Mergers are generally differentiated from acquisitions partly by the way in which they are financed and partly by the relative size of the companies. Various methods of financing an Mergers & Acquisitions deal exist:
a) Payment by cash
Such transactions are usually termed acquisitions rather than mergers because the shareholders of the target company are removed from the picture and the target comes under the (indirect) control of the bidder’s shareholders alone.
A cash deal would make more sense during a downward trend in the interest rates. Another advantage of using cash for an acquisition is that there tends to lesser chances of EPS dilution for the acquiring company. But a caveat in using cash is that it places constraints on the cash flow of the company.
b) Equity share Financing or exchange of shares
It is one of the most commonly used methods of financing mergers. Under this method shareholders of the acquired company are given shares of the acquiring company. It results into sharing of benefits and earnings of merger between the shareholders of the acquired companies and the acquiring company. The determination of a rational exchange ratio is the most important factor in this form of financing merger. The actual net benefit to the shareholders of the two companies depends upon the exchange ratio and the price earning ratio of the companies. Usually, it is an ideal method of financing a merger in case of price earning ratio of the acquiring company is comparatively high as compared to that of the acquired company.
c) Debt and preference share financing
A company may also finance a merger through issue of fixed instruct bearing convertible debentures and convertible preference share being a fixed rate of dividend. The shareholders of the acquired company sometimes prefer such a mode of payment because of security of income along with an option of conversion into equity within a stated period. The acquiring company is also benefitted on account of lesser or on dilution of earnings per share as well as voting/ controlling power of its existing shareholders.
d) Deferred payment or earn- out plan
Deferred payments also known as earn–out plan is a method of making payments to the target firm which is being acquired in such a manner that only a part of the payment is made initially either in cash or securities. In addition to the initial payment, the acquiring company undertakes to make additional payments in future years if it is able of increase the earning after the merger or acquisition. It is known as earn out plan because the future payments are linked with the firms future earnings. This method helps the acquiring company to negotiate successfully with Target Company and also help in increasing the earning per share because of lesser number of shares being issued in the initial years. However, to make it successful, the acquiring company should be prepared to co-operate towards the growth and success of the target firm.
e) Leverage buy-out
A merger of a company which is substantially financed through debt is known as leveraged buy-out. Debt, usually, forms more than 70% of the purchase price. The shares of such a firm are concentrated in the hands of a few investors and are not generally, traded in the stock, exchange. It is known as leveraged buy –out because of the leverage provided by debt source of financing over equity. A leveraged buy-out is also called management buy-out (MBO). However, a leveraged buy-out may be possible only in case of a financially sound acquiring company which is viewed by the lenders as risk free.
f) Tender offer
Under this method ,the purchaser, who is acquisitioned of some company, approaches the shareholders of the target firm directly and offers them a price (which is usually more than the market price) to encourage them sell their shares to them. It is a method that results into hostile or forced take over. The management of the target firm may also tender a counter offer at still a higher price to avoid the take over. It may also educate the shareholders by informing them that the accusation offer is not in the interest of the shareholders in the long run.
An acquisition can involve a combination of cash and debt or of cash and stock of the purchasing entity.