Important Elements of Merger Procedure – Scheme and Valuation

Scheme of Merger

The scheme of any arrangement or proposal for a merger is the heart of the process and has to be drafted with care. There is no specific form prescribed for the scheme. It is designed to suit the terms and conditions relevant to the proposal but it should generally contain the following information as per the requirements of sec. 394 of the companies Act, 1956:

1. Particulars about transferor and transferee companies
2. Appointed date of merger
3. Terms of transfer of assets and liabilities from transferor company to transferee company
4. Effective date when scheme will came into effect
5. Treatment of specified properties or rights of transferor company
6. Terms and conditions of carrying business by transferor company between appointed date and effective date
7. Share capital of Transferor Company and Transferee Company specifying authorized, issued, subscribed and paid up capital.
8. Proposed share exchange ratio, any condition attached thereto and the fractional share certificate to be issued.
9. Issue of shares by transferee company
10. Transferor company’s staff, workmen, employees and status of provident fund, Gratuity fund, superannuation fund or any other special funds created for the purpose of employees.
11. Miscellaneous provisions covering Income Tax dues, contingent and other accounting entries requiring special treatment.
12. Commitment of transferor and Transferee Company towards    making an application U/S 394 and other applicable provisions of companies Act, 1956 to their respective High court.
13. Enhancement of borrowing limits of transferee company when scheme coming into effect.
14. Transferor and transferee companies consent to make changes in the scheme as ordered by the court or other authorities under law and exercising the powers on behalf of the companies by their respective boards.
15. Description of power of delegates of Transferee Company to give effect to the scheme. Qualifications attached to the scheme which requires approval of different agencies.
16. Effect of non receipt of approvals/sanctions etc.
17. Treatment of expenses connected with the scheme.

Valuation in a Merger: Determination of Share Exchange Ratio

An important aspect of merger procedure relates to valuation of business in order to determine share exchange ratio in merger. Valuation is the means to assess the worth of a company which is subject to merger or takeover so that consideration amount can be quantified and the price of one company for other can be fixed. Valuation of both companies subject to business combination is required for fixing the consideration amount to be paid in the form of exchange of share. Such valuation helps in determining the value of shares of acquired company as well as acquiring company to safeguard the interest of shareholders of both the companies.

Broadly there are three methods used for valuation of business:

1. Net Asset Value (NAV) Method

Net Asset Value (NAV) is the sum total of value of asserts (fixed assets, current assets, investment on the date of balance sheet less all debts, borrowing and liabilities including both current and likely contingent liability and preference share capital). Deductions will have to be made for arrears of preference dividend, arrears of depreciation etc. However, there may be same modifications in this method and fixed assets may be taken at current realizable value (especially investments, real estate etc.) replacement cost (plant and machinery) or scrap value (obsolete machinery). The NAV, so arrived at, is divided by fully diluted equity (after considering equity increases on account of warrant conversion etc.) to get NAV per share.

The three steps necessary for valuing share are:

1. Valuation of assets
2. Ascertainment of liabilities
3. Fixation of the value of different types of equity shares.

NAV = All assets (value by appropriation method – all liabilities – preference shares) / Fully diluted equity shares

2. Yield Value Method

This method also called profit earning capacity method is based on the assessment of future maintainable earnings of the business. While the past financial performance serves as guide, it is the future maintainable profits that have to be considered. Earnings of the company for the next two years are projected (by valuation experts) and simple or weighted average of these profits is computed. These net profits are divided by appropriate capitalization rate to get true value of business. This figure divided by equity value gives value per share. While determining operating profits of the business, it must be valued on independent basis without considering benefits on account of merger. Also, past or future profits need to be adjusted for extra ordinary income or loss not likely to recur in future. While determining capitalization rate, due regard has to be given to inherent risk attribute to each business. Thus, a business with established brands and excellent track record of growth and diverse product portfolio will get a lower capitalization rate and consequently higher valuation where as a cyclical business or a business dependent on seasonal factors will get a higher capitalization rate. Profits of both companies’ should be determined after ensuring that similar policies are used in various areas like depreciation, stock valuation etc.

3. Market Value Method

This method is applicable only in case where share of companies are listed on a recognized stock exchange. The average of high or low values and closing prices over a specified previous period is taken to be representative value per share.

Now, the determination of share exchange ratio i.e., how many shares of amalgamating company, are to be exchanged for how many shares of amalgamated company, is basically an exercise in valuation of shares of two or more of amalgamating company. The problem of valuation has been dealt with by Weinberg and Blank (1971) by giving the relevant factors to be taken into account while determining the final share exchange ratio. These relevant factors has been enumerated by Gujarat High court in Bihari Mills Ltd. and also summarized by the Apex court in the case of Hindustan Levers. Employees union vs. Hindustan Lever Ltd. (1995) as under.

1. The stock exchange prices of the shares of the companies before the commencement of negotiations or the announcement of the bid.
2. The dividends presently paid on the shares of two companies. It is often difficult to induce a shareholder to agree to a merger if it involves a reduction in his dividend income.
3. The relative growth prospects of the two companies.
4. The cover, (ratio of after tax earnings to divided paid during the year) for the present dividends of the two companies. The fact that the dividend of one company is better covered than the other is a factor which has to be compensated to same extent.
5. The relative gearing of the shares of the two companies. The gearing of an ordinary share is the ratio of borrowings to equity capital.
6. The value of net assets of the two companies.
7. The voting strength in the company of shareholder of the two companies.
8. The past history of the prices of two companies.

There are however, no rules framed specially for the working out of share exchange ratio in case of amalgamations. According to Delhi High Court statement, “The valuation of shares is a technical matter which requires considerable skills and expertise. There are bound to be difference of opinion as to what the correct value of the shares of the company is. If it is possible to the value the shares in a manner difference from the one adopted in the given case, it cannot be said, that the valuation agreed upon has been unfair.”

In CWT vs. Mahadeo Jalan (1972) 86 ITR 621 (SC), Supreme Court has evolved the following guidelines and aspects which should be considered:

• Regard should be had to price of shares prevailing in stock market

• Profit earning capacity (yield method) or dividend declared by the company (dividend method) should be considered. If result of two methods differs, a golden mean should be found.

• In computing yields, abnormal expenses will be added back to calculate ‘yield’ (e.g. company incurring expenses disproportionate to the commercial venture, possibly to reduce income tax liability)

• If lower dividend or profits are due to temporary reasons, then estimate of share value before the set-back and proportionate fall in price of quoted shares of companies which have suffered similar reverses should be considered

• If company is ripe for winding up, break up value method to determine what would be realized in winding up process should be considered.

• Valuation can be done on basis of asset value, if reasonable estimation of future profits and dividend is not possible due to wide fluctuations in profits and uncertain conditions.

Valuation of shares on book value method is proper and valid mode of valuation of shares- Tinsukhia Electric Co. Ltd. vs. State of Assam. Often share value cannot be finalized on basis of one parameter only. Thus, final decision depends on judicious consideration of usual methods of valuation i.e. break —up value, yield value, market value or on net worth basis. Qualitative factors like market fluctuations, competition, Government policy, managerial skills are also relevant for the purpose-Sanghi industries Ltd.