MERGER, ACQUISITION & CORPORATE

RECONSTRUCTURING

REGULATORY & LEGAL FRAMEWORK IN INDIA- In

business, combinations or any form of takeover, acquisition, merger
or amalgamation, the interest of shareholders, creditors, employees
and consumers exist in several ways. Provisions have been made in
different Acts enacted for the said purpose to regulate the procedure
of takeover and mergers. These Acts ensure that such business
organizations don’t jeopardise the public interest by exploiting the
minority shareholders of the company or the interest of prospective
investors, creditors and consumers etc. It brings many benefits such
as:

1. creating a market for corporate control,

2. increase in the value of shares, and
3. ensure greater operational efficiency

The liberalized and globalised Indian economy demands that

firms should either grow or exit. It has happened in the last 10
years that firms are looking at M&A as a mode of growth. Corporate
are restructuring their capital structure and returning debts, thereby
reducing interest burden in order to ensure maximization of
shareholder’s wealth. Hence, for the said purpose, in most of the
cases the process of financial restructuring has been implemented
through amalgamation, merger, takeover and acquisition etc.

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A series of reforms, such as the formulation of takeover code,
simplification of the laws on mergers and amalgamation, diluting of
MRTP Act and introduction of AS-14 etc. are the efforts that are
taken in this direction. The liberalization of foreign investment
norms, the entry of foreign players through Joint Ventures and direct
investment has added the heat of corporate restructuring.

In the present economic scenario and market trends, corporate

restructuring through mergers, amalgamation, takeovers and
acquisitions has emerged as a major thrust for survival and growth of
economy. In recent times, India has followed the global trends in
consolidation of companies through M&As., various companies are
being taken over, units are being hived off and joint ventures similar
to acquisition are being made
In India there are various laws which directly or indirectly relate to
M&As. But the major laws which regulate and deal with it are given
as under:

1. Companies Act, 1956, Companies (court) Rules, 1959 and

amendments made in companies act from time to time are
predominant in the procedural aspects of M&As. that are dealt u/s.
390 to 394

2. Competition Act, 2002- It deals with regulations of monopolistic

powers arising out of M&As. and ensures that interest of minority
shareholders and public is protected. For this purpose competition
Commission of India (CCI) has been set up that considers the whole
process of corporate restructuring. This commission is authorized to

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penalize the monopolistic powers and can also reject the acquisition
of corporations involved, if not in the interest of nation and public.

3. Income Tax Act, 1961- It specifies various taxable deductions or

tax benefits associated with merger and acquisitions (M&As.)

4. SEBI (Substantial Acquisition of Shares & Takeovers)

Regulation Act, 2011 – This Act is commonly referred as Takeover
Code and governs the takeover of listed companies. SEBI is the main
regulatory body in the country that plays a dominant and important
role in this regard

5. Securities Contracts (Regulation) Act, 1956

6. Sick Industrial Companies (Special Provisions) Act,1985
7. Securities and Exchange Board of India Act, 1992
8. Listing Agreement of the Stock Exchanges

CORPORATE RESTRUCTURING-If any company or business

organization undergoes through a continuous change, because of
external environment, such as impact of liberalization and
globalization of economy, increased competition, advent of efficient
technology, emergence of new markets, demographic changes,
business cycles etc., the prudent businessman make changes
accordingly in order to increase their cutting edge over the
competition and enhance their leadership position

MERGER & ACQUISITION– Various terms such as merger,

amalgamation, takeover, consolidation and reconstruction etc., are
used interchangeably to denote the process of corporate restructuring.

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It is difficult to define these terms with reference to restructuring of
one type with the other. Generally, it refers to a situation when two or
more existing entities combine together and form terms used for the
said purpose that are explained as under:

MERGER – It includes consolidation, amalgamation and absorption

that a new entity, either:

a. by forming a new company, or

b. by transferring or merging their business with an existing entity

When a new company is formed, it is called an ‘amalgamation or

consolidation’ and if an existing company is merged with another
existing company, it is called as ‘absorption’

The merger of first Tata Oil Mills Ltd. (TOMCO) and Brook Bond
Lipton (India) Ltd. into Hindustan Lever Ltd (HLL) were cases of
Absorption

Hence, merger is an arrangement for bringing the assets of two firms

under the control of one, which may or may not be one of the two
original firms. In merger one company takes over the ownership of
another company and combines its operations with its own operations

ACQUSISITION – It includes takeovers also. It refers to the

acquiring of ownership right in the property and assets of other
company. It denotes a situation when one company acquires:

a. the ownership in the assets and controlling interest in other

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 company, and
b. but the other company whose control is so acquired, remains a
separate company and is not liquidated, but there is a change in
control

Hence, acquisition results, when one company purchases (acquires)

the controlling interest in the share capital of another existing
company in any of the following ways:

a. by entering into an agreement with a person or persons holding

controlling interest in the other company
b. by subscribing new shares being issued by the other company
c. by purchasing shares of other company at the stock exchange
d. by making an offer to buy the shares of other company, from its
existing shareholders

The term TAKEOVER is used to denote the acquisition, which is

hostile in nature and the company which is being taken over may put
resistance and oppose the takeover (e.g. DCM Ltd. & Escorts
successfully resisted the takeover bid on their companies by Lord
Swaraj Pal’s Capro Group of U.K.) in 1980’s era.

ACQUISITION may also take place in the form of holding &

subsidiary relationship between two companies. Here, both the
companies maintain their individual identity in the eyes of law as
well in practice, e.g. Reliance Petro Chemical was incorporated as a
subsidiary of Reliance Industries Ltd., later merged into Reliance
Industry and the merger of JSW steel group

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AS-14 deals with the accounting procedure to be followed for
amalgamation, merger and acquisition. The term amalgamation
is classified as:

a. amalgamation in the nature of merger, and

b. amalgamation in the nature of purchase

It is called in the nature of merger, when it satisfies following

conditions:

1. All the assets and liabilities of the Transferor Company becomes

the assets & liabilities of Transferee Company
2. Consideration is to be paid in shares only. The fractional part of
shares can be paid in cash
3. Share Holders holding at least 90% (excluding shares held by
Transferee Company before amalgamation) should have agreed for
the scheme of amalgamation
4. Business of the transferor company is to be carried on by
Transferee Company even after amalgamation
5. No change is to be made in the book value of the assets and
liabilities taken over from transferor company, while preparing
accounts in the books of the Transferee Company, except to ensure
uniformity of accounting policies and procedures being adopted by
Transferee Company

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 DIFFERENCE BETWEEN AMALGAMATION IN THE
NATURE OF PURCHASE AND MERGER
Pooling of interest
Applicable in case of
1 amalgamation in the
nature of merger
Assets & Liabilities of the
transferor company (seller),
including reserves and surplus
2 are incorporated at book value
in the books of purchasing
company
At least 90% of the equity
shareholders of vendor company
3 (excluding shares held by
transferee) agree to become
shareholders of transferee
company
Difference between purchase
consideration and assets &
4 liabilities of Vendor company is
adjusted in P/L a/c. or Revenue
Reserve a/c.
All reserves &surplus appearing
in Vendor’s book are shown in
5 the books of Purchasing
Company
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Purchase Method
Applicable in the nature of
purchase method in amalgamation
Assets and Liabilities that are
taken over by the transferee
company are shown either at book
value or at agreed value (i.e. fair
value)
Share holders of Vendor company
may or may not become
shareholders of transferee
company after amalgamation
Difference between net assets and
purchase consideration is adjusted
either in Goodwill or in Capital
Reserve a/c.
Only Statutory Reserves of
Vendor company are shown in the
books of Purchasing Company
 Reimbursement of Liquidation
Exp. of Vendor company by the
6 Purchasing Company are
adjusted/written off from
General Reserve or P/L a/c.
Equity share holders of Vendor
Company are paid in shares only
7 (except fractional shares) in
purchasing company
Reimbursement of Liquidation
Exp. of Vendor company by the
purchasing company are debited
to Goodwill a/c.
Equity share holders of Vendor
company can be paid either in
Equity shares, Preference shares,
Debentures, Cash or any
combination of the above

REVERSE MERER – It is a merger of a prosperous and profit

making company into a loss making company viz. a sick company. If
one of the merging companies is a sick company then the matter is
referred to Board of Industrial & Financial Reconstruction (BIFR)
under the Sick Industrial Company Act. Reverse merger entitles the
transferee company for concessions and rebates under Income Tax
Act, 1961

To summarise, M&As. are part of the corporate restructuring

exercise. It aims at re-allocation of corporate resources to optimize
their value, either by adding the related or divesting the unrelated
business.

A merger is a combination of two companies into one larger

company. In it the action involves stock swap or cash payment to the
target company. In merger, the acquiring company takes over the
assets and liabilities of the merged company. All the combining

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companies are dissolved and only the new company continues to
operate.

Generally, when the combination involves firms of similar size, it is

said to be Consolidation or Amalgamation and if the size differs
significantly, term merger is used.

In Absorption one entity gets absorbed into other, as under:

A+B = A, where ‘B’ is merged into A = Absorption

A+B = C, where ‘C’ is a new company = Amalgamation
or Consolidation
Usually, merger occurs in a consensual setting that ensures the deal
to be beneficial to both the companies. In merger, the board of
directors of the two firms agrees to combine and seek approval from
the shareholders. The target firm ceases to exist and becomes part of
the acquiring firm, e.g. Digital Computers absorbed by Compaq in
1997; TOMCO with HLL is a case of Absorption

In case of Consolidation or Amalgamation, a new firm is created

after merger, acquiring firm and the target firm receives shares of
new firm, e.g. City Group was created after merging Citicorp and
Travelers Insurance Group

ACQUISITION refers to acquire control, leading to takeover of a

company that can be made possible by acquiring tangible assets,
intangible assets, rights and other obligations. Hence, Acquisition is
also called Takeover. It can be friendly or hostile. In a friendly
takeover, companies proceeds through negotiations, and in hostile

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bid target firm has no prior knowledge of offer. Usually, acquisition
refers to purchase of a smaller firm by a larger one. Though,
sometimes a smaller firm may buy a larger one (e.g. takeover of Patni
Computers by I Gate). But in this case it will be called ‘Reverse
Merger’.

REASONS TEMPTING FOR TAKEOVER BID:

1. Target firm has underperformed in preceding years
2. Target firm has been less profitable than other firms of the same
type and category
3. Promoter group has lower holding in target firm

TAX TREATMENT FOR MERGER & ACQUISITION – The

benefits under Income Tax Act, 1961 are available, provided
following conditions given u/s. 2(IB) of the Act are fulfilled:

a. Amalgamating companies should be defined as a company u/s.

2(I7) of the I.T. Act, 1961
b. All the assets & liabilities of the amalgamating company
(i.e. target firm)should be transferred to the amalgamated company
(i.e., acquiring firm) and become the assets & liabilities of
amalgamated company, and
c. Not less than 90% of the stake holders of the amalgamating
company should become the share holders of the amalgamated
company

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Some of the benefits available under the I.T. Act, are
summarized as under:
1. Depreciation – The amalgamated company continues to claim
depreciation on the basis of W.D.V. of assets transferred to it by
the amalgamating company. However, unabsorbed depreciation, if
any, cannot be assigned to the amalgamated company and hence
no tax benefit is available for such depreciation

2. Unabsorbed Capital Expenditures of the amalgamating company

transferred to the amalgamated company on scientific research are
deductible in the hands of amalgamated company

3. Exemption from Capital Gains Tax is available to the

shareholders of the amalgamating company under the scheme of
amalgamation provided following conditions are met:

a. that the amalgamated company is an Indian company, and

b. the shares are issued to the shareholders of the amalgamating
company by the amalgamated company in consideration of
merger, because such transfer of shares is not considered as sale.
Hence, there will be no profit or loss on such exchange of shares.

4. Carry Forward of losses in case of Sick Companies – Merger

made u/s.72A(I) of Income Tax Act, 1961 of the sick companies
with profit making companies allows the benefits in respect to
unabsorbed depreciation and carry forward of losses, provided
following conditions are met:

i. The amalgamating company is an Indian company

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 ii. The amalgamation paves the way for revival of the business of
amalgamating company
iii. The scheme of amalgamation is approved by the prescribe
authorities
iv. The amalgamating company is not financially viable
v. The amalgamation is in public interest, and
vi. The amalgamated company continues to carry on the business of
the amalgamating company even after merger without any
modification, except bringing uniformity in accounting policies

5. Amalgamation Expenses paid to solicitors and consultants for the

services rendered in respect with the scheme of amalgamation are
deductable in the hands of amalgamated company

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 ACCOUNTING TREATMENT IN THE BOOKS OF
TRANSFEROR (VENDOR) COMPANY

After calculating consideration to be paid to the transferor (vendor) company

by the transferee (purchaser) company, the following process will start to
close down the books of transferor, irrespective of the nature of amalgamation
in the nature of purchase or in the nature of merger as per AS-14:

Step 1. Open the following necessary accounts:

i. Realisation A/c.
ii. Equity Shareholders’ A/c.
iii. Preference Shareholders’ A/c.
iv. Bank/Cash A/c. (if not taken over by the Transferee Company)
v. Account of the Transferee Company
vi. Shares (Preference & Equity Shares) in Transferee Company’s
A/c

Step 2. Transfer all Assets (except fictitious assets) to the Debit side of
Realisation A/c., given as under:
Realisation a/c. Dr.
To Individual Assets a/c.

a. The assets, whether taken over or not by the transferee company,

should be individually transferred to Resalisation a/c. at their
respective gross value
b. Fictitious assets, such as discount on issue of shares/debenture,
debit balance of P/L a/c., preliminary exp. and so on, are not
transferred to Realisation a/c., even if the transferee company takes
over all assets or business of the transferor company
c. Cash in hand and at bank are separately transferred in Realisation
a/c., provided these are taken over by the transferee company in an
amalgamation in the nature of purchase, but in case of

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 amalgamation in the nature of merger, these two accounts must be
transferred in Realisation a/c.
d. Goodwill and other intangible assets like trademarks, patent rights,
copyrights etc. are also transferred to Realisation a/c.

Step 3. Transfer all Liabilities and Provisions against assets individually

at their book value in Cr. side of Realisation a/c., given as under:
Individual Liabilities a/c. Dr.
Provisions (against assets) a/c.
To Realisation a/c

a. Liabilities include external liabilities. Only those liabilities are

transferred that are taken over by the transferee company. But in
case of amalgamation in the nature of merger all the liabilities are
transferred, whether taken or not
b. Accumulated profits and funds in the nature of the profits such as,
Sinking Fund, Dividend Equalization Fund, Debenture Redemption
Fund and Workmen’s Compensation Fund etc., should not be
transferred to Realisaton a/c., because these are in the nature of
Reserves, hence are transferred in Equity Share Holder’s a/c.
c. Items such as, Pension Fund, Provident Fund and Superannuation
Fund are external liabilities and should be transferred to Realisation
a/c.

Step 4. When purchase consideration becomes due, then:

Transferee Company a/c. Dr.
To Realisation a/c.
[with the amount of purchase consideration]

Step 5. On receipt of Purchase Consideration in different forms:

Bank a/c., (if any) Dr.
Equity Shares in Transferee Co. a/c. Dr.

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 Pref. Shares in Transferee Co. a/c. Dr.
Debt Securities a/c. Dr.
To Equity Share Holder’s a/c.

Step 6.: When expenses are paid and borne by the transferee
company:
Realisation a/c. Dr.
To Bank a/c.

When expenses paid by Transferor Company, but reimbursed

by the transferee company:

Transferee company’s a/c. Dr. [with due amount]

To Bank a/c.
Bank a/c. [with the amount received]
To Transferee company’s a/c.

[Difference between actual exp. paid and amount received is

automatically adjusted. This entry may be ignored, if actual amount
received and paid is same. Realisation expenses reimbursable are
not included in purchase consideration]

Step 7. Sale of assets (recorded or unrecorded), not taken over by the

transferee company:
Bank a/c. Dr.
To Realisation a/c.
[with the actual amount realized]

Step 8. Payment of liabilities (recorded or unrecorded), not specifically

taken over by the transferee:
Realisation a/c. Dr.
To Bank a/c.

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Step 9. Payment to Preference Shareholders:
When payable at Par:
Preference Share Capital a/c. Dr.
To Preference Share holders a/c.

When Payable at Premium:

Preference Share Capital a/c. Dr. [face value]
Realisation a/c. Dr. [premium payable]
To Preference Share Holders a/c.

When Payable at Discount:

Preference Share Capital a/c. Dr.
To Preference Share Holders a/c.
To Realisation a/c. [amount of discount]

Step 10. Transfer Equity Share Capital a/c., accumulated profits and
reserves in to Equiy Share Holder’s a/c., given as under:
Equity Share Capital a/c. Dr.
Reserves & Surplus a/c Dr.
Security Premium a/c Dr.
Revaluation Reserve a/c Dr.
Capital Redemption Reserve a/c. Dr.
Sinking Fund a/c. Dr.
Workmen’s Compensation Fund a/c. Dr.
To Equity Share Holder’s a/c.

Transfer accumulated losses and fictitious assets to Equity

Share Holder’s
Equity Shareholders a/c. Dr.
To Preliminary Exp. a/c.
To Underwriting Commission a/c

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 To Exp. on Issue of Shares/Deb. a/c.
To Discount on Issue of Shares/Deb. a/c.
To Profit & Loss a/c. (if loss)

Step 11. Compute Profit or Loss on Realisation

For Loss on Realisation:
Equity Share Holders a/c. Dr.
To Realisation a/c.
For Profit on Realisation:
Realisation a/c. Dr.
To Equity Share Holders a/c.

Step 12. Settlement of claims of Preference Shareholders:

Preference Shareholders a/c. Dr.
To Bank a/c
To Equity Shares in transferee’s a/c.
To Pref. Shares in transferee’s a/c.

Step 13. Settlement of claims of Equity Shareholder’s – Close all the

accounts and transfer their balance in Equity Shareholder’s
account, given as under:

Equity Shareholders a/c. Dr.

To Bank a/c.
To Equity shares in Purchasing Co.

With the result of all the above steps taken all the accounts
of vendor (seller) company will be closed

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 ACCOUNTING TREATMENT IN THE BOOKS OF
TRANSFEREE (PURCHASING) COMPANY

While the accounting procedure is same for all types of amalgamation in the
books of transferor (vendor) company, but the accounting treatment in the
books of Transferee Company depends on the nature of amalgamation. As
per AS-14, amalgamation may be either in the nature of purchase or merger.

Accordingly, there are two main methods of accounting for

amalgamation, stated as under:

1. pooling of interests method for amalgamation in the nature of Merger,

2. amalgamation in the nature of Purchase

1. POOLING OF INTEREST METHOD – Under this method there is

pooling of assets, liabilities, share capital, reserves and business of both the
companies, provided following conditions are fulfilled:

a. Book Value of Assets & Liabilities – All the assets (including fictitious
assets, such as Preliminary exp., Discount on issue of Shares/Debentures,
Advertising, Suspense a/c., Underwriting Commission etc.), liabilities and
all types of Reserves (capital, revenue or revaluation reserve) of the
Vendor Company are recorded by the Purchasing Company at their book
values in the same form as shown in the books of Vendor Company as on
the date of amalgamation.

However there is an exception to this rule, that the book value of an item
of an asset or liability may be adjusted or changed to conform the
accounting policy

b. Profit & Loss, Reserves and Surplus of the Transferor Company should
be aggregated with the corresponding balance of the Transferee Company,

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 because, in an amalgamation in the nature of merger, the identity of P/L
and Reserve & Surplus is maintained and are shown in the B/S. of the
transferee Company. As a result, the P/L a/c. and Reserves & Surplus
which were available for distribution as dividend before amalgamation
would also be available for distribution as dividend even after
amalgamation

Following steps are taken for incorporating the books of accounts:

Step 1. For recording the purchasing the business of transferor

company:
Business Purchase a/c. Dr.
To Liquidators of Vendor Co. a/c.
[entry is made with the amount of purchase consideration]

Step 2. For incorporating the assets, liabilities and reserves taken

over from the transferor company:
Sundry Assets (individually) a/c. Dr.
To Sundry Liabilities (individually) a/c.
To Security Premium a/c.
To Capital Redemption Reserve a/c.
To Revaluation Reserve a/c.
To Export Profit Reserve a/c.
To Development Rebate Reserve a/c.
To Investment Allowance Reserve a/c.
To Workmen’s Compensation Fund a/c.
To Debenture Redemption Reserve a/c.
To Profit and Loss a/c
To Capital Redemption Reserve a/c.
To General Reserve a/c.
To Business Purchase a/c.
[The difference appearing either in Dr. side or in Cr. side is

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 charged to P/L Adjustment a/c. in the books of the
purchasing company]

Step 3. For discharging of Purchase Consideration, when:

Shares are issued at par:
Liquidators of Transferor Company’s a/c. Dr.
To Equity Share Capital a/c.
To Preference Share Capital a/c.
To Bank a/c. (for fractional part)

Shares issued at Discount:

Liquidators of Transferor Company’s a/c. Dr.
Discount on Issue of Shares a/c. Dr.
To Equity Share Capital a/c.
To Preference Share Capital a/c.
To Bank a/c. (for fractional part)

Shares issued at Premium:

Liquidators of Transferor Company’s a/c. Dr.
To Equity Share Capital a/c.
To Security Premium a/c.
To Preference Share Capital a/c.
To Bank a/c. (for fractional part)

Step 4. If the liabilities of the transferor company are discharged,

after merger
Type of Liability a/c Dr.
To Cash/Debentures etc.
[Liabilities can be discharged at par, at discount etc. as the
case may be]

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Step 5. For recording Liquidation Expenses – When the liquidation
exp. are paid and born by the transferee company, cost of the
business taken over increases by the amount of such expenses
is adjusted in Profit & Loss a/c., stated as under:

Liquidation Expenses a/c Dr.

To Bank a/c.
Profit & Loss a/c Dr.
To Liquidation Exp. a/c

Step 6. For recording Preliminary Expenses:

Preliminary Expenses a/c. Dr.
To Bank a/c.

2. PURCHASE METHOD – As per AS-14 amalgamation in the

nature of purchase is done in the following manner:

1. Assets and liabilities that are taken over from the transferor
company are shown in the following manner:

a. at their given book values, or

b. on the basis of their fair/agreed values

2.Treatment of Reserve – The P/L a/c., Reserves and Surplus,

Securities Premium etc. of the vendor company are not
incorporated in the books of the purchasing company

3. Statutory Reserve – are reserves created under law, such as,

Export Profit Reserve, Development Rebate Reserve, Investment
Reserve Allowance, Project Export Reserve, Tea Development
Reserve, Foreign Project Reserve etc. that were maintained by
the transferor company to obtain benefit under Income Tax laws.

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 Hence, it is necessary to carry forward such reserves in the
books of the transferee company for legal compliance for a
specified period, which is achieved with the following entry:

Amalgamation Adjustment a/c. Dr.

To Specific Statutory Reserve a/c.

4. Disclosure – Amalgamation Adjustment a/c. should be shown

as a fictitious asset as Miscellaneous Expenditure and the
relevant statutory reserve should be shown separately as
Reserve & Surplus in the B/S of purchasing company.

When the statutory reserve/s is no longer required to be

maintained, both the Statutory Reserve/s and Amalgamation
Adjustment should be eliminated by means of a reverse entry,
given as under:

Specific Statutory Reserve/s a/c. Dr.

To Amalgamation Adjustment a/c.

5. Goodwill/Capital Reserve – If the amount of purchase

consideration is more than the value of the net assets acquired,
the difference is transferred to Goodwill A/c. and if net assets
acquired is more than the amount of purchase consideration, the
surplus is credited to Capital Reserve Account. Thereafter,
following steps are taken:

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Step 1. Recording the Purchase of Business
Business Purchase a/c. Dr.
To Liquidator/s of Transferor Company
[with the amount of purchase consideration]

Step 2. For Recording of Assets & Liabilities Taken Over

Sundry Assets (individually) a/c. Dr.
Goodwill (balancing figure) a/c. Dr.
To Sundry Liabilities (individually) a/c.
To Business Purchase a/c.
To Capital Reserve a/c. (balancing figure)
[with the agreed take over value]

Step 3. Discharging the value of Purchase Consideration, if:

Securities Issued at Par:
Liquidator/s of Transferor Company a/c. Dr.
To Bank a/c.
To Equity Share Capital a/c.
To Preference Share Capital a/c.
To Debentures a/c.

Securities Issued at Premium:

Liquidator/s of Transferor Company a/c. Dr.
To Bank a/c.
To Equity Share Capital a/c.
To Preference Share Capital a/c
To Security Premium a/c

Securities Issued at Discount:

Liquidator/s of Transferor Company a/c. Dr.
Discount on Issue of Securities a/c. Dr.
To Bank a/c.

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 To Equity Share Capital a/c.
To Preference Share Capital a/c.
To Debentures a/c.

Step 4. For Recording Statutory Reserves of TransferorCompany

Amalgamation Adjustment a/c. Dr.
To Specific Statutory Reserve/s a/c.

Step 5. For Discharging Liabilities of Transferor Company, if

needed:
Types of Liability a/c. Dr.
Discount on Issue of Securities a/c Dr.
To Debentures a/c.
To Bank a/c
To Securities Premium a/c.
To Share Capital a/c. (Equity/Preference)

Step 6. For Recording Liquidation Expenses paid and born by

Transferee Company:
Goodwill a/c. Dr.
To Bank a/c

Step 7. For Recording Formation Expenses, (if a new company

is formed e.g., External Reconstruction)

Preliminary Expenses a/c. Dr.

To Bank (Exp.)

If, both Goodwill and Capital Reserve appear in theB/S of

Purchasing Company, Goodwill a/c. must be adjusted
against Capital Reserve, the entry is under:

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 Capital Reserve a/c. Dr.
To Goodwill

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MOTIVES/OBJECTIVES AND BENEFITS OF MERGER- The
benefit of synergy of merger and the resultant expectation of risk
reduction may affect both the acquiring firm and the target firm. If
benefit is perceived to exist in a takeover, the value of combined firm
would be greater than the sum of the values of the target firm and the
acquiring firm, enumerated as under:

V(AT) > V(A) + V(T)

Here, V(AT) = Value of the new firm consisting existing firm

A and firm T
V(A) = Value of the acquiring firm A
V(T) = Value of target firm T

Generally, the existence of synergy implies that the combined firm

will be more profitable and will grow faster after the merger than the
merging firms individually. A stronger test of synergy is to evaluate
whether the merged firms improved their performance, profitability
and growth, in relation to their competitors,, after merger

The merger may be considered as a capital budgeting decision. The

acquiring firm should take over the target firm provided the NPV of
such merger is positive or the merger benefits are more than the cost
of merger. Symbolically:

B = CV - (T+A)
Cost = MP – T

Where, B = Merger Benefits

26
 CV = Combined Value of New Firm
A = Present value of acquiring firm
T = Present value of target firm
MP = Merger Price paid

It may be observed from the above that for the acquiring firm, merger
cost is the excess of merger price paid over the value of the target
firm. In capital budgeting, the net benefit is defined as under:

NPV = Benefits - Cost, Or

NPV = [CV – (T+A)] – (MP-T)
= CV –T – A - MP + T
= CV – A - MP

Take case, The value of firm A Ltd. and firm T Ltd. is Rs.
2,50,00,000 and Rs. 15,00,000 respectively, the merger benefits are
Rs. 10,00,000. If A Ltd. acquires T Ltd. and agrees to pay Rs.
22,00,000, then

B = CV – (T +A)
= Rs. 2,75,00,000 – (2,50,00,000 + 15,00,000)
= Rs. 10,00,000, and

Cost = MP – T
= Rs. 22,00,000 – Rs. 15,00,000
= Rs. 7,00,000

NPV, to A Ltd. = Benefits - Cost

= Rs. 10,00,000 – Rs. 7,00,000

27
 = Rs. 3,00,000

NPV, to T Ltd. = MP – T (i.e. cost to the acquiring firm A

Ltd.)
= Rs. 22,00,000 – Rs. 15,00,000
= Rs. 7.00.000 (i.e. merger benefit to the
target firm)

Hence, it may be seen that the total benefits of the merger i.e. Rs.
10,00,000 are divided between A Ltd. (Rs. 3,00,000), and T Ltd. (Rs.
7,00,000). If the NPV of the net Cash Flows from the target firm is
positive, then the merger is viable proposition otherwise not. in the
above case the NPV is simply the difference between the price paid
and the present worth of the future expected Cash Flows from the
target firm.

After elaborating merger benefits and synergies arising out of merger

in the above case, let us explain some of the main motives and
benefits that are stated as under:

1. Increase in the Value of the combined firm after merger

i.e. the value of AB Ltd. > Value of A Ltd. + value of B Ltd.

2. To acquire controlling interest in the target firm – The

value of the control of acquiring firm increases after merger,
explained as under:

Value of Control = Value of the combined firm – Agreed

value of the acquired firm

28
3. To avoid competition – Competition between the acquiring and
target firm is avoided, because after merger they become one entity

4. Operating Economies – It reduces the cost of production on

account of the increase in marketing power because of the increase in
sales and profit of the combined firm. When two firms combine their
resources and efforts, they produce better results, because of savings
in various types of operating costs. Such economies are known as
synergistic operating economies

5. Diversification of activities into new areas and products, e.g. a

firm of North India merges with South India will cover broader
economic areas. It can also help in fighting cyclical and seasonal
variations, which may neutralize the earnings and will increase the
profit of the combined firm. It will also pave the way in the increase
of marketing activities and its resultant economies

6. Increase in E.P.S. – Increase in the EPS of the combined firm is

the main motive of the merger which can be achieved by acquiring
a profitable and having a low PE (Price Earnings Ratio) firm,
which is enumerated as under: (figures are in Rs.)

Particulars A Ltd. T Ltd.

Earnings 10,00,000 3,00,000
Number of Shares 10,00,000 2,00,000
EPS 1 1.5
Market Price 20 12
PE Ratio 20 8

29
A Ltd. is acquiring T Ltd. and evaluates three options for offer price
I. Rs. 12 per share (i.e. MP of T Ltd.)
ii. Rs. 30 per share of T Ltd. (i.e. EPS * existing PE Ratio of
A ltd.),
iii. Rs. 35 per share of T Ltd. (i.e. a price higher than i &ii)
See, the affect of all the above three options given as under:

Option 1 Option 2 Option 3

Price payable per share (Rs.) 12 30 35
Amount (Price*No. shares)Rs. 24,00,000 60,00,000 70,00,000
Issue Price of shares of A Ltd (MP) Rs. 20 Rs. 20 Rs. 20
No. of shares issued 1,20,000 3,00,000 3,50,000
Post merger shares of A Ltd. 11,20,000 13,00,000 13,50,000
Total Earnings after merger 13,00,000 13,00,000 13,00,000
EPS (after merger)Rs. 1.16 1 0.96
PE (Price Paid/EPS of T Ltd.) 8 20 23.3
PE Ratio, calculated as: 12/1.5 30/1.5 35/1.5

See, when the price offered is Rs. 12 (less than the PE of firm A
Ltd,), the EPS of the new firm A Ltd. increases. When, the price
offered is Rs. 30 (based on EPS of T Ltd. and PE of A Ltd.), the EPS
of acquiring firm A Ltd. is same as that of T Ltd., and when the price
offered is Rs. 35 (i.e. more than the PE of A Ltd. & EPS of T Ltd.),
the EPS of the acquiring firm A Ltd. decreases. Hence, the increase
in EPS might be a main motive of the merger that can easily be
achieved by merging another firm having a lower PE Ratio

Remember, increase in EPS need not necessarily increase the market

price of the share. Moreover, increase in EPS as a main motive is not

30
a good idea. The main concern of the financial manager should be to
maximize the market value of the share and not the EPS

7. Financial Synergy – It refers to increase in the value of firm that

accrues to the combined firm from financial factors, such as better
case management and tax benefits etc.

FINANCIAL EVALUATION of a MERGER PROPOSAL or

VALUATION of FIRM – Merger is advisable provided it leads to
economies and increases the value of the combined firm, for the said
purpose due diligence is to be taken in to consideration, while
determining the purchase price to be paid to the target firm. A few of
the techniques and methods can be adopted for this purpose, stated as
under:

Determination of Purchase Price – During the process of merger,

while calculating the bid price, following factors should be
considered:

1. Tangible and Intangible Assets of the target firm

2. Book/Market/Realisable value and Net Worth of the target firm
3. Earnings of the target firm
4. Future Government Policy
5. Global trend, situation and condition etc.
6. Market scenario

31
METHODS OF VALUING THE TARGET FIRM:
A. Valuation based on Book Value of the Assets – Under this
method bid value is calculated on the basis of the book value of the
assets of the target firm. This method of finding out bid price of the
target firm is not reliable and reasonably good, because the values of
its assets are based on historical values not on their realizable values
or market price. Symbolically as;

Book Value of Assets

Less - External Liabilities
= Net Worth/Net Value of Assets

B. Valuation Based on Earnings – Valuation of target firm

based on its earnings is calculated as under:
Earnings 15,00,000
Value = --------------------- *100, = ----------------* 100 = 1,50,00,000
Rate of Return 10

C. a. Dividend Based Valuation – Valuation of the target firm

on the basis of constant growth dividend method is calculated
as under:
Do (1+g) D1
Ke = -------------- + g = ------- + g
Po Po

Do (1+g) D1
or, Po = -------------- = -----------
Ke – g Ke - g

32
Here, Po = Current Price of Equity Share
Do = Current Dividend
D1 = Expected Dividend in year 1 and so on D2, D3....
Ke = Required Rate of Return
g = Expected Percentage growth in Dividend

Note – The idea of constant rate increase in dividend in unrealistic

Example: Dividend Rs. 15 per share

Equity Capitalisation Rate (Ke), 20%
Constant rate growth of Dividend, 7%

Hence, Market Price of Share will be as under:

Do (1+g) 15 ( 1+ .07 )
Po = --------------- = --------------------
Ke – g .2 - .07
15 + 1.05 16.05
= --------------- -----------
.13 .13
= 123.46 Rs.

b. Dividend Yield Based Valuation - Valuation made on

the basis of return on market value of share is called
Yield Based Valuation and the valuation of target firm
with this method is made as under:
Dividend Per Share
= ---------------------------- * 100
Market Price of Share

33
Example: Dividend paid, Rs. 10 per share
10
-------- * 100 = 2.5%
400
Note – For this kind of valuation, earning capacity (i.e. retained
earnings) of the target firm should also be considered

D. Capital Asset Pricing Model – It is called CAPM based share

valuation and used to find out the expected rate of return, ‘Rs’
calculated as under:

‘Rs’ = IRF + ( RM – IRF) B

‘Re’ or ‘Rs’ = Expected Rate of Return for Equity Share
Holders, i.e. ‘Ke’
IRF = Risk Free Rate of Return
RM = Rate of Return on Market Portfolio
B = Sensitivity of a share of market

Example: RM = 12%, IRF = 8%, B = 1.3

‘Rs’ = IRF + ( RM – IRF) B
= .08 + ( .12 - .08 ) 1.3
= .08 + .052 = .132 * 100
= 13.2%
If the dividend paid is Rs. 20, the market price will be:
Dividend 20
Po = ---------------------------- = -------
Rate of Return (Ke) .132
= 151.51 Rs.
Here, Po = Market Value of the Share

34
E. Valuation based on Cash Flows – Value of the target firm may
also be calculated by discounting Cash Flows, as applicable in
finding out the NPV’s of future cash flows. For this, steps taken for
the purpose are as under:

a. Estimate future Cash Flows (i.e. PAT + Non Cash Exp.)

b. Find out PV (Present Value) of Cash Flows by discounting
at appropriate rate, with reference to risk class and other
factors.
c. If liabilities are taken, then liabilities are treated as
Cash out Flows at time Zero and deducted from PVs.
of Future Cash Inflows, as calculated under above 3
steps
d. Balance will be NPV that may be considered as maximum
purchase price, calculated as under:
n C1
MPP = E -------------- - L
i=1 i
( 1 + K)
MPP = Maximum Purchase Price
C1 = Future Cash Inflows over different years
L = Current Liabilities
K= Appropriate Discounting Rate, Ke

However, in this method of valuation, calculation of estimated future

cash flows and the discounting rate is difficult. Expected cash flows
may be calculated either from the point of view of the combined firm
or for share holder’s point of view

35
Cash flows from the point of view of total firm are Net Operating
profit after tax + depreciation + non cash expenses. Hence, the
valuation of firm is equal to the Present Value (PV) of all expected
operating cash flows in future. These cash flows may further be
adjusted for long term investments and change in working capital.
The resultant cash flows may be termed as Operating Cash Flows to
the Firm (OCFF). These flows then may be discounted at WACC, i.e.
‘Ko’

Cash Flows from the point of view of Equity Shareholders In this

case OCFF may further be adjusted to find out free cash flows to
equity share holders, stated as under:

OCFF [operating cash flows to the firm]

Less – Interest on debentures and loan
Less – Preference Dividend
= CF (cash flows) to Equity Share Holders

Then, these free cash flows are discounted at equity capitalization

rate ‘Ke’ to find out value of equity. But for finding out the value of
firm, cash flows are discounted at weighted overall cost of capital
(WACC or ‘Ko’)
Example – Capital employed Rs. 50,00,000 consisting 10%
Debentures of Rs. 20,00,000 and Equity Share Capital Rs. 30,00,000.
Cost of capital, ‘Ke’ 15%, Rate of corporate tax 30%, Debentures
repayable after 5 yrs. at par. Calculate the value of Firm and that of
Equity Shareholders, if the OCF (operating cash flows) of the firm
for 5 yrs. are as under: (figures are in lacs of Rs.)

36
 Yr. 1 Yr. 2 Yr. 3 Yr. 4 Yr. 5
20 10 25 20 35

Solution - The value of the firm can be found by discounting the

operating cash flows at WACC and the value of equity shareholders
may be found by discounting the cash flows for equity shareholders
at ‘Ke’ which is 15%, ‘Kd’ is 10% (10-.3) = 7% and the WACC,
‘Ko’ is:

Ko = Ke * Ve + Kd * Vd
= .15 (3/5) + .07 (2/5)
= .09 + .028 = .118
= 11.8%

Here, Ve = Value of Equity

Vd = Value of Debts

The value of the firm may be calculated by discounting future cash

flows @ 11.8%, given as under (in Rs.):

Year CF PVF @ 11.8% PV

1 20,00,000 1/(1.118)’ = .894 17,88,000
2 10,00,000 1/(1.118)” = .800 8,00,000
3 25,00,000 1/(1.118)’’’ = .716 17,90,000
4. 20,00,000 1/(1.118) = .640 12,80,000
5. 35,00,000 1/(1.118 = .572 20,02,000
Total Present Value 76,60,000*

37
* This value includes Rs. 20,00,000 as value of Debt and Rs.
56,60,000 as value of Equity
This value of Equity may further be calculated by discounting future
cash flows to Equity shareholders @ ‘Ke’ 15%, calculated as under:

Year CF Intt.+Pref. Divd. Equity CF PVF PV

1 20,00,000 2,00,000 18,00,000 .870 5,66,000
2 10,00,000 2,00,000 8,00,000 .756 6,04,800
3 25,00,000 2,00,000 23,00,000 .658 15,13,400
4 20,00,000 2,00,000 18,00,000 .572 10,29,600
5 35,00,000 22,00,000 13,00,000 .497 6,46,100
Value to Equity Shareholders 53,59,900

Value of per equity share can be calculated as:

Equity value 56,60,000
Value per share = --------------------------- = ----------------
No. of equity share 30,000
= 188.67 Rs.

F. Other Methods of Valuation – There are other two methods of

valuing the firm. Investors provide funds to a company and expect a
minimum return which is measured as the opportunity cost of the
investors, what the investors could have earned elsewhere. If the
company is earning less than this opportunity cost of the investors,
the company is belying the expectations of the investors. Conversely,
if it is earning more, then it is creating additional value. New
concepts such as Economic Value Added (EVA) and Market Value
Added (MVA) can be used along with traditional measures of Return

38
on Net worth (RONW) to measure the creation of shareholders value
over a period.

1. Economic Value Added – EVA is based upon the concept

of economic return which refers to the excess, after tax return on
capital employed over the cost of capital employed. The concept of
EVA, as developed by Stern Stewart & Co. of U.S. compares the
return on capital employed with the cost of capital of the firm. It
takes into account the minimum expectations of the shareholders.
EVA is defined in terms of return earned by the company in
excess of the minimum expected return of the shareholders. EVA
is calculated as the Net Operating Profit (EBIBAT) minus the capital
charges (capital employed * cost of capital), explained as under:

EVA = EBIT – Taxes – Cost of capital employed

= NOPAT – Cost of Capital Employed

where, NOPAT represents the total pool of profit available to

provide a return to the lenders and the shareholders and cost of
capital employed is WACC * Average capital employed. EVA can be
used as a tool in decision making within an enterprise.
Example–Find out EVA from the following information, when,
WACC is 15% (figures are in Rs.):

Balance Sheet Income Statement

Liabilities Assets Sales 65,00,000
Sh. capital 25,00,000 Fixed Assets 55,00,000 EBIT 14,00,000
Reserves 15,00,000 Curr. Assets 15,00,000 - Interest _2,16,000
12% Debt. 18,00,000 PBT 11,84,000

39
Curr. Liab. 12,00,000 - I. Tax 3,55,200
70,00,000 70,00,000 PAT 8,28,800

Solution:
Total Funds Employed (Cap + Res. + Debt) = Rs. 58,00,000
Cost of Funds ( 58,00,000 * 15% ) = Rs 8,70,000

Hence, EVA = (EBIT- Tax – Cost of Funds)

= (14,00,000 – 3,55,200 – 8,70,000)
= Rs. 1,74,800

2. Market Value Added (MVA) is another concept used to measure

the value of a firm and its performance. MVA is determined by
measuring the total amount of funds that have been invested in the
company (based on cash flows) and comparing it with the current
market value of the securities of the company. The funds invested
include borrowings and share holders’ fund. If the market value of
securities exceeds the funds invested, the value has been created.
EVA & MVA is calculated in the following table: (figures are Rs. in
crores)
2011 2012
Average Capital Employed 656.46 992.95
WACC (weighted average cost of capital) 17.57% 18.93%
Cost of Capital 115.34 188.00
Operating Profit after Tax 135.13 225.38
EVA (Economic Value Added) 19.79 37.38
Market Value of Debt & Equity 9,814.80 1,186.60
Less – Book Value 828.20 1,346.40
MVA (Market Value Added) 8,986.60 - 159.80

40
It may be noted from the above that EVA gives an idea of
incremental wealth created by the firm during the period. However,
as pointed out earlier, EVA is not the same thing as accounting profit

After finding out the value of the target firm with the help of
methods, stated as above, the acquiring firm will then have to decide
the technique of merger, i.e. whether the payment to the shareholders
of the target firm is to be made in cash or discharged by the issue of
shares of acquiring firm, elaborated as under:

A. Payment in Cash – In this case, the value per share of the target
firm is paid in cash to the shareholders of the target firm that does not
affect the ownership pattern of the acquiring firm, but needs
availability of sufficient funds to make payment. However, the
payment in cash is subject to the agreement and consent of the
shareholders of the target firm. If both the acquiring and the target
firm agree to merge and the purchase price is payable in cash, then
the valuation of the firm based upon assets, cash flows and earnings,
etc. will be the price consideration for the merger.

B. Payment in Shares – Generally in case of negotiated deals, a

common method is adopted for financing a merger proposal to be
paid in terms of shares of acquiring firm. In this case, the shares of
the target firm are exchanged for shares in the acquiring firm at an
agreed value to the shareholders of the target firm. Thus it will result:

a. increase in the number of shares of the acquiring firm, and,

b. sharing the ownership along with the existing shareholders
of the acquiring firm

41
The future earnings of the acquiring firm will now be shared by both
these groups of shareholders. This type of merger is only acceptable
and beneficial, provided long term return per share of the acquiring
firm is improved. Similarly, the shareholders of the target firm are
better off, if the cash or securities received in the merger deal are
worth more than the pre-merger situation

In case of payment in shares, the offer is stated in terms of an

exchange ratio or share swap ratio. The share exchange ratio is the
number of shares that the acquiring firm is willing to issue for each
share of the target firm. There are different methods of calculating
Share Exchange Ratio, that are given as under:

EPS of Target Firm

i. Based on EPS = --------------------------------
EPS of Acquiring Firm

MP of share of Target Firm

ii. Based on MP = ---------------------------------------
MP of share of Acquiring Firm

BV of share of Target Firm

iii. Based on BV = -----------------------------------------
BV of share of Acquiring Firm

Share Exchange and Earnings Per Share – When the acquiring

firm pays the shareholders of the target firm in the form of shares, the
analysis of market price, calculation of EPS and resultant share
exchange ratio (SER) is very difficult exercise

42
A common method of analysis examines present as well as
anticipated future earnings per share with and without merger.
Earnings, like cash flows, can be viewed as a measure of the firm’s
capacity to pay dividends and therefore, represent a basis for
determining the value of the firm. Generally, the shareholders want
an increase in the level of long term earnings as a result of merger.
The firms will therefore, try to negotiate merger terms which increase
their earnings per share after merger. So, in order to arrive at the
number of shares that acquiring firm ‘A’ will issue to the target firm
‘T’ following considerations are to be made:

a. The shareholders of the acquiring firm will compare the

current and anticipated future earnings per share of their own
firm ‘A’ and target firm ‘T’ with or without the merger.
b. The shareholders of the target firm will compare the current
and expected future earnings per share of their firm ‘T’ with
the current and expected future earnings per share before
and after merger

Therefore, a proposed merger may be acceptable to the shareholders

of the target firm ‘T’ if the offered SER takes into account the
following:

a. The future EPS of the target firm

b. The impact of synergistic efforts on the EPS of the acquiring firm
after merger, and
c. The change in the market value of the target firm that the
shareholders of the target firm will be able to realize by

43
 exchange of shares after merger.

Example – Following details are available for acquiring firm A Ltd.

and target firm T Ltd, find out SER:
A Ltd. T Ltd.
Market Price per share Rs. 50 Rs. 25
EPS Rs. 4 Rs.1.50
Number of shares 5,00,000 60,000
Net Worth (BV) Rs. 1,00,00,000 Rs. 20,00,000
Total Market Value Rs. 2,50,00,000 Rs. 15,00,000
Current Earnings Rs. 20,00,000 90,000
PE Ratio 12.5 16.67
Expected Future Increase
in EPS for 5 yrs 2% 8%

Solution:
A. SHARE EXCHANGE RATIO on the basis of EPS
S.E.R = EPS of Target Firm / EPS of Acquiring Firm
= 1.5 / 4
= .375

Hence, acquiring firm A Ltd. will offer .375 of its share for every one
share of target firm T Ltd. hence, A Ltd. will issue 22,500 shares (i.e.
60,000 * .375) to T Ltd. Therefore, after merger;
Total shares of A Ltd. would be = 5,22,500 (5,00,000 + 22,500), and
Total Earnings of A Ltd. = Rs, 20,90,000 (i.e. 20,00,000 + 90,000)

EPS of the new firm = Rs. 4 (i.e. 20,90,000 / 5,22,500)

44
See, in the above example shareholders of T Ltd., holding 100 shares
will get 37.5 shares (100 * .375) in A Ltd. The earnings of the target
firm, as well as of its shareholders, even after merger remain
unchanged, given as under:

Earnings of T Ltd. before merger = Rs. 90,000 (60,000 * 1.5)

Earnings of T Ltd. after merger = Rs. 90,000 (22,500 * 4)
Earnings of 100 shares in T Ltd. before merger = Rs. 150 (100* 1.5)
Earnings of 37.5 shares in T Ltd. after merger = Rs. 150 (37.5 * 4)

Let us find out the position of T Ltd. taken in to consideration the

value of T firm based on MP of both the firms, given as under:

The Market Value of;

T Ltd. before merger = Rs. 15,00,000 (60,000 * 25)
T Ltd. after merger = Rs. 12,25,000 (22,500 * 50)
Hence, loss = Rs. 3,75,000 (15,00,000-11,25,000)
100 shares in T Ltd. before merger = Rs. 2,500 (100 * 25),
while,
100 shares in T Ltd. after merger = Rs. 1,875 (37.5 * 50)

In this case shareholders of T Ltd. will suffer a loss of Rs. 625

(2,500-1,875), hence they will not agree to the merger proposal.
Though this loss is because of different PE Ratios of A Ltd. and T
Ltd., but in certain situations irrespective of its present gain and loss,
option of merger may be opted, provided future synergies are
expected, which is explained as under. Take a situation, when the:

EPS of A Ltd. is expected to increase @ 2% p.a., and

45
 EPS of T Ltd. is increasing @ 8% p.a. Hence,

SER on the basis of EPS, say after 5 yrs may be ascertained as

under:

EPS of T Ltd. after 5 yrs. will be = Rs. 1.5 (1+.08)* = 1.5 * 1.4693
= Rs. 2.21 (approx.) [2.204]
EPS of A Ltd. after 5 Yrs. will be = Rs. 4 (1+.o2)* = 4 * 1.1041
= Rs. 4.42 (approx.) [4.4164]

Hence, SER = EPS of target firm/EPS of Acquiring Firm

= 2.204/4.416
= .4991 [i.e. .5 approx.]

Therefore, T Ltd. would receive 29,946 shares (.4991 * 60,000), then

EPS after merger = Total earnings/Total no. of shares
= Rs 20,90,000/5,29,946
= Rs. 3.9438

Post merger Earnings of T Ltd. = Rs. 1,18,101 (3.9438 * 29946)

Pre-merger Earnings of T Ltd. = Rs. 90,000

Net increase in the earnings of T Ltd = Rs. 28,101(1,18101-

90,000)
Post merger MP of 100 shares of T Ltd. = Rs. 2,500 (50 * 50)
Pre-merger MP of 100 shares of T Ltd. = Rs. 2,496 (49.91 * 50)
= Rs. 2,500 (approx.)

46
Hence, SER Ratio of .5 (approx.) maintains the Market Value and
also increase in the earnings available to the shareholders of T Ltd.
after merger

Suppose, future merger benefits (i.e. financial synergies) to A Ltd.

are estimated to Rs, 10,00,000. Since the SER based on MP is .5:1 or
1:2, then A Ltd. will issue 30,000 shares. Therefore, post merger
Market Value of A Ltd would be Rs. 2,75,00,000 (i.e.
2,50,00,000+15,00,000+10,00,000). Hence, Post Merger scenario:

MP of share in A Ltd. would be = Rs. 51.889

(2,75,00,000/5,30,000)
It appears as if, share holders of T Ltd. did not get the merger benefit,
but this is not the reality. Because the, Market Value of share holders
of T Ltd. in A Ltd, after merger is Rs. 15,56,604 (51.8868 * 30,000),
so merger benefit to the shareholders of T Ltd., would be Rs.
56,604 (15,56,604 – 15,00,000)

Remember, if the new PE ratio of A Ltd. after merger is same as that

of T Ltd. i.e. 16.667, then the value of shareholders wealth in T Ltd.,
before or after merger will remain unchanged, explained as under:

MP of share of A Ltd. = Rs. 66.667 (PE 16.667 * EPS Rs.4)

Value of T Ltd. after merger = Rs. 15,00,000 (22,500 * 66.667)
Value of T Ltd. before merger = Rs. 15,00,000 (60,000 * 25)

Hence, it is clear that the shareholders of T Ltd. would not agree for
any shares worth less than Rs. 15,00,000 and A Ltd. would not offer
any price more than Rs. 25,00,000 (i.e. Rs. 15,00,000 + merger

47
benefits of Rs. 10,00,000) Arithmetically, it can be expressed as
under:

15,00,000 < or = MP < or = 15,00,000 + 10,00,000

T < or = MP < or = T+B

Where, T = Present Value of Target Firm

MP = Merger Price
B = Merger Benefits

B. SHARE EXCHANGE RATIO ON THE BASIS OF

MARKET PRICE

SER = MP of Target Firm / MP of Acquiring Firm

= 25/50
= .5

Hence, acquiring firm will issue 30,000 shares (.5 * 60,000) to target
firm T Ltd., Then:

EPS of A Ltd. after merger would be:

= Combined Earnings of A Ltd./Total number of shares of A Ltd.
= Rs. 20,90,000/5,30,000
= Rs. 3.9434

Hence, Value of T Ltd. before merger = Rs. 90,000 = (60,000 * 1.5)

Value of T Ltd. after merger = Rs. 1,18,302 (30,000 * 3.9434)

48
In this case the merger proposal will be acceptable, because there is a
merger benefit of Rs. 28,302 (1,18,302 – 90,000) to the shareholders
of T Ltd.

C. SHARE EXCHANGE RATIO ON THE BASIS OF BOOK

VALUE:

SER = BV of Target Firm / BV of Acquiring Firm

= 20,00,000 / 1,00,00,000
= .2 (i.e., .2 share of A Ltd. for one share of T Ltd.)

Hence, the acquiring firm will issue 12,000 share (.2*60,000) to the
target firm T Ltd., then:

EPS of T after merger = 20,90,000/5,12,000 = 4.082

Post-merger earnings of T Ltd. = Rs. 48,984 (4.082*12,000)

Pre-Merger earnings of T Ltd. = Rs. 90,000 (1.5*60,000)
Decrease in earnings of T Ltd. = Rs. 41,016 (90,000-48,984)

Post-merger MP of T Ltd. = Rs. 6,00,000 (50*12,000)

Pre-merger MP of T Ltd = Rs. 15,00,000 (25*60,000)

Decrease in value of T Ltd.= Rs. 9,00,000 (15,00,000-6,00,000)

In the above case, though the EPS increases after merger, but the
earnings as well as market value of T Ltd. decreases. Therefore, the
proposal of SER on the basis of Book Value will not be acceptable by
the target firm.

49
As stated earlier, the Acquiring Firm can pay bid consideration to the
shareholders of Target Firm in different forms i.e., in cash, in equity
shares or even in other types of securities. The different forms of
consideration have different implications and affects that are
elaborated as under:

1. Cash Payment by Acquiring Firm:

a. It does not dilute the ownership of the acquiring firm
b. It does not dilute the EPS of the acquiring firm
c. It reduces the liquidity of the acquiring firm
d. It may invite tax liability for the shareholders of the target
firm on the cash receipts, treated as sale of shares by
earning capital gain.
e. If the bid price is reasonable and profitable to the target
firm, cash mode of payment is always preferable for the
shareholders of the target firm
f. If there are huge cash reserves available with the acquiring
firm, then it is more beneficial to make payment in cash

2. Payment made through Equity Shares:

a. Ownership of the acquiring firm is diluted
b. It does not invite tax liability for the shareholders of the
target firm, since it is not treated as sale
c. It preserves the liquidity of the target firm intact, because
the payment of bid price is made in shares
d. Since, shareholders of the target firm acquire ownership
right in the acquiring firm, hence they also take interest in
the affairs of the combined firm
e. Generally, in such a mode of payment the acquiring firm

50
 has to pay more than the market value of the target firm

3. Payment made through Convertible Debentures:

a. It does not dilute the immediate liquidity of the acquiring
firm
b. Shareholders of the target firm get a guaranteed return as
interest till the date of conversion of debentures in to Equity
share capital
c. When the debentures are converted, the ownership of the
acquiring firm is also diluted.

DIFFERENT TECHNIQUES AND METHODS OF

ACQUISITION

1. BY TENDER OR OPEN OFFER - When one firm offers to buy

the outstanding stock of other firm at a specific price and
communicates this offer through advertisements and mailings to the
stock holders of target firm is called an open offer. This process
bypasses the incumbent management and board of directors of the
target firm. Hence, it may also be called ‘Hostile Takeover’. The
acquired firm will continue to exist as long as there are minority
shareholders, who refuse the offer. But eventually most tender offer
become merger

2. MANAGEMENT BUYOUT - A firm can also be acquired by its

own management or by a group of its own investors. After the
completion of such transaction the acquired form ceases to exist as
publicly traded firm and becomes a private business. Such type of

51
acquisition is called ‘Management Buyout’. Generally, in such cases
the firm is delisted from stock exchange

3. FRIENDLY AND HOSTILE TAKEOVERS – In friendly

acquisition, managers of the target firm welcome the acquisition. In a
friendly takeover the controlling group may sell its controlling shares
to another group at its own will, while in hostile acquisition the
management of the target firm does not want to be acquired. It is
done without informing or bringing the confidence of the
management of the target firm. The buyer buys the shares and
therefore, the control of the target company is changed. The acquired
firm remains intact as a going concern, but sudden jumps in share
prices and sudden rise in trading volume of targeted firm are the
warning signals of an hostile take over

Prior to such acquisition, the acquiring firm offers higher price than
the prevailing market price to the stock holders of the target firm,
thus attracting shareholders to tender their shares in favour of
acquiring firm. The acquisition price, in the context of mergers &
consolidations is the price per share paid by the acquiring firm to the
share holders of the target firm. This price is usually based on
negotiations between the acquiring firm and the management of the
target firm. In tender offer or open offer, the acquisition price is the
price at which the acquiring firm receives enough shares to gain
control of the target firm. The price may be higher than the initial
price offered, if there are other firms in bidding process for the same
or if insufficient number of shareholders opting initial offer.

52
In Feb. 1998, Sterlite Company made a bid for 10% stake in Indal at
Rs. 90 per share. Indal’s Canadian Parent, Alcan with 34.6% in Indal
made a counter offer at Rs. 105, and then Sterlite stepped up it to Rs.
115 per share. Alcan responded to Rs. 120 per share. In May 1998,
Sterlite offered Rs. 221 per share through a mix of cash and
preference share to each shareholder of Indal. Alcan responded Rs.
175 per share cash down. Finally, Alcan offered Rs. 200 per share to
all share holders of Indal and the deal was finally settled. Hence,
during the bidding process bidding price per share went 3 times. But
soon after the final deal, market price per share of the Sterlite came
down to Rs. 66

4. ARRANGED MERGERS – In case of sick industries, the matter

is referred to BIFR (Board of Industrial & Financial Reconstruction)
which facilitates such type of mergers. In such cases, merger schemes
are arranged in consultation with lead banks, by bringing the target
firm and acquiring firm together. Such types of mergers are
motivated and the lead bank takes the initiative and decides terms and
conditions of merger, e.g. recent case of such takeover of Modi
Cement Ltd. by Gujarat Ambuja Cement Ltd. Same happened for
financial reconstruction of Orrisa Synthetics, Orrisa Cement and
Paras Rampuria Synthetics Ltd. etc.

53
 DEFENCE AGAINST TENDOR OFFER, OPEN
OFFER OR HOSTILE BID

If an offer is made for negotiated merger, it is up to the management

of the target firm either to accept or to reject the offer, depending on
its attractiveness. However, the acquiring firm may still persist either
with revised offer or attempting the forced takeover exercise that is
called a hostile takeover bid. Hence, it is the responsibility of the
management of the target firm to take defensive measures to thwart
away such takeover bid in order to protect the interest of
shareholders.

In such a situation, the present management can increase its stake to

51%, but it is impractical, because public offer or issue of shares is
expensive and time consuming process, besides, it may expose
counter bid. Hence, such a situation is not preferable for listed
companies. Alternatively, promoters and the existing management
have the following options:

1. LEGAL STRATEGY - Target firm can move to the court of law

for taking legal action for getting injunction against the offer under
relevant provisions of Securities Contracts (Regulation) Act, 1956
and Companies Act, 1956. It may be done either to:

a. Block the deal, or

b. at least seek time or make delay, or
c. Refused to transfer registration of shares in the name of such
acquiring firm that is most successful step. But for this, adequate
home work and preparation will have to be made in advance in

54
 order to make such refusal successful and upheld by the court

2. TACTICAL STRATEGY – In order to thwart away hostile

takeover bid, different types of tactical methods can be adopted, a
few of them are given as under:

a. Media campaign against the tender offer, but it should be based on

facts and figures
b.Target Firm can also inform its share holders by explaining the
after affects and shortcomings in the bid made by the acquirer
c. Management of the target firm can explain to its share holders that
the offer made is not adequate and it may be economically
unviable that will adversely affect the interest of the company
d. Management of the Target Company can also persuade its own
business associates, directors, employees and friends etc. to
purchase its shares from the market, thereby resulting in reduction
of floating stock available to the acquiring firm and hence, making
it difficult for the bidder to acquire controlling interest in the
target firm.
e. Management can find out a ‘White Knight’, who may offer
highest bid for the target firm. With this, it will not be
economically viable proposition for original bidder. However, in
this situation the target company still loses its hold to ‘White
Knight’ but will get a better deal. This way of thwarting away
cannot stop takeover bid
f. Management can increase its stake in the Target Company
by issuing Warrants, Convertible Preference Shares and
Convertible Debentures at a relatively low price. However, this
seems to be a good strategy to fight away the takeover bid, but

55
 fixation of the issue price of such convertible preference shares and
debentures is a difficult exercise, because rules and regulation
provided under takeover code for the said purpose are to be
followed.

3. DEFENSIVE STRATEGY – When the target firm takes steps

that destroy the attractiveness of its own firm, such as by selling,
mortgaging, leasing or otherwise disposes off some of its valuable
and precious assets is called defensive strategy This strategy is also
known as ‘Poison Pill”. Target firm can also take an exorbitant and
expensive debt. But in India, because of legal restrictions this strategy
is not popular and hence, considered only a theoretical strategy

4. OFFENSIVE STRATEGY – When a counter takeover bid on

acquiring firm is launched by the target firm is called offensive
strategy. It is also known as ‘Pacman Strategy’. However, this
strategy is only feasible when the targeted firm is quite big and
financially sound. As a variant, the target firm may also buy-off the
acquirer by placing a lucrative offer before the management of the
acquiring firm. The management of the target firm may also offer to
pay a higher price for the shares already purchased by the acquiring
firm in the target firm. Hence, it is quite possible that such move
initiated by the targeted firm may thwart away the takeover bid

56
 TYPES OF MERGER

1. HORIZONTAL MERGER (i.e. Inorganic Growth) -When the

two merging firms produce similar products in the same type of
industries and are in competition with each other, come to gather is
called Horizontal Merger. In such type of acquisition market power
of acquiring firm increases by exploiting cost-based and revenue
based synergies. In such type of M&A, firms having similar
characteristics combine their operations. This kind of merger gives
inorganic growth to the combined business

2. VERTICAL MERGER (i.e. Organic Growth) - When two

firms, each of them working at different stages in the production of
the same type of goods combine together is called Vertical Merger. In
a vertical merger or acquisition a firm acquires the supply or
distribution line of the target firm, modifies and improves the value
chain of combined firm through calibration of various value drivers.
In the pharmaceutical industry, the manufacturer has a tendency to
acquire the drug distributers to create more value by combining its
own distribution line with the target firm. Sometimes vertical
acquisitions lead to alienate some of the customers, even though there
are chances of increasing the firm’s performance, e.g. Pepsi
Company discovered the affect after acquiring Pizza Hut, Taco Bell
and KFC. One objective of such acquisitions was to use of three
restaurant chains as distribution channels to sell Pepsi drinks. Same
way Coca-Cola acquired Thumps Up, Gold Spot, Limca and Manza
from Ramesh Chauhan in order to increase its distribution line

57
3. CO-GENERIC OR CONCENTRIC MERGER - When two
merging firms are engaged in the same type of business, but both the
merging firms have no mutual customers or supply relationship, is
called Concentric Merger such as the merger between a bank and
leasing company, e.g. Prudential’s acquisition of Bache & Company.

4. CONGLOMERATE MERGER –When the two firms operate in

different types of products and are interested in looking for
manufacturing new products in order to add new customers, is called
Conglomerate Merger. These firms have no relationship as regards to
the company’s current technology, products or markets. ITC Ltd. is a
classic case of conglomerate diversification. Now ITC is engaged
into may unrelated businesses, i.e. from cigarettes to Hotel, Retail,
Paper, Paperboard to biscuits and Flour etc.

FRIENDLY vs. HOSTILE TAKEOVER

In friendly takeover, in principle the promoters and the management

of the target company are agreeable to be taken over by the acquirer
that will only be made possible, when the entire promoter group is
willing to exit, such type of takeover is called friendly takeover

Sometimes, the target company prefers only one specific acquirer,

provided it agrees to the price and other conditions of takeover bid
made by the acquirer, such as no-retrenchment of employees, post
acquisition role of existing promoter or management, noncompeting
fees, continuation of certain business etc. If the bid conditions do not
suit, the target company is open to approach any other acquirer who
offers them a best deal

58
In certain cases, the management of the target company has a
negative list of acquirers to whom they don’t want to sell out their
business. Hence, if an offer is received from such prospective
acquirer whom they don’t want to sell out their business that was
followed by hostile takeover, the target company can take steps to
stop takeover bid made by such type of acquirers, if possible.

In the case of Tata Steel’s acquisition of Corus, the latter was in

search of a prospective acquirer, who was a low cost producer of
steel. Hence, Corus preferred Tata being culturally close to their
thinking such as retention of existing management and non
retrenchment of employees etc. Corus was also open to sell its
business to Companhia Siderurgica National (CSN), a Brazilian
company. Hence, there was a bidding war between Tata Steel and
Corus. However, finally it was a friendly takeover, because Corus
was able to sell out its business to Tata Steel.

While, in the case of Mittal Steel’s acquisition of Arcelor, the

management of Arcelor was against such acquisition, thinking it a
company run by Indian management. Then, Mittal had to resort to
hostile takeover that was successful.

In the case of Indian Aluminum Company (Indal) the management

was not ready to sell out to Sterlite, but had no objection to Hindalco
taking them over.

Whenever, the takeover is friendly, there is cooperation between the

acquirer and the Target Company. Acquirer shares the critical

59
information required for valuation and facilitates due diligence and
cooperates in carrying out legal formalities for acquisition process.
In hostile takeover, an acquirer has to depend upon information
available in public domain only and forces his way for due diligence
and regulatory compliance.

There are always better chances of getting best deal and fulfillment of
conditions in friendly takeover, chances of the acquirer allowing
Promoter and Management of the target company to continue having
important role post acquisition are better, e.g. Ranbaxy’s takeover by
Daiichi Somkyo of Japan, wherein erstwhile promoter and CEO of
Ranbaxy, Mr. Malvinder Singh continued as its CEO post
acquisition.

In India, most of the takeovers are friendly, though there are some
hostile ones like demerger of Larsen and Toubro’s (L&T) Cement
from Ultra Tech Cement Ltd. which was then taken over by Grasim

In friendly takeover, neither does the acquirer have to adopt any

‘tactics’ to acquire, nor does the target company have to resort to
‘tactics’ to defend it. However, in case of hostile takeover both sides
indulge into tactics that are stated as under:

TAKEOVER TACTICS:
1. DAWN RAID – In this tactic, brokers act on behalf of Acquirer or
Raider swoops down on Stock Exchange by buying all available
shares before the target company comes to know. This is not a good
tactic. This way the acquirer buys a chunk of shares. Secondly,
whether the target company wakes up or not, this would certainly

60
increase the price of its share, hence, requiring the acquirer to shell
out much more money. Sensing the acquisition, investors may hold
back their stake offered, thereby, reducing the liquidity and making
the ‘Dawn Raid’ fail.

In India it is more expensive because, as soon as 25% or more shares

are acquired by the acquirer, then it is mandatory for the acquiring
firm to give an open offer to buy another 26% shares from the
existing shareholders of the target firm. Hence, it is prudent to
acquire below 25% shares gradually over a period of time and then
make an open offer

2. BEAR HUG – When an acquirer makes an attractive offer to the

management of Target Company for its shareholders is called Bear
Hug tactic. This tactic sounds good, which is normally backed by
hostile open offer made to the public shareholders. Though this type
of bid is not liked by Target Company, but the management of the
target company is bound to consider it impartially due to the
fiduciary capacity in protecting the interest of shareholders. If the
offer is good, it cannot be rejected; otherwise public shareholders and
the institutional investors would favourably respond to the offer,
either through private negotiated deals or in the subsequent hostile
open offer made by the acquirer

3. PROXY FIGHT – In this tactic the acquirer convinces majority

shareholders to issue ‘Proxy Rights’ in his favour so that the
prospective acquirer can remove the existing directors from the board
of the target company and appoint his own nominees as directors in
order to manage the control of the target company. This tactic of

61
acquiring proxy right is called ‘Proxy Fight’. However, this method
of control is not sustainable for all the time to come in future, because
every time the acquirer will have to keep on acquiring ‘Proxy Right’
from the shareholders of the target firm. Also such control over the
target company will be treated as an acquisition and will require an
open offer to the public shareholders. Hence, it is not sustainable and
viable tactic of hostile acquisition.

4. SATURDAY NIGHT SPECIAL – This is same as ‘Bear Hug’

but is made on Friday or Saturday night asking the target firm to take
a decision as regards to acquisition by next Monday. The idea behind
this tactic is to give very little time to the promoters and board of
directors of the target company to seek their defence. This is also
called ‘God Father Offer’

5. DIRECT OFFER TO THE SHAREHOLDERS OF TARGET

COMPANY – In this tactic, the acquirer or raider makes an open
offer to the shareholders of the target company without acquiring any
substantial shares either from the open market or through a negotiated
deal. In such a case the acquirer has to make an open offer for a large
stake (depending upon the stake of existing promoters) that reduces
the chances of success of an open offer. There may be a possibility of
such an offer gets failed, but still a good amount of shares are
tendered by the shareholders of the target company, thereby, sinking
a good amount without gaining any control over the target company.
Hence, if one were to adopt this tactic, the best way is to make the
offer conditional upon minimum acceptance as permitted under the
takeover regulation.

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6. POISON PILL OR SUPPER POISON PILL – Generally the
term ‘Poison Pill’ is referred to such strategy that creates negative
financial results and destruction in the value of target firm after
successful acquisition. This term is derived from warfare
terminology. Poison Pills were pills laced with poison that spies used
to carry with them to consume, when captured, in order to avoid the
possibility of being interrogated by the enemy. It also represents an
anti-takeover defence, wherein the current management team of the
target firm threatens to quit en masse. Hence, the acquirer would be
left without experienced management following takeover. Other ways
can also be used to achieve this strategy that is given as under:

a. The target firm can issue right shares or warrants at a very

lucrative price to the existing shareholders, entitling them to
acquire large number of shares in future, thereby diluting the
acquirers’ stake after acquisition. This tactic is called ‘Shareholder’s
Rights Plan’.

b. The target company can change its charter by providing a

provision that will entitle the shareholders of the target firm an
exorbitant price, if the acquirer’s stake in the company reaches to a
certain limit (say 30%). However, this way may not stop takeover
bid, but will certainly give an opportunity to shareholders of the
target firm to exit at a high price.

c. The target company may borrow long-term funds for its own
genuine need, with the condition of paying off immediately if
takeover is exercised by the acquiring company. The long term loan
can also be taken for making one time huge payment of dividend to

63
the shareholders. This tactic is called as ‘leveraged cash out’ that
may discourage the acquirer for takeover

d. In order to increase promoter’s stake, the company may buy back

its own equity shares, using borrowed funds, thereby making their
company less attractive to the acquirer, who may drop the plan of
acquisition. This tactic is called as ‘Leveraged Recap’ or ‘Leveraged
Recapitalisation’ or ‘Poison Put’

‘Poison Pill’ is a defensive strategy that involves a security with

special rights exercisable by a triggering event. It can be an
announcement of an acquisition attempt or the accumulation of a
certain percentage of stock by another company.

There are two plans of such strategy viz. ‘Flip-over and Flip-in’.
A flip-over plan provides for a bargain price of the acquirer’s share, a
flip-in plan provides a bargain price of the target company’s share.
While a ‘Poison Pill’ does not prevent an unwanted takeover, but it
strengthens negotiating position of the management and promoter of
the target company.

A back-end plan is another different type of ‘Poison Pill’. It

provides share holders of the target company certain rights. A right
and a share of the target company can be exchanged for cash or
senior debts (i.e. Bonds) at a specific price with put option set by the
board of directors of the target company. The ‘put option’ will only
be effective, provided a hostile acquisition takes place. The bonds are
put (i.e. sold back) to the acquiring company, thus giving an

64
additional drain on the cash requirements for the completion of the
deal.

While a ‘Poison Pill’ may not stop hostile takeover, but certainly
slowdowns the takeover process, paves the way for more intense
negotiations and hence, will open the doors for more attractive offers
made by the acquirer

7. STANDSTILL AGREEMENT – A voluntary agreement that

creates an understanding between an acquiring firm and large block
of stock holders in the target company is called ‘Standstill
Agreement’, which is generally followed by ‘green mail’.

In this form of hostile takeover defence, an unfriendly bidder agrees

to limit his holding in the target firm that may be made possible by
the target firm’s willingness to purchase the shares in the firm of
potential acquirer (raider’s) at a premium. This offer takes a long way
in implementing a Standstill Agreement or eliminating the chances of
a takeover attempt by the potential acquirer (i.e. raider). This tactic
also gives some time to the target company to build other takeover
defences. This strategy though beneficial to the target firm but not
liked by the shareholders of the target firm, since it limits the
potential return on investment which would otherwise been available
through takeover.

8. PARACHUTES – An agreement made in between management

and employees of the target firm that are triggered when a change in
control takes place is called ‘Parachutes’. The purpose is to provide
the management and employees of the target firm, a piece of mind

65
and opens the door for discussion during the transitional process of
acquisition. It helps the company to retain key employees, who may
feel threatened by a potential acquisition. It also helps the
management to address personal concerns, while acting in the best
interest of the stock holders. It becomes effective, when an acquirer
exceeds a specified percentage of ownership in the target firm. This
tactic is used in friendly takeover. The conditions of ‘Parachutes’
may be used even without the approval of stock holders. ‘Parachutes’
can be of three kinds, stated as under:

i. Golden Parachute – It is designed for the team of the most

senior management of the target firm. Under this option, a substantial
amount of huge payment is paid to the top management, who are
terminated after acquisition

ii. ‘Silver Parachute’ – It provides the protection to a much larger

number of employees of the target firm that may include middle
managers. Generally, it covers the payment of equivalent salary for 6
months to 1 year, per employee for those who are terminated after
takeover.

iii. ‘Tin Parachute’ – It covers an even wider circle of employees or

even all employees of the target firm. It may cover payment equal to
1 or 2 weeks of pay for the employees terminated after acquisition for
every year of service put in the target firm

9. GREEN MAIL – It is a practice of ‘paying off’ anyone who holds

a large chunk of stock in the target company, raising the threat of
acquisition. In order to remove these threats the target company can

66
simply pay a premium price over and above the price paid by such
shareholders at the time of purchasing such a large chunk of shares
in the target company. It is a technique that can be used in a hostile
takeover. However, paying ‘Green Mail’ may be counterproductive
with less than desired effects that may invite other acquirers stepping
in to receive their ‘Green Mail’ as well

10. PAC-MAN DEFENSE – When the target company starts

acquiring sizeable holding in the acquirer’s/raiders’ company,
threatening to acquire the raider itself, is called ‘Pac-Man Defence’
It is an extremely aggressive (i.e. rarely used) defence, where the
target company gives counter offer and launches its own acquisition
attempt on the potential acquirer. But this technique is only effective
when the original acquirer is smaller than the original target
company, thus providing the original target company the opportunity
to finance a potential deal with the original acquirer.

Remember, this defence is extremely risky. Hence, it is essentially

suggested that the management of the original target company should
proceed for takeover bid very cautiously.

11. WAR CHEST – Many large companies have a list of potential

group of acquirers that could fit into their strategic plans of
acquisition. Hence, some companies may build ‘War Chests’ (i.e.
cash and unused debt capacity) in anticipation of an acquisition. This
‘War Chest’ is also a catalyst that can turn a potential acquirer into
the target. The immediate threat of a hostile takeover, looming
around the target company may quicken its own acquisition plan
against the acquirer. If the target company successfully acquires the

67
original acquiring company, then its ‘War Chest’ is greatly reduced,
thus it may be too large and complicated for the hostile acquirer to
afford, assimilate and manage the hostile bid. Moreover, this type of
strategy is not common in India. While, in U.S.A. it is a common
practice of acquisition.

12. WHITE KNIGHT – In a ‘White Knight’ defence, the target

company seeks a friendly acquirer. The target company might prefer
or approach another friendly and interested acquirer, because it
believes that there is a great competition between the acquirer and its
own company. Hence, another bidder might be sought to acquire its
own company in order to ensure and seek promises not to break up
the target company as well as not to dismiss its employees’ en mass.

13. WHITE SQUIRE - It is almost similar to ‘White Knight’, but

the difference is that the ‘White Squire’ does not take control of the
target firm. Instead, the target firm sells a block of shares to a ‘white
squire’ that is considered friendly takeover and the acquiring firm
will vote in favour of target firm. There is also a possibility of
imposing other considerations, such as, a ‘Standstill Agreement’, that
means the ‘White Squire’ cannot acquire more of the shares of the
target company at least for a specific period of time, and a restriction
on the sale of that block of shares already purchased. The restriction
on the sale of that block of shares usually stipulates that the target
firm has the ‘Right of First Refusal’. The ‘White Square’ may receive
a discount on the shares purchased, a seat on the board of target firm
and extra-ordinary dividend paid by the company.

68
14. GREY KNIGHT – In this tactic, the services of a friendly
company or a group of investors are engaged to acquire shares of the
raider itself to keep the raider busy defending himself and eventually
forcing a truce in favour of the target company. Such type of tactic is
commonly used in India

15. DIVEST CROWN JEWELL – A company may also consider

selling its most valuable line of business or division. This line of
business or division is referred to as the ‘Crown Jewells’, once this
valuable line of business has been divested, the proceeds can be used
to repurchase stock or to pay an extra ordinary dividend to its
shareholders. Besides, once the ‘Crown Jewells’ have been divested
the hostile acquirer may withdraw its bid, because after the sale of
attractive and valuable assets the bid becomes unattractive

16. BLANK CHEQUE – When the target company makes a

preferential allotment to its promoters or in favour of friendly share
holders, in order to increase the control of the promoter’s group, is
called ‘Blank Cheque’ technique. Such an issue is governed by SEBI
guidelines, under Disclosure & Protection Guidelines 2000, that
stipulates pricing formula for such an allotment which is based on the
highest market price during the past 26 weeks or past 2 week’s time,
whichever is more. Remember, that it is an expensive tactic for the
acquiring company to go ahead for acquisition.

17. SHARK REPELLENTS – When the target company makes

changes in its charter (i.e. Memorandum of Association or Article of
Association) in order to make the takeover expensive or impossible is
called Shark Repellents technique. Another way of ‘Shark-Repellent’

69
could be by stipulating a super majority merger, say 90% would be
required to approve a merger, thereby making the merger more
difficult. But such a case is rare. In most of the cases, an acquirer can
achieve his objective through an acquisition without going for
merger.

18. BUY BACK OF SHARES – In Indian context, ‘Buy Back of

Shares’ can be used as an effective defence tactic. In this technique, a
company redeems its own equity shares, for this, legal formalities are
required to be fulfilled. When the target company is rich in cash and
has accumulated huge cash reserves, it is always advisable to make a
call for Buy Back of its own equity shares, this technique increases
the holding of promoters of the target company by decreasing the
holdings of outside shareholders, hence, it will not be possible for
acquirer to achieve controlling interest in the target firm. However,
due to the tough guidelines of SEBI, one has to do it tactfully

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FORMS OF CORPORATE RESTRUCTURING – It can be done
in the following manner:

a. change in the portfolio of company that is carried out by

taking inorganic route, or
b. change in the capital structure of a company, or
c. change in the ownership of a company or control over its
management, or
d. by combining any two or all of the above ways.

MAIN FORMS OF CORPORATE RESTRUCTURING The

following methods can be used for restructure of companies:

1. Merger 6. Carve Out

2. Amalgamation/Consolidation 7. Joint Venture
3. Acquisition 8. Reduction of Capital
4. Divestiture 9. Buy Back of Securities
5. Demerger: a. Spin Off or, 10. Delisting of Securities
Split Up, and c. Split Off Co. from Stock Exchange

1. MERGER – It involves combination of all assets, liabilities, loans

and business (on a going concern basis at book value of the assets &
liabilities) of two or more companies, wherein one of them survives.
It is one of the most frequently used forms of corporate restructuring
around the world, which is primarily a strategy of inorganic growth.
In India also thousands of companies get merged into other
companies. India’s largest private company Reliance Industries Ltd.
(RIL) is indeed a result of many mega mergers of group companies
into RIL

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2. AMALGAMATION/CONSOLIDATION – This term is used in
India only. It includes both merger and consolidation. The term
amalgamation is rarely used and consolidation is not so frequently
practiced. Examples of one company taking over the other and merge
that other with itself are most common. Even if three companies
combine into one, the preferred route is to merge two companies with
the third rather than consolidating all three companies into a new
company. The rationale behind this is to preserve the identity of the
company or companies with the best brand and take advantage for the
combined business. Consolidation is used to combine a large number
of companies of which at least two to three largest companies are of
comparable size.

3. ACQUISISTION – When an attempt or a process by which a

company or an individual or a group of individuals acquires control
over another company i.e., ‘Target Company’ is called acquisition. It
gives the right to control the management and policy decisions of the
target company. It can also be defined as acquiring the right to
appoint and remove majority of the directors of the target company

In acquisition, unlike merger, the identity of the target company

remains intact. Different ways and techniques can be used to have a
control over the target company that is stated as under:

a. by purchasing a substantial percentage of voting control

b. by acquiring voting rights through power of attorney or
through a proxy voting arrangement
c. by acquiring control over an investment of holding

72
 company whether listed or unlisted in stock exchange.
d. by simply acquiring management control through a formal
or informal understanding or agreement for control of the
target company.

4. DIVESTITURE – It refers to the sale of all the assets or

substantial assets of the company or any of its business, divisions,
usually for cash or for a combination of cash and debt and not against
exchange of equity shares is called divestiture of the business. In
brief, divestiture means sale of assets at one time in lump sum, but
not in a piecemeal manner.

Normally, in divestiture, creditors are not taken over by the acquirer.

The transferor (i.e. divesting company) repays the loans out of
consideration received in cash from the transferee company.
However, other liabilities can be taken over by transferee (i.e.
divestee) company. Normally, the consideration is paid in cash.
Divestiture is normally used to mobilize resources for core business
by realizing the assets of the non-core business of the target
company.

5. DEMERGER – It can be done in the following forms:

a. Spin-off – It involves transfer of all or substantial assets and
liabilities of one of the business divisions or undertakings to another
company whose shares are allotted to the shareholders of the
transferor company on a proportionate basis. In spin-off, Transferor
Company remains in existence.

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b. Split-Up – It involves transfer of all or substantial assets and
liabilities of the company in favour of two or more companies. Like
spin-off, the shares in each of the new companies are allotted to the
original shareholders on a proportionate basis, but in split-up the
transferor company ceases to exist.

Hence, it is clear that in spin-off, the transferor company continues to

carry on at least one of the businesses. But, if a company transfers all
of its businesses to different companies or ceases to exist by the
process of liquidation or reconstruction, without winding up its
business, it is called as split-up

Unlike divestiture, where Transferor Company receives consideration

in cash, in spin-off and split-up, share holders of the transferor
company receive consideration, like in case of amalgamation. In case
of both (spin-off & split-up) consideration is always paid in form of
equity shares of the transferee company.

Normally, for the purpose of spin-off or split-up a new company (ies)

having small share capital is/are incorporated. In the demerger
process, assets & liabilities of the business/division are transferred to
the transferee company, which then becomes the resulting company.
However, it is not necessary that one has to float a new company to
act as resulting company. It is also not necessary that the resulting
company should not be having its own running business prior to
demerger.

c. Split-Off –It is as good as spin-off with the difference that in split-

off, all the shareholders of the transferor company do not get the

74
shares of the transferee company in the proportion held by them in
the transferor company

Generally, in split-off, only few of the shareholders get shares of the

transferee company in exchange of shares held by them in the
transferor company.

6. CARVE OUT – It is a mix of divestiture and spin-off, where in

carve-out, a company transfers all the assets & liabilities of one of its
divisions/undertakings to its 100% owned subsidiary company.
Hence, at the time of transfer, shares are issued to the transferor
company itself and not to its shareholders. Later on the company sells
the shares in parts either to the outsiders or to the institutional
investors by private placement or to retail investors through offer for
sale. In case of carve-out the consideration eventually comes in the
coffers of the transferor company. Hence, it is normally used to
mobilize funds for core business of a company by realizing the value
of the non-core business. It is also used to carve-out capital hungry
businesses from those businesses requiring normal levels of capital so
that further funds can be raised by equity dilution

7. JOINT VENTURE – It is an arrangement in which, two or more

companies (called joint venture partners) contribute to the equity
capital of a new company (called joint venture) in a pre-decided
proportion. Generally these are limited companies. The largest
example of joint venture in India was of Maruti Suzuki and the Govt.
of India.

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Normally, Joint ventures are formed to pool the resources of the
partners and carry out a business or a specific project beneficial to
both the partners

8. REDUCTION OF CAPITAL – It is a legal process provided u/s.

100 to 104 of Companies Act, 1956 wherein, a company is allowed to
extinguish or reduce the liability in respect of its uncalled up and
unpaid amount on its share capital or is allowed to cancel any paid up
share capital which is lost due to the continuous loss suffered by the
company or is allowed to pay off any paid up capital that is in excess
of requirement.

9. BUY-BACK OF SECURITIES – This technique is an important

tool of capital restructuring. Generally, it is advisable in case of a
company holding excess cash reserves, which it does not require in
the immediate future; say for 3 to 5 yrs. Hence, it is prudent for the
company to return this excess cash to its shareholders that will
increase EPS and profitability of the company. It is one of the
methods used in such a situation to return the excess cash to the
shareholders. This legal process is covered u/s. 77 of Companies Act,
1956

10. DELISTING OF SECURITIES OR COMPANY FROM

STOCK EXCHANGE – A company can delist either its Equity
shares, Preference shares or Debt securities from a Stock exchange or
from different stock exchanges. Delisting can be of any security or of
all securities from any of the stock exchanges or from all stock
exchanges. When we talk of delisting of a company from stock

76
exchange as a form of corporate restructuring, we are mainly
referring to delisting of its equity shares.

THEORIES OF MERGER & ACQUISITION

1. MONOPOLY THEORY – This theory explains M&A as being

planned and executed to achieve market share and market power. At
times, it includes price war. This theory is primarily used as growth
strategy that can work in the following three ways:

a. As market leader, trying to consolidate its position further –

e.g., Acquisition of Arcelor by Mittal Steel was a case of market
leadership, consolidating its leadership position that became second
largest steel company in the world after acquisition. In this case
acquirer as well as the target company was engaged in the same type
of business

b. Strategy to enter in new market – Hutchison Essar’s acquisition

by Vodafone was in fact, a market entry strategy that was looking for
entering in the lucrative Indian market as a part of its global
expansion strategy, who estimated the real intrinsic value much
higher than the present market capitalisation of Hutchison Essar’s

c. Trying to gain market leadership and monopoly: Generally,

such type of acquisition is done by the profitable and cash rich
companies, e.g. Acquisition of Corus Steel by Tata Steel and
acquisition of Larsen & Tubro’s (L&T) cement division were the
cases of cash rich companies trying to gain market leadership that

77
pushed up Tata Steel’s ranking from fifty-sixth global steel company
to fifth largest global steel company. Same way Grasim Industries
ranked third cement industry in India after acquisition of L&T.

2. EFFICIENCY THEORY – Under this theory, M&A is planned

and executed to achieve synergies to maximize the value of firm as
well as increase in the wealth of shareholders by pooling various
resources of the acquirer and the target company. Efficiency
synergies achieved from M&A can be mainly classified as under:

a. Revenue generating synergies – These synergies can be described

as the generation of much higher growth rate and turnover as
compared to the growth of individual companies before merger

b. Cost reduction synergies – The synergies that are obtained after

combined operations, resulting in cost savings in any of the areas,
viz. manufacturing, marketing, operation, manpower, corporate
overhead, etc. are called cost reduction synergies

3. VALUATION THEORY – According to this theory M&A is

planned and executed by the acquirer, who has better information
regarding the valuation of Target Company than anybody else. Using
due diligence, the acquirer makes an analytical study of the financial
statements of the target company, thereby making a comparison in
intrinsic value and market value of share for finding out the amount
of purchase consideration to be paid to the transferee.

4. RAIDER THEORY – It explains the M&A activity in the specific

context of PE funds, where the acquirer acquires controlling stake in

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cash needy companies at a much lower valuation than their potential
worth of business and present market value of shares. Induction of PE
funds transfers the wealth from existing share holders to them (i.e. PE
fund managers), without any strategic intention of running these
companies by themselves. In case of unlisted companies it is easier
for PE funds to acquire equity shares at a lower price than their
present intrinsic value of shares. But in case of listed companies
SEBI and its Disclosure and Investor Protection guideline, 2000 has
specified minimum acquisition price based on the average market of
past 26 weeks and/or past 2 weeks high and lows of the prices of the
shares, below which shares can’ t be allotted to PE fund managers.

5. EMPIRE BUILDING THEORY – Under this theory M&A is

planned and executed by the management for expanding their own
empire rather than creating wealth for its shareholders. The CEO’s of
the larger companies regard themselves as more capable and
respectable heads as compared to their counterparts of smaller
companies. Therefore, many times top management of the larger
companies resort to acquire small companies in order to grow in size
so that they can build up their own empire, without bothering and
taking care of the interest of shareholder’s wealth and increase in the
market value of share. Remember, this process may create negative
impact in shareholder’s mind

6. HUBRIS THEORY (Hypothesis) – When a manager commits

errors in evaluating the valuation price of acquisition and values its
price more than the real value of the target firm, such exercise is
called Hubris Theory of valuation. Managers of bidding firms are
infected by hubris and calculate more price than the real value of the

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target firm, because they over estimate their own ability and
capability of valuation. In the takeover exercise the acquiring firm
identifies a potential target firm and values its net worth. If the
valuation is below the market value of the target firm, then no offer is
made. Takeover exercise will only be initiated when the bid amount
is more than the market value of the target firm. If there are no
synergies or other take over gains, the average value of both the
valuation (i.e. bid price and market value of the target firm) would be
considered as takeover price of the target firm. Offer and counter
offers are made when the market valuation of the target firm is too
high. The takeover premium is a random error, a mistake made by the
bidder. The ‘Hubris Hypothesis’ assumes strong efficiency of
markets and the share price reflects all public and non public
information.

7. REDISTRIBUTION THEORY – This theory advocates the

source of value increase in mergers that is redistributed among the
shareholders of the combined firm. An increase in leverage following
mergers might also enhance shareholder’s wealth through an
expropriation of wealth from bondholder. Immediate fallout of
merger is that the existing shareholders are better off because of debt
being relatively cheaper. Shareholders can appropriate a part or all of
the benefits from bond holders, financing the merger with debt and
increasing the financial leverage of the merged firm.

8. ASYMMETRIC THEORY – This theory explains how any

incremental value associated with a particular merger is shared
between the acquiring and acquired firm? This theory predicts that a
competitive hierarchy is developed by the price that each competing

80
firm is willing to pay for the target firm. The price is approximated in
each case by the discounted value of the expected post merger
earnings. As a general rule, the ‘best fit buying firm’ will pay at least
marginally above the highest price offered by the ‘best fit firm’. A
key assumption of both the merger contingency framework and
Asymmetric Theory is that the value added is a function of
relatedness.

SYNERGIES

Synergies can be either revenue generating or cost savings or both.

These two main synergies can be obtained from any five types of the
following synergies arising out of M&A, e.g. manufacturing synergy
can be either revenue generating or cost savings or both, and so on,
given as under:

1. MANUFACTURING SYNERGY – It is obtained by combining

core competence of the acquiring company and the target company in
the different areas of manufacturing, technology, design and
development, procurement, thereby reducing cost in manufacturing
activities bringing cost savings.

2. OPERATING SYNERGY – These are the benefits achieved by

rationalizing the combined operations of the acquirer and the target
firm in such a manner that can be obtained through sharing of
facilities such as increase in warehouses, transportation facilities,
software facilities and improvement in the logistics, etc., resulting
savings in cost of production so that the operating profits can be
increased after merger.

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3. MARKETING SYNERGY – These benefits are achieved with
the increase in sales, distribution channel or media to push the
products and brands of both the acquirer and Target Company at
lower costs than the different cost of the companies before merger.
Marketing benefits also depend on leverage of brand equity of one of
the two companies to push the sale of the other product of the
company.

4. FINANCIAL SYNERGY – These benefits are achieved either by

reducing the weighted average cost of capital (WACC) or a better
gearing ratio or by introducing other improved financial parameters
by combining the financial statements of both the companies

5. TAX SYNERGIES – These benefits are available by merging a

loss making company with a profit making company so that the profit
making company can get tax exemptions and benefits available after
merger, u/s. 394-395 of Company’s Act, 1956

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 HISTORY OF TAKEOVER CODE IN INDIA

Pre-1992 – Listing agreement governed substantial acquisition of

shares
1992 – SEBI constituted
1994 – Takeover Code of 1994 notified
1995 – Bhagwati Committee constituted
1997 – Revamped Takeover Code of 1997 notified, known as SEBI
(Substantial Acquisition of Shares and Takeovers) Regulation, 1997
2001 – Bhagwati Committee reconstituted
2002 – Takeover Code, 1997 was revised that was based on the
recommendations of reconstituted Bhagwati Committee
2009-2011
i. TRAC was formed on 4th Sept. 2009
ii. TRAC released its report on 19th July 2010
iii. The SEBI Board considered TRACK recommendation on 28th July
2011
iv. SEBI notified the new Takeover Code on 23rd Sept. 2011
v. The new Takeover Code became effective w.e.f. 22nd Oct. 2011

1. Limits on Acquisition of Shares or voting rights:

i. Any person, singly or jointly (referred as acquirer), can
acquire up to 24.99% shares or voting rights in a listed
company in India (target company), provided the acquirer does
not take control over the target company.
ii. If the acquisition results into entitlement of 25% or more voting
rights in the target company, the acquirer is required to make an
open offer to acquire at least 26% stake (open offer obligation)
from the existing public shareholders of the target company

83
 Creeping Acquisition Limit:
The acquirer holding 25% or more voting rights in the target
company can acquire additional stake to the extent of 5% of the total
voting rights in any financial year, up to a maximum permissible non-
public shareholding limit of 75% Acquisition of voting rights
exceeding 5% in any financial year automatically triggers open offer
obligation

2. Acquisition of ‘Control’ – It include right to:

i. Appoint majority of directors
ii. Control the management
iii. Control policy decisions

3 A. Exemptions from open offer in all cases of acquisition:

S.No
Transaction Key Condition
.
Inter transfer between:
1 i. Acquisition price per share should not
a. Immediate Relatives*
be higher by more than 25% of the
volume weighted average market price
b. Company, its
for a period of 60 trading days
subsidiaries, its
preceding the date of issuance of notice
holding company,
for the proposed transfer
fellow subsidiaries
ii. The acquirer needs to intimate the stock
etc. (i.e. group)
exchange(s), the details of the proposed
acquisition at least 4 working days prior
to the proposed acquisition
2 Inter transfer between: i. same as (i) and (ii) above
a. Promoters ii. Additionally, promoters or PACs should
b. Acquirers be disclosed as such for at least 3 years prior
c. Shareholders (PACs) to the proposed acquisition

84
 and companies owned
by them
Acquisition pursuant to
scheme
a. no condition prescribed
a. U/s. 18 of SICA
b. no condition prescribed
b. Of arrangement or
reconstruction
3
involving the target
company, including
merger or demerger,
pursuant to an order
of a court or compet-
ent authority under
c. 1) consideration in cash and its
any law, Indian or
equivalents should be less than 25%
foreign
of the total consideration being paid
c. Of arrangement, not
pursuant to the scheme
directly involving the
2) Person directly or indirectly holding
target company,
at least 33% of voting right in the
including merger or
combined firm should be the same
demerger, pursuant to
as those who held the entire voting
an order of a court or
rights before implementation of the
competent authority
scheme
under any law, Indian
or foreign
Acquisition of voting
rights on preference
4 No condition prescribed
shares u/s. 87(2) of
Companies Act, 1956

*It includes spouse of a person and includes parents, brothers, sisters

and children of such persons (acquirers) or of his spouse

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3 B. Exemption from Open Offer obligation in case of substantial
acquisition of share or voting rights
S.N. Transaction Key conditions
1 Increase in voting rights of The shareholder needs to reduce
any shareholder exceeding his or her shareholding so that the
24.99%, pursuant to buy voting rights fall below the
back threshold of 25% within 90 days

3 C. Exemption from Open Offer obligation in case of consolidation

of shares or voting rights beyond creeping acquisition limit
S.N. Transaction Key conditions
1 Acquisition of shares a. The acquirer should not renounce any
pursuant to right issue of his or her entitlement in right issue
b. Price of rights issue is not higher than
the ex-rights price to be calculated as
per Takeover Code
2 Increase in voting rights of a. The shareholder should not vote (in
any shareholder exceeding capacity as director or shareholder) in
creeping acquisition limit favour of resolution authorizing buy
of 5%, pursuant to buy back u/s. 77A of Companies Act,
back 1956
b. Shareholder’s resolution, if
applicable, is passed through ballot
c. Increase in voting rights does not
result in acquisition of control by the
shareholder
d. The shareholder should reduce his
shareholding within 90 days from
the date of increase in voting rights,
if any of the above specified
conditions is not met

3 D. Special Exemptions by SEBI:

1. The acquirer may apply to SEBI seeking exemption from open offer
obligation

86
 2. The target company may apply to SEBI seeking relaxation from strict
compliance with any procedural requirement of open offer process and
other obligations

4. Open Offer: Trigger and conditions

Mandatory Open Offer – It gets triggered in any of the following
conditions:
i. Acquisition of substantial shares or voting right entitling
the acquirer 25% or more voting rights in the target
company
ii. Creeping acquisition of more than 5% voting rights in a
financial year by the acquirer, who already holds 25% or
more voting rights in the target company
iii. Acquisition of control over the target company,
irrespective of shares or voting rights held by the acquirer
In a mandatory open offer, the acquirer has to offer to
acquire minimum of 26% of total shares of the target
company from the public shareholders.

Voluntary Open Offer – An acquirer holding 25% or more

voting rights in the target company can make a voluntary
offer for at least 10% of the total shares of the target
company, subject to the following conditions:
i. Total post open offer shareholding of the acquirer should
not exceed 75% of the total shares of the target company
ii. The acquirer should not have acquired shares of the
target company in the preceding 52 weeks without
attracting open offer
The acquirer who has made voluntary offer is not entitled to
acquire further shares of the target company for a period of 6
months after the completion of offer, except as a result of
another voluntary open offer or participation in a competing

87
 offer

5. Key aspects of Open Offer Obligations:

Offer Size:
i. The minimum offer size of 26% of the total shares of the
target company needs to be computed, as of 10th working
day from the closure of the tendering period
ii. The total shares as on 10th working day should take into
account all potential increases in the number of
outstanding shares during the offer period contemplated
as on the date of acquisition, the open offer size will
need to be increased
iii. In case of an increase in the total number of shares post
acquisition, not contemplated as on the date of
acquisition, the offer size will need to be increased
proportionally

Offer Price: The minimum offer price should be highest of the following,
computed with reference to the cut-off-date
Direct Acquisition Indirect Acquisition
1. Highest negotiated price 1. Highest negotiated price
2. Volume weighted average price 2. Volume weighted average price
Paid or payable by the acquirer paid or payable by the acquirer
prevailing during the preceding 52 prevailing during the preceding 52
weeks weeks
3 .The highest price paid or payable 3. The highest price paid or payable
By.The acquirer during preceding By.The acquirer during preceding
26 weeks 26 weeks
4. 60 trading day’s volume weighted 4. The highest price paid or payable
average market price in case of By.The acquirer during the date of
frequently traded shares*, the price contracting or announcing the
determined by the acquirer and the primary acquisition (PA) and the
manager to the open offer taking date of PA in India
into account valuation parameters 5. 60 trading day’s volume weighted

88
5. The per share value of the target
company, if computed (in case of
indirect acquisition where value of 6. The per share value of the target
the target company exceeds 80% of
overall transaction)
6. Cut-off-date: Date on which PA is
made
average market price, in case of
frequently traded shares
company (if value of the target
company is not more than 80% of
the overall transaction)**
7. Cut-off-date: The date on which
the PA is contracted and the date on
which intention or decision to make
primary acquisition (PA) is
announced

* Infrequently traded shares of the target company are the ones in

which trading turnover during 12 months (preceding the calendar
month) is less than 10% of total number of shares traded.

**If the value of the target company is more than 15% but limited to
80% of the overall transaction, the per share value of the target
company needs to be specifically computed and disclosed along
with detailed description of the valuation methodology in the
letter of offer (LO)

Mode of Payment of Offer Price – Offer Price may be paid through any one
or a combination of any of the following:
1. Cash
2. Issue, exchange or transfer of:
a. listed equity shares* of the acquirer or PACs
b. listed debt instruments issued by the acquirer or PACs
c. convertible debt securities entitling the holders to acquire
listed shares* of the acquirer or PACs

* Subject to certain conditions, e.g. shares to be issued must have

been listed at least for two years, must be frequently traded,

89
 issuer company must have redressed at least 95% of the
investor’s complaints, impact of auditor’s qualification etc.

Conditional Offer:
1. An acquirer may make an open offer conditional as to
minimum level of acceptance. If the offer is in pursuant to an
agreement, such agreement must contain a clause to the
effect that in case minimum level of acceptance is not
achieved, the acquirer will not acquire any shares under open
offer
2. During the period of such offer, the acquirer will not acquire
any share in the target company

Competing Offer:
1. Competing offer can be made within 15 working days from
the date of announcement made by the first PA
2. Unless the first open offer is a conditional offer, the
competing offer cannot be made conditional as to the
minimum level of acceptance
3. A competing offer is not regarded as a voluntary and hence,
all the provisions of Takeover Code, including that of offer
size, apply accordingly
4. On PA of competing offer, an acquirer who has made a
preceding offer is allowed to revise the terms of his open
offer, if the terms are more beneficial to the shareholders of
the target company. The upward revision of the offer price
can be made any time up to 3 working days prior to
commencement of the tendering period

Withdrawal of Offer – An open offer once made can be withdrawn under

any of the following circumstances:
1. Statutory approvals for open offer or for effecting

90
 acquisitions attracting the obligation to make an open offer is
refused
2. The acquirer, being a natural person, dies
3. Any condition made in open offer is not met for reasons
beyond control of the acquirer
4. Such other circumstances as in the opinion of SEBI, merits
withdrawl

Completion of acquisition under open offer:

The acquirer needs to complete the acquisition process not later
than 26 weeks from the end of the offer period

Extension:
If the acquirer is subject to any statutory approval (e.g. CCI
approval takes time), SEBI may grant extension of time,
provided the acquirer agrees to pay interest to the shareholders
of the target company at a specified rate for the delay

6. Key Obligations of parties during Open Offer:

Acquirer’s Obligation-
i. Before acquisition, necessary financial arrangements
should be made for fulfilling the payment obligation
ii. Ensure that the contents of Acquisition, Letter of offer,
advertisements etc. are true, fair and correct
iii. Cannot sell shares of the target company
iv. Jointly and severally responsible with PACs

Target Company’s Obligations

i. to carry on business in the ordinary course consistent
with past practice
ii. to take decisions on material events, such as alienation

91
 of assets, buyback and issue of shares, material
contracts etc. in it or any of its subsidiaries, only by way
of special resolution passé by the shareholders of the
target company to be passed through postal ballot.
iii. restriction on fixing record date for a corporate action,
during the specified period
iv. constitute committee of independent directors to provide
reasoned recommendations on open offer and publish
the recommendation

Obligations of Directors of the target company

i. cannot appoint any person representing the acquirer as
directors of the target company
ii. cannot allow the director on board who represents the
acquirer to participate in any deliberations or vote on
any matter in relation to open offer

7. Minimum Public Shareholding:

i. The acquirer is not entitled to acquire or enter into any
agreement to acquire shares or voting rights exceeding
maximum permissible limit of 75%
ii. If non-public shareholding exceeds 75%, pursuant to
open offer, the acquirer has to bring his holding down up
to 75%.
iii. If the acquirer’s holding goes beyond 75%, the acquired
company will be delisted from stock-exchange under the
SEBI Delisting Regulations, at least for 1 year from the
date of completion of open offer.

92
8. Disclosures:
Events based disclosures*
Regulation Triggering Event Disclosure Disclosure
by to
29(1) Acquisition of 5% or more Acquirer Target Co. & stock
shares or voting right exchange(s)
29(2) Acquisition or disposal of Acquirer or Target company &
2% or more shares or voting seller stock exchange/s
rights by the acquirer
alreadyHolding 5% or more
shares or voting rights
31(1)/(2) Creation or innovation or Promoter Target co. & stock
release of encumbrance** exchange/s
on the shares held by
promoter or PACs
Continuous disclosures*
Regulation Disclosure by Disclosure to
30(1) Acquiring holding 25% or Target company and stock
more shares or voting rights exchange/s
30(2) Promoter and PACs Target company and stock
exchange/s

* All disclosures will be the aggregated shareholding and voting rights of

the acquirer or promoter along with PACs
** ‘Encumbrance’ includes a pledge, lien or any such transaction, by whatever
name called

9. Repeal and Savings:

The 1997 Code stands repealed from the date the new
Takeover Code, 2011 comes into force, hence any
reference made thereof in any other regulations,
guidelines or circulars issued by SEBI shall be considered
to be a reference to the provisions of the new Takeover
Code

93
 Notwithstanding such repeal, an offer for which
acquisition was made under the 1997 Code will be
required to continue and completed as per the 1997 Code
itself

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 GIST OF SEBI’s New Takeover Code & Few
Historic Takeovers
Takeover Trigger Point 15% to 25 %
Open Offer Size 20% to 26%
Non-Compete Fees Removed
Era of Takeover May Begin-Threat of takeover may begin,
provided the equity participation (% stake) of promoter’s along with
their friends and relatives is increased to the extent of more than 50%.
Otherwise there is every possibility of Hostile Takeover. Cases of
few of the following companies are given as under that shows the
stake in their own promoted companies, thereby inviting threat
perception from the acquirers:

1. ITC vs. EIH

In 2010, Reliance Industries played a role of ‘White

Knight’for the Promoters of East India Hotels, a chain

of Oberoi Hotels ITC group which had gradually
raised its stake in EIH to 14.98% over the years
Promoters + 35.23%
ITC Ltd. 14.98%
Reliance Industries 18.53%

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2. PRAJ
Promoters + 26.22%
Institutions + 25.29%

3. SWARAJ PAUL vs. ESCORTS, DCM SHRIRAM

Ltd.
In the yearly 1980’s, UK based NRI business magnate
Swaraj Paul made a hostile bid for Indian Companies
Escorts and DCM Shriram, but had to backtrack
eventually in the face of political opposition.

4. RELIANCE INDUSTRIES vs. LARSEN &

TOUBRO
Initially roped in as a ‘White Knight’ in the late 1980’s,
Reliance Industries tried to take control of L &T, but
had to retreat after financial institutions withdrew
support. The development coincided with Congress
losing power at the Centre

5. BAT vs. ITC

In the mid 1990s, global tobacco major BAT tried to

96
 take control of ITC, in which it already owned a stake.
Here too, political opposition and regulatory hurdles
forced BAT to give up its ambitious plan to strengthen
its presence in India

6. FINANCIAL INSTITUTIONS vs. MODI RUBBER

In 1998, financial institution threatened to sell their
holdings in Modi Rubber to any interested buyer, for
non repayment of loans. Brothers B.K. Modi and V.K.
Modi averted a hostile takeover by repaying the loan
and later buying out the FIs stake.

7. ICI vs. ASIAN PAINTS

In 1997, the Indian arm of UK based paint major ICI
bought 9.1% in Asian Paints from investment bank Kotak
Mahindra. However, the FIPB refused to approve the deal, forcing
ICI to sell the stake

8. INDIA CEMENT vs. RAASI CEMENTS

Probably it is the only case of a successful hostile
takeover in corporate India till 1998. Tamil Nadu
based India Cements bought out Hyderabad based

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 Raasi Cements in 1998 after winning over key
shareholders, public shareholders as well as some
members of the promoters group
9. ARUN BAJORIA vs. BOMBAY DYEING
In 2000, Kolkatta based Arun Bajoria bought 15% in
Bombay Dyeing, and threatened to make an open
offer to public shareholders. He finally sold out his
stake to the Wadias, the promoters of Bombay Dyeing
at a profit
10. ABHISHEK DALMIA vs. GESCO
In 2000, Abhishek Dalmia cornered 10.5% stake in
the Sheth’s controlled GESCO Corporation and made
an open offer for another 20%. But rather than
dislodging the existing promoters, Dalmia sold his
stake to them for a profit of Rs. 9 crore.
11. R.K. DAMANI vs. VST INDUSTRIES
In 2001, stockbroker Radha Kishen Damani made an
open offer for BAT controlled VST Industries, but
was foiled by ITC which entered the fray as a ‘White
Knight’ with the support of BAT. Damani still holds
26% in VST

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12. HARISH BHASIN vs. DCM SHRIRAM
INDUSTRIES
In 2007, stock broker Harish Bhasin bought 25% in
DCM Shri Ram Industries through a combination of
open market purchases and an open offer. But the
promoters countered the move by issuing warrants to
themselves and increasing their stake

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GIST/SUMMARY OF TAKEOVER CODE, 2011:

SEBI (Substantial Acquisition of Shares and Takeovers) Regulation,

2011, commonly referred to as the new Takeover Code is made to
align it closer to global practices. The main purpose for the new
takeover code is to prevent hostile takeovers and at the same time,
provides more opportunities to make an exit route for innocent
shareholders, who do not wish to be associated with a particular
acquirer.

To understand the concept of the new takeover code, it would be

pertinent to first go through some of the important definitions, stated
as under:

1. Acquirer [Regulation 2 (10)(a)] - Acquirer means:

a. any person who, directly or indirectly,
b. acquires or agrees to acquire whether by himself, or through, or
with persons acting in concert with him.
c. shares or voting rights in, or control over a target company

It means that any person who enters into an agreement for

acquiring the shares in future will also be an acquirer for the
purpose of the takeover code

2. Acquisition [Regulation 2 (1)(b)] – Acquisition means:

a. directly or indirectly, acquiring or agreeing to acquire
b. shares or voting rights in, or control over a target company

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 It means that any agreement entered into between two persons for
acquiring the shares in future will also be covered within
acquisition for the purpose of takeover code.

3. Person acting in concert [Regulation 2 (1)(q), means:

a. persons who, with a common objective or purpose of
b. acquisition of shares or voting rights, or exercising control in a
target company
c. pursuant to an agreement or understanding, formal or informal,
directly or indirectly cooperate
d. for acquisition of shares or voting rights, or exercise of control
in the target company

OLD TAKEOVER CODE VS. NEW TAKEOVER CODE

Basis Old TO. Code New TO. Code Impact

When an acquirer’s In the new As a result, an
holding in a listed takeover rules, the acquirer can buy up
Threshold firm reaches 15%, triggering limit for to 24.99% in a listed
limit(initial the acquirer has to making the public firm without being
acquisition bring a public offer offer has been required to bring a
to the existing increased to 25% public offer
shareholders
As soon as the 15% The offer size has The revised offer
limit reaches, the been changed to size will provide an
acquirer has to 26% exit option to more
Minimum make a public offer investors, who do
offer size to acquire another not wish to be
20% of the voting associated with the
share capital of the new acquirer

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 target company
Whenever an If an acquirer The rationale behind
acquirer, already holding 25% or creeping acquisition
holding 15% or more shares in a is that the
more shares, but target company shareholders are
less than 55% of will have to make given an opportunity
Creeping shares, acquired a mandatory public to exit every time a
acquisition more than 5% offer, if he major shareholder
voting rights in the acquires more than increases his
target company in a 5% voting rights in shareholding in the
Financial Year, the target company target company by a
then he had to in a Financial Year material percentage
make another man- (SEBI considers 5%
datory public offer as the material
to the remaining percentage)
shareholders
If the holding of an With the increase in
acquirer in the the limits of initial
Limit of target company acquisition and the
55% - 74% reaches 55%, then No such provision minimum offer size
he has to bring a in the new takeover
mandatory public code, this provision
offer, every time he has become almost
acquires even a redundant
single share in the
target company

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 Under this code the The payment of
acquirer could non-compete fees to
Non make a payment up No such payment the seller promoters
Compete to 25% of the offer in the nature of results in differential
fees price to the seller non-compete fees pricing, which is
promoters to is allowed under against the principle
prevent the later the rules of new of equity*
from entering the takeover code
same business

Recently, in the Cairn-Vedanta deal (year 2012-2013), the seller

promoters were likely to be paid Rs. 50 more than the remaining
shareholders representing a non-compete fee, which was rejected by
regulatory authorities. Abolishing this explains that the price
premium will be distributed over a wider base of shareholders

Rationale behind the New Takeover Code – The main object

behind the new takeover code is to align India’s M&A scene to the
global practices. The code spells different things to different
stakeholders, stated as under:

1. For Retail Investors - The retail investors will be benefitted with

the removal of the non compete fees. Henceforth, the price
premium will be distributed over a wider base of shareholders and
not just to the promoters.

2. For Institutional Investors – The earlier threshold limit of 15%

was too early to trigger an open offer considering the fact that a
major portion of almost all the listed companies is financed by the
Private Equity (PE) firms. The 15% limit meant that the PE had to

103
 restrict their holding in the company to less than 15% if they did
not want to make an open offer. But with the new takeover code,
the institutional investors, especially the PE firms will now be able
to acquire up to 24.99% without triggering an open offer, which
means that the listed companies do not necessarily have to depend
only on public markets for capital.

3. Easy Exit to Shareholders – The minimum offer size has been

increased from 20% to 26%. However, this has been a matter of
controversy.. The 12 member takeover advisory committee had
recommended a 100% public offer once the trigger button is
pressed as it will give all minority shareholders an opportunity to
exit. The corporate sector was not favour of the proposal, because
a public offer to all the remaining shareholders would have proven
to be very expensive as there would be a lot of financial issues in
raising finances for the entire remaining shareholding. The main
financial concern is that the RBI does not allow banks to finance
domestic acquisitions; hence a middle path was chosen and
minimum offer size was increased from 20% to 26%

4. For Promoters – The new takeover code means, that the

promoters with low holding should increase their holding in their
companies to shield themselves from a potential hostile takeover
bid

Operation of Takeover Code – it operates in the following manner:

Step 1. An acquirer’s shareholding in the target company reaches the

initial acquisition limit of 25%

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Step 2. Acquirer makes a public announcement for public offer
at least to the extent of 26%
Step 3. Any other person may make a public announcement of
counter offer in within 15 days from the date of earlier public
announcement
Step 4. Public offer is actually made to the public shareholders (i.e.
other than promoter’s)
Step 5. Shareholders may accept or reject Year he offer
Step 6. The acquirer makes the payment to the shareholders who
accept the offer and completes the process of offer
Step 7. Subsequently, if the acquirer acquirers in a Financial Year
more than 5% voting rights in the target company, then again
he has to make another public offer in the same manner.

Procejure of Open Offer:

Step 1. Appoint a merchant banker [Reg. 12(1)]

Step 2. Before making a public announcement, open an Escrow a/c.
with the following amount:
1. 25% amount of the consideration value payable under the
open offer on first Rs. 500 cr. (Rs. 100 cr. in old takeover
code)
2. additional 10% of the balance value of purchase
consideration [Reg. 17(1)]
Step 3. 1. send public announcement to the concerned stock
exchange/s, SEBI and target company
2. publication of announcement in English daily, Hindi
daily, Regional newspapers of the concerned stock
exchange/s & Regional newspapers of the area of the

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 target company
Step 4. within 5 days (14 days in the old takeover code) from the date
of public announcement, file a draft letter of offer with SEBI along
with non refundable fee (calculated on the basis of consideration
payable under the offer)
Step 5. 1. SEBI can give its comments on the draft letter of offer
within 15 days (21 days in the old takeover code) from the
date of receipt of such draft letter of offer.
2. if SEBI specifies any change, then make such changes in
the letter of offer (LO) before dispatching to shareholders
3. if no comments are specified by SEBI, then it shall be
deemed as approved by the SEBI [Reg. 16(4)]
Step 6. within 7 days from the receipt of the comments from SEBI or
where no comments are offered by SEBI within 7 days, the
LO should be dispatched to shareholders.

Conclusion:
Though the new takeover code has increased the threshold limit and
the minimum offer size, but it is still felt that the RBI should do away
with the restriction on banks to fund domestic acquisition.

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 LEVERAGED BUYOUT (LBO)
LBO is defined as the acquisition financed largely by
borrowing against all the assets or few of the assets of the
acquired company by a small group of investors. Acquirer
group may consult advisors and investment bankers that
arrange such deal. A LBO debt financing typically represents
50% or more of the purchase price. The debt is secured by the
assets of the acquired firm and is usually amortised over a
period of less than 10 years and is paid off from the funds
generated from operational activities or form the sale of assets
of the acquired firm. Following completion of the buyout, the
acquired firm is usually run as a privately held company. The
combination of high debts with its threat of bankruptcy pays
the way of creating incentives for managers to improve the
company’s performance.
Generally, in more than 90% of the LBO transactions,
purchase price of an acquisition has been financed with debt.
The tangible assets of the target firm are used as collateral for
the loan. Hence, LBO is a financing technique used by the
acquirers. Bank loans are primarily secured by the liquid
assets of the acquired company such as receivables and
inventories, while a portion of long-term senior financing is
secured by the acquirer’s assets. Subordinate debt or junk
bond is used to raise the balance amount of the purchase price.
In a typical LBO, a group of investor’s purchase a presumably
underperforming firm by raising an unusually large amount of
debt relative to equity capital (may be up to 5 as debt-equity

107
ratio). The strategy is to restructure the firm, improve its
performance and increase the cash flows generated by the
firm’s assets in order to repay a large part of the initial debt
within a reasonable period of time, say 3 to 5 years. The new
shareholders do not normally receive any cash dividends
during restructuring period.
Improperly structured LBOs can be disastrous and may lead to
bankruptcy, if a highly leveraged transaction is not backed by
sufficient cash flows. The new company created by the LBO
must be strong enough to meet its obligations to its creditors
and investors.
The ability to execute LBO transaction depends on the level of
market prices and the availability of high yield financing.
Leveraged Buyouts are now international phenomena and
have become global in scope. They play an important role in
the renewal of the economic system. The pricing for an LBO
depends on the debt capacity of the company and the return
required by investors. Debt capacity determines how much is
left for equity holders at exit time.
PROCESS OR STAGES FOLLOWED IN LBO - Basically
there are four stages in LBO operation that are stated as
under:
In the I stage, the target company is identified and selected,
there after the LBO firm enters into the lengthy process of
“Due Diligence and Deal Structuring”, if satisfied, then a
detailed business plan and financial details of the transaction

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are negotiated with the current owner. Generally, the equity
base of the new firm, say 10% is contributed by the top
management of the acquirer. Outside investors provide the
remainder of the equity. About 50% to 60% of the required
cash is raised by borrowing against company’s assets in
secured bank loans. The rest of the cash is obtained by issuing
senior and junior subordinated debt in a private placement or
from public offering.
In the II stage of operation, the acquirer buys all the
outstanding shares of the company or purchases all the assets
of the company.
In the III stage, the management tries to increase profits and
cash flow by cutting operating costs and changing marketing
strategies. It may even lay-off employees, cut spending on R
& D.
In the IV stage, the investor may take the company public
again, provided the company emerges financially stronger and
the goals of the group are achieved.
HISTORY OF LBO - Immediately after WW II,
entrepreneurs in USA, who were considering retirement, were
concerned with the continuity of their family businesses. They
were also worried about the impact of estate taxes upon their
death. Consequently, in the 1950s and early 1960s, they sold
their businesses at or below book value to the new generation,
who were willing to expand the newly acquired businesses.
Such buyers generally provided equity amounting to 20% to

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25% of the purchase price and borrowed the remainder from
financial institution, using the assets of the target firm as
security to the lender in order to pay their dues. A portion of
the purchase price thus received was utilized to pay any taxes
owed by the seller.
By the early 1970s, in the wake of escalating bankruptcies and
sky-high price-to-earning (P/E) ratios, the interest of the
public got shattered. Therefore, a renewed interest in LBOs
emerged in the late 1980s. Great depression of 1930s created
discontentment amongst investors on account of the poor
response for financing of debt that followed WW II.
Though LBO in India is not as popular as in foreign countries,
but this phenomenon is being witnessed from the year 2007
onwards, when about a dozen companies have taken debt of
nearly $1.5 bn. to buy foreign companies, which were about 3
to 5 times bigger their size. The observed trend is that the
companies are taking debt of about 4 to 5 times their net worth
at a steep rate of interest, as high as 9% to 10% on their LBO
loans.
India’s first global LBO was Tata Tea buyout of U.K’s
Tetley in March 2000. For funding the acquisition of Tetley,
Tata Tea floated a special purpose vehicle (SPV) Tata Tea GB
in UK, by capitalizing it with £71 million, consisting £60
million from Tata Tea, £10 million from Tata Tea Inc and £1
million from Tata Sons.

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In ------Tata Steel took loans of about $7 bn., more than twice
of its net worth for the Corus deal and created a special
purpose vehicle (SPV) to take debt against the assets of the
acquiree. The acquisition of Corus made Tata Steel world’s 5th
largest steel producer.
In 2007 India’s largest aluminum producer Hindalco
Industries, with revenues of $4.57 bn. and a manufacturing
capacity of 4,61,000 tons acquired $9.8 bn. Novelis of Canada
for $6 bn. The debt component of deal amounted to $3.1 bn.,
which was about 5 times the company’s net profit of $650
million and 70% of its revenues in the year 2006-07. Hindalco
became a world leader in aluminum after the acquisition of
Novelis.
United Spirits acquired Glasgow based whisky maker Whyte
& Mackay for $1.18 bn., of which $675 million was raised
through loans. UB group, after acquisition was catapulted into
the position of world’s liquor maker, behind UK’s Diageo
In 2006, Dr Reddy’s bought German generic drug maker
Betapharma for $570 million, of which $475 million was
raised through loans.
Hyderabad based Rain Calcining funded its Rs. 2,440 cr.
acquisition of the US based CII Carbon with a debt-equity
ratio of 4:1. CII carbon acquisition made Rain Calcining
world’s largest producer of calcined petroleum coke, a raw
material used in aluminum and titanium dioxide production.

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There are many reasons for Indian companies adopting the
debt laden LBO rout, because RBI prohibits domestic
companies from leveraging more than 3 times their net worth
for foreign acquisitions. Hence, companies have to take debt
on their own balance sheets.
REASONS TEMPTING FOR LBO:
 Firms having good financial structure are more vulnerable to
takeovers.
 Firms having better cash flow relative to their current stock
prices, highly liquid B/S, large amount of excess cash reserves,
and favourable security port folio are more attractive targets.
 Companies with steady cash-flows, significant unused debt
capacity and steady growth are the main candidates for LBO.
 Another reason for promoting LBO is the period of sustained
economic growth since 1982, which has pushed the growth of
merger and acquisition activity
REMEDIES TO STOP LBOs TAKEOVER - Anti takeover
measures can be divided into preventive and defensive
measures, given as under:

 The firm can take defensive measures to make it less attractive.

Hence, it can sell its attractive assets, increase debts and use its
cash reserves in paying more dividends or make a call to buy
back its own shares.
 Preventive anti-takeover defenses include anti takeover
amendments, dual capitalisation and using hostile takeover

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 tactics, such as poison pill, parachutes and buy back of shares
etc.
 Sometimes, an LBO or MBO or announcement of going private
is a defensive measure against a feared or unwanted takeover,
which may sometimes stimulate competative bids by outsiders.
TYPES OF LEVERAGED BUY OUTS - LBOs are either
asset based or cash flow based. As there are high chances of
bankruptcies in the overleveraged cash flow based LBO, the
most common form of LBO today is asset-based. This type of
LBO can be accomplished in the following ways:
1. The sale of assets by the target company to the acquiring
company, or
2. A merger of the target company into the acquiring company
(direct merger), or
3. Merger of a wholly-owned subsidiary of the acquiring company
(subsidiary merger)
4. LBO
5. MBO
6. MBI (Management Buy In) – In this case, the team of managers,
who are proponents of the initiative are external to the target
firm.
7. BIMBO (Buy Out Management Buy In) – In this case the
nucleus of the proponent, is composed of some managers
operating within the target firm, who are in a position to involve
in the initiative.
8. FBO & FBI(Family Buy Out & Family Buy In) – FBO happens
when a group of shareholders inside the owning family, takeover

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 the share of other members who are not interested in the
maintenance of their investment in the target firm. If a part of
the owning family decides to exit from the firm in reference to
try to buy another corporate entity using a LBO, then it is called
a family buy in (FBI)
 WBO (Workers Buy Out) – This type of deal is widespread in
the United States, which envisions that the acquisition is done
by the dependent workers of the target, through the intervention
of pension funds and the use of employee stock ownership plan
(ESOP)
 CBO (Corporate Buy Out) – In this case the acquirer is a
company desirous of growing through external means without
inserting the acquired company directly into its corporate
family. On the other hand, the transaction would be visible and
connectable with the acquirer at the time when the latter would
be considered a part of the group
REVERSE LBO - A reverse LBO occurs when a company
goes private through an LBO and becomes public again at a
later date. This may be done if the buyers who take the
company private believe that it is undervalued, perhaps
because of poor management. They may buy the firm and
bring in various changes, such as replacing senior
management and other forms of corporate restructuring. If the
new management successfully converts the company into a
more profitable private enterprise, it may be able to go through
the initial public offering (IPO) process again. This may make
the assets of the LBO candidate undervalued in a poor market
and possibly overvalued in the bull market.

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VALUE CREATION OR MERITS OF LBO - Debt is
always cheaper than equity and can create more value as
compared to the firm having more modest level of debt.
Because a high debt level increases the tax savings that
increases its EPS and thereby, making an increase in the value
of firm. LBOs are expected to create value through:
1. the discipline of debt that reduces the abuse of free cash flows
2. efficient monitoring done by buyout specialists
3. better alignment of managerial interests with the interest of
equity and debt holders.
4. expropriation of lenders through high leverage and making high-
risk investments
5. expropriation of government through tax subsidies on high debt
levels
6. reduction in agency cost
7. increase in efficiency, because a private firm is much
more efficient in taking decision
8. tax benefits.
9. increase in operating profits.
DIFFERENCE BETWEEN LBO AND AN
ACQUISITION: LBOs are structured transactions, where a
sponsor company uses another company or creates special
purpose vehicle (SPV) to borrow the funds for acquiring the
target firm. In an acquisition, usually the company that is
being acquired is used to raise the funds to ensure no financial

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liability flows back to the sponsor. The acquirer gives
managerial and operational support to the project but shuns
financial responsibility for it.
FEATURES OR CHARACTERISTICS OF LBO - There
are certain characteristics of LBO that the lenders would look
for in a prospective LBO candidate. A few of them are given
as under:
1. Stable cash flows (Sustainable and regular cash flow) –
Statistical measures, such as the standard deviation, may be used
to measure the variability of cash flow. The more erratic the
historical cash flows are, greater the perceived risk in the deal
would be. Even in cases where the average cash flow exceeds
the loan payments by a comfortable margin, the existence of
high variability may worry a lender. The lender must make a
judgment as to whether the past will be a reliable indicator of
what the future will hold.
2. Stable management – Lenders feel more secure, when the
management is experienced and it has been with the firm for a
reasonable period of time that will indicate that there is a greater
likelihood that the management will stay on after the deal is
completed.
3. Scope for substantial cost reduction – If the target firm has
potentiality of cutting costs in some areas, such as cut in extra
employees, reduction in capital expenditure, elimination of
redundant facilities, tightening cost controls on operating
expenses and so on. Cuts in R&D expenditure may cause the

116
 company to fall behind its competitors and eventually lose
market share, hence acquirer should take care of these cuts.
4. Equity interest of owners – The collateral value of LBO
candidate provides risk protection to lenders. The equity
investment of the managers, buyers and outside parties also acts
as a cushion to protect lenders. More participation of the
manager’s equity indicates their likelyhood of staying with the
firm.
5. Debt capacity – Lower the amount of debt on the B/S of the
target firm, greater will be the borrowing capacity of the firm.
Greater leverage (debt-equity ratio) will be more cumbersome to
finance the LBO candidate.
6. Non-core business – If the LBO owns some non-core
businesses that can also be sold off in order to pay off a
significant part of the firm’s post-LBO debts, then the deal may
be easier to finance.
7. Other intangible factors – The existence of unique or
intangible factors may provide the impetus for a lender to
provide financing. A dynamic growing and innovative company
may induce lenders with sufficient incentives to overlook some
shortcomings. Both lenders and the incumbent managements of
LBOs need to identify in each LBO candidate, the existence of
different products or services with a different history.
FINANCING OPTIONS AND CAPITAL STRUCTURE
FOR LBOs -The LBO buyer has a number of financing
options and the ideal objective is to finance the transaction out
of cash held by the target firm in excess of normal working
capital requirements. But such situations are rarely found.

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Venture capital investors are also available to fund the LBO
transaction. However, it may represent very expensive
financing, since at times the buyer may have to give up as
much as 70% of the ownership of the acquired company to the
venture capitalists. The seller may be willing to accept debt
issued by the buyer if an up-front cash payment is not
possible. The use of a public issue of the long-term debt to
finance the transaction may minimize the initial cash outlay,
but it is also subject to restrictions as to how the business may
be operated by the investors, who are buying the issue.
Moreover, public issues are expensive in terms of
administrative, marketing and regulatory reporting costs. For
these reasons, asset-based lending has emerged as an attractive
alternative.
FINANCING OF LBO - Generally, two types of debt, such
as Senior debt and Junior subordinate debt are employed in
LBO, given as under:
1. Senior debt consists of loans secured by liens on particular
assets of the company. The collateral, which provides the risk
protection required by lenders, includes physical assets such as
land, plant and equipment, accounts receivable and inventories.
Lenders usually will give 85% of the value of the accounts
receivable and 50% of the value of the target inventories
(excluding work-in-progress)
2. Junior debts or mezzanine debt financing has both equity and
debt characteristics. For such type of financing, lenders receive

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 warrants that may be converted into equity in the target firm in
future.
Debt referred as subordinated junior debt has a secondary
claim on the assets of the target firm. Junior debts are not only
subordinate to senior debts but also to trade creditors.
Unsecured financing often consists of several layers of debt
each secondary (subordinate) in liquidation to the next most
senior debt. Those with the lowest level of security normally
get the highest yields to compensate for their higher level of
risk. The warrant allows the holder to buy stock in the firm at
a pre-determined price within a defined time period.
JUNK BOND - A high yield or ‘junk’ bond is a bond issued
by a company that is considered to be a ‘higher credit risk’.
The credit rating of a high yield bond is considered
‘speculative’ or below ‘investment grade’
A case study of LBO of Tetley (UK) by Tata Tea:
In 2000 Tata Tea Ltd. acquired the ‘UK heavy weight brand’
and the world’s second largest tea producer Tetley for £271 m
through a cross border LBO deal, giving a good signal of
acquiring global brand which was the first ever LBO deal by
an Indian company. This method of financing had never been
successfully attempted before by any Indian company.
Tetley’s price tag of £271 m ($450 m) was more than 4 times
the net worth of Tata Tea that stood at $114 m. In 1976 Tata
Tea also acquired Sterling Tea companies from James Finlay

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& Company for Rs. 115 m, using Rs. 19.8 m of equity and Rs.
95.2 m of unsecured loans at 5% p.a.
Tata Tea created a Special Purpose Vehicle (SPV) as Tata Tea
GB (Great Britain) to acquire all the properties of Tetley, to be
capitalized as under:
Equity contributed by Tata Tea £ 15 m

GDR Issue £ 45 m

Tata Tea Inc (Equity by US subsidiary of Tata) £ 10 m

Total Equity £ 70 m

Debt * £ 235 m

Total Capitalisation £ 305 m

[Debt-Equity Ratio 3.36]

* The loan of £235 m was funded by junior loan subscribed by institutional

investors including the vendor’s institution. Mezzanine loan was arranged by
Intermediate Capital Group Plc and the senior debt financing was arranged and
underwritten by Rabobank International.

MANAGEMENT BUY OUTs (MBOs)

MBO is a specific type of LBO that occurs when the
management of a company decides to take over its publicly
held company or any of its division and consequently makes it
private. Management relies on borrowing to accomplish this
objective. To convince stockholders to sell their holding, the

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management must offer them a premium above the current
market price.
MBO occurs when the management of a company buys out a
distinct part of the business which the company is seeking to
divest. MBOs usually arise because a parent company decides
to divest a subsidiary company for strategic reasons, e.g. it
may decide to exit a certain activity to concentrate on its core
activities.
When the management feels that the business has great
potential as compared to the parent company, MBO is called
purchase driven. Many managers thrust an MBO, when the
existing owners feel a particular part of the business, as a non-
core to the company and hence, may be planning either to sell
or close it. Therefore, they may be more open to MBO offers.
Family-run businesses are frequently taken over through
MBOs, because the existing directors might not have any
children interested or capable in running the business. In these
circumstances, they may be keen to ensure the business and its
workforce continues to work successfully.
Generally, companies prefer MBO, because it gives them the
best value, without running the risk of exposing trade secrets
to the competitors.
MERITS OR MOTIVATIONS FOR MBOs - There are
various factors that drive the managers to become owners of
their businesses being run under the direction and control of

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their parents. Generally, in MBOs managers invest hardly 1%
in equity of the total funding for a buyout, but it may still
represent a substantial part of their individual wealth. Various
studies have shown that one of the most important reasons is
the desire to run one’s own business. Some of the important
managerial motivations in MBOs are stated as under:

 Opportunity to control own business

 Long-term faith in company
 Better financial rewards
 Opportunity to develop own talents
 Absence of head office constraints
 Fear of redundancy
 Fear of new owner after anticipated acquisition
Raising funds in MBO-(A case study)
Example: DRG Litho Supplies Ltd. was bought out by the
management team for £23.35 m in 1989. A new company,
L.S. Holdings Ltd. was formed to acquire the business.
Financing was made as under:
Price payable to vendor £ 20.70 million

Working capital £ 1.65 ,,

Fees £ 1.00 ,,

Total Price £ 23.35 million

Financed by:

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 Management equity £ o.50 ,,

Institution: Share capital 7.35 ,,

Mezzanine 4.00 ,,

Senior debt: Term loan 7.00 ,,

Overdraft and short term 4.50 ,,

£ 23.35 million

In the above example senior debt of £ 11.5 m is backed by £11.85 m

of equity and mezzanine debt. However, larger the mezzanine’s debt,
the greater would be the cash outflow, smaller the retained earnings on
account of interest payment, the smaller would be the resulting net
worth of the target firm. Senior lenders are therefore wary of too much
mezzanine debt, although it ranks behind senior debt. Institutional
equity providers earn their reward from the return realized at the time
of exit of the LBO. Equity investors may expect an internal rate of
return (IRR) of 25% to 30%. The return depends on the risk of the
LBO, demand for funds, competition among institutional equity
providers and the lead time to exit.

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 EMPLOYEE STOCK OPTION PLANS (ESOPs)
Stock option plans have been used to reward the top
management and ‘key’ employees of an organisation. The
popularity of employee’s ownership and profit sharing has
increased since the late 1980s and seen as an important tool of
human resource management. The rationale behind ESOPs is
that they help companies to retain staff, attract talent, motivate
employees and enable them to share the long term growth of
the company. It gives an employee the right to purchase a set
amount of shares at a fixed price in future.
At present, ESOPs have become the norm in high technology
companies and are becoming popular in other industries as an
overall equity compensation strategy. Basically, ESOPs work
in industries where intellectual capital is precious and attrition
level is high. Dynamic ownership culture symbolizes the
promotion of engaged employee’s ownership, which could
enhance the performance of a company. Financial and
psychological aspects of ownership engage employees in
giving better business results and act as an incentive to
increase productivity and performance
Despite the advantages the ESOPs possess, it has led to many
problems, such as dilution in the interest of outside
shareholders. In fact, shareholders of companies, like
Peoplesoft, Intel, HP and IBM, have recently rejected

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proposals to grant ESOPs to its employees. In Dec. 2003,
Microsoft decided to do away with ESOPs.
One of the main limitations of ESOPs is that it operates
effectively in profitable firms only. The ESOPs trend in India
indicates that maximum companies offering ESOPs are MNCs
Indian companies, working in technology sector.
MERITS OF ESOPs
 as a motivating tool to improve worker’s involvement and
productivity
 decrease in tax burden
 wage concession that increases employee’s income
 helpful in making defensive bid for future takeovers.

DUE DILIGENCE
INTRODUCTION – Due Diligence is the process through
which a potential buyer evaluates a target company or its
assets for acquisition. With reference to M&A, it covers the
following aspects of the target company:
1. organizational and managerial structure
2. operational aspects that include production technology, process
and systems
3. financial aspects that include operating performance information
and potential tax liabilities.
4. human resources environment

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 5. various legal and regulatory aspects
6. information system
7. qualities of assets and liabilities
8. labour issues
NEED FOR DUE DILIGENCE - These days, organizations
operate in a very uncertain environment that is full of risks,
some of which can be controlled, but most of which cannot.
To understand the past and future earning capabilities of the
entity, one needs to analyse thoroughly the industry and the
environment in which one is expected to operate. DD becomes
important due to the following reasons:

 It enables the investors to know the strengths and weaknesses of

the target company.
 It gives a fair value of the investment to the potential investor,
thereby, increasing his bargaining power. In its absence, the
investor often relies on facts and figures provided by the vendor
that need not necessary be correct. Once the process of DD is
completed, he has the following options:
1. withdrawing the deal, or
2. adjusting the valuation of the deal, or
3. going ahead with the deal
 It helps in identifying the hidden irregularities existing in the
business of the target company.
 It is an effective tool for ensuring that the prevailing system of
check works. In creating a system, one must consider all aspects
of business, from the design stage to after-sale, identify the
risks, adopt appropriate controls and safeguards, record the

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 action and keep the system under review. All this can be
achieved through DD.
WHAT DOES DUE DILIGENCE INVOLVE - DD is a
very lengthy process that involves the following:

 Historical financial data

 Current financial data, such as company’s books & financial
records, analysis of financial statements, quality of current-
assets, etc.
 forecasted financial information
 business plans
 minutes of director’s meetings
 audit paperwork files
 contract with suppliers, customers and staff and so on
DD should not be restricted to reviewing documentation alone.
Discussion with the staff, both formal and informal talks,
visiting the premises of the target company and observing the
ongoing activities also give an idea about the state of the target
candidate, one needs to analyse the past, present and future
business prospects of the related industry and firm. The
analysis covers all the areas highlighted and the entire process
is carried out through DD. The potential buyer carries out
extensive due diligence to know more about the target
company. The expectation of the buyer is to get better value’
from the acquisition. During the process of DD, the buyer
takes steps to reduce uncertainties. It also considers a detailed
study to look for conflict of interest and other problems.

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PARTIES INTERESTED IN DUE DILIGENCE - Apart
from acquirer and acquiree, there are other parties interested in
the outcome of the DD process. Interest of few of them is
stated as under:
1. Employees – DD is undertaken to address the fears of the
employees that they might be laid off or their salaries may be
reduced after merger.
2. Trade Unions – Trade Unions are interested in DD, because
they want to ensure that no employee faces the axe or cut in pay
post merger. They ensure that the agreement addresses the
concerns of the employees and assures them continuity in
employment.
3. Shareholders and Creditors – Shareholders and creditors have
a financial stake in the business. They are not only concerned
about the principal amount invested by them, but also expect
regular returns from the target firm. DD gives them a fair idea
about the risk involved in the project, which in turn determines
future returns from the business. If DD indicates that the project
is highly risky and returns are uncertain, they may decide
against making an investment in the business and vice-versa
4. Vendors – Vendors are entities who supply various inputs, such
as raw-material, tools and equipment to the business. The
decision of continuing the relationship or distancing one’s
business from the entity is based on the results of DD.
5. Customers – Customers desire that their needs and
requirements should be fulfilled by the company. DD provides
details about the future operational strategy of the business and
helps them decide on their consumption patterns.

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 6. Government – The Govt. can decide on the course of action it
needs to pursue to protect the interests of the stakeholders. If it
finds that the merger will have an adverse impact on the
stakeholder’s rights, it may enact laws to prevent or reduce the
adverse impact of the merger.
7. Society – It is important for the society to understand the
consequences of M&A and make itself ready for appropriate
action. This is where the DD process provides it with the much
needed feedback and basis for action.
PROCESS OF DUE DILIGENCE - The most effective due
diligence process begins in the earliest stages of the
acquisition. The due diligence process should help the firm
selecting its target so that value creation occurs with a long-
term perspective, through competitive advantage. If a wrong
target firm is selected, the due diligence process may not have
much value. Dynamic due diligence begins with an
empowered due diligence team with the responsibility and
authority to obtain and analyse information for effective
integration.
A critical part of the due diligence process is analyzing the
firm’s financial resources. This should include return on assets
per employee, economic value added, percentage of revenues
and profits from new businesses. Due diligence process also
carefully and completely analyses customer and marketing
related issues. Customer relationship issues should be
evaluated and a customer satisfaction index be developed.

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The analysis of major processes, like manufacturing and
provisions of services, is another area of importance in the due
diligence process. This analysis may include achievement of
quality goals, assessment of effectiveness of management
information systems and administrative expense per employee.
Due diligence will help firms to minimize the risks involve,
especially for the acquirer. In another perspective, due
diligence also involves mutual review by both the acquirer and
target. The basic aim of DD is to assess the benefits and
liabilities of a proposed acquisition by exploring the status of
the business, particularly the future of business along the
framework of risk.
The role of investment bankers is vital as they can add value
by identifying appropriate acquisition targets. The top
investment banking institutions providing support for mergers
and acquisitions include Merrill Lynch, Morgan Stanley,
Goldman Sachs, Salomon Smith Barney and Amarchand
&Mangal Das
A major DD problem is known as managerial hubris.
Overestimation and hype about the target firm may become
the major reason for the high premium paid for acquisitions
Equity in human resource system can be bought out only by
rectifying differences in compensation structure and
performance appraisal system. Another area of concern is the
grading or organizational structures. Issues related to
management-union relations, number of trade unions and the

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dynamics among trade unions also occupy much significance
in the DD.
DUE DILIGENCE REPORTING – The DD report should
be submitted to the management for consideration and
adoption, which may contain the following issues:

 It should reflect a fair and independent analysis and evaluation

of financial and commercial information
 It should ensure collection, analysis and interpretation of
financial, commercial and tax information etc. in detail.
 The report should provide properly reviewed financial
information to bidders and various stake holders.
 It should provide feedback on auditing of the special purpose
accounts.
TYPES OF DUE DILIGENCE – DD provides valuable
information to the buying company and helps in identifying
the right target. The different types of DD made, include the
following:
1. Financial Due Diligence – It analyses the financial performance
of an entity, both qualitatively and quantitatively.
2. HR Due Diligence – It is a process that aims at evaluating the
contribution of the HR function to the success of the business in
a purchasing, outsourcing or market testing environment.
3. Intellectual Property Due Diligence – IP DD is a process that
provides a prospective investor with detailed information about
the intellectual property assets of a target company. These assets
often affect pricing or other key elements of the proposed

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 transaction or in certain circumstances, even recommend
termination of proposed investment. IPRs can be broken down
into four main categories, given as under:
a. Patents b. Copyrights
c. Trademarks d. Trade secrets
4. IT Due Diligence – IT DD involves analyzing the use and
relevance of IT services for business operations, management
information and financial reporting in business. It also involves
finding better ways of deriving value and leverage from IT
assets.
5. Legal Due Diligence – Legal DD consists of scrutiny of all or
specific parts of the legal affairs of the target company with a
view of uncovering any legal risks and providing the buyer with
an extensive insight into the company’s legal matters
6. Operational Due Diligence – Operational DD involves
operational activities of the business and on sight analysis of the
daily proceedings of the target business. The analysis includes
an evaluation of the key employees, managers, independent
contractors, suppliers and other factors that are necessary for the
business to conduct normal operations.
DUE DILIGENCE IN INDIA:
Any M&A in India has to be carefully planned and executed,
cutting through a wide spectrum of tax and regulatory issues,
such as exchange control, income tax, and capital market
regulations, etc. Outbound acquisitions are guided not only by
the tax laws of foreign countries but also by political
relationships, free trade agreements (FFTs) and double

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taxation avoidance agreements (DTAAs or tax treaties)
between the countries. Deal structuring from tax perspective
has become one of the most important, because very few
geographies have similar legal systems.
As per RBI’s guidelines Indian companies cannot bid for
overseas acquisition for more than 2 times of their own net-
worth. As per Indian Company’s Act, if the acquisition value
exceeds 60% of the Indian company’s net-worth or 100% of
its free reserves, then the Indian company is required to take
prior approval from its shareholders for making the investment
in the target company, thereby disclosing vital details about
the target company to the shareholders, including price being
paid.
The business and legal system in India differs from the
systems of overseas. Each country has its own set of issues,
regulatory framework in terms of legal and judicial system,
tax regime, social and cultural issues and business dynamics,
etc. There are geographies that have similar legal systems.
A few cases of failure – Due to improper application of Due
Diligence, certain failed cases of M&A are given as under:
Quaker oats had acquired Snapple beverage co. in 1994 for
$1.7 bn. In 1997, it had to sell Snapple for only $300 million
that was less than 18% of the original purchase price.

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AT&T bought NCR Corporation for $7.5 bn. in 1991.
Afterwards, NCR accumulated almost $4 bn. net losses before
AT&T spun it off as a separate company.
Novell lost almost $700 m. on its acquisition and sale of
World Perfect
Sony’s controversial acquisition of Columbia Studios for $5
bn. Sony had to pay $800 m. to two producers in order to
extricate them as they had signed a long-term contract with
Warner Brothers.
Union Pacific’s acquisition of Southern Pacific is another case
where DD process was ineffective. It had to implement
substantial cost cutting actions immediately after its
acquisition. It had to lay off thousands of experienced workers
and consolidated the rail yard of two companies. But, shortly
thereafter, because of the crisis in the company, Union Pacific
lost its cargo business. In this case, DD process failed to
consider the importance of the experienced employees of
Southern Pacific.
A classical example of cultural issue is of HLL’s acquisition
of TOMCO. The employees of TOMCO had better terms and
conditions of service prior to merger. The employees of HLL
argued that if the TOMCO employees are allowed to work on
their original terms and conditions, it will lead to segregation
of employees into two classes reflecting discriminatory
policies.

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Similar problems cropped up during the merger of Glaxo and
Wellcome Burroughs in 1996. For 7 years the Indian
subsidiaries of these two companies could not merge due to
the different pay structure of the companies. The employees of
Wellcome refused the one time compensation of Rs. 2 lakhs in
1998. Hence, since then the companies are operating as
independent subsidiaries since 1997.
DIFFICULTIES IN DUE DELIGENCE PROCESS IN
INDIA:
1. lack of Adequate Information – Comprehensive information
required for DD process is not readily available with the Indian
companies due to lack of detailed management information
system
2. Quality of Information – the quality of financial statement,
financial infrastructure and business processes are generally
lower and less explicit than what western investors are
accustomed to. This results in the need to explore more risk
areas and take more time for the DD process.
3. Insufficient Disclosure – Inadequate disclosures impede the
ability to access critical information that might alter the
investor’s perception with regard to the value of the company
4. Lack of Corporate Governance – Companies are slowly
realizing the importance of corporate governance. Weak
corporate governance is often supplemented with tardy legal
system, where settlement of dispute takes a long period.

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 5. Dilution of control – Very often, founding members of a start-
up company refuse to give up control and want to satisfactory
settlement.

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