Pricing issues in listed companies’ M&A, restructuring

By Jiang Fengtao and Cheng Zhiyuan, Hengdu Law Firm
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Why do listed companies carry out mergers and acquisitions (M&A)? From a macro point of view, M&A and restructuring can effectively realize the rational allocation of market resources, enhance the efficiency of capital market operations, and play a role of “lighter” and “accelerator” in strengthening the national economy and boosting economic development and industry consolidation. On a micro level, M&A of another company to obtain its control by equity transactions on the one hand strengthens the enterprise itself, and on the other expands its market share. Since equity transactions are at the core of M&A and restructuring, the pricing of equity or assets is therefore the top priority.

FORMS OF M&A

Mergers and acquisitions of listed companies, judged from the forms of equity transfer, fall into two categories: the acquisition of shares, and the acquisition of assets.

Jiang Fengtao Managing and Founding Partner Hengdu Law Firm
江锋涛
JIANG FENGTAO
恒都律师事务所创始合伙人
Founding Partner
Hengdu Law Firm

Share acquisition, that is, the acquisition of all or part of the equity of the shareholders of listed companies, is generally divided into two types: either by buying shares of target shareholders to acquire shares issued by the target company, or the issuing of the acquiring party’s shares to the target company’s shareholders in exchange for the shares of the target company they hold.

In asset acquisitions, the acquisition subject is a company’s assets, and the acquisition, following the principle of market transactions, is a paid consideration. Asset acquisitions usually occur because the acquiring company settles on the quality assets of the business acquired, featuring in the purchase of the company’s assets rather than the equity.

PRICING ISSUES

Share pricing. Article 45 of the Measures for the Administration of Material Assets Reorganization of Listed Companies stipulates that, “the price for the shares issued by a listed company must not be lower than 90% of the market reference price. The market reference price must be the average trading price of stocks of the company for the 20 trading days, 60 trading days or 120 trading days before the resolution of the board of directors on the present purchase of assets through issuance of shares is announced, and such resolution must specify the basis for choosing the market reference price.”

程志远  CHENG ZHIYUAN 恒都律师事务所资本市场资深律师 Senior Capital Market Associate  Hengdu Law Firm
程志远
CHENG ZHIYUAN
恒都律师事务所资本市场资深律师
Senior Capital Market Associate
Hengdu Law Firm

As for the pricing of the stake purchase, the Measures for the Administration of Material Assets Reorganization of Listed Companies provide a relatively lenient time limit. At the same time, the measures stipulate that the resolution of the board of directors should explain the choice of market reference price. Therefore, this pricing is reasonable and is no longer discussed in this article.

Asset pricing. The pricing of asset acquisitions is usually assessed by a third party. The evaluator usually adopts three methods: market method, cost method, and income method. The first is to use the existing trading case on the market for reference to determine the prices of the target company’s asset. However, it requires a large number of cases, and sometimes it can be impossible to find comparable companies among the listed ones, which actually obstructs the practical application.

Another approach is to examine the balance of the company with its total assets minus the total liabilities, so as to determine the value of the target company. In the process, the difficulty lies in the evaluation of the original value of assets and liabilities because the assets valuation of a going concern is prone to be unfair, as it is hard to determine the condition of ongoing assets of the company.

The third method mainly involves the future earnings of the target company. However, higher subjectivity of the pre-judgment of such returns makes it difficult to get an accurate assessment, resulting in high risk for this method. Besides, in the specific evaluation process, it may also face challenges like cash flow and discount rate. As the name suggests, cash flow is the cash liquidity of the company. For the specific evaluation criteria, different valuers may adopt different methods and different lengths of time, so the result of the evaluation inevitably varies greatly, causing a bigger error to the anticipation of the company’s future earnings.

The discount rate is the rate at which the prospective earnings are converted into present value, where there is a cost error and a ẞ-value error (a risk index used to measure stock volatility). The over-valuation or under-valuation of the company’s cost of assets, and the errors in the evaluation and calculation model, will result in an unreasonable assessment of the assets of the merged company.

LEGAL ADVICE

Of the three evaluation methods commonly used in the pricing of M&A of listed companies, the market method and the cost method are limited by the number of cases and the deviation of the cost valuation, resulting in low accuracy of the asset evaluation and unsatisfactory application. Therefore, in practice they are usually applied as a reference to the result of the income method.

For problems in the pricing by using the income approach, we propose improvements in two aspects. On the one hand, the valuer can appropriately extend the budget time for cash flow; the longer the period of time is, the smaller error in the evaluation results of the enterprise’s cash flow. For example, previously we may refer to values of the past five years, and now we can use the value of the past five to 10 years to calculate and forecast.

On the other hand, as for the discount rate, the valuer should not only choose the correct calculation model and cautiously count the ẞ-value, but also make comparative analysis and exact calculation according to the actual situation of the target company, including its finance condition, creditor’s rights and liabilities by referring to similar businesses, so as to achieve a closer and more persuasive assessment result to the asset value, providing a reliable reference for the pricing of M&A of listed companies.

Jiang Fengtao is the founding partner and Cheng Zhiyuan is a senior capital market associate at Hengdu Law Firm

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