Basic Steps To A Merger

Agribusiness Series

Basic Steps To A Merger: A Planning Tool For Cooperatives Oklahoma Cooperative Extension Service • Division of Agricultural Sciences and Natural Resources

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Phil Kenkel Extension Economist

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ergers and acquisitions occur in all forms of business; hence, they have generated a variety of opinions such as:

compete for market share over a period of time. When successful, a merger allows both cooperatives a favorable reputation and customer goodwill to be transferred to a leaner organizational form. Most importantly, a business combination between cooperatives is one method of maintaining service to the members and also maintaining the cooperative presence in the marketplace. Some cooperatives see mergers or other forms of business combinations as a means of acquiring facilities more cheaply than by building. The possibility of acquiring facilities at “bargain” prices does not necessarily imply a bad deal for the other cooperative. The value of a facility to the acquiring firm is determined by the return which the facility will provide under their management. It may be that the acquiring firm can better utilize the capacity, provide superior management, or augment the capacity with other equipment. The value of the facility to the acquiring firm is based on the return they anticipate when the facility is fully consolidated under their management. Thus, the combination can be a positive deal for the memberships of both firms.

Mergers and acquisitions improve efficiency, transfer scarce resources to higher value uses and stimulate effective management... (The President’s Council of Economic Advisors, 1985). Out of five mergers, two are outright disasters, two neither live nor die, and one works (Peter Drucker, Management Expert, Forbes, January 1982). Over half of the managers responding to a recent OSU survey had either been involved in a merger during the last five years or were anticipating one within the next five years. A merger or reorganization may provide a means of reducing costs, increasing market share, and more efficiently meeting member needs. However, according to surveys conducted by the Agricultural Cooperative Service, not all cooperative mergers are successful. Analyzing a merger opportunity and implementing a merger are the most difficult challenges a cooperative board and manager will ever undertake. The purpose of this fact sheet is to describe the basic steps involved in analyzing a merger.

What in the World is Synergism? Synergism occurs when the earnings of the combined cooperatives can be made greater than the earnings of the uncombined firms without sacrificing any member services. In this case, the “merger math” comes out 2 + 2 = 5. Sources of synergism include: • Combining duplicate functions • Better utilizing excess capacity in one or both organizations • Achieving economies of scale • Risk-spreading • Reducing the cost of capital • Better cash and inventory management • Increased market power. Specific examples of synergism include reduced personnel costs, reduced accounting costs, and reduced auditor and consultant fees. Most merged cooperatives operate with a smaller staff than the total of the pre-merged firms. Obviously, one manager position is often eliminated. The merger may also allow two bulk fuel routes to be combined or for the bookkeeping responsibilities to be combined with a net per-

Why Get the Urge to Merge? Mergers, consolidations, and acquisitions fall under the broad category of business combinations. Fundamentally, a business combination is a growth strategy. That is, at least one of the cooperatives involved must perceive benefits to growth. These benefits might include increased market power, the opportunity to add new business lines, or the potential for increased efficiency. Unfortunately, some cooperatives consider a merger only when their financial condition has deteriorated to the point that no other options are available. Unlike other methods of expansion, a business combination allows for almost instantaneous growth. Business combinations allow the firm to increase its physical facilities, market trade area, and personnel base. A merger not only avoids the time lag of internal growth, but it also avoids destabilizing the marketplace by having two cooperatives

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sonnel savings. Auditing and consulting fees may also be reduced since it is easier to provide these services to one large firm than to two smaller entities. In some cases, a merger has made it feasible to dedicate an employee to functions previously filled by consultants (such as regulatory compliance). The replacement of consulting fees with inhouse expertise can represent another source of savings. Some cooperatives have improved their cash management, inventory management, and marketing operations subsequent to a merger since they became large enough to utilize more sophisticated management techniques. Unfortunately, mergers and other combinations also have many negative aspects. In some cases, the merger math comes out 2 + 2 = 3. If not handled properly, a merger can lead to bad feelings and a loss of membership identity with the cooperative. The combination can also lead to internal conflicts as the manager attempts to blend two different firm cultures into a single unit. At times, a manager who has done an excellent job with a smaller cooperative is unable to effectively manage a larger firm. Not only does the merger put new stresses on management capabilities, it may also require the manager to delegate more effectively and require considerably more communication and people skills. Some cooperatives have also avoided major problems in the merger process but have found that the expected savings never materialize.

Figure 2. Statutory consolidation of cooperative A and cooperative T.

Figure 3. A “purchase of assets” combination.

Types of Business Combinations The reorganization of two or more firms into a single firm can be accomplished in three basic ways. Under a merger (Figure 1), all of the assets and liabilities of the dissolving firm are transferred to another firm. All of the stock in the dissolving firm is retired, in exchange for cash, bonds, or stock in the surviving firm. A consolidation (Figure 2) is an alternative form of reorganization in which two or more firms dissolve and a new firm is formed. Once again, all of the assets and liabilities are transferred to the new firm, and the stock of the original firms is retired. An acquisition occurs when one firm purchases another firm. The acquired organization may or may not survive. A purchase of assets acquisition (Figure 3) occurs when only the assets of a firm are transferred to an acquiring firm in exchange for cash and/or stock in the other firm. The transferring firm typically uses the proceeds of the sale to pay off the liabilities, and eventually dissolves. Cooperatives may use the purchase of assets strategy to acquire only some aspects of another firm or to

avoid taking on any liabilities (such as liabilities for environmental clean-up) which may be associated with the other firm. While the form of the combination has important legal implications, each of these alternatives raises similar issues for the board, manager, and membership.

A Strategic Planning Approach Cooperatives differ in their approach to mergers. In some cooperatives, the directors maintain a discouraging tone toward mergers, but would probably consider a merger if it were presented to them. In other organizations, the board may take a proactive role in aggressively pursuing a merger or acquisition opportunity. Decisions involving mergers and reorganization fall under the general category of strategic planning. Strategic planning involves answering questions such as: • What is the purpose of our organization? • Who do we serve? • What are our strengths, weaknesses, opportunities, and threats? • Where do we need to take this company? • How do we plan to get there? Viewing mergers and acquisitions within the context of strategic planning facilitates a proactive rather than a reactive approach. It may also help the cooperative avoid tying up too

Figure 1. Statutory merger of cooperative into cooperative A.

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much time, energy, and effort in pursuing mergers at the expense of operations and other types of opportunities.

• Review of feasibility study • Approval by board of directors at each cooperative • Presentation and approval at joint board meeting.

Basic Steps in a Merger

Step 4-Formal Feasibility Study

The evaluation and negotiation of a merger are a major business decision. Your attorney, auditor, and banker are important sources of expertise and assistance. Other outside resources include business consultants, regional cooperatives, and university experts. Each merger situation is different, but most successful mergers involve the same basic steps: • Informal discussion • Formation of a steering committee • Determining a calendar of events • Formal feasibility study • Negotiating the merger agreement • Membership approval • Implementation of the reorganization.

The most crucial step within the calendar of events is the formal feasibility study. The study should consider the last two years’ financial information for each organization as well as a projected balance sheet and statement of operations for the combined operation. The study should also include historic and projected financial ratios for the separate firms and the combined organization including: • Current Ratio • Member Equity to Term Debt • Member Equity to Total Assets • Return on Assets • Expense Ratios Salary and Wage Expense to Gross Income Fixed Expense to Gross Income Total Expense to Gross Income Possible expense savings can be identified by a two-step process. First, the study should indicate what savings can be realized without making operational changes. Examples of this type of savings include reduction in insurance premiums or annual audit expenses. Secondly, the study should outline what savings can be generated through changes in operations. The elimination of a general manager, the elimination of a service station, or the combination of fuel delivery routes would be examples of this type of expense savings. In addition to the financial analysis, the membership characteristics of both cooperatives should be analyzed. Document the location, condition, and utilization rate of the plant facilities. A list of the specific assets and liabilities which are involved in the merger or acquisition should be developed. A method for evaluating inventory (cost or market value) and accounts receivable assets (how much should be discounted) must be agreed upon during the study process. The study should also include an environmental audit. The purpose of the environmental audit is to determine if any of the assets acquired may have associated environmental liabilities. The environmental audit is typically conducted in two stages. In the first stage, a certified professional determines if there are any environmental problems which would warrant a Phase II study. If problems are identified, the second phase study should describe what materials are available and also provide an estimate of the clean-up costs. However, some cooperatives proceed with the merger process, contingent upon the clean-up of any minor environmental problems which have been identified. If this is the case, it is essential to document what clean-up procedures will be undertaken as well as who will fund the clean-up.

Step 1-Informal Discussion The first step of the process involves an informal discussion by the board of directors. The board should consider the history of the cooperative, the present status, and, above all, what the cooperative should do to survive, prosper, and meet members’ needs. The basic objective at this stage is to determine if further investigation is warranted. Some factors to consider at this stage include: How well do the business activities match the cooperative’s core areas? Do the trade areas fit together or side-by-side? Is the merger partner a viable, on-going concern? Does the potential for merger merit a formal study? This stage of the merger process generally ends with the board’s passing a formal resolution to investigate a merger.

Step 2-The Merger Steering Committee When the informal study and discussion by the board are favorable, the next step is to appoint a steering committee composed of board members from the two cooperatives. The committee should avoid any premature announcements concerning the merger study. Premature comments by the board as to the potential savings, the name of the merged cooperative, the closing of facilities, or potential personnel actions could kill an otherwise successful merger.

Step 3-The Calendar of Events Most cooperatives use a “green light-red light” system in designing a calendar of events. The steering committee defines a calendar of events for the entire merger process and proceeds with each step, provided the results from the previous step indicate that a merger is feasible and beneficial. However, if the feedback from any step is unfavorable, the committee immediately abandons the merger or puts the merger activities on hold. The calendar of events might include: • Effective date for the merger • Target date for approval • Information meetings: membership, employees • Announcements: letters to membership, notification of meetings • Tour of facilities by steering committee • Recommendation by steering committee

Step 5-Negotiating the Agreement The actual merger agreement will reflect the unique situation facing each potential set of merger partners. Your cooperative’s attorney can assist you in codifying the actual contract terms. Specifying the exact terms of a merger or acquisition brings up a number of difficult issues. These include combining the equity retirement plans, combining the board of directors, deciding on a name for the merged cooperative, designing a program for unifying operations, and selecting a manager for the merged firm. 893 / 3

The first step in combining the equity retirement plans is for the merger committee to examine both plans. The next step is to determine how difficult it would be to convert one plan into the other. A transition plan must be developed whenever conversation is possible. If the merger involves a financially stressed cooperative, the merger partner must determine how the equity will be valued. The main challenge in combining the board of directors is in maintaining representation for all of the geographic areas and still have a workable number of directors on the board. Typically, a transition plan is established whereby some director positions are eliminated as their terms expire. Just as in establishing a personnel plan, it is important that all discussions focus on the positions and not on the individuals involved. If the merger is to be effective in reducing costs and maintaining service, a formal plan for unifying operations must be established. Board members should avoid any premature discussion of the closure of specific facilities. However, unless specific goals for the merger are established and monitored, the potential savings will evaporate. The board should establish the general direction and strategy of the new merged firm. It is up to the manager of the new firm to implement specific staffing and operational changes. When selecting a manager for the merged firm, the board should carefully consider communication skills and the ability to delegate responsibility along with overall management capability. A manager who has been effective with a “handson” style may not be able to effectively manage a larger merged firm. Maintaining communication with the membership and with the employees represents the largest single challenge for the new manager.

extremely important at this stage. In addition to changes in specific operating areas, the merger will imply changes in credit policy, pricing policy, and numerous other areas of dayto-day management. It is important to clearly inform the membership of these changes and keep the emphasis on member service. The goal should be to communicate to every member that they are important to the cooperative. As the organization works through the host of transitional issues related to the merger, it is essential that the opportunities for reorganization, cost savings, and efficiency be aggressively pursued. The combined organization may demand changes in the management structure. More involved communication and control procedures may be needed. More formal and involved decision-making processes may also be needed. While it is unfortunate that these changes must be made at the time when the organization is struggling to cope with the integration of facilities, policies, and personnel; it does provide an opportunity to improve and upgrade the management process. The new organization may also need to revamp its budgetary process and improve its inventory and cash management systems. The final step in a merger is to monitor whether the merger achieved the strategic and operational objectives and to implement further changes.

Mistakes to Avoid Managers and directors who have been involved in the merger process list mistakes they wish could have been avoided: • Poor communication with the membership and the employees • Directors’ failure to spend more time defining specific goals for the merger • Announcing prematurely a new name for the organization or the closure of facilities • Letting a deteriorating financial situation force board members into a merger without a thorough study • Over-emphasizing immediate savings and underestimating the problems which will occur during the transition.

Step 6-Member Approval Stage If the merger is approved by the board, the next step is to present the issue to the membership. Communication is one of the keys to a successful merger. One manager put this as “take care of the `me’ issues.” Members, customers, and employees want to know what the merger will mean to them. Financial and feasibility information can be provided in condensed form. Informational mailings and/or informational meetings are often used at this point. Legal requirements concerning the notice of meetings and what constitutes a quorum for a merger vote must be strictly observed. The directors of both cooperatives should strongly urge approval by the membership through letters and personal appearances at informational meetings. It is important to keep employees informed. Good communication with employees protects productivity. When employees are well advised, the chances for a successful merger increase. As a rule, employees handle change much easier than they handle uncertainty.

Summary A merger is, in itself, neither good nor bad. A cooperative should view a potential merger in terms of its overall mission to meet members’ needs. The success of a merger depends upon planning, careful study, and management. Attitudes toward mergers change as the business environment changes. Cooperatives which rejected a merger have later become involved in successful mergers. Other cooperatives which have merged have later split operations. However, according to a study by the Agricultural Cooperative Service, approximately 80 percent of cooperative mergers are classified as successful. The successful mergers tend to make a cooperative a more potent, competitive factor or halt the decline of one or more organizations or provide the organization with a base for future growth.

Step 7-Implementing the Reorganization If both memberships approve the merger, the formidable task of implementing the merger or reorganization occurs. The manager and directors should start managing the transition as soon as the deal is announced. Communication is

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