What it Means, How It Works, Tactics

What Is a Target Firm?

The term target firm refers to a company that is an attractive merger or acquisition option by a potential acquirer. Companies are seen as possible targets for different reasons, including the potential for new markets, new products, and increased profitability. When the management and shareholders of target firms favor a takeover, a friendly and orderly transaction takes place. In this case, the target company becomes grafted into the acquiring firm or company. The takeover becomes hostile if the target doesn’t want to be purchased.

Key Takeaways

  • A target firm is an attractive company sought for merger or acquisition.
  • A transaction can proceed only if the target firm’s management, shareholders, and board of directors agree to the takeover.
  • If not in agreement, the target firm can use special tactics to try to stop a hostile takeover, such as the crown jewel or poison pill strategy.
  • Target firms are usually acquired at a premium, a value exceeding its current fair market value.

Understanding Target Firms

Mergers and acquisitions (M&A) are a big part of the corporate world. It isn’t uncommon for larger companies to buy and acquire smaller firms. In other cases, two companies of similar size may decide to merge to form a single unit. Regardless of the situation, there are two sides to the transaction: the acquirer, which is the one initiating the transaction, and the target firm.

As noted above, companies become target firms for different reasons. Potential acquirers may choose target firms to:

  • Boost profitability
  • Provide access to a new market
  • Access an attractive product or service that the acquirer wants
  • Eliminate the competition
  • Gain market share

Target firms are often acquired at a price that is somewhat more than their fair market value (FMV). This is widely known as a takeover premium. This is rational when the acquiring firm perceives an additional strategic value to the acquisition, such as greater economies of scale.

These economies do not always materialize since there can be additional hidden costs associated with the integration of two firms, particularly for business operations with deeper cultural or social differences than previously recognized.

In the case of mergers and acquisitions (M&A), friendly takeover attempts are far more common, though hostile takeover attempts tend to dominate the news. In reality, hostile takeover attempts of the Hollywood variety are far more costly and time-consuming than potential acquirers would prefer.

The target firm’s identity may remain part of the new entity after the acquisition is complete. This is common when the target firm has a good reputation and/or a good customer or supplier base and vacating the name would cause irreparable harm.

Special Considerations

More contemporary definitions of the term target firm also lump them with shareholder activism campaigns. Shareholder activism is a modern approach to driving change without the messy hassle of expensive takeover attempts. As such, it’s not uncommon to hear a company or industry described as a target of environmental social, and governance (ESG)-led shareholder engagement initiatives.

For instance, as gender equality, environmental concerns, and cybersecurity issues grow in popularity and importance, it’s common for the media, analysts, and shareholders to target a firm for a variety of shareholder or stakeholder activism efforts.

Target Firm Resistance Tactics

A target firm’s management or board of directors may not agree with the merger or acquisition and may resist being taken over. As such, they may use different tactics to remain autonomous and stop the takeover, such as the poison pill or crown jewel defense.

  • Under the poison pill strategy, the target firm employs a shareholder rights plan whereby the company extends options or warrants to existing shareholders to purchase additional shares at a discount. If successful, the acquirer’s ownership interest is diluted, making the target firm less attractive. The poison pill strategy may be used to stop a takeover or to transfer bargaining power to the target firm.
  • The crown jewel defense refers to when a target firm sells its most valuable assets, known as the crown jewels, to a third party, known as the white knight. If successful, the acquirer is no longer interested in acquiring the company and withdraws its bid. To restore itself to a better position, the target firm can then repurchase the assets from the white knight at a specific price.

Examples of Target Firms

There are numerous examples of target firms in the corporate world. For instance, Amazon (AMZN) acquired target firm One Medical in 2023 for $3.9 billion. The e-commerce giant’s acquisition of its target allows Amazon to assist in the delivery of healthcare and pharmaceutical products to consumers.

Microsoft (MSFT) announced that it was acquiring the professional networking site LinkedIn in 2016. Microsoft, the acquirer, paid $26.2 billion to purchase the target firm LinkedIn. The deal was approved by shareholders of both companies.

What Makes a Target Firm Attractive?

There are many reasons why an acquirer may find a target attractive. There may be one rationale for choosing a target or multiple factors. For instance, the target may provide the acquirer with access to a new market or a new product or service line. Others may want to eliminate the competition, increase shareholder value, or gain market share.

How Is the Target Firm of an Acquisition Valued?

Target firms can be valued using market-based methods. After identifying a potential target, the acquirer can compare the target to its direct competitors and use key financial metrics to determine its value. For instance, it may use the target’s price-to-earnings (P/E) or its enterprise value-to-EBITDA to value the target.

What Options Do Target Firms Have if They Don’t Want to Be Taken Over?

Target firms can use one or more defensive strategies to avoid being taken over. One of the most common is the poison pill defense, which involves offering shareholders additional options or warrants to purchase additional shares at a discount, thereby diluting ownership and preventing the acquirer from gaining a majority stake. Other tactics include the crown jewel defense, the white knight defense, and the gold parachute defense.

The Bottom Line

There are usually two parties involved in the M&A process—especially when it comes to acquisitions. The acquirer is the one that initiates the transaction while the target firm is the sought-after company. Although some target firms may agree to be purchased, not every target wants to be acquired. These firms may use tactics to defend themselves from hostile takeovers, such as the poison pill or crown jewel defense.

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