What Is a Target Firm in Mergers and Acquisitions?

What Is a Target Firm?

The term "target firm" refers to a company that is an attractive candidate for a merger or acquisition by a potential acquirer. Companies are considered targets for a variety of reasons, including the potential for new market penetration, new products, and increased profitability. When the target firm's management and shareholders favor a takeover, a friendly and orderly transaction ensues. In this case, the target firm will be absorbed into the acquiring company. If the target firm does not want to be acquired, the takeover becomes hostile.

Key Takeaways

• A target firm is an attractive business that is sought out for a merger or acquisition.
• A deal can only proceed if the target firm's management, shareholders, and board of directors agree to the takeover.
• If there is no agreement, the target firm may use special tactics to ward off a hostile takeover, such as a "crown jewel" or "poison pill" strategy.
• Target firms are often acquired at a premium to their current market value.

Understanding Target Firms

Mergers and acquisitions (M&A) are a vital part of the corporate world. It is not uncommon for large corporations to buy and merge with smaller companies. In other cases, two companies of a similar size may decide to merge to form a single entity. Regardless of the situation, there are two parties in the deal: the acquirer, who is the party that initiates the transaction, and the target firm.

As noted above, companies become targets for a variety of reasons. A potential acquirer may choose a target firm to:

• Increase profitability
• Gain access to new markets
• Gain access to a desirable product or service that the acquirer wants
• Eliminate a competitor
• Increase market share

Target firms are often acquired at a slight premium to their current fair market value (FMV). This is called a "takeover premium" and is justified when the acquiring company sees additional strategic value from the acquisition, such as greater economies of scale.

However, these economies of scale don't always materialize because there can be additional hidden costs associated with merging the two companies, especially in business operations with a deep cultural or social difference.

In the case of mergers and acquisitions (M&A), friendly takeover efforts are more common, although hostile takeover efforts tend to capture the headlines. In reality, Hollywood-style hostile takeover efforts are more expensive and time-consuming than a potential acquirer wants.

The identity of the target firm may be retained in the new entity after an acquisition is complete. This often occurs when the target firm has a good reputation and/or a good customer or supplier base, and abandoning the name could cause irreparable harm.

Special Note: More contemporary definitions of the term "target firm" also include activist shareholder campaigns. Activist shareholders are a modern approach to driving change without having to go through the complicated troubles of costly takeover efforts. Therefore, it is not uncommon to hear that a company or industry is described as a target of environmental, social, and governance (ESG)-led shareholder engagement initiatives.

For example, as issues of gender equality, environmental concerns, and cybersecurity become more prevalent and important, the media, analysts, and shareholders often target a company for stakeholder or shareholder activist efforts.

Target Firm Resistance Tactics

A target firm's management or board of directors may not agree to a merger or acquisition and may resist a takeover. As such, they may use various tactics to maintain autonomy and ward off a takeover, such as a "poison pill" or "crown jewel" strategy.

Under a poison pill strategy, the target firm adopts a shareholder rights plan, whereby the company extends options or rights to purchase shares to existing shareholders at a discount. If successful, the acquirer’s ownership would be diluted, making the target firm less attractive. A poison pill strategy may be used to deter a takeover or to shift bargaining power to the target firm.

The crown jewel strategy refers to when a target firm sells its most valuable assets, referred to as "crown jewels," to a third party, which is known as a "white knight." If successful, the acquirer will no longer be interested in acquiring the company and will withdraw the offer. To restore its better position, the target firm can then reacquire the assets from the "white knight" at a specified price.

Example of Target Firms

There are many examples of target firms in the corporate world. For example, Amazon (AMZN) acquired the target firm One Medical in 2023 for $3.9 billion. The e-commerce giant’s acquisition of the target allowed it to support the delivery of medical and pharmaceutical products to consumers.

Microsoft (MSFT) announced that it would acquire the professional social network 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 firm attractive. There may be just one reason or multiple factors to choose a target. For example, the target firm may offer the acquirer access to a new market or a new product or service line. Other reasons may include eliminating a competitor, increasing shareholder value, or increasing market share.

How is a target firm in an acquisition deal valued? Target firms can be valued using market-based methods. After identifying a potential target firm, the acquirer can compare the target firm to its direct competitors and use key financial metrics to determine its value. For example, they can use the target firm's price-to-earnings (P/E) ratio or enterprise value-to-EBITDA to value the target firm.

What options do target firms have if they don't want to be taken over? Target firms can use one or more defense strategies to avoid a takeover. One of the most popular is the "poison pill" strategy, which involves giving shareholders additional options or rights to purchase shares at a discount, thereby diluting ownership and preventing the acquirer from gaining a controlling stake. Other tactics include the "crown jewel," "white knight," and "golden parachute" strategies.

Conclusion

There are usually two parties involved in the mergers and acquisitions process—especially when it comes to acquisitions. The acquirer is the party that initiates the transaction while the target firm is the one that is sought out. While some target firms may agree to be acquired, not all targets want to be. These companies can use tactics to defend themselves from hostile takeovers, such as a "poison pill" or "crown jewel" strategy.