In order to adapt to competitive pressures, advancements in technology, and economic conditions, privately-held companies are often forced to adapt their business by acquiring or partnering/merging with another company in order to remain competitive or simply to grow their business. A private company may also sell itself to a larger public company for the same reasons. Private companies may reconfigure their assets, operations, and relationships with the stockholders in search of higher growth, new technology, business expansion, and greater revenues.
Mergers, acquisitions, and corporate restructurings often enable a private company to develop a competitive advantage by increasing flexibility, growth, and shareholder value. Common M&A motives include: strategic growth, talent growth (“acq-hire”), preparation for an IPO or exit, and entering a new geographic or demographic market (buy vs. build).
Types of Private Company M&A and Similar Transformative Transactions
Expansion is an increase in the size of a private company’s business due to a transformative transaction. There are a variety of reasons private companies choose to expand through an expansion transaction rather than naturally (“organically”). First of all, growth happens much faster, virtually overnight in some cases, whereas natural organic growth takes time as its sales grow. A private-held company may want to eliminate a competitor, enter a new geographic market, introduce a new product line, or bring on the talent and management team that results from an expansion transaction.
Expansion can be accomplished through mergers, asset acquisitions, tender offers or joint ventures. The following methods can be used to help a private company grow without having to create a whole other business entity.
- Merger—A private company merger is when two or more private companies combine to form a single entity under a consolidated management and ownership. A merger can take place through an amalgamation or absorption.
- Amalgamation—An amalgamation is when two or more private companies enter into the merger agreement to form a completely new entity. In this type of merger both private companies lose their identity and a new private company is formed to manage the consolidated assets. Amalgamation tends to occur when both private companies are of equal size.
- Absorption—Absorption is when the merger occurs between a two entities of dissimilar size. In such a case, the larger private company would absorb the smaller one. The fusion dissolves the smaller private company and places all its assets in control of the larger private company. Absorption may also take a smaller private company and make it a stand alone operating division or subsidiary of a larger private company.
- Acquisition—A private-market acquisition is when a company (public or private) buys up the stock of a private company. An acquisition may also take the form of an “asset acquisition”, where rather than buying the stock, the buyer simply buys the entirety or a portion of the assets of another private company. The assets may be tangible such as plants and machinery, or intangible assets such as patents and trademarks. The target private company may then continue as a smaller company or dissolve.
- “Acq-hire”—An “acq-hire” (or acquisition-by-hire) may occur especially when the target private company is quite small or is in the startup phase. In this case, the acquiring company simply hires the staff of the target private company, thereby acquiring its talent (if that is its main asset and appeal). The target private company simply dissolves and little legal issues are involved.
- Tender Offer—A tender offer is an offer by an acquiring company to the general shareholders of a target private company to purchase a majority of the equity at a premium to market value. Tender offers are an attempt to gain management control through holding the majority of voting equity. Note that tender offers are less common for private companies than they are for publicly traded companies.
- Joint Venture—A joint venture is when two or more private companies enter into an agreement to allot a portion of resources towards the achievement of a particular goal over a designated period of time. Synergies occur when businesses capitalize on joint opportunities or other combined efforts to obtain an effect greater than working alone, whether it is increased revenue or decreased costs.
Key Differences Between Mergers and Acquisitions
Although often very similar, mergers and acquisitions are two distinctly separate types of transactions. In the purest sense, a “merger” refers to a merger of equals: two companies of the same size come together, surrender their shares, and issue new shares for a new, combined company. In a merger, the merging organizations surrender their shares and issue new shares for a new, combined company.
A merger of equals is actually quite rare since most deals that are reported as a merger are actually acquisitions, where one firm actually purchases and assumes ownership of the other. Acquisitions are often publicized as mergers because they’re easier for the target firm and PR teams to swallow and are believed to help promote a more successful integration of the firms’ operations. In some acquisitions, the acquirer will create a Merger Sub for the transaction. A Merger Sub is a non-operating legal entity that acts as an investment vehicle for the acquirer, allowing it to merge the target with the Merger Sub entity, labeling the acquisition as a merger.
Many small private firm targets are actually acquired as an asset purchase rather than a formal acquisition. An asset purchase transaction may take place in lieu of an acquisition if the target firm’s accounting practices are not in compliance with Sarbanes-Oxley or if the acquiring firm couldn’t afford to spend the time or resources required for a full due diligence process. After the asset purchase transaction is complete, the target company will often still exist, although without active operations, in order to pay off its remaining bills before dissolution and the distribution of remaining funds to shareholders.
Types of Mergers
- Horizontal Merger—A horizontal merger is when two private companies from the same business class or market enter into a merger agreement. In a horizontal merger, the merged private companies benefit from economies of scale and increase total market share by consolidating facilities, combining operations, increasing working capital, reducing competition, or reducing advertisement costs, etc.
- Vertical Merger—A vertical merger occurs when two firms from different stages of the same business class, activity or operation enter into a merger agreement. These types of private companies typically have buyer-seller or supply chain relationships before the merger. Generally, private companies attempt vertical mergers or hostile takeovers of other firms to maximize backward or forward integration along their supply chain. The acquiring private company reaps the benefits of a reduced inventory and more efficient allocation working capital.
- Conglomerate Merger—A conglomerate merger is when two private companies that operate in different or unrelated business lines enter into the merger agreement. Firms choose to enter into a conglomerate merger to benefit from the access to greater financial resources. Firms, by expanding into new markets and different businesses, create a diverse portfolio of products that balance business risk.
Key Differences Between Public and Private M&A
Both Public and private companies engage in M&A transactions, but there are several key differences to note between the processes for each. These characteristic differences are expanded upon below:
Public Company M&A Private Company M&A
Due to the high liquidity of publicly traded stock, public firms may more easily use their shares as M&A currency.
Can raise money from the public market to help finance an M&A transaction.
Not subject to an illiquidity discount.
Public M&A transactions must be approved by the SEC for anti-trust purposes and also require Sarbanes-Oxley compliance.
Private Company M&A
Although in some cases, a private company may use its stock as currency for an M&A transaction, an illiquidity discount applies. A valuation method that consists primarily of discounted cash flow and asset valuation is most likely to apply and the private firm will most often use cash to acquire a given target.
Cannot raise money from the public market and must resort to debt financing, venture capital, or other private forms of funding.
Private firms suffer an illiquidity discount that may revolve around 20-30%.
Sarbanes-Oxley compliance is only relevant to private companies that have future plans to go public or to be acquired by a public firm.
Strategic Vs. Financial Buyers
Potential private company buyers and investors fall into two primary categories:
- Financial Buyers—Financial buyers include private equity firms (also known as financial sponsors), venture capital firms, hedge funds, family investment offices and ultra high net worth individuals. These firms and executives are in the business of making investments in private companies and realizing a return on their investments. Financial buyers look to identify private companies with attractive future growth opportunities and durable competitive advantages, invest capital in their operations, and realize a return on their investment upon exit via a direct sale or an IPO.
- Strategic Buyers—Strategic buyers search for operating private companies that offer products or services similar to their own. Targets of strategic buyers are often competitors, suppliers or customers of the original firm. Strategic buyers can also aim to acquire firms that have operations that are unrelated to their core businesses. Such an acquisition would be considered as an attempt of a strategic buyer to diversify their revenue sources. Their goal is to identify private companies whose products or services can synergistically integrate with their existing businesses to create long-term shareholder value.
Contraction is the reduction in the size of the private company or business due to corporate restructuring. For more information on contractual corporate restructuring, please see PrivCo’s Knowledge Bank chapter on Bankruptcy and Restructuring.
- Spin-Offs—A spin-off transaction is when a parent private company separates the shares of its subsidiary from the original private company shares and distributes those shares, on a pro-rata basis to its shareholders. In essence, two separate entities are formed in which the stockholders are issued the shares in the legal subsidiary proportional to their original holdings in the parent private company. Both the entities have their own management and run individually after the spin-off. The distribution of the subsidiary’s stock to shareholders is in the form of a dividend. This is typically a tax-free transaction for both the shareholders and the parent.
- Split-Offs—A split off is the separation of a subsidiary from the parent by splitting the shareholders of the parent private company’s stock from the shareholders of the subsidiary’s stock. Most split-offs are tax-free transactions and used to downsize a private company or defend against a hostile takeover. In a split-off a new private company is created to take over the operations of an existing unit or division and some of the parent private company’s shareholders will receive the stocks in subsidiary or in new private company in exchange for the parent private company’s stocks. As a result, the parent private company will be able downsize its overall business.
- Split-Ups—A split up is when an entire firm is broken up in the series of spin-offs. After a split-up the parent private company no longer exists, only the spun-off businesses of the original private company survive. In a split-up transaction, new classes of stock are created to track the operations of each of the individual subsidiaries. The new classes of shares are distributed as a dividend to current stockholders and then the parent private company is dissolved.
- Divestiture—A divestiture is a direct sale of a portion of the parent private company to an outside party in return for cash. Generally a firm sells struggling operations that operate at a loss or require upkeep capital. A parent private company may also divest non-strategic or non-gaining businesses and invest the proceeds of the sale in potentially higher return opportunities or core business expansion. Divestitures may also be used to realize the true potential of an outperforming asset, whose performance is not properly valued by the market. The tax basis of the asset intended for divestiture will be considered before deciding on the appropriate type of divestiture.
- Equity Carve-Out—An Equity carve-out is a sale of a portion of equity in a subsidiary to the public via an IPO. The parent private company retains the majority stake in the subsidiary, usually greater than 80%. With ownership of over 80%, the parent private company still retains the right to undertake spin-offs and split-offs on a tax free basis. In an equity carve-out, a new legal entity is created and issues new shares, which are distributed to outside investors.
- Asset Sale—An asset sale involves the sale of tangible or intangible assets of the private company to generate cash. This cash can be used to pay out a dividend, adjust capital structure, or purchase other assets or investments. In an extreme case, an asset sale may be part of a Chapter 7 liquidation plan where a private company ceases all business operations and sells all its assets. (See PrivCo’s Knowledge Bank chapter on Bankruptcy and Restructuring for more information on Chapter 7 liquidations.)
Ownership Change Transactions
An ownership change transaction is exactly what it sounds like: a transaction where the company’s ownership changes so the firm welcomes new owners or a different composition of ownership stakes for its existing shareholders.
- Minority Share Sale & Venture Capital—A private company can have a change in its ownership structure if it sells some of its shares to an outside investor, such as an individual (“Angel”) or venture capital firm (“VC Firm”). Note that in the case of venture capital deals, this often occurs in conjunction with a Change of Control since the VC Firm will usually demand Board seats, preferred stock and dividend rights in addition to other rights and terms.
- Initial Public Offering (IPO)—By going public via an Initial Public Offering (IPO), the company can change control of the company from the private owners’, founders’, or controlling family’s hands to partially (even a majority) public investors. An IPO often has the added benefit of providing both expansion capital as well as liquidity for the company.
Leveraged Buyout (LBO)—A leveraged buyout is a situation in which a group of investors (usually a private equity firm) acquire a controlling interest in a given private company’s equity by borrowing a large portion of the capital necessary to finance the transaction. The acquired private company’s assets are often used as collateral against the borrowed capital. In a leveraged buyout situation, a combination of debt instruments from bank and capital markets are deployed.
Leveraged buyouts use a highly leveraged capital structure where the majority of the cash flow from the acquired private company, division or subsidiary is used to service and repay the loan. Leveraged buyouts may be used to enhance shareholder value, counter takeover threats or realize the value of undervalued assets.
- Employee Stock Ownership Plan (ESOP)—An employee stock option plan is a transaction where a private company makes a tax deductible contribution of cash or company stock into a trust. The trust’s assets are then allocated to employees through the use of stock options and are not taxed until the employees exercise their option. Since the creation of an ESOP concentrates a private company’s ownership, they can be used as an anti-takeover defense mechanism.
- Leveraged ESOP—Although uncommon, leveraged ESOPs are typically used to concentrate the ownership of a private company into the employees’ hands, often to defend against a possible takeover. An ESOP is an employee stock ownership plan where employees own a piece of equity in the private company. Leveraged ESOPs are initiated by borrowing capital to capture a majority of the equity at one time. This equity can then be vested over a period of time to the employees. Leveraged ESOPs drastically alter both the capital structure of a private company (by increasing the liabilities), and the ownership concentration from the original owners/management to the employees.
- Share Repurchase—A share repurchase program is a measure implemented by cash-rich corporations to concentrate the ownership of the private company by purchasing equity shares at a premium to market value. Private companies can use share repurchase programs to accrete the ownership of upper level management, lever up the balance sheet and thwart the threat of a takeover. Share repurchases lead to decreased equity capital of the private company. While less rare for private companies than for publicly traded ones, many private companies that have the cash to do so can make a tender offer in order to reduce the number of shareholders and concentrate ownership and control of the company.
- Takeover—In recent years there has been a high level of hostile takeovers. Takeovers can be defined as acquiring control of the private company or management by stock purchase or stock exchange. The majority of takeovers have come in the form of leveraged buyouts, proxy battles, or forced internal restructuring by vocal institutional investors who aim to maximize the shareholder value of their clients. Hostile takeovers are relatively rare for private companies, but can and do occur.
Change of Corporate Control Without a Transaction
Changes in control of a private company often occur as a result of a Change of Ownership Transaction (see above) such as an M&A deal or a Venture Capital or Private Equity investment. However, change in control of a private company can also occur without an acquisition or divestiture. Corporate control is the control over the management of the firm. Management decisions influence strategy of the organization and directly impact employee tasks.
During an internal restructuring or change of control, a private company evaluates its internal process, and management team. A change of control can result from:
- Board Seat Changes—Since ultimately the company’s Board of Directors controls the company, voluntary changes made to the private company’s Board of Directors will result in a change of control without a merger, acquisition, or other transformative transaction. Changes in the private company’s Board of Directors may be made for a variety of reasons: the company may need additional expertise in a certain area for example. A Director may also be forcibly removed by the private company due to the Director’s conflict of interest, or the private company’s accountants may force the addition or removal of a Director because the accounting firm feels the Board lacks independence from management, needs an Audit Committee or a Compensation Committee to make independent decisions regarding the firm’s books and records (Audit Committee) or management’s pay and compensation (Compensation Committee).
- Management Changes—Via its Board, a firm may hire a new CEO, CFO or make other changes in its Executive Team, resulting in a change of control without any M&A transaction (Note that PrivCo has a Leadership Change” tag that enables users to search by this tag in order to target M&A or investment opportunities).
- Generational Changes—Change of control of the private company may also take place without an M&A transaction due to the death of the private company’s Founder and passage of the company to the next generation (Note that PrivCo has a “Generational Change” tag on a private company when this occurs to allow our users to search by this tag in order to target M&A opportunities or investment opportunities).