Corporate Restructuring

Module - 1
Introduction
With Indian corporate houses showing sustained growth over the last decade, many have shown an interest in
growing globally by choosing to acquire or merge with other companies outside India. ne such e!ample
would be the acquisition o" #ritain$s Corus by %ata an Indian conglomerate by way o" a leveraged buy-out.
%he %atas also acquired &aguar and 'and Rover in a signi"icant cross border transaction. Whereas both
transactions involved the acquisition o" assets in a "oreign (urisdiction, both transactions were also governed
by Indian domestic law.
Whether a merger or an acquisition is that o" an Indian entity or it is an Indian entity acquiring a "oreign
entity, such a transaction would be governed by Indian domestic law. In the sections which "ollow, we touch
up on di""erent laws with a view to educate the reader o" the broader areas o" law which would be o"
signi"icance. Mergers and acquisitions are methods by which distinct businesses may combine. &oint ventures
are another way "or two businesses to wor) together to achieve growth as partners in progress, though a (oint
venture is more o" a contractual arrangement between two or more businesses.
Corporate Restructuring Classi"ications
*. M+R,+R- *./ *M*',*M*%I.-.
%he term 0merger$ is not de"ined under the Companies *ct, 1123 4the 0Companies *ct$5, the Income %a! *ct,
1131 4the 0I%*$5 or any other Indian law. -imply put, a merger is a combination o" two or more distinct
entities into one6 the desired e""ect being not (ust the accumulation o" assets and liabilities o" the distinct
entities, but to achieve several other bene"its such as, economies o" scale, acquisition o" cutting edge
technologies, obtaining access into sectors 7 mar)ets with established players etc. ,enerally, in a merger, the
merging entities would cease to be in e!istence and would merge into a single surviving entity.
8ery o"ten, the two e!pressions 9merger9 and 9amalgamation9 are used synonymously. #ut there is, in "act, a
di""erence. Merger generally re"ers to a circumstance in which the assets and liabilities o" a company
4merging company5 are vested in another company 4the merged company5. %he merging entity loses its
identity and its shareholders become shareholders o" the merged company. n the other hand, an
amalgamation is an arrangement, whereby the assets and liabilities o" two or more companies 4amalgamating
companies5 become vested in another company 4the amalgamated company5. %he amalgamating companies
all lose their identity and emerge as the amalgamated company6 though in certain transaction structures the
amalgamated company may or may not be one o" the original companies. %he shareholders o" the
amalgamating companies become shareholders o" the amalgamated company. While the Companies *ct does
not de"ine a merger or amalgamation, -ections :1; to :1< o" the Companies *ct deal with the analogous
concept o" schemes o" arrangement or compromise between a company, it shareholders and7or its creditors. *
merger o" a company 0*$ with another company 0#$ would involve two schemes o" arrangements, one
between * and its shareholders and the other between # and its shareholders.
Mergers may be o" several types, depending on the requirements o" the merging entities=
>ori?ontal Mergers= *lso re"erred to as a 0hori?ontal integration$, this )ind o" merger ta)es place between
entities engaged in competing businesses which are at the same stage o" the industrial process.@ * hori?ontal
merger ta)es a company a step closer towards monopoly by eliminating a competitor and establishing a
stronger presence in the mar)et. %he other bene"its o" this "orm o" merger are the advantages o" economies o"
scale and economies o" scope.
8ertical Mergers= 8ertical mergers re"er to the combination o" two entities at di""erent stages o" the industrial
or production process. Aor e!ample, the merger o" a company engaged in the construction business with a
company engaged in production o" bric) or steel would lead to vertical integration. Companies stand to gain
on account o" lower transaction costs and synchroni?ation o" demand and supply. Moreover, vertical
integration helps a company move towards greater independence and sel"-su""iciency. %he downside o" a
vertical merger involves large investments in technology in order to compete e""ectively.
Congeneric Mergers=%hese are mergers between entities engaged in the same general industry and somewhat
interrelated, but having no common customer-supplier relationship. * company uses this type o" merger in
order to use the resulting ability to use the same sales and distribution channels to reach the customers o" both
businesses.
Conglomerate Mergers= * conglomerate merger is a merger between two entities in unrelated industries. %he
principal reason "or a conglomerate merger is utili?ation o" "inancial resources, enlargement o" debt capacity,
and increase in the value o" outstanding shares by increased leverage and earnings per share, and by lowering
the average cost o" capital.< * merger with a diverse business also helps the company to "oray into varied
businesses without having to incur large start-up costs normally associated with a new business.
Cash Merger= In a typical merger, the merged entity combines the assets o" the two companies and grants the
shareholders o" each original company shares in the new company based on the relative valuations o" the two
original companies. >owever, in the case o" a 0cash merger$, also )nown as a 0cash-out merger$, the
shareholders o" one entity receive cash in place o" shares in the merged entity. %his is a common practice in
cases where the shareholders o" one o" the merging entities do not want to be a part o" the merged entity.
%riangular Merger= * triangular merger is o"ten resorted to "or regulatory and ta! reasons. *s the name
suggests, it is a tripartite arrangement in which the target merges with a subsidiary o" the acquirer. #ased on
which entity is the survivor a"ter such merger, a triangular merger may be "orward 4when the target merges
into the subsidiary and the subsidiary survives5, or reverse 4when the subsidiary merges into the target and the
target survives5.
#. *CBCI-I%I.-.
*n acquisition or ta)eover is the purchase by one company o" controlling interest in the share capital, or all
or substantially all o" the assets and7or liabilities, o" another company. * ta)eover may be "riendly or hostile,
depending on the o""erer company$s approach, and may be e""ected through agreements between the o""erer
and the ma(ority shareholders, purchase o" shares "rom the open mar)et, or by ma)ing an o""er "or acquisition
o" the o""eree$s shares to the entire body o" shareholders.
Ariendly ta)eover= *lso commonly re"erred to as 0negotiated ta)eover$, a "riendly ta)eover involves an
acquisition o" the target company through negotiations between the e!isting promoters and prospective
investors. %his )ind o" ta)eover is resorted to "urther some common ob(ectives o" both the parties.
>ostile %a)eover= * hostile ta)eover can happen by way o" any o" the "ollowing actions= i" the board re(ects
the o""er, but the bidder continues to pursue it or the bidder ma)es the o""er without in"orming the board
be"orehand. %he acquisition o" one company 4called the target company5 by another 4called the acquirer5 that
is accomplished not by coming to an agreement with the target companyDs management, but by going directly
to the company$s shareholders or "ighting to replace management in order to get the acquisition approved. *
hostile ta)eover can be accomplished through either a tender o""er or a pro!y "ight.
'everaged #uyouts= %hese are a "orm o" ta)eovers where the acquisition is "unded by borrowed money.
"ten the assets o" the target company are used as collateral "or the loan. %his is a common structure when
acquirers wish to ma)e large acquisitions without having to commit too much capital, and hope to ma)e the
acquired business service the debt so raised.
#ailout %a)eovers= *nother "orm o" ta)eover is a 0bail out ta)eover$ in which a pro"it ma)ing company
acquires a sic) company. %his )ind o" ta)eover is usually pursuant to a scheme o"
reconstruction7rehabilitation with the approval o" lender ban)s7"inancial institutions. ne o" the primary
motives "or a pro"it ma)ing company to acquire a sic)7loss ma)ing company would be to set o"" o" the losses
o" the sic) company against the pro"its o" the acquirer, thereby reducing the ta! payable by the acquirer. %his
would be true in the case o" a merger between such companies as well.
C. -%R*%+,IC *''I*.C+
* partnership with another business in which you combine e""orts in business e""orts in a business e""ort
involving anything "rom getting a better price "or goods by buying bul) together, to see)ing business
together, with each o" you providing part o" the product. %he basic idea behind alliances is to minimi?e ris)
while ma!imising your leverage.
/. &I.% 8+.%CR+-.
* (oint venture is the coming together o" two or more businesses "or a speci"ic purpose, which may or may
not be "or a limited duration. %he purpose o" the (oint venture may be "or the entry o" the (oint venture parties
into a new business, or the entry into a new mar)et, which requires the speci"ic s)ills, e!pertise, or the
investment o" each o" the (oint venture parties. %he e!ecution o" a (oint venture agreement setting out the
rights and obligations o" each o" the parties is usually a norm "or most (oint ventures. %he (oint venture
parties may also incorporate a new company which will engage in the proposed business. In such a case, the
byelaws o" the (oint venture company would incorporate the agreement between the (oint venture parties.
+. /+M+R,+R-.
* demerger is the opposite o" a merger, involving the splitting up o" one entity into two or more entities. *n
entity which has more than one business, may decide to 0hive o""$ or 0spin o""$ one o" its businesses into a
new entity. %he shareholders o" the original entity would generally receive shares o" the new entity. I" one o"
the businesses o" a company is "inancially sic) and the other business is "inancially sound, the sic) business
may be demerged "rom the company. %his "acilitates the restructuring or sale o" the sic) business, without
a""ecting the assets o" the healthy business. Conversely, a demerger may also be underta)en "or situating a
lucrative business in a separate entity. * demerger, may be completed through a court process under the
Merger Erovisions, but could also be structured in a manner to avoid attracting the Merger Erovisions.
%he terms 9demerger9, 9spin-o""9 and 9spin-out9 are sometimes used to indicate a situation where one
company splits into two, generating a second company which may or may not become separately listed on a
stoc) e!change.
A. /I8+-%I%CR+-
* /ivestiture is the sale o" part o" a company to a third party. *ssets, product lines, subsidiaries, or divisions
are sold "or cash or securities or some combination thereo". %he buyers are typically other corporations or,
increasingly, investor groups together with the current managers o" the divested operation.
Reasons = /ismantling Conglomerates
Restructuring activity
*dding 8alue by selling into a better "it
'arge additional investment required
>arvesting East investments success"ully
/iscarding Cnwanted #usiness divisions
,. '+8+R*,+/ #CFC%- 4'#5
* leveraged #uyout or G#ootstrapH transaction occurs when a "inancial sponsor gains control o" a ma(ority o"
a target company$s equity through the use o" borrowed money or debt. * '# is essentially a strategy
involving the acquisition o" another company using a signi"icant amount o" borrowed money 4bonds or loans5
to meet the cost o" acquisition. "ten, the assets o" the company being acquired are used as collateral "or the
loans in addition to the assets o" the company.
>. +ME'F++ -%CI E%I. E'*. 4+-E5
+- plans are allows employees can buy company$s stoc) a"ter certain length o" employment or they can
buy share at any time. -ome corporations have policies to compensate employees with company$s shares
instead o" other monetary bene"its. %his will increase the accountability and commitment o" employee with
his wor) and organi?ational growth. *t the same time accumulation o" shares to employees hands also
wea)ens the power o" top management.
I. -+''-AA-
* sell-o"", also )nown as a divestiture, is the outright sale o" a company subsidiary. .ormally, sell-o""s are
done because the subsidiary doesnDt "it into the parent companyDs core strategy. %he mar)et may be
undervaluing the combined businesses due to a lac) o" synergy between the parent and subsidiary. *s a result,
management and the board decide that the subsidiary is better o"" under di""erent ownership.
&. +BCI%F C*R8+-C%- More and more companies are using equity carve-outs to boost shareholder
value. * parent "irm ma)es a subsidiary public through an initial public o""ering 4IE5 o" shares, amounting
to a partial sell-o"". * new publicly-listed company is created, but the parent )eeps a controlling sta)e in the
newly traded subsidiary
I. -EI.AA-
* spino"" occurs when a subsidiary becomes an independent entity. %he parent "irm distributes shares o" the
subsidiary to its shareholders through a stoc) dividend. -ince this transaction is a dividend distribution, no
cash is generated. %hus, spino""s are unli)ely to be used when a "irm needs to "inance growth or deals. 'i)e
the carve-out, the subsidiary becomes a separate legal entity with a distinct management and board.
+ Merger J *cquisition
#asic Concepts
Mergers and acquisitions represent the ultimate in change "or a business. .o other event is more di""icult,
challenging, or chaotic as a merger and acquisition. It is imperative that everyone involved in the process has
a clear understanding o" how the process wor)s. >ope"ully this short course will provide you with a better
appreciation o" what is involved. Fou might be as)ing yoursel", why do I need to learn the merger and
acquisition 4M J *5 processK Well "or starters, mergers and acquisitions are now a normal way o" li"e within
the business world. In todayDs global, competitive environment, mergers are sometimes the only means "or
long-term survival. In other cases, such as Cisco -ystems, mergers are a strategic component "or generating
long-term growth. *dditionally, many entrepreneurs no longer build companies "or the long-term6 they build
companies "or the short-term, hoping to sell the company "or huge pro"its. In her boo) %he *rt o" Merger and
*cquisition Integration, *le!andra Reed 'a(ou! puts it best= 8irtually every ma(or company in the Cnited
-tates today has e!perienced a ma(or acquisition at some point in history.
M J * /e"ined
When we use the term 9merger9, we are re"erring to the merging o" two companies where one new company
will continue to e!ist. %he term 9acquisition9 re"ers to the acquisition o" assets by one company "rom another
company. In an acquisition, both companies may continue to e!ist. >owever, throughout this course we will
loosely re"er to mergers and acquisitions 4 M J * 5 as a business transaction where one company acquires
another company. %he acquiring company will remain in business and the acquired company 4which we will
sometimes call the %arget Company5 will be integrated into the acquiring company and thus, the acquired
company ceases to e!ist a"ter the merger.
/istinction between Mergers and *cquisitions
*lthough they are o"ten uttered in the same breath and used as though they were synonymous, the terms
merger and acquisition mean slightly di""erent things. When one company ta)es over another and clearly
established itsel" as the new owner, the purchase is called an acquisition. Arom a legal point o" view, the
target company ceases to e!ist, the buyer 9swallows9 the business and the buyerDs stoc) continues to be
traded. In the pure sense o" the term, a merger happens when two "irms, o"ten o" about the same si?e, agree to
go "orward as a single new company rather than remain separately owned and operated. %his )ind o" action is
more precisely re"erred to as a 9merger o" equals.9 #oth companiesD stoc)s are surrendered and new company
stoc) is issued in its place. Aor e!ample, both /aimler-#en? and Chrysler ceased to e!ist when the two "irms
merged, and a new company, /aimlerChrysler, was created. In practice, however, actual mergers o" equals
donDt happen very o"ten. Csually, one company will buy another and, as part o" the dealDs terms, simply allow
the acquired "irm to proclaim that the action is a merger o" equals, even i" itDs technically an acquisition.
#eing bought out o"ten carries negative connotations, there"ore, by describing the deal as a merger,
Merger %heories
/i""erential e""iciency theory.
Ine""icient management theory.
-ynergy.
Eure diversi"ication.
-trategic realignment to changing environment.
>ubris hypothesis
/i""erential e""iciency theory.
*ccording to this theory i" the management o" "irm * is more e""icient than the "irm # and i" the "irm *
acquires "irm #, the e""iciency o" "irm # is li)ely to be brought up to the level o" the "irm *.
%he theory implies that some "irms operate below their potential and as a result have below average
e""iciency. -uch "irms are most vulnerable to acquisition by other more e""icient "irms in the same
industry. %his is because "irms with greater e""iciency would be able to identi"y "irms with good
potential but operating at lower e""iciency.
*ccording to this theory, some "irms operate below their potential and consequently have low
e""iciency. -uch "irms are li)ely to be acquired by other, more e""icient "irms in the same industry.
%his is because, "irms with greater e""iciency would be able to identi"y "irms with good potential
operating at lower e""iciency. %hey would also have the managerial ability to improve the latter$s
per"ormance.
>owever, a di""iculty would arise when the acquiring "irm overestimates its impact on improving the
per"ormance o" the acquired "irm. %his may result in the acquirer paying too much "or the acquired
"irm. *lternatively, the acquirer may not be able to improve the acquired "irm$s per"ormance up to the
level o" the acquisition value given to it. %he managerial synergy hypothesis is an e!tension o" the
di""erential e""iciency theory. It states that a "irm, whose management team has greater competency
than is required by the current tas)s in the "irm, may see) to employ the surplus resources by
acquiring and improving the e""iciency o" a "irm, which is less e""icient due to lac) o" adequate
managerial resources. %hus, the merger will create a synergy, since the surplus managerial resources
o" the acquirer combine with the non-managerial organi?ational capital o" the "irm. When these
surplus resources are indivisible and cannot be released, a merger enables them to be optimally
utili?ed. +ven i" the "irm has no opportunity to e!pand within its industry, it can diversi"y and enter
into new areas. >owever, since it does not possess the relevant s)ills related to that business, it will
attempt to gain a 0toehold entry$ by acquiring a "irm in that industry, which has organi?ational capital
along with inadequate managerial capabilities.
Ine""icient management theory.
%his is similar to the concept o" managerial e""iciency but it is di""erent in that ine""icient management
means that the management o" one company simply is not per"orming upto its potential.
Ine""icient management theory simply represents that is incompetent in the complete sense.
-ynergy.
-ynergy re"ers to the type o" reactions that occur when two substances or "actors combine to produce
a greater e""ect together than that which the sum o" the two operating independently could account "or.
%he ability o" a combination o" two "irms to be more pro"itable than the two "irms individually.
%here are two types o" synergy=
Ainancial synergy.
perating synergy.
Eure diversi"ication.
/iversi"ication provides numerous bene"its to managers, employees, owners o" the "irms and to the
"irm itsel". /iversi"ication through mergers is commonly pre"erred to diversi"ication through internal
growth, given that the "irm may lac) internal resources or capabilities requires.
-trategic realignment to changing environment.
It suggests that the "irms use the strategy o" MJ*s as ways to rapidly ad(ust to changes in their e!ternal
environments. When a company has an opportunity o" growth available only "or a limited period o" time
slow internal growth may not be su""icient.
>ubris hypothesis
>ubris hypothesis implies that manager$s loo) "or acquisition o" "irms "or their own potential motives
and that the economic gains are not the only motivation "or the acquisitions. %his theory is particularly
evident in case o" competitive tender o""er to acquire a target. %he urge to win the game o"ten results
in the winners curse re"ers to the ironic hypothesis that states that the "irm which overestimates the
value o" the target mostly wins the contest.
Module - II
8aluing synergy in MJ* deals *
+very merger has its own unique reasons why the combining o" two companies is a good business decision.
%he underlying principle behind mergers and acquisitions 4 M J * 5 is simple= @ L @ M 2. %he value o"
Company * is N @ billion and the value o" Company # is N @ billion, but when we merge the two companies
together, we have a total value o" N 2 billion. %he (oining or merging o" the two companies creates additional
value which we call 9synergy9 value.
-ynergy value can ta)e three "orms=
1. Revenues= #y combining the two companies, we will reali?e higher revenues then i" the two companies
operate separately.
@. +!penses= #y combining the two companies, we will reali?e lower e!penses then i" the two companies
operate separately.
:. Cost o" Capital= #y combining the two companies, we will e!perience a lower overall cost o" capital.
Why MergersK- Motives
%he dominant rationale used to e!plain MJ* activity is that acquiring "irms see) improved "inancial
per"ormance. %he "ollowing motives are considered to improve "inancial per"ormance=

+conomy o" scale= %his re"ers to the "act that the combined company can o"ten reduce its "i!ed costs
by removing duplicate departments or operations, lowering the costs o" the company relative to the same
revenue stream, thus increasing pro"it margins.

+conomy o" scope= %his re"ers to the e""iciencies primarily associated with demand-side changes,
such as increasing or decreasing the scope o" mar)eting and distribution, o" di""erent types o" products.

Increased revenue or mar)et share= %his assumes that the buyer will be absorbing a ma(or competitor
and thus increase its mar)et power 4by capturing increased mar)et share5 to set prices.

Cross-selling= Aor e!ample, a ban) buying a stoc) bro)er could then sell its ban)ing products to the
stoc) bro)erDs customers, while the bro)er can sign up the ban)Ds customers "or bro)erage accounts. r, a
manu"acturer can acquire and sell complementary products.

-ynergy= Aor e!ample, managerial economies such as the increased opportunity o" managerial
speciali?ation. *nother e!ample are purchasing economies due to increased order si?e and associated
bul)-buying discounts.

%a!ation= * pro"itable company can buy a loss ma)er to use the targetDs loss as their advantage by
reducing their ta! liability. In the Cnited -tates and many other countries, rules are in place to limit the
ability o" pro"itable companies to 9shop9 "or loss ma)ing companies, limiting the ta! motive o" an
acquiring company.

,eographical or other diversi"ication= %his is designed to smooth the earnings results o" a company,
which over the long term smoothens the stoc) price o" a company, giving conservative investors more
con"idence in investing in the company. >owever, this does not always deliver value to shareholders 4see
below5.

Resource trans"er= resources are unevenly distributed across "irms 4#arney, 11115 and the interaction
o" target and acquiring "irm resources can create value through either overcoming in"ormation
asymmetry or by combining scarce resources.

8ertical integration= 8ertical integration occurs when an upstream and downstream "irm merges 4or
one acquires the other5. %here are several reasons "or this to occur. ne reason is to internali?e
an e!ternality problem. * common e!ample o" such an e!ternality is double marginali?ation. /ouble
marginali?ation occurs when both the upstream and downstream "irms have monopoly power and each
"irm reduces output "rom the competitive level to the monopoly level, creating two deadweight losses.
Aollowing a merger, the vertically integrated "irm can collect one deadweight loss by setting the
downstream "irmDs output to the competitive level. %his increases pro"its and consumer surplus. * merger
that creates a vertically integrated "irm can be pro"itable.
OPQ

>iring= some companies use acquisitions as an alternative to the normal hiring process. %his is
especially common when the target is a small private company or is in the startup phase. In this case, the
acquiring company simply hires the sta"" o" the target private company, thereby acquiring its talent 4i"
that is its main asset and appeal5. %he target private company simply dissolves and little legal issues are
involved.

*bsorption o" similar businesses under single management= similar port"olio invested by two di""erent
mutual "unds namely united money mar)et "und and united growth and income "und, caused the
management to absorb united money mar)et "und into united growth and income "und.
>owever, on average and across the most commonly studied variables, acquiring "irmsD "inancial
per"ormance does not positively change as a "unction o" their acquisition activity.
O1Q
%here"ore, additional
motives "or merger and acquisition that may not add shareholder value include=
/iversi"ication= While this may hedge a company against a downturn in an individual industry it "ails
to deliver value, since it is possible "or individual shareholders to achieve the same hedge by diversi"ying
their port"olios at a much lower cost than those associated with a merger.
b(ectives in a MJ* transactionK
1. *n opportunity "or achieving "aster growth
@. btaining ta! concessions
:. +liminating competition
<. *chieving diversi"ication with minimum cost
2. Improving corporate image and business value
3. ,aining access to management or technical talent
b(ective "or Companies to o""er themselves "or saleK
1. /eclining earnings and pro"itability
@. %o raise "unds "or more promising lines o" business
:. /esire to ma!imi?e growth
<. ,ive itsel" the bene"it o" image o" larger company
2. 'ac) o" adequate management or technical s)ills
Aor the most part, the biggest source o" synergy value is lower e!penses. Many mergers are driven by the
need to cut costs. Cost savings o"ten come "rom the elimination o" redundant services, such as >uman
Resources, *ccounting, In"ormation %echnology, etc. >owever, the best mergers seem to have strategic
reasons "or the business combination.
%hese strategic reasons include=
Eositioning - %a)ing advantage o" "uture opportunities that can be e!ploited when the two companies are
combined. Aor e!ample, a telecommunications company might improve its position "or the "uture i" it were to
own a broad band service company. Companies need to position themselves to ta)e advantage o" emerging
trends in the mar)etplace.
,ap Ailling - ne company may have a ma(or wea)ness 4such as poor distribution5 whereas the other
company has some signi"icant strength. #y combining the two companies, each company "ills-in strategic
gaps that are essential "or long-term survival.
rgani?ational Competencies - *cquiring human resources and intellectual capital can help improve
innovative thin)ing and development within the company.
#roader Mar)et *ccess - *cquiring a "oreign company can give a company quic) access to emerging global
mar)ets.
Mergers can also be driven by basic business reasons, such as=
#argain Eurchase - It may be cheaper to acquire another company then to invest internally. Aor e!ample,
suppose a company is considering e!pansion o" "abrication "acilities. *nother company has very similar
"acilities that are idle. It may be cheaper to (ust acquire the company with the unused "acilities then to go out
and build new "acilities on your own.
/iversi"ication - It may be necessary to smooth-out earnings and achieve more consistent long-term growth
and pro"itability. %his is particularly true "or companies in very mature industries where "uture growth is
unli)ely. It should be noted that traditional "inancial management does not always support diversi"ication
through mergers and acquisitions. It is widely held that investors are in the best position to diversi"y, not the
management o" companies since managing a steel company is not the same as running a so"tware
company.
-hort %erm ,rowth - Management may be under pressure to turnaround sluggish growth and pro"itability.
Consequently, a merger and acquisition is made to boost poor per"ormance.
Cndervalued %arget - %he %arget Company may be undervalued and thus, it represents a good investment.
-ome mergers are e!ecuted "or 9"inancial9 reasons and not strategic reasons. Aor e!ample, Iohlberg Iravis
J Roberts acquires poor per"orming companies and replaces the management team in hopes o" increasing
depressed values.
%he verall Erocess
%he Merger J *cquisition Erocess can be bro)en down into "ive phases=
Ehase 1 - Ere *cquisition Review= %he "irst step is to assess your own situation and determine i" a merger and
acquisition strategy should be implemented. I" a company e!pects di""iculty in the "uture when it comes to
maintaining core competencies, mar)et share, return on capital, or other )ey per"ormance drivers, then a
merger and acquisition 4M J *5 program may be necessary.
Ehase @ - -earch J -creen %argets= %he second phase within the M J * Erocess is to search "or possible
ta)eover candidates. %arget companies must "ul"ill a set o" criteria so that the %arget Company is a good
strategic "it with the acquiring company. Aor e!ample, the targetDs drivers o" per"ormance should compliment
the acquiring company. Compatibility and "it should be assessed across a range o" criteria - relative si?e, type
o" business, capital structure, organi?ational strengths, core competencies, mar)et channels, etc. It is worth
noting that the search and screening process is per"ormed in-house by the *cquiring Company. Reliance on
outside investment "irms is )ept to a minimum since the preliminary stages o" M J * must be highly guarded
and independent.
Ehase : - Investigate J 8alue the %arget= %he third phase o" M J * is to per"orm a more detail analysis o" the
target company. Fou want to con"irm that the %arget Company is truly a good "it with the acquiring company.
%his will require a more thorough review o" operations, strategies, "inancials, and other aspects o" the %arget
Company. %his detail review is called 9due diligence.9 -peci"ically, Ehase I /ue /iligence is initiated once a
target company has been selected. %he main ob(ective is to identi"y various synergy values that can be
reali?ed through an M J * o" the %arget Company. Investment #an)ers now enter into the M J * process to
assist with this evaluation.
Ehase < - *cquire through .egotiation= .ow that we have selected our target company, itDs time to start the
process o" negotiating a M J *. We need to develop a negotiation plan based on several )ey questions=
>ow much resistance will we encounter "rom the %arget CompanyK
What are the bene"its o" the M J * "or the %arget CompanyK
What will be our bidding strategyK
>ow much do we o""er in the "irst round o" biddingK
%he most common approach to acquiring another company is "or both companies to reach agreement
concerning the M J *6 i.e. a negotiated merger will ta)e place. %his negotiated arrangement is sometimes
called a 9bear hug.9 %he negotiated merger or bear hug is the pre"erred approach to a M J * since having
both sides agree to the deal will go a long way to ma)ing the M J * wor).
Ehase 2 - Eost Merger Integration= I" all goes well, the two companies will announce an agreement to merge
the two companies. %he deal is "inali?ed in a "ormal merger and acquisition agreement. %his leads us to the
"i"th and "inal phase within the M J * Erocess, the integration o" the two companies. +very company is
di""erent - di""erences in culture, di""erences in in"ormation systems, di""erences in strategies, etc. *s a result,
the Eost Merger Integration Ehase is the most di""icult phase within the M J * Erocess. .ow all o" a sudden
we have to bring these two companies together and ma)e the whole thing wor). %his requires e!tensive
planning and design throughout the entire organi?ation.
%he integration process can ta)e place at three levels=
1. Aull= *ll "unctional areas 4operations, mar)eting, "inance, human resources, etc.5 will be merged into one
new company. %he new company will use the 9best practices9 between the two companies.
@. Moderate= Certain )ey "unctions or processes 4such as production5 will be merged together. -trategic
decisions will be centrali?ed within one company, but day to day operating decisions will remain
autonomous.
:. Minimal= nly selected personnel will be merged together in order to reduce redundancies. #oth strategic
and operating decisions will remain decentrali?ed and autonomous. *s mentioned at the start o" this course,
mergers and acquisitions are e!tremely di""icult. +!pected synergy values may not be reali?ed and there"ore,
the merger is considered a "ailure.
-ome o" the reasons behind "ailed mergers are=
Eoor strategic "it - %he two companies have strategies and ob(ectives that are too di""erent and they con"lict
with one another.
Cultural and -ocial /i""erences - It has been said that most problems can be traced to 9people problems.9 I"
the two companies have wide di""erences in cultures, then synergy values can be very elusive.
Incomplete and Inadequate /ue /iligence - /ue diligence is the 9watchdog9 within the MJ * Erocess. I" you
"ail to let the watchdog do his (ob, you are in "or some serious problems within the M J * Erocess.
Eoorly Managed Integration - %he integration o" two companies requires a very high level
o" quality management. In the words o" one C+, 9give me some people who )now the drill.9 Integration is
o"ten poorly managed with little planning and design. *s a result, implementation "ails.
Eaying too Much - In todayDs merger "ren?y world, it is not unusual "or the acquiring company to pay a
premium "or the %arget Company. Eremiums are paid based on e!pectations o" synergies. >owever, i"
synergies are not reali?ed, then the premium paid to acquire the target is never recouped.
verly ptimistic - I" the acquiring company is too optimistic in its pro(ections about the %arget Company,
then bad decisions will be made within the M J * Erocess. *n overly optimistic "orecast or conclusion about
a critical issue can lead to a "ailed merger.
M J * 8aluation approaches
8aluation o" %arget Company
%he principal incentive "or a merger is that the business value o" the combined business is e!pected to be
greater than the sum o" the independent business values o" the merging entities. %he di""erence between the
combined value and the sum o" the values o" individual companies is the synergy gain attributable to the
MJ* transaction. >ence,
8alue o" acquirer L -tand alone value o" %arget L 8alue o" -ynergy M Combined 8alue.
%here is also a cost attached to an acquisition. %he cost o" acquisition is the price premium paid over the
mar)et value plus other costs o" integration. %here"ore, the net gain is the value o" synergy minus premium
paid.
-uppose
8* M Rs. @;; 4Merging Company, or *cquirer5
8# M Rs. 2; 4Merging Company, or %arget5
8*# M Rs. :;; 4Merged or *malgamated +ntity5
%here"ore,
-ynergy M 8*# R 4 8* L 8# 5 M Rs. 2;. I" the premium paid "or this merger is Rs. @;, .et gain "rom merger
o" * and # will be Rs. :; 4i.e. Rs. 2; R Rs. @;5. It is this :;, because o" which companies merge or acquire.
ne o" the essential steps in MJ* is the valuation o" the %arget Company. *nalysts use a wide range o"
models in practice "or measuring the value o" the %arget "irm. %hese models o"ten ma)e very di""erent
assumptions about pricing, but they do share some common characteristics and can be classi"ied in broader
terms. %here are several advantages to such a classi"ication= it is easier to understand where individual models
"it into the bigger picture, why they provide di""erent results and where they have "undamental
errors in logic.
%here are only three approaches to value a business or business interest. >owever, there are numerous
techniques within each one o" the approaches that the analysts may consider in per"orming a valuation. %he
*pproaches and %echniques are as "ollows= -
1. Income *pproach
%he Income *pproach is one o" three ma(or groups o" methodologies, called valuation approaches, used by
appraisers. It is particularly common in commercial real estate appraisal and in business appraisal. %he
"undamental math is similar to the methods used "or "inancial valuation, securities analysis, or bond pricing.
>owever, there are some signi"icant and important modi"ications when used in real estate or business
valuation.
Cnder this approach two primary used methods to value a business interest include=
a5 /iscounted Cash "low method
b5 Capitali?ed Cash "low method
+ach o" these methods depends on the present value o" an enterprise$s "uture cash "lows.

/iscounted Cash "low %echnique
%he /iscounted Cash "low valuation is based upon the notion that the value o" an asset is the present value o"
the e!pected cash "lows on that asset, discounted at a rate that re"lects the ris)iness o" those cash "lows. %he
nature o" the cash "lows will depend upon the asset, dividends "or an equity share, coupons and redemption
value "or bonds and the post ta! cash "lows "or a pro(ect. %he -teps involved in valuation under this method
are as under=
ACA+ %echnique 4Aree Cash Alow Arom +quity5
%he Capitali?ed Cash "low technique o" income approach is the abbreviated version o" /iscounted Cash "low
technique where the growth rate 4g5 and the discount rate 4)5 are assumed to remain constant in perpetuity.
%his model is represented as under=
8alue o" Airm M .et Cash "low in year one 4 ) R g 5
@. Mar)et *pproach
%he origin o" mar)et approach o" business valuation is established in the economic rationale o" competition.
It states that in case o" a "ree mar)et, the demand and supply e""ects direct the value o" business properties to
a particular balance. %he purchasers are not ready to pay higher amounts "or the business and the vendors are
not ready to receive any amount, which is lower in comparison to the value o" a corresponding commercial
entity. It is the value o" a "irm by per"orming a comparison between the "irms concerned with organi?ations in
the similar location, o" equal volume or operating in the similar sector.
It has a large number o" resemblances with the comparable sales technique, which is generally utili?ed in case
o" real estate estimation. %he mar)et value o" shares o" companies that are traded publicly and are involved in
identical commercial activities may be a logical signal o" the value o" commercial operation. In this case the
company shares are bought and sold in an open and "ree mar)et. %his process allows purpose"ul comparison
o" the mar)et value o" shares.
%he problem e!ists in distinguishing public companies, which are adequately corresponding to the company
concerned "or this intention. In addition, in case o" a private company, the liquidity o" the equity is lower 4put
di""erently, its shares are di""icult to trade5 in comparison to a public company. %he value is regarded as
somewhat lesser in comparison to that a mar)et-based valuation will render.
+.g. - -uppose a company operating in the same industry as *#C with comparable si?e and other situations
has been sold at Rs. 2;; crores in last wee) provides a good measurement "or valuation o" business.
Considering the circumstances, 1; value o" the business o" *#C should be around Rs. 2;; crores under
mar)et approach.
:. *ssets *pproach
%he "irst step in using the assets approach is to obtain a #alance -heet as close as possible to the valuation
date. +ach recorded asset including intangible assets must be identi"ied, e!amined and ad(usted to "air mar)et
value. .ow all liabilities are to be subtracted, again at "air mar)et value, "rom the value o" assets derived as
above to reach at the "air mar)et value o" equity o" the business. It is important to note here that any
unrecorded assets or liabilities should also be considered while arriving at the value o" business by the assets
approach.
.et *sset 8alue *pproach
.et asset value 4.*85 is a term used to describe the value o" an entityDs assets less the value o" its liabilities.
%he term is most commonly used in relation to open-ended or mutual "unds due to the "act that shares o" such
"unds are redeemed at their net asset value.
+conomic 8alue *dded 4+8*5 *pproach
+conomic 8alue *dded or +8* is an estimate o" economic pro"it, which can be determined, among other
ways, by ma)ing corrective ad(ustments to ,**E accounting, including deducting the opportunity cost o"
equity capital. +8* is similar to Residual Income 4RI5, although under some de"initions there may be minor
technical di""erences between +8* and RI 4"or e!ample, ad(ustments that might be made to .E*% be"ore it
is suitable "or the "ormula below5.
Mar)et 8alue *dded *pproach 4M8*5
Mar)et 8alue *dded 4M8*5 is the di""erence between the current mar)et value o" a "irm and the capital
contributed by investors. I" M8* is positive, the "irm has added value. I" it is negative, the "irm has destroyed
value. %he amount o" value added needs to be greater than the "irmDs investors could have achieved investing
in the mar)et port"olio, ad(usted "or the leverage 4beta coe""icient5 o" the "irm relative to the mar)et.
%he "ormula "or M8* is=
M8* M 8 R I
Where=
M8* is mar)et value added, 8 is the mar)et value o" the "irm, including the value o" the "irmDs equity and
debt I is the capital invested in the "irm %he higher the M8* the better it is. * high M8* indicates the
company has created substantial wealth "or the shareholders. * negative M8* means that the value o"
managementDs actions and investments are less than the value o" the capital contributed to the company by the
capital mar)et 4or that wealth and value have been destroyed5.
'egal and Regulatory Considerations
Introduction
When one company decides to acquire another company, a series o" negotiations will ta)e place between the
two companies. %he acquiring company will have a well-developed negotiating strategy and plan in place. I"
the %arget Company believes a merger is possible, the two companies will enter into a 9'etter o" Intent.9
%he 'etter o" Intent outlines the terms "or "uture negotiations and commits the %arget Company to giving
serious consideration to the merger. * 'etter o" Intent also gives the acquiring company the green light to
move into Ehase II /ue /iligence. %he 'etter o" Intent attempts to answer several issues concerning the
proposed merger=
1. >ow will the acquisition price be determinedK
@. What e!actly are we acquiringK Is it physical assets, is it a controlling interest in the target, is it intellectual
capital, etc.K
:. >ow will the merger transaction be designedK Will it be an outright purchase o" assetsK Will it be an
e!change o" stoc)K
<. What is the "orm o" paymentK Will the acquiring company issue stoc), pay cash, issue notes, or use a
combination o" stoc), cash, and7or notesK
2. Will the acquiring company setup an escrow account and deposit part o" the purchase priceK Will the
escrow account cover unrecorded liabilities discovered "rom due diligenceK
3. What is the estimated time "rame "or the mergerK What law "irms will be responsible "or creating the M J
* *greementK
S. Will there be any ad(ustment to the "inal purchase price due to anticipated losses or events prior to the
closing o" the mergerK
M J
M J * *greement
M J * *greement
*s the negotiations continue, both companies will conduct e!tensive Ehase II /ue /iligence in an e""ort to
identi"y issues that must be resolved "or a success"ul merger. I" signi"icant issues can be resolved and both
companies are convinced that a merger will be bene"icial, then a "ormal merger and acquisition agreement
will be "ormulated. %he basic outline "or the M J * *greement is rooted in the 'etter o" Intent. >owever,
Ehase II /ue /iligence will uncover several additional issues not covered in the 'etter o" Intent.
Consequently, the M J * *greement can be very lengthy based on the issues e!posed through Ehase II /ue
/iligence. *dditionally, both companies need to agree on the integration process. Aor e!ample, a %ransition
-ervice *greement is e!ecuted to cover certain types o" services, such as payroll.
%he %arget Company continues to handle payroll up through a certain date and once the integration process is
complete, the acquiring company ta)es over payroll responsibilities. %he %ransition -ervice *greement will
speci"y the types o" services, time"rames, and "ees associated with the integration process.
Indemni"ication
*nother important element within the M J * *greement is indemni"ication. %he M J * *greement will
speci"y the nature and e!tent to which each company can recover damages should a misrepresentation or
breach o" contract occur. * 9bas)et9 provision will stipulate that damages are not due until the
indemni"ication amount has reached a certain threshold. I" the bas)et amount is e!ceeded, the
indemni"ication amount becomes payable at either the bas)et amount or an amount more than the bas)et
amount. %he seller 4%arget Company5 will insist on having a ceiling "or bas)et amounts within the M J *
*greement.
-ince both sides may not agree on indemni"ication, it is a good idea to include a provision on how disputes
will be resolved 4such as binding arbitration5. Ainally, indemni"ication provisions may include a 9right o" sell
o""9 "or the buyer since the buyer has deposited part o" the purchase price into an escrow account. %he Right
to -ell "" allows the buyer 4acquiring company5 to o""set any indemni"ication claims against amounts
de"erred within the purchase price o" the merger. I" the purchase price has been paid, then legal action may be
necessary to resolve the indemni"ication.
*ccounting Aor M J *
ne last item that we should discuss is the application o" accounting principles to mergers and acquisitions.
Currently, there are two methods that are used to account "or mergers and acquisitions 4M J *5=
Eurchase= %he M J * is viewed prospectively 4restate everything and loo) "orward5 by treating the
transaction as a purchase. *ssets o" the %arget Company are restated to "air mar)et value and the di""erence
between the price paid and the "air mar)et values are posted to the #alance -heet as goodwill.
Eooling o" Interest= %he M J * is viewed historically 4re"er bac) to e!isting values5 by combining the boo)
values o" both companies. %here is no recognition o" goodwill. It should be noted that Eooling o" Interest
applies to M J *Ds that involve stoc) only. In the good old days when physical assets were important6 the
Eurchase Method was the leading method "or M J * accounting. >owever, as the importance o" intellectual
capital and other intangibles has grown, the Eooling o" Interest Method is now the dominant method "or
M J * accounting. >owever, therein lies the problem. #ecause intangibles have become so important to
businesses, the "ailure to recogni?e these assets "rom an M J * can seriously distort the "inancial statements.
*s a result, the Ainancial *ccounting -tandards #oard has proposed the elimination o" the Eooling o" Interest
Method. I" Eooling is phased out, then it will become much more important to properly arrive at "air mar)et
values "or the targetDs assets.
Module R III
-+#I %a)eover Code
-+CCRI%I+- *./ +TC>*.,+ #*R/ A I./I*. %a)eover Code
I" an acquisition is contemplated by way o" issue o" new shares @;, or the acquisition o" e!isting shares, o" a
'isted company, to or by an acquirer, the provisions o" the %a)eover Code may be applicable. Cnder the
%a)eover Code, an acquirer, along with persons acting in concert.
cannot acquire shares or voting rights which 4ta)en together with shares or voting rights, i" any, held by
him and by persons acting in concert5, entitle such acquirer to e!ercise 12U or more o" the shares or voting
rights in the target,
who has acquired, 12U or more but less than 22U o" the shares or voting rights in the target, cannot acquire,
either by himsel" or through persons acting in concert
who holds 22U or more but less than S2U o" the shares or voting rights in the target, cannot acquire
either by himsel" or through persons acting in concert, any additional shares or voting rights therein
who holds S2U o" the shares or voting rights in the target, cannot acquire either by himsel" or through
persons acting in concert, any additional shares or voting rights therein.
unless the acquirer ma)es a public announcement to acquire the shares or voting rights o" the target in
accordance with the provisions o" the %a)eover Code. %he term 0acquisition$ would include both, direct
acquisition in an Indian listed company as well as indirect acquisition o" an Indian listed company by virtue
o" acquisition o" companies, whether listed or unlisted, whether in India or abroad. Aurther, the a"oresaid
limit o" 2U acquisition is calculated aggregating all purchases, without netting o" sales.
>owever, vide a recent amendment, any person holding 22U or more 4but less than S2U5 shares is permitted
to "urther increase his shareholding by not more than 2U in the target without ma)ing a public announcement
i" the acquisition is through open mar)et purchase in normal segment on the stoc) e!change but not through
bul) deal 7bloc) deal7 negotiated deal7 pre"erential allotment or the increase in the shareholding or voting
rights o" the acquirer is pursuant to a buybac) o" shares by the target.
%hough there were certain ambiguities as to the period during which the 2U limit can be e!hausted, -+#I has
clari"ied that the 2U limit shall be applicable during the li"etime o" the target without any limitation as to
"inancial year or otherwise. >owever, (ust li)e the acquisition o" 2U up to 22U, the acquisition is calculated
aggregating all purchases, without netting o" sales.
%he -+#I may also require valuation o" such in"requently traded shares by an independent valuer.
Mode o" payment o" o""er price. %he o""er price may be paid in cash, by issue, e!change or trans"er o" shares
4ther than pre"erence shares5 o" the acquirer, i" the acquirer is a listed entity, by issue, e!change or trans"er
o" secured instruments o" the acquirer with a minimum 0*$ grade rating "rom a credit rating agency registered
with the -+#I, or a combination o" all o" the above
.on-compete payments. Eayments made to persons other than the target company under any non-compete
agreement e!ceeding @2U o" the o""er price arrived at as per the requirements mentioned above, must be
added to the o""er price.
Ericing "or indirect acquisition or control. %he o""er price "or indirect acquisition or control shall be
determined with re"erence to the date o" the public announcement "or the parent company and the date o" the
public announcement "or acquisition o" shares o" the target company, whichever is higher, in accordance with
requirements set out above.
I" the acquirer intends to dispose o" 7 encumber the assets in the target company, e!cept in the ordinary
course o" business, then he must ma)e such a disclosure in the public announcement or in the letter o" o""er to
the shareholders, "ailing which, the acquirer cannot dispose o" or encumber the assets o" the target company
"or a period o" @ years "rom the date o" closure o" the public o""er
Restrictions on the target company.
*"ter the public announcement is made by the acquirer, the target company is also sub(ect to certain
restrictions. %he target company cannot then 4a5 sell, trans"er, encumber or otherwise dispose o"" or enter into
an agreement "or sale, trans"er, encumbrance or "or disposal o" assets, e!cept in the ordinary course o"
business o" the target company and its subsidiaries, 4b5 issue or allot any securities carrying voting rights
during the o""er period, e!cept "or any subsisting obligations, and 4c5 enter into any material contracts.
%he "ollowing acquisitions 7 trans"ers would be e!empt "rom the )ey provisions o" the %a)eover Code=
15 acquisition pursuant to a public issue6
@5 acquisition by a shareholder pursuant to a rights issue to the e!tent o" his entitlement and sub(ect to
certain other restrictions6
inter-se trans"er o" shares amongst=
o quali"ying Indian promoters and "oreign collaborators who are shareholders,
o quali"ying promoter, provided that the parties have been holding shares in the target company "or a
period o" at least three years prior to the proposed acquisition,
o the acquirer and E*C, where the trans"er o" shares ta)es place three years a"ter the date o" closure o"
the public o""er made by them under the %a)eover Code and the trans"er is at a price not e!ceeding
1@2U o" the price determined as per the %a)eover Code 4as mentioned above56
acquisition o" shares in the ordinary course o" business by 4a5 ban)s and public "inancial institutions as
pledgees, 4b5 the International Ainance Corporation, *sian /evelopment #an), International #an) "or
Reconstruction and /evelopment, Commonwealth /evelopment Corporation and such other international
"inancial institutions6
acquisition o" shares by a person in e!change o" shares received under a public o""er made under the
%a)eover Code6
acquisition o" shares by way o" transmission on succession or inheritance6
trans"er o" shares "rom venture capital "unds or "oreign venture capital investors registered with the -+#I
to promoters o" a venture capital underta)ing or to a venture capital underta)ing, pursuant to an
agreement between such venture capital "und or "oreign venture capital investors, with such promoters or
venture capital underta)ing6
change in control by ta)eover o" management o" the borrower target company by the secured creditor or
by restoration o" management to the said target company by the said secured creditor in terms o" the
-ecuriti?ation and Reconstruction o" Ainancial *ssets and +n"orcement o" -ecurity Interest *ct, @;;@6
acquisition o" shares in companies whose shares are not listed on any stoc) e!change, unless it results in
the acquisition shares7voting rights7control o" a company listed in India6 and
acquisition o" shares in terms o" guidelines or regulations regarding delisting o" securities "ramed by the
-+#I.
Financing M&A Deals
Mergers are generally di""erentiated "rom acquisitions partly by the way in which they are "inanced and partly
by the relative si?e o" the companies. 8arious methods o" "inancing an MJ* deal e!ist=
Cash
Eayment by cash. -uch transactions are usually termed acquisitions rather than mergers because the
shareholders o" the target company are removed "rom the picture and the target comes under the 4indirect5
control o" the bidderDs shareholders.
Stock
Eayment in the "orm o" the acquiring companyDs stoc), issued to the shareholders o" the acquired company at
a given ratio proportional to the valuation o" the latter.
Financing options
%here are some elements to thin) about when choosing the "orm o" payment. When submitting an o""er, the
acquiring "irm should consider other potential bidders and thin) strategically. %he "orm o" payment might be
decisive "or the seller. With pure cash deals, there is no doubt on the real value o" the bid 4without
considering an eventual earn out5. %he contingency o" the share payment is indeed removed. %hus, a cash
o""er preempts competitors better than securities. %a!es are a second element to consider and should be
evaluated with the counsel o" competent ta! and accounting advisers. %hird, with a share deal the buyer$s
capital structure might be a""ected and the control o" the buyer modi"ied. I" the issuance o" shares is
necessary, shareholders o" the acquiring company might prevent such capital increase at the general meeting
o" shareholders. %he ris) is removed with a cash transaction. %hen, the balance sheet o" the buyer will be
modi"ied and the decision ma)er should ta)e into account the e""ects on the reported "inancial results. Aor
e!ample, in a pure cash deal 4"inanced "rom the company$s current account5, liquidity ratios might decrease.
n the other hand, in a pure stoc) "or stoc) transaction 4"inanced "rom the issuance o" new shares5, the
company might show lower pro"itability ratios 4e.g. R*5. >owever, economic dilution must prevail towards
accounting dilution when ma)ing the choice. %he "orm o" payment and "inancing options are tightly lin)ed. I"
the buyer pays cash, there are three main "inancing options=
Cash on hand= it consumes "inancial slac) 4e!cess cash or unused debt capacity5 and may decrease
debt rating. %here are no ma(or transaction costs.
It consumes "inancial slac), may decrease debt rating and increase cost o" debt. %ransaction costs
include underwriting or closing costs o" 1U to :U o" the "ace value.
Issue o" stoc)= it increases "inancial slac), may improve debt rating and reduce cost o" debt.
%ransaction costs include "ees "or preparation o" a pro!y statement, an e!traordinary shareholder meeting
and registration.
I" the buyer pays with stoc), the "inancing possibilities are=
Issue o" stoc) 4same e""ects and transaction costs as described above5.
-hares in treasury= it increases "inancial slac) 4i" they don$t have to be repurchased on the mar)et5,
may improve debt rating and reduce cost o" debt. %ransaction costs include bro)erage "ees i" shares are
repurchased in the mar)et otherwise there are no ma(or costs.
In general, stoc) will create "inancial "le!ibility. %ransaction costs must also be considered but tend to have a
greater impact on the payment decision "or larger transactions. Ainally, paying cash or with shares is a way to
signal value to the other party, e.g.= buyers tend to o""er stoc) when they believe their shares are overvalued
and cash when undervalued.
O3Q
-pecialist MJ* advisory "irms
*lthough at present the ma(ority o" MJ* advice is provided by "ull-service investment ban)s, recent years
have seen a rise in the prominence o" specialist MJ* advisers, who only provide MJ* advice 4and not
"inancing5. %hese companies are sometimes re"erred to as %ransition companies, assisting businesses o"ten
re"erred to as 9companies in transition.9 %o per"orm these services in the C-, an advisor must be a licensed
bro)er dealer, and sub(ect to -+C 4AI.R*5 regulation. More in"ormation on MJ* advisory "irms is provided
at corporate advisory
/+#% R+-%RCC%CRI.,
/ebt restructuring is a process that allows a private or public company "acing cash "low problems
and "inancial distress, to reduce and renegotiate its delinquent debts in order to improve or restore liquidity
and rehabilitate so that it can continue its operations. * debt restructuring is usually less e!pensive and a
pre"erable alternative to ban)ruptcy. %he main costs associated with a business debt restructuring are the time
and e""ort to negotiate with ban)ers, creditors, vendors and ta! authorities. /ebt restructurings typically
involve a reduction o" debt and an e!tension o" payment terms
/e"inition o" D/ebt RestructuringD
* method used by companies with outstanding debt obligations to alter the terms o" the debt agreements in
order to achieve some advantage. Companies use debt restructuring to avoid de"ault on e!isting debt or to
ta)e advantage o" a lower interest rate. * company will o"ten issue callable bonds to allow them to readily
restructure debt in the "uture. %he e!isting debt is called and then replaced with new debt at a lower interest
rate. Companies can also restructure their debt by altering the terms and provisions o" the e!isting debt issue.
Related terms
Replacement o" old debt by new debt when not under "inancial distress is re"erred to as Re"inancing
/ebt consolidation entails ta)ing out one loan to pay o"" many others. %his is o"ten done to secure a
lower interest rate, secure a "i!ed interest rate or "or the convenience o" servicing only one loan
-hare #uybac) 4or5 -hare Repurchase
* program by which a company buys bac) its own shares "rom the mar)etplace, reducing the number o"
outstanding shares. -hare repurchase is usually an indication that the companyDs management thin)s the
shares are undervalued. %he company can buy shares directly "rom the mar)et or o""er its shareholder the
option to tender their shares directly to the company at a "i!ed price. #ecause a share repurchase reduces the
number o" shares outstanding 4i.e. supply5, it increases earnings per share and tends to elevate the mar)et
value o" the remaining shares. When a company does repurchase shares, it will usually say something along
the lines o", 9We "ind no better investment than our own company.9
1. -hareholders may be presented with a tender o""er whereby they have the option to submit 4or tender5 a
portion or all o" their shares within a certain time "rame and at a premium to the current mar)et price. %his
premium compensates investors "or tendering their shares rather than holding on to them.
@. Companies buy bac) shares on the open mar)et over an e!tended period o" time.
-hare Repurchase
*lternative to the payment o" cash dividends, the company may purchase the shares bac). Eurchase o" shares
outstanding can be done through the secondary mar)et -toc) +!change. -hares purchased are included in
treasury stoc) account. %heoretically, the value o" the company be"ore and a"ter the purchase o" shares will be
the same again.
%he *dvantages o" -toc) Repurchases
#uying bac) shares could save on ta!es.
*nnouncement o" buy-bac) could be considered a positive signal by investors, because -toc)
repurchases o"ten driven by the motivation o" managers who assume that the undervalued stoc) price
4lower than they should5.
Eayment o" dividends is usually done with a stable pattern.
-hareholders have the option to -toc) Repurchases. When need cash, they can sell the shares they
acquire. Conversely, i" do not need cash, or evading ta!es, they can invest bac) into the company stoc).
In some speci"ic situations, -toc) Repurchases done selectively
%he /isadvantages o" -toc) Repurchases
%he shareholders may have di""erent pre"erences between cash dividends and -toc) Repurchases 4pro"its
derived "rom capital gains5. Cash dividends tend to be 0unreliable$ because it gives a clear income 4cash
received5, and relatively stable.
%he Company may pay the repurchase price is too high, to the detriment o" current shareholders 4who
still holds the shares5.
-hareholders who sell their shares may not )now e!actly the implications and the -toc) Repurchases
program e""ects. I" it turns out to "eel aggrieved, they can sue the company.
VMerits o" -hare Repurchase
Reduce ta)eover chances=
#uyi ng bac) s t oc) us es up e!ces s cas h. %her e t ur ns on e!ces s cas h i n money mar )et
account s can dr ag down over al l company per"ormance. Cash rich companies are also very attractive
ta)eover t ar get s . #uyi ng bac) s t oc) al l ows t he company t o ear n a bet t er r et ur n on
e!cess cash and )eep itsel" "rom becoming a ta)eover target.
VIncrease R+=
#uying bac) stoc) can increase the return on equity 4R+5. %hi s e" " ect i s gr eat er t he mor e
under val ued t he s har es ar e when t hey ar e repurchased. I" shares are undervalued, this may be the
most pro"itable course o" action "or the company.
V Esychological +""ect=
Wh e n a c o m p a n y p u r c h a s e s i t s o w n s t o c ) i t i s es s ent i al l y t el l i ng t he mar )
et t hat t hey t hi n) t hat t he company$s s t oc) i s undervalued. %his can have a psychological e""ect
on the mar)et.
V
#uying bac) stoc) allows a company to pass on e!tra cash to shareholders without raising the
dividend. I" the cash is temporary in nature it may prove more bene"icial to pass on value to
shareholders through buybac)s rather than raising the dividend.
V +!cellent %ool "or Ainancial Reengineering=
In the case o" pro"it ma)ing, h i g h d i v i d e n d -
p a y i n g c o mp a n i e s wh o s e s h a r e p r i c e s a r e l a n g u i s h i n g , buybac)s can actually boost
their bottom lines since dividends attract ta!es. * buybac) and t he s ubs equent neut r al i s at i on o"
s har es can r educe di vi dend out"lows, and i" the opportunity cost o" "unds used is lower than the
dividend savings, the company can laugh all the way to the ban).
V %a! Implication=
+!empt i on i s avai l abl e onl y i " t he s har es ar e s ol d on a recognised stoc) e!change and
i" securities transaction ta! 4-%%5 on the sale has been pai d. I n a buybac) s cheme,
nei t her does t he s al e t a)e pl ace on a recognised e!change nor is the -%% paid. -o, you will have
to pay income ta! on your long-term capital gain on the buybac) a"ter deducting the acquisition cost o" your
shares plus the bene"it o" inde!ation "rom the year o" purchase to the year o" buybac). n the resultant
gain, the ta! would be @; per cent plus the applicable surcharge, i" any, plus @ per cent education cess.
Fou may also wor) out the ta! at 1; per cent o" the gain without considering inde!ation. Four ta!
liability will be limited to the lower o" the two calculations.
-toc) buybac)s also raise the demand "or the stoc) on the open mar)et. %his point is rather
sel" e!planatory as the company is competing against other investors to purchase shares o" its own
stoc).
/emerits o" -hare Repurchase
V -ending .egative -ignals=
* buybac) announcement can send a negative signal i n t hes e s i t uat i ons . * t ypi cal e!ampl e i s
t he >E cas e= Ar om .ovember 111P through ctober @;;;, the computer giant >ewlett-
Eac)ard spent NP.@ billion to buy bac) 1@P million o" its shares. %he aim was to ma)e opportunistic
purchases o" >E stoc) at attractive pricesWin other words, at prices they "elt undervalued the
company. Instead o" signalling good operating prospects to the mar)et, the buybac) signal was
completely drowned out more power"ul contradictory signals
about t he company$s " ut ur e whi ch ar e an abor t ed acqui s i t i on, a pr ot r a ct ed bus i nes s
r es t r uct ur i ng, s l i ppi ng " i nanc i al r es ul t s , and a decay i n t he gener al pro"itability o" )ey
mar)ets. #y last &anuary, >E$s shares were trading at around hal" the average N3< per share paid to
repurchase the stoc).
#ac)"ire=
#uybac)s can also bac)"ire "or a company competing in a high-growth industry because they may be
read as an admission that the company has "ew i mpor t ant new oppor t uni t i es on whi ch t o
ot her wi s e s pend i t s money. I n s uch cases, long-term investors will respond to a buybac)
announcement by selling the company$s shares. %he s har e buybac) s cheme mi ght become a bi g
di s advant age t o t he company when i t pays t oo much " or i t s own s har es . I ndeed, i t i s
" ool i s h t o buy i n an overpriced mar)et. Instead, the company should put the money into assets that
can be easily converted bac) into cash. %his way, when the mar)et swings the other way and is
trading below its true value, shares o" the company can be bought bac) at a discount, ensuring current
shareholders receive ma!imum bene"it. -trictly, acompany should repurchase its shares only when its
stoc) is trading below its e!pected value and when no better investment opportunities are available.
ER8I-I.- 7 C./I%I.- R+'*%I., % #CF#*CI.
%he restrictions were imposed to restrict the companies "rom using the stoc) mar)ets as short term money
provider apart "rom protecting interests o" small investors. -ec SS*= Eower o" a company to purchase its own
securities. -ection SS* was introduced by the Companies 4*mendment5 *ct, 1111, pursuant to the report o"
the wor)ing group which was set up to suggest re"orms to the Companies *ct. -ection SS*4@5 o" the
Companies *ct, 1123=
15*uthorised by *rticles o" *ssociation and a -pecial Res olution
@ 5 #u y b a c ) s h o u l d b e e q u a l t o o r l e s s t h a n @ 2 Uo " t h e t o t a l p a i d u p
c a p i t a l a n d " r e e reserves
:5 -har es t o be bought bac) s houl d be " ul l y pai d up
<5/ebt +quity ratio should not e!ceed @=1 post buybac)
25.otice o" meeting to the shareholders should have all the details necessary
35#uybac) o" shares listed on any recognised stoc) e!change should be in accordance with
-+#I guidelines
S5+!planatory statement stating the "ollowing should be prepared-
a5* "ull and complete disclosure o" all material "acts6
b5 %he neces s i t y " or t he buy- bac)
c5%he class o" security intended to be purchased under the buy-bac)6
d5%he amount to be invested under the buy-bac)6 and
e5 %he t i me l i mi t " or compl et i on o" buy- bac)
P5* declaration o" solvency has to be "i led with -+#I and Registrar " Companies
15Completion o" the buybac) should be within 1@ months
1;5 %he shares bought bac) should be e!tinguished and physically destroyed6
115 %he company should not ma)e any "urther issue o" securities within @ years, e!cept bonus,
conversion o" warrants, etc.
/+%+RMI.*%I. A -W*E R*%I MJ* /+*'-
/e"inition o" D-wap RatioD
%he ratio in which an acquiring company will o""er its own shares in e!change "or the target companyDs
shares during a merger or acquisition. %o calculate the swap ratio, companies analy?e "inancial ratios such as
boo) value, earnings per share, pro"its a"ter ta! and dividends paid, as well as other "actors, such as the
reasons "or the merger or acquisition.
Aor e!ample, i" a company o""ers a swap ratio o" 1=1.2, it will provide one share o" its own company "or
every 1.2 shares o" the company being acquired.
%his can also be applied as a debt7equity swap, when a company wants investors to trade their bonds with the
company being acquired "or the acquiring companyDs own shares.
-wap Ratio 4or +!change Ratio5
%he shareholders o" the amalgamating company are given the shares o" the amalgamated company in
e!change "or the shares held by them in the amalgamating company. Aor e!ample when %MC was
emerged with >industan 'ever 'imited, shareholders o" %MC were given the shares o" >industan 'ever
'imited in the ratio o" @=126 that means @ shares o" >industan lever 'imited were given in lieu o" 12 shares o"
%MC . >ow is the e!change ratio determinedK %he commonly used bases "or establishing the e!change
ratio are= earnings per share, mar)et price per share, and boo) value per share.
+arnings per share= -uppose the earnings per share o" the acquiring "irm are Rs 2.;; and the earnings per
share o" the target "irm Rs @.;;. *n e!change ratio based on earnings per share will be ;.< that is 4@725. %his
means @ shares o" the acquiring "irms will be e!changed "or 2 shares o" the target "irm.
While earnings per share re"lect prime "acie the earnings power, there are some problems in an e!change ratio
based solely on current earnings per share o" the merging companies because it "ails to ta)e into account the
"ollowing=
X %he di""erence in the growth rates o" earnings o" the two companies
X %he gains in earnings arising out o" merger
X %he di""erential ris)s associated with the earnings o" the two companies
Moreover, there is the measurement problem o" de"ining the normal level o" current earnings. %he current
earnings per share may be in"luenced by certain transient "actors li)e a wind"all pro"it, or an abnormal labor
problem, or a large ta! relie". Ainally, how can earnings per share, when they are negative, be usedK
Mar)et Erice per share= %he e!change ratio may be based on the relative mar)et prices o" the shares o" the
acquiring "irm and the target "irm. Aor e!ample, i" the acquiring "irm$s equity share sells "or Rs 2; and the
target "irm$s equity share sells "or Rs 1; the e!change ratio based on the mar)et price is ;.@ that is 41;72;5.
%his means that 1 share o" the acquiring "irm will be e!changed "or 2 shares o" the target "irm.
When the shares o" the acquiring "irm and the target "irm are actively traded in a competitive mar)et, mar)et
prices have considerable merit. %hey re"lect current earnings, growth prospects and ris) characteristics. When
the trading is meagre mar)et prices, however, may not be very reliable. In the e!treme case mar)et prices
may not be available i" the shares are not traded. *nother problem with mar)et prices is that they may be
manipulated by those who have a vested interest.
#oo) value per share= %he relative boo) values o" the two "irms may be used to determine the e!change rate.
Aor e!ample, i" the boo) value per share o" the acquiring company is Rs @2 and the boo) value per share o"
the target company is Rs 12, the boo) value based e!change ratio is ;.3 M4127@25.
%he proponents o" boo) value contend that it provides a very ob(ectives basis. %his however is not
convincing argument because boo) values are in"luenced by accounting policies which re"lect sub(ective
(udgments. %here are still serious ob(ections against the use o" the boo) value.
1. #oo) values do not re"lect changes in purchasing power o" money.
@. #oo) values o"ten are highly di""erent "rom true economic values
->*R+ #CF#*CI I. R+,C'*%+/ I./C-%RI+-
%he regulation is applicable to buybac) o" shares or other speci"ied securities o" a company listed on a -toc)
+!change. %he buybac) o" shares can$t ta)e place "or delisting o" shares "rom the -toc) +!change.
When the company is buying bac) shares it can$t buy bac) through negotiated deals with any person or
through spot transactions or through any private arrangement.
-pecial Regulation
In case the ""er si?e is greater than @2U o" its +quity share capital J "ree reserves, the company can
go ahead with the buy bac) only i" a special resolution is passed at the general meeting. When the notice is
being sent to the shareholders an +!planatory -tatement must be anne!ed to the notice containing various
disclosures % h e c o mp a n y c a n a l s o c o mp a n y c a n g o a h e a d wi t h t h e b u y b a c ) o n l y
i " a s p e c i a l
r es ol ut i on i s t hr ough t he pos t al bal l o t r out e as per %he Compani es 4 Eas s i ng o" t he
Resolution by Eostal #allot5 Rules, @;;1.GEostal #allotH includes voting by share holders by postal
or electronic mode instead o" voting personally by presenting "or transacting businesses in a
general meeting o" the company,
Method "or sending notice=4a5 %he company may issue notices either,-4i5 Cnder Registered Eost
*c)nowledgement /ue6 or 4ii5 Cnder certi"icate o" posting6
and4 b 5 Wi t h a n a d v e r t i s e me n t p u b l i s h e d i n a l e a d i n g +n g l i s h .e ws p a p e r a n d
i n o n e ver nac ul ar .ews paper ci r cul at i ng i n t he -t a t e i n whi ch t he r egi s t er ed
o" " i ce o" t he company is situated, about having despatched the ballot papers.H

+!planatory -tatement
%he company needs to ma)e the "ollowing disclosures in the statement
1. %he date o" the #oard meeting at which the proposal "or buy bac) was approved by the #/.
@ . %h e n e c e s s i t y " o r t h e b u y b a c )
:. %he company may speci"y one reason to be adopt ed "or buy-bac) so that the shareholders
authori?e the #/ "or the same.
<. %he ma!imum amount required under the buy bac) and the sources o" "unds "r om which the
buy bac) would be "inanced.
2. %he bas i s o" ar r i vi ng at t he buy- bac) pr i ce.
3. %he number o" securities that the company proposes to buy bac).
S. a. %he aggregate shareholding o" the promoter and o" the directors o" the promoters, as on the
date o" the notice convening the ,eneral Meeting.
b. *ggregate number o" shares purchased or sold by such persons during a period o" si! months
preceding the date o" the #oard Meeting
c. %he ma!imum and minimum price at which purchases and sales were made along with the
relevant dates.
P. Intention o" the promot ers and persons in control o" the company to tender their shares "or
buy-bac) indicating the number o" shares and details o" acquisition with dates and price.
1. * con"irmation that there are no de"aults subsisting in repayment o" deposits, redemption o"
debentures or pre"erence shares or repayment o" term loans to any "inancial institutions or ban)s.
1;. * con"irmation that the #/ has made a "ull enquiry into the a""airs and prospects o" the company and
is o" the opinion.

a. that there will be no grounds on which the company could be "ound unable to pay its debts6
b.%he company during that year, the company will be able to meet its liabilities as and when they
"all due and will not be rendered insolvent within a period o" one year "rom that ,eneral Meeting date 6 and
c. In "orming their opinion "or the above purposes, the directors have ta)en into account the
liabilities as i" the company were being wound up under the provisions o" the Companies *ct, 1123
Who Is Merchant #an)erK
* merchant ban)er, according to -+#I 4Merchant #an)ers5 Regulations, 111@ G
is a person who is engaged in the business o" issue management either by ma)ing arrangements regarding
selling, buying or subscribing to securities as manager, consultant, advisor or rendering corporate advisory
services in relation to such issue managementH
Merchant ban)ers render services to meet the needs o" trade, industry and also investors by per"orming as
intermediary, consultant and a liaison. Merchant ban)ing is a service oriented industry speciali?ing in
investment and "inancial decision ma)ing, assisting in ma)ing corporate strategies, assessing capital needs
andhelping in procuring the equity and debt "unds "or corporate sectors and ultimately helping in establishing
"avourable economic environment.
-W+*% +BCI%F J CRER*%+ E+RARM*.C+
What is D-weat +quityDK
-weat equity is a partyDs contribution to a pro(ect in the "orm o" e""ort -- as opposed to "inancial equity, which
is a contribution in the "orm o" capital. In a partnership, some partners may contribute to the "irm only capital
and others only sweat equity
Contribution to a pro(ect or enterprise in the "orm o" e""ort and toil. -weat equity is the ownership interest, or
increase in value, that is created as a direct result o" hard wor) by the owner4s5. It is the pre"erred mode o"
building equity "or cash-strapped entrepreneurs in their start-up ventures, since they may be unable to
contribute much "inancial capital to their enterprise. In the conte!t o" real estate, sweat equity re"ers to value-
enhancing improvements made by homeowners themselves to their properties. %he term is probably derived
"rom the "act that such equity is considered to be generated "rom the 9sweat o" oneDs brow.9
Aor e!ample, consider an entrepreneur who has invested N1;;,;;; in her start-up. *"ter a year o" developing
the business and getting it o"" the ground, she sells a @2U sta)e to an angel investor "or N2;;,;;;. %his gives
the business a valuation o" N@ million 4i.e. N2;;,;;;7;.@25, o" which the entrepreneurDs share is N1.2 million.
-ubtracting her initial investment o" N1;;,;;;, the sweat equity she has built up is N1.< million.
8aluation o" sweat equity can become a contentious issue when there are multiple owners in an enterprise,
especially when they are per"orming di""erent "unctions. %o avoid disputes and complications at a later stage,
it may be advisable to arrive at an understanding o" how sweat equity will be valued at the outset or initial
stage itsel".
+mployee -toc) ption 4+-E5 and -weat +quity 4-+5 are new tools, which are in use by a lot o"
multinational companies and consulting companies coming to India and engaging the real brain o" Indian
pro"essionals who are o""ered +-E7-+ by such companies as an incentive to them. In absence o" any set law
or precedent about its legality, ta!ation and accounting, a great deal o" con"usion is prevailing and an attempt
is made to resolve the same.
Why +-E or -+ K
%he employee stoc) option plan is a good management tool "or retention o" human talent and guarding
against poaching o" sta"" o" a running organisa-tion by a rival company.
When a company is newly "ormed or starts a new line o" business, the company engages the best e!ecutives
and employees available, who bring in their IER 4Intellectual Eroperty Rights5 and )now-how, s)ill and
e!pertise with them, which ma)e a value addition "or the company. Certain )ey pro"essionals would li)e to
invest in the company$s capital and would li)e to ris) their own contribution to the capital o" the company
along with their own IER, )now-how, s)ill and e!pertise. -uch employees would li)e to be a strategic part o"
the promoter group and would li)e to ma)e value addition to their capital invested in the company. -uch an
employee is awarded with -weat +quity as an incentive to (oin the company.
*s the company grows, the management would li)e to see that all its core management team remains with
them and "urther, such core management team is given additional incentive as a reward "or the e""orts put in
by them in managing the company. -uch employees are o""ered +-E at a price which is less than the real
value o" the share.
+mployee -toc) wnership Elan 4+-E5
*n employee stoc) ownership plan 4+-E5 is a de"ined contribution plan that provides a companyDs wor)ers
with an ownership interest in the company. In an +-E, companies provide their employees with stoc)
ownership, typically at no cost to the employees. -hares are given to employees and are held in the
+-E trust until the employee retires or leaves the company, or earlier diversi"ication opportunities arise.
C-+- A *. +-E
* Readily *vailable Mar)et "or Controlling -hareholders
Arequently, controlling shareholders desire to sell a part o" their shares in order to diversity their holdings, or
to provide liquidity "or investment or estate planning purposes. Csually, however, there is no mar)et "or the
sale o" a minority interest in a closely-held company.
* great deal o" "le!ibility is available in structuring sales to the +-E. I" a shareholder desires immediate
liquidity, the plan may obtain a ban) loan and purchase the shares "or cash. I" a shareholder does not need
immediate liquidity, he may de"er the ta! on the sale by selling his shares to the trust on an instalment sale
basis, or by selling only a portion o" his shares to the trust on a year-by-year basis.
* Readily *vailable Mar)et "or Minority -hareholders and utside Investors
%he +-E also provides a readily available mar)et "or the minority shareholders and other GoutsideH
investors who desire to reali?e their gain or to liquidate a part or all o" their investment "or reinvestment in
other companies. I" the +-E acquires at least :;U ownership, a minority shareholder may also elect ta!-"ree
rollover treatment under Y1;<@ o" the Internal Revenue Code.
* %a!-*dvantaged *lternative to -ale or Merger
Eurchase o" an owner$s stoc) by an +-E will almost always be more bene"icial to the owner than sale or
merger. Aor e!ample, in the case o" a sale, the seller will incur an income ta!, will lose control, will usually
lose his salary and "ringe bene"its, and will seldom be able to )eep any retained equity. In comparison, there
will be no ta! to the seller i" he sells stoc) to the +-E under the ta!-"ree rollover provision o" the 11P< %a!
Re"orm *ct. In addition, under an +-E, the seller can )eep control, can continue to receive his salary and
"ringe bene"its, and can )eep as much or as little o" the stoc) as he desires.
*n +""ective %ool "or Increasing Cash Alow and .et Worth
* company can reduce its corporate income ta!es and increase its cash "low and net worth by simply issuing
treasury stoc) or newly issued stoc) to an +-E in any amount up to @2U o" eligible annual payroll. Csing
this approach, a company may drastically reduce or even eliminate its corporate ta! liability. %he cash "low
impact can be dramatic. I" the contribution to the +-E is made in lieu o" cash contributions to a pro"it
sharing plan, the cash "low savings are even more dramatic. " course, the owners must consider that these
contributions o" stoc) will result in some dilution o" their ownership interest.
* -uperior +mployee Incentive /evice
*n +mployee -toc) wnership Elan is designed to provide employees with the incentive o" a Gpiece o" the
action,H and to enable employees to share in the capital growth o" the company. +mployee stoc) ownership
gives employees a direct and vested interest in the success o" their company, enables employees to share in
the pro"its o" their own labor, and creates an identity o" interest between management and labor.
*s an employee incentive device, the +-E is usually superior to other incentive plans. In an ordinary pro"it
sharing plan, "or e!ample, the "unds are invested in stoc)s o" unrelated companies, and the incentive e""ects
are minimal. In an +-E, on the other hand, the employees acquire an ownership interest in their own
company, and the incentive element is ma!imi?ed.
%he +-E is a "le!ible plan that can be used either in lieu o" or in combination with other employee bene"its
plans. #ecause o" its many advantages, the +-E is becoming an increasingly popular "orm o" employee
bene"it. %he +-E is particularly advantageous "or companies whose rapid growth has required the
reinvestment o" pro"its, resulting in a shortage o" cash available "or employee bene"its. * collateral bene"it is
that the +-E o"ten serves to diminish employee interest in unioni?ation.
* .ew Way to Ainance /ebt Reduction
Companies "requently "ind it necessary to borrow money in order to "inance corporate growth. ne
disadvantage o" debt "inancing is that repayment o" the loan principal is not a deductible e!pense. *n +-E
can be used to mitigate this problem by having the company issue newly issued stoc) or treasury stoc) to an
+-E. %he resulting ta! savings can then be applied against the principal payments so that ta!-deductible
dollars are used to pay part, or all, o" the loan principal.
>ow the Elan is /esigned
*n +-E is a plan quali"ied by the Internal Revenue -ervice as an equity-based de"erred compensation plan.
*s such, it is in the same "amily as pro"it sharing plans and stoc) bonus plans.
*n +-E, however, di""ers "rom a pro"it sharing plan in that an +-E is required to invest primarily in
employer securities, while a pro"it sharing plan is usually prohibited "rom investing primarily in employer
securities.
*n +-E also di""ers "rom pro"it sharing plans and "rom stoc) bonus plans in that an +-E is permitted and
authori?ed to engage in leveraged purchases o" company stoc). Consequently, an +-E required di""erent
accounting procedures and a di""erent method o" allocating stoc)s and other investments among the
employees than other types o" plans. Aor this reason, the plan should be designed by an +-E specialist in
order to avoid Internal Revenue -ervice di""iculties.
%he +-E, li)e a pro"it sharing plan, must cover all non-union employees who are at least age @1 and have
one year o" service. *n +-E may either include or e!clude union employees. In practical e""ect, share
ownership under the plan is usually proportionate to the relative salaries o" the participants in the plan.
>ow do -toc) Eurchase Elans wor)K
Cnder a typical -toc) Eurchase Elan, employees are given an option to purchase their employerDs stoc)
generally at a discounted price at the end o" an o""ering period. Erior to each o""ering period, eligible
employees indicate i" they wish to participate in the plan.
I" the employee wishes to participate, he7she indicates the percentage or dollar amount o" compensation to be
deducted "rom their payroll throughout the o""ering period. %he percentage or dollar amount employees are
allowed to contribute varies by plan, however, the IR- limits the total purchase to N@2,;;; annually.
Cnder most stoc) purchase plans, the purchase price is set at a discount "rom the "air mar)et value. While
some plans provide that the discount is applied to the value on the stoc) on the purchase date 4e.g., P2U o"
the "air mar)et value on that date5, it is more common to apply the discount to the value o" the stoc) on the
"irst or last day o" the o""ering period, whichever is lower.
Most plans allow employees to increase or decrease their payroll deduction percentage at any time during the
o""ering period. +ach plan is unique, your plan materials will detail how a speci"ic plan wor)s.
%op
%wo %ypes o" +mployee -toc) Eurchase Elans
%here are two types o" +mployee -toc) Eurchase Elans, classi"ied by their ta! status=
Buali"ied +mployee -toc) Eurchase Elans 4-ection <@:5
Buali"ied +mployee -toc) Eurchase Elans meet conditions described by -ection <@: o" the Internal Revenue
Code. %here is special ta! treatment "or shares that are held "or more than a year. * quali"ied plan must meet
the "ollowing requirements=
nly employees o" the company 4or its parent or subsidiary corporations5 may participate in the plan
%he purchase plan must be approved by the shareholders o" the company within the 1@ months be"ore
it is adopted by the board.
*ny employee owning more than 2U o" the company stoc) may not participate in the plan
*ll eligible employees must be allowed to participate in the plan, although certain categories o"
employees may be e!cluded 4e.g. employees employed less than two years5
*ll employees must en(oy the same rights and privileges under the plan, e!pect that the amount o"
stoc) that may be purchased may be based on compensation di""erences
%he purchase price may not be less than the lesser o" P2U o" the "air mar)et value o" the stoc) 15 at
the beginning o" the o""ering period, or @5 on the purchase date
%he ma!imum o""ering period cannot e!ceed @S months unless the purchase price is based solely on
the "air mar)et value at time o" purchase, in which case the o""ering period may be as long as 2 years
*n employee may not purchase more than N@2,;;; worth o" stoc) 4based on "air mar)et value on the
"irst day o" the o""ering period5 "or each calendar year in which the o""ering period is in e""ect
.on-Buali"ied +mployee -toc) Eurchase Elans
.on--ection <@: +mployee -toc) Eurchase Elans are simple payroll deduction plans that allow employees to
purchase company stoc), sometimes at a discount. %here is no special ta! treatment o" any proceeds, and the
plan is not necessarily available to all employees.