levels.  Earnouts require consideration of a number of factors, including the type of contingent payment (cash or stock), the method of measuring performance (operating income, cash flow, net income, etc.) the measurement period, maximum limits and the timing of the payments. 

The parties may disagree on the value of the business because of their different opinions about projected profitability.  However, earnouts are difficult to administer and raise numerous issues.  The parties must agree on a definition of operating income.  The buyer will request that income is from ongoing operations and not from extraordinary events.  The selling parties will request that target be operated separately and consistently with past practice.  However, the buyer may be planning changes in the business which will impact the earnings.

INTERNATIONAL TRANSACTIONS
Global corporations cannot realize all of their growth potential by internal means alone.  Most corporations lack the experience, infrastructure or resources to establish businesses in a number of countries.  Transactions permit companies to expand on a global basis.  Technology companies particularly need to develop global business strategies due to the rapid development of the industry and products. 

Cross-border transactions offer several benefits.  These include immediate name recognition from a well known business with successful products.  Other benefits include opening of new distribution systems, availability of manufacturing facilities, access to new customers and access to new technology.

On the other hand, there can be certain obstacles to international transactions.  These include culture shock, differing business practices and negotiating styles.  For example, there may be differing practices regarding contacts with target businesses, the role of the intermediaries, negotiating styles and pricing practices and due diligence procedures.  It is essential to understand the differences in order to avoid communications problems.  There may be different labor and other laws and practices which need to be understood.

STRATEGIC ALLIANCES
A strategic alliance is a substitute for a merger or acquisition and in U.S. law is treated as such for antitrust and other legal purposes.  The most common strategic alliance is the joint venture in which two different corporations set up a third, jointly owned enterprise in corporate form.  Some JV’s do not produce expected results if the partners lack complementary skills. 

Successful alliances are those in which the corporate owners have complementary skills or resources (e.g., one of the partners supplies the technology and the other supplies the marketing).  The most successful alliances are often those in which one of the partners owns a controlling interest.

If more than two corporations are involved in a venture, it is called a consortium rather than a joint venture.  For example, in Europe, consortia are quite common with several corporations often setting up new corporations.  Other forms of strategic alliances are joint marketing agreements, technology exchanges, and cooperative agreements in which a U.S. manufacturer makes a deal to sell and service a foreign manufacturer's line of products, while the foreign manufacturer sells and services the U.S. manufacturer's line of planters.

There has been an international burst of growth in strategic alliances.  In the U.S., digital media business is generating a wealth of new alliances.  These are American family of "keiretsu," the Japanese form of interlocking manufacturer-supplier groups which own a majority of Japanese industry.  U.S. corporations entertain these alliances because it is impossible to know exactly what will happen in this rapidly evolving field of digital technology.

The General Magic consortium is embraced by Motorola, Philips, Sony, Apple, AT&T, and Matsushita.  Even though these companies cooperate in the consortium, each has launched competing products, such as handheld personal communicators.

Certain alliance deals entail high-risk because their success requires an understanding and successful implementation of a myriad of problems.  For example, the IBM-Blockbuster alliance to produce "instant CD’s" in retail outlets in order to solve inventory problems failed partially because it failed to obtain cooperation of major copyright holders such as Sony and Time-Warner.

SUMMARY
Successful transactions, particularly international deals, involve a number of market forces which must be considered.  A business deal with a leading company in a dynamic market typically involves completion of a planned strategy.  Even opportunistic deals should be made within a framework of a rationale business development strategy.

The structuring of a merger/acquisition/buyout transaction is often the most challenging aspect of a deal.  The range of available forms (asset sales, stock transfers, mergers of a variety of types, tender offers, etc.) and the variety of important considerations (legal, taxation, accounting, etc.) require imaginative planning in order to address the competing interests of buyers, sellers, investors and lenders.  Changes in tax and other laws need to be considered because of their impact on merger taxation.

The purpose of this newsletter is to provide a short overview of some issues which often arise during the process of accomplishing a purchase and sale of a business.  Because the relevant principles and law are very complex and constantly changing., the processes should be guided by experienced professionals in a variety of disciplines.

Additional Topics in Complete Paper
* VALUATION ISSUES
* DOCUMENTATION
* Confidentiality
* Indemnification
* PROJECTIONS & DUE DILIGENCE
* ACCOUNTING & FINANCING ASPECTS
* GOVERNMENT APPROVALS
* CLOSING THE DEAL
* RISK MANAGEMENT
* HUMAN RESOURCES
* POST-MERGER INTEGRATION