Just like the romantic union of global pop superstar Taylor Swift and Super Bowl champion Travis Kelce, in the business world, combinations of similarly sized companies – or so-called mergers of equals – can yield positive benefits if executed with care[1]. Successful mergers of equals transactions prove the age-old saying that the whole is greater than the sum of its parts by providing the go-forward company with new access to financing and the opportunity to diversify revenue, build to scale and/or streamline operations. As dealmakers know all too well, however, these transactions are easier said than done, and parties must remain focused on their theory of the deal to avoid a messy and prolonged transaction, or shall we say “bad blood.”
In this piece, we discuss the top 13 considerations for parties contemplating a merger of equals transaction. Are you ready for it?
Call it what you want – defining a merger of equals transaction and process
1. Overview of mergers of equals transactions
A merger of equals transaction varies from a traditional acquisition because one party is not taking control of the other party and no control premium is paid. Mergers of equals can be effected using various legal structures, with the ultimate structure typically driven by tax considerations. A key feature of a merger of equals transaction is that stock consideration is issued to the stockholders of one or both companies on a tax-deferred basis[2]. Any stock-for-stock combination of two companies with relatively similar valuations is typically referred to as a merger of equals transaction, and even some stock-for-stock acquisitions where the “acquirer” is valued significantly higher than the “target” share some key elements of a merger of equals transaction.
2. When it works, it works
Typically, a merger of equals transaction works best when similarly sized companies with complementary businesses can combine in such a way that one plus one does not equal two – it equals three. Upfront, the key component of a merger of equals transaction involves making sure that it is a good overall “fit.” In other words, consider the impact on employees, customers, suppliers and stockholders, because the transaction should be value-creating and beneficial for all stakeholders in order to be successful. Prime candidates for mergers of equals transactions are companies with complementary products in the same industry where a combination can enhance revenue growth, strengthen the balance sheet and provide access to capital at lower costs.
3. Process to protect value
Because of the complexities and sensitive issues involved, a merger of equals is not a deal for everyone. It is a bespoke transaction that will only make sense in certain situations. Dealmakers should consider keeping conversations at a high level until key issues are resolved. One strategy for moving forward in a merger of equals transaction is to agree on a timeline for aligning on key issues and then only move to drafting definitive documents once the key issues have been agreed. Negotiating a transaction can move quickly once key points are agreed – after all, each side is a “buyer” and “seller” and therefore many of the provisions in the definitive agreement, such as representations, warranties and covenants, are reciprocal.
You belong with me – valuation and financing issues in a merger of equals transaction
4. Relative valuation
Rather than focusing on the value of the consideration to be received by a target company’s equityholders, in a merger of equals transaction, the constituent companies are valued on a relative basis to determine the percentage of the combined company to be owned by each company’s equityholders. Post-closing adjustments for changes in cash, debt and working capital are challenging to implement and are not used as frequently in merger of equal combinations as compared to traditional private company acquisitions. As a result, the parties often agree to tighter interim operating covenants to limit any potential leakage of value.
5. Per-share valuation
Although most of the focus is on relative value, most mergers of equals transactions also require the parties to determine the deemed per-share valuation of each company, which is used to calculate the exchange ratio for convertible securities, such as options and warrants. Often, the relative valuation of each company is divided by the “fully diluted” shares outstanding of such company to arrive at a deemed per-share valuation. However, how the “fully diluted” number is calculated can vary and depend on various factors – such as the proportion of vested versus unvested options outstanding at each company and the exercise prices of outstanding options, warrants and other convertible securities outstanding at each company. Such calculations should be made on an “apples-to-apples” basis to ensure the agreed post-closing ownership percentage split of the combined company is reflected.
6. Treatment of equity awards and go-forward equity grants
Typically, the outstanding equity awards of the “target” (including vested awards) are assumed and converted into equity awards of the “acquirer” and remain subject to the same vesting schedule and terms (with the number of shares subject to such award and exercise price adjusted based on an exchange ratio set forth in the definitive agreement). The companies should consider the size and structure of go-forward equity awards, including any go-forward equity awards to address differences in historical equity award practices between the two legacy companies. Like in an equity financing transaction, the combined company will often establish a new go-forward equity pool. Such go-forward equity pool would typically dilute the shareholders of the two legacy companies on a pro rata basis and not be taken into account in determining the relative or per-share valuation of either company.
7. Structuring and investor rights considerations
The treatment of liquidation preferences of outstanding preferred stock of the parties often presents the most complexity in a merger of equals transaction and requires careful thought with respect to tax consideration and incentives. There are two primary ways of addressing the liquidation preferences of each company’s preferred stock. In the first structure, the parties can preserve the liquidation preferences (often with a cutback due to common stock being “underwater”) of each of the parties’ preferred stock. The preferred stockholders of the “target” may receive a mirror security of the “acquirer” replicating its existing liquidation preference in the “acquirer’s” capital structure (subject to any cutback), or all or certain classes of preferred stock of the combined company may be treated on a pari passu (equal footing) basis. In the second structure, the pro forma cap table of the combined company is “flattened” by converting all preferred stock of both parties into common stock. This structure may make it easier for the combined company to raise additional financing going forward. Conversion of all the outstanding preferred stock to common stock, however, will require stockholder approval and may require a complex negotiation with stockholders concerning the conversion rate for each class of preferred stock.
Delicate – key transaction execution issues
8. Extensive diligence
While there are some imperfect methods available to address post-closing recourse – including instituting a holdback or clawback of stock for indemnification claims or obtaining representation and warranty insurance policy – mergers of equals transactions are more likely than other private company acquisitions to be done on a no-indemnity, “public-style” basis, which makes it even more paramount for parties to conduct thoughtful diligence. The parties should align on the goals of the transaction to help zero in on the best processes and structure for diligence. The parties should treat the diligence process as an exercise to combat confirmation bias and ensure that the combination makes sense from a strategic, legal and financial perspective.
9. Allocating management
Deciding who will run the combined company, including the CEO and the rest of the C-suite, is often one of the most contentious issues in a merger of equals transaction. Sometimes, the allocation of management power can be an “easy” issue, because the management teams have complementary visions of the world and certain executives of one or both companies agree to step down (often after a transition period to ensure a smooth integration) or into an advisory or other role. Other times, a merger of equals transaction may make sense financially, but neither side is willing to cede management control, or the negotiations reveal a cultural clash between the parties that cannot be overcome.
10. Board composition and resolving deadlock
Like management control, the board composition of the combined company can be a hotly contested issue in mergers of equals transactions – including the size of the board, the incumbent directors of each party joining the combined company board and whether any new independent directors will be added to the board of the combined company. Even if the parties agree on the ideal board size, and that each side should get a number of board seats proportionate to its pro forma ownership percentage of the combined company, the individual desires of incumbent directors who want to remain on the board may need to be managed. If the parties do not have an equal number of board seats, the parties should consider what decisions require a supermajority board vote. There are many creative options available – including rotating the chair role, parsing out control to various subcommittees or recruiting a new independent director (or directors) who can hold a tie-breaking vote. Ideally, the combined company operates in a cohesive manner with a shared vision such that disputes are not common.
Reputation – integration and managing culture issues
11. Integration strategy
Focused diligence also yields benefits for the post-closing operations of the combined businesses. While parties must be careful to comply with antitrust regulations and avoid “gun-jumping” by making changes to their businesses before closing, parties can use their diligence findings to prepare for post-closing integration. The parties should consider determining the key principles of integration, developing a comprehensive integration strategy, preparing a consistent message and script for communications to employees, customers and suppliers, and anticipating any cultural integration issues. Taking the time to prepare in advance for integration and employee reactions will help the companies realize the hoped-for benefits of the deal.
12. Social issues
Governance and other “social issues” are more significant negotiating points in mergers of equals transactions, especially with companies of comparable sizes. This can be particularly challenging to navigate because of underlying emotional stakes. Aligning on the future goals of the combined company (including capital plans) can help inform governance plans. In the transaction, it is key to address company culture. Parties also should develop a plan to mitigate any risks resulting from a mismatch of company culture. Tangible social factors – business name, location and employee benefits – and intangible social factors – trust, values and vision – can impact the go-forward business if not adequately addressed and communicated in the integration process. It is important to come to a consensus on whether the combined company will use the name of one of the parties going forward or a new name, signaling a fresh start.
13. Workforce considerations
A merger of equals transaction often leads to employee redundancies. The parties should consider appropriate timing for any reductions in force, ways to mitigate adverse impacts to employee morale, and any legal requirements that need to be followed. The ability of the combined company to retain key employees is often an important factor in the outcome of a merger of equals transaction, so the parties should consider whether any changes to existing incentive plans or new incentive plans should be adopted to harmonize incentives between employees of the two legacy companies and properly employees on a go-forward basis. Refresh equity award grants out of a go-forward equity pool is often used as one solution to motivate employees to be invested in the success of the combined business.
Contributors
[1] Note to Swifties: As discussed below, most mergers of equals are not exactly “equal.”
[2] Note that mergers of equals can include some cash consideration (including to cash out non-accredited investors) or the payment of pre-deal cash dividends if the parties are not of equal value. The cash consideration would not be tax-deferred. In addition, cash will be used to pay off transaction expenses and, depending on the structure of the transaction, may be needed to pay off indebtedness for borrowed money. The parties will need to consider the sources of cash (including any funding required) to make these payments and leave sufficient cash on the combined company’s balance sheet post-closing.
