The Path to Successful Equal Mergers

0:00Hello, M &A friends. If you're looking to improve your in-house training, we have corporate training plans provided through the M &A Science Academy. Give your team members access to the best-in-class courses, templates, and networking opportunities in the industry. Our academy was designed to lead practitioners with the how-to of M &A practices. If you're interested in learning more about individual or team plans, go to mascience.com slash academy. It's also a great way to show your support for M &A science. Again, that's mascience.com slash academy. On to the interview.

0:45I'm Kisan Patel, and you're listening to M &A Science, where we talk with deal professionals and learn valuable lessons from their experience. This podcast focuses on stories, strategies, and what actually happened during M &A deals.

1:09Hello, M &A scientists. Here at M &A Science, our goal is to continuously expand our understanding of M &A and use that knowledge to create top-notch training programs and resources by visiting mascience.com. You'll find all the information you need to take your M &A skills to the next level. Get started by signing up for our free weekly newsletter. Stay up to date on our latest courses, upcoming events, and expert interviews. Again, that's mascience.com. I'm your host, Kisan Patel, CEO and founder of M &A Science. Joining me today is Scott Crofton, partner at Sullivan & Cromwell. Sullivan & Cromwell is an American multinational law firm that handles high-profile work such as complex M &A, securities litigation, white-collar defense, and government investigations.

1:54Today, we're going to talk about the intricacies of mergers of equals. Scott, how are you doing today? I'm good, thanks. Thanks for having me on today, Kisan. Thanks for taking a break from the big deals to have this conversation. My pleasure. Can we kick things off with a bit about your background? I've been a practicing lawyer for 17 years. I went to law school at Columbia, and I had a vague idea of wanting to practice corporate law, but I didn't know exactly what that meant. When I started my career, I was a generalist, and so I tried a lot of different things. I worked on securities, filings.

2:25I worked on private fund formation and debt financing, and I found a number of the things that I tried tedious, but I immediately took to M &A. I love the adrenaline that you feel on a deal. I love the roller coaster nature of deals and the highs and lows. And I found that was what really got me excited about getting up and going into work in the morning. And once I really got into M &A, I committed to it and I've been doing it ever since. And you work in a capacity to work on all different types of deals. Are you working across industries as well? I am. I spend a good amount of my time in the industrial space, but I've done a number of life sciences deals as well.

3:00We view ourselves at Sullivan & Cromwell as industry agnostic. We focus on getting the deals done. We have a lot of relationships in different industries. So we'll know key executives and board members in places and bankers. And that helps us develop relationships with folks. But at the end of the day, fundamentally, a deal is a deal. And we think we can work across industries. Any specific industry have more maturity when it comes to M &A or creativity or something unique? I find that the life sciences industry is really driven by M &A. So a lot of the big pharma companies, they have reduced their overall R &D spend and they've increased their M &A spend.

3:36And so you'll find that they have fully built out functions where they do a ton of M &A. They're kicking the tires on hundreds of deals a year and they really know their business well. And they're looking for how do we develop the pipeline. They're also in an industry in which there's always patent cliffs. they run into the risk of having generic competitors come in and significantly reduce their revenues on any given product at any given time. So their products have limited life cycles. They always need to be regenerating and developing new products they can sell on patent exclusivity. So that gives them a ton of reps at just doing deals.

4:10And they're very thoughtful and constructive at the way they approach deals to try to develop their pipeline. All right. Now I know where to go to take my next enemy notes here. Now, Scott, I came up in the industry with the philosophy that there is no such thing as mergers. Everything is an acquisition. So can we break this down? What exactly is a merger of equals? When does it happen? What does it look like? Is it actually a thing? And you are not alone in the view that there's no such thing as a merger of equals. But the reality is that there are deals that bear the hallmark of a merger of equals.

4:40So when we talk about an acquisition, what we're really talking about is a deal in which there's a premium being paid to take over control of a company. The target company's stockholders are receiving a 30 to 50 % premium on their stock, the controlling company gets to call the shots. The CEO of the buyer gets to run the combined company. The company is certainly not changing its name. Any changes to the board of directors would be modest at most if those take place. And the culture of the combined company is really going to inherit the culture of the acquirer. A merger of equals is designed to be different from all of that.

5:12It's designed to be a transaction in which no one is taking control. So there's no control premium paid to one side or the other. The deal is typically structured as a stock-for-stock deal, so it's tax-free. So that gives it a nice little boost to the economics of the deal. There are a lot of social issues because if you're not having one company acquire the other, then there's no one party that gets to call the shots. And you need to resolve those social issues in an equitable way that's going to leave both sides comfortable with the idea of combining two companies that have, to at least some extent, a different culture.

5:43Those social issues can be thorny. There are topics like who's going to run the combined company. So who's the CEO? What's the succession plan at the CEO level? What does the board look like at the combined company? How do you take two boards and turn them into one? And how do you make that board a manageable size? How do you allocate subcommittee positions? Where's the company going to be headquartered? Where's the sort of the focus of power going to be at the company? What's the company's name going to be? There are a lot of different questions that come up. And a lot of times merger of equals die before they get too far because of intractable issues related to these soft social issues that come up.

6:17I want my notebook already here. The characteristics of this mergers of equals is no control change. This is a tax-free transaction. I like the sound of that. And there's no premium being paid with that. So it's, and we'll talk more about that. And then there's the social issues that you got to address, which is who's going to be the CEO? What's this combined board going to look like? How do we right-size it as well? The subcommittees that need to be created. and where's the headquarters going to be. When you talk through having a tax-free transaction and then also there's no premium being paid, how does that come to be?

6:53Because if transactions happen, usually there's always tax things around it. And then there's got to be some assessment of value. How do you define that and position it where there's no premium technically around it? I'll take those questions in order. So first, on the tax side of things, there are ways to structure a deal so that if you're not receiving cash and exchange for your stock, but you're receiving a different form of stock, that the government doesn't view that as a taxable event. So therefore, as a stockholder, you maintain the basis you had in company A in the new company B or the combined company.

7:24So you never have a taxable event. It's basically like you just continue to hold your stock. So if you bought Apple 30 years ago and you haven't sold it, you haven't had a taxable event occur yet. It's the same thing, but the merger of equals doesn't trigger that. So there's no involuntary taxable event takes place. That's fairly easy to structure in an all-stock deal. from the perspective of why there is no stock premium, the answer to that question is you ultimately need to come up with a third-party way of valuing that. So for two public companies, you're going to compare and contrast, well, company A's stock is at 37 for a market cap of 5 billion today.

7:58Company B's stock is at 65 for a market cap of 4.8 billion today. There will always be a degree of argumentation as to, of course, we don't use the spot price. We use a BWAP of some sort. Is it 20 days? Is it 60 days? is how do you measure it? Or are you going to use the two market caps to compare? You're going to come up with the method to say, more or less, we should have an exchange rate that reflects basically just if you'd swapped one stock for the other. And so that usually leads to a very small premium and it depends on what mechanism you use as to whether there is a premium or how it's calculated.

8:29So a lot of people do the same math and come up with a slightly different number, but there's no 30 to 50 % premium that we see in a lot of M &A takeover type transactions. What does VWAP stand for? The volume weighted average price. So a lot of the times you'll take, for example, the typical one is a 20 day volume weighted average price. You look at the last 20 trading days, and you take that volume weighted average price and you say, okay, there's 3627 here, there's 4225 here, and you average it all together and you come up with a number. So the bankers will spend days and days arguing about which is the right metric to use here.

9:03And coincidentally, their math always aligns with what's in their client's interest. But usually you wind up with a solution to that if you've figured out the thornier social issues. How's this work in a private deal? That's trickier. There's no question. I've done one of those. There was a company called Inventive, which was private equity backed. It conducted a merger of equals with another company called INC, which was public. And the answer is, it's really the same way you conduct any other private deal. You eventually need to find valuation, even of a private company, since you're going to use the typical tools that bankers use.

9:32So there will be some sort of discounted cash flow analysis where they'll look at future earnings and they'll discount those, try to come up with the math that would work. There's a sum of the parts analysis where you try to evaluate individual pieces of the business and decide what it's worth altogether. You look at comparable transactions for companies with similar EBITDAs and other financial metrics, and you try to compare those. And you're comparing company A with company B. If company A has$6 billion in revenues and$1 billion in profits and company B is very close to that, I think you probably recognize that the valuation here is overall pretty close.

10:05It may not be quite as scientific as using a volume-weighted average price, but the same idea still applies. What do you usually see? Does it happen more in the public setting or private setting? It is certainly more common in the public setting, I would say. And it's a transaction that only works in certain circumstances because of all the soft social issues that I described. So it really is, it works best in a situation where there are two CEOs who have complementary visions of the world and where one CEO is prepared to no longer be the CEO of a combined company. Maybe they want to step up to a more senior role to be the chairman of the board and they're ready to retire from full-time duties.

10:41Or maybe there's going to be a transitional plan in place where one person is going to be the CEO for a few more years, help groom his successor, who would be the other CEO, who would then ultimately step into the role of CEO. But you need to really have the right mix of CEOs at the right point in their career cycle. And the two companies that are in the right place where it makes sense, there's a ton of synergy there. Their cultures aren't so dissimilar where they can try to find a way to make things fit together. So it's a tricky dynamic. It's most common in the public space where you have those factors in place.

11:13That's why I'm still trying to wrap my head around is how do you get these two management teams to come together? CEO doesn't want to step down. How's that going to work? The short answer is that usually doesn't work. I don't want to sugarcoat it. There are examples of some of the world's biggest mergers of equals have been failure. So AOL Time Warner was a merger of equals. I think that's generally recognized to be one of the worst deals in corporate history. So there are situations where it doesn't work. And a merger of equals, I would view as the exception in the M &A world, not the rule. Acquisitions are more common, but there are situations where there are two similarly sized competitors who have complementary businesses.

11:50is one plus one doesn't equal two, it equals three. It's just a question of finding the right situations and putting in place the right conditions and rules around how the combined company is going to be run that actually works so the combined company is a cohesive whole once it's combined. Do you have an example of it working really well? My client L3 Harris is the product of a merger of equals. They've been quite successful since that took place. Part of it is the question of, are you going to go with sort of an us versus them approach versus a we're all on the same team approach? And it's easy to describe that on a podcast, But putting that in place effectively in the real world can be challenging, but you can create a ton of value when you do it.

12:26We've had Daniel Gitzovich, who heads their corporate development on the podcast, and we've briefly mentioned it. But maybe that's one to revisit and take apart further in how that's been working. Going back to this management team, so taking that deal as an example, what about the rest of the management team? Obviously, there's the CEO and figuring out who's going to lead and if one is ready to move in a different direction so that they can work well together. but the different functional leads, the rest of the C-suite. Is that similar? How do you figure out how that's going to come together?

12:53I think those different deals make those decisions on different timelines. And so in some deals, you'll pre-bake everything up front where you have the decision, okay, this person's going to serve in the CF role. This person's going to serve in the GC role. Those types of decisions. In other deals, these conversations take place at such a high level. It's the chairman of the board talking to the chairman of the board. And it's really a board-driven process, unlike most deals, which are more management-driven, that sometimes you don't get into all of that at the earlier stages. Now, the two CEOs may have ideas how that works.

13:25And frankly, when the two CEOs have those conversations, there may be some sort of informal understanding. But typically, it's only the CEO role that's going to be formally documented and reflected in the public announcement of the transaction. On some deals, they take what they call a best-of-breed approach, meaning that they'll functionally have folks interview for their same roles at the combined company where they'd be taking charge, one person will take charge of a twice as large company. The other person may find a different role within the organization or may move on to different things.

13:53It's a concept that creates a lot of stress within an organization leading up to a merger of equals. And that's why these conversations take place at a high level. And oftentimes they don't move forward at all. But when they do, this is what happens. Yeah, I can imagine because an acquisition happens, sort of see it coming that, hey, they're acquiring us. I got some uncertainty about my role in the coming future here. You can see that. But this merger of equals, who's the best fit? Are we going to have a bake-off to see who's going to run this division going forward? So I could see that. How about the board of directors?

14:25Because you mentioned you can't just add them all up and have 25 board members. How do they right-size that? And is that like a similar exercise? You're typically not going to wind up with a much larger board than one or the other board. There are some key questions around who gets more directors versus the other side. There are different ways to handle that. One is to take the approach of, we're going to legislate for exactly how this works. One side has six, the other side says six, we'll have an even number of directors. One side's company will take the chair role of these two committees. The other will take the chair role at the other two committees.

14:58And you can prescribe things that way and then put in place super majority rules so that those rules can't be upset for a period of time. In other circumstances, you take the approach of, we're all in this together and we're going to form a board with overall the same number or very close to the same number of directors. We're going to hardwire the CEO rules. But otherwise, we're going to have a lot of retreats and try to find our kumbaya moments so that we view ourselves as a combined company. We see both in nearly equal amounts and it just depends on the approach folks want to take. You're not making any of this sound fun or easy at all.

15:30It's not. It is fun, but it certainly isn't easy. Fun for who? It's the opportunity to create a company that you could never create in any other circumstance. You're functionally two companies that could never buy each other, have a way to come together and create a much larger competitor. So a lot of the biggest companies in the world today, frankly, have been created by mergers of equals in the past. So the reality is that it's not always fun for everyone involved in the transaction. It's a transformative deal. And it allows you to do a deal using no cash that creates a company that's twice as large, which is functionally undoable in any other way.

16:03Good point. Can we talk about the execution of these type of mergers? we can walk through a timeline of events that happen. Yeah, sure. So like I said, the conversations that take place are typically at the board level rather than the executive level as an initial matter. Because of the disruption that a merger of equals can create, as you rightly noted, you're not going to have a big tent of folks involved in the deal until it's very clear that this has legs. So you'll have a very limited number of advisors involved. You'll have the boards of directors of the two companies involved, and they'll probably be talking to their CEOs.

16:35And those CEOs may involve a couple of their direct reports, but not more than that. And that's the dynamic in which the key social issues that I'm describing get hammered at. And the majority of the time, those key social issues don't get hammered at. It's only once you find an agreement on those threshold type issues that you're going to advance the ball and then you're going to advance the ball very quickly. To be candid, negotiation of the deal itself is typically rather easy because the parties know each other's business very well. they're very familiar with it, they're in the same industry, so they know what to look for.

17:09The deal is so big and much bigger than any other deal you do that the materiality thresholds that you're going to think about, about here's a red flag, are going to be much higher than they would be in any other circumstance. So the diligence you do is very targeted and focused on what are the big picture issues. When you're involving the other key components of the deal team, an outsized portion of it is around communications. Because explaining to the markets why combining these two companies is a very delicate topic. The market knows there have been big merger of equals that have failed in the past.

17:38They're going to want a good story as to why this makes sense. And both parties are putting themselves in play because they're both announcing functionally that they are, while not control is an upper sale, that functionally they are up for sale. And they're conducting a transformative transaction. And you don't want to go out announcing a transformative transaction unless you have a very good story as to why this is the best decision and will create the most value for stockholders. And then I guess lastly, there are key components related to communicating with customers and suppliers who may use both parties or may have a view about one versus the other.

18:09So you need to come up with a very carefully crafted message to them as well. The step from agreeing on the key social issues to announcing the deal is usually very short. It's a matter of a couple of weeks. And so things move very quickly on a merger request. You still need to send out an LOI. The LOI, frankly, it's usually a dinner conversation between the chairman or the two directors who talk about the transaction. Then you'll have the LOI that spells out the social issues. Let's say we spend four weeks talking about the LOI, but it's really going to cover those key social issues. The bankers at the same time are talking about their VWAPs and the math that makes sense to make the deal work.

18:43And then when those key issues are hammered out, call it after four weeks. Then two weeks later, you're announcing the deal because you have a merger agreement signed. But there is like an official LOI? Not always, but usually there'll be some sort of term sheet that says the headquarters will be in place X or place Y. the name of the company will be company A, company B, we'll hire a consulting company to name it company C, or we'll say it's company AB now, combining the two companies' names. That's the term sheet that they usually create. That's when you're talking about the social issue. That sounds like it's very mutual.

19:12It is. This is all very mutual. It's easy to negotiate the contract because what you're giving is what you're getting. You're basically both the buyer and the seller in the deal. What does diligence look like? Because again, you do an acquisition, it's very buyer-driven diligence process. Who's driving diligence here? It's very easy to rein a client's diligence request in in a merger of equals because I've told clients this before, whatever you ask them for, they are going to ask you for the same exact thing. And that really disciplines a client's mind around, all right, let's ask for the stuff that really matters and that is relatively easy for them to produce.

19:44So I actually find that it's a very orderly diligence process for what it's worth. I'm showing hard to imagine that. Let me see your customer list. Let me see your customer list. Exactly. Let me see your employment agreements. Exactly. It doesn't turn to spin out into any passive-aggressive diligence behaviors around there, does it? Look, there's always passive-aggressive diligence behaviors. But no, at least in my experience, the diligence process is the least of my concerns in a merger of equals. You might not have large organizations and you just know teams have their own concerns and may not be completely on board with the decision there.

20:16That's certainly true. You always need to manage for the fact that individuals in an organization may not be happy about the idea of a merger of equals. A deal team and the manager of an M &A process needs to be disciplined about who they're bringing into the deal and to make sure that they're getting the right advice as to what are the issues that matter and what are the issues that don't matter. That's why communications is so important. That's right. They're having a good strategy, painting that narrative and picture. Given that, because I take it there's usually an announce period and then you sign and close.

20:45What impact do you typically see this making or does it just completely vary when you announce the merger of equals? Your goal is to have a stock pot. And there are reasons why there should be an increase in both parties' stock price. The two stocks will trade in tandem because they're eventually going to be exchanged for each other, assuming the deal is going to go through. But the expectation is that there are going to be synergies created by the transaction, both on the cost side and on the revenue side, because they're complementary businesses. And you can streamline some things and you can cross sell other things.

21:14And one plus one equals three is the theory behind it. You're expecting that stock pop and you're expecting for the market to like the deal. And I think that more often than not, the market does like the deal. The risk you're taking, though, when you're announcing a deal for yourself is that you've put yourself in play, right? In a typical situation where you haven't announced merger equals, if someone were to come in and say they want to buy your company, you have a variety of answers, including we're not for sale. We have a long-term plan. It doesn't involve this. We think we can create more value for our stockholders by remaining independent rather than selling to you, interloper, who's coming about at an opportunistic time.