I know you’ve been dying to know how mergers and acquisitions (M&A) work. You’ve been sitting on the other side of the Weakonomics front page every day for months just waiting for me to talk about M&A. Well to the one person that was actually waiting for that, today is your lucky day.

For the rest of you, bear with me. M&A is an interesting side of Wall Street that doesn’t make the headlines the same other stories do that deal with outlandish profits or betting against the economy, or whatever Congress pretends to care about this week.

If you weren’t aware, yesterday afternoon computer maker HP announced they would purchase Palm, which makes cell phones and was previously known for their PDAs and the Palm Treo, what I consider to be the best smartphone ever made before the iPhone. I’m not going to go into the intricacies of M&A, but I am going to talk about why M&A happens, how its paid for, and what the acquiring company’s chances are of being successful.

Let’s first look at why a merger or acquisition happens. Fundamentally, M&A happens when two companies agree they are better off together than they are apart. But many times the deal happens because the acquiring company really wants to buy the selling company, or the selling company really wants to sell itself. For Palm and HP, the case was Palm really wanted to sell itself. Why? Palm has been getting raped by the iPhone, and with Google, Microsoft, and RIM’s Blackberries all in the smartphone game, it was just too crowded for another smartphone. This is a shame because Palm’s phones are phenomenal devices. The problem for Palm is they just don’t have the resources to sell it the way it needs to be sold.

HP does. And not only that, HP really wants to get into the smartphone market because everyone knows that is where the money is. Dell is getting in the smartphone game too now, and HP can’t be left behind. So they can devote hundreds of millions to developing software and hardware for an already crowded market, or buy their way in. They decided to buy their way in. This is probably a good idea since HP doesn’t have much experience here, and Palm does. On top of that, Palm plucked a number of people from Apple that developed the iPhone. You can’t develop that kind of talent, you have to buy it. There’s another reason to buy Palm over doing it on your own from scratch, but we’ll get to that at the end.

So how do these deals get paid for? Palm sold itself for $1.2 billion. A popular way to make an acquisition is to do a stock transaction. If that were the case here, Palm shareholders would trade their stock for $1.2 billion in HP stock. Another popular method, though more frequent in private acquisitions, is the leveraged buyout (LBO). In an LBO, the buying party may put up 5% of the price in cash, and borrow 95% from banks to pay for the rest. An example of this was Toys-R-Us which was bought in an LBO in 2005 putting about 20% down and borrowing the rest. But a large portion of mergers and acquisitions are paid for in cash. This is especially true in the technology industry as tech companies like to keep a lot of cash on hand. Buying Palm will reduce HP’s cash situation by less than 10%. They’ll still have more cash than Microsoft, Google, or Apple. We aren’t going to talk about it here, but the way an acquisition is paid for also has different tax implications.

And finally, what are the chances of the purchase actually panning out? Unfortunately, mergers and acquisitions have a bad history. More often than not, the buying company is just never able to accomplish what they want with the company they buy. But everyone thinks they’re different. This could work out for HP, but it’s probably going to be the death of Palm. We’ll see, I hope to be wrong. More competition in this market is always good for the consumer in terms of pricing and innovation.

As I said before, there is one other thing that HP gets when they buy Palm: patents. Palm dominated the PDA market, and was the biggest player in touchscreen phones before Apple. They developed a lot of the technologies that Apple, Samsung, Microsoft, Blackberry, Dell, HTC, and anyone else uses to make their phones. They have patents on these technologies, and they’re older than the patents these other companies have. This is why these companies have been suing each other left and right, but no one is suing Palm. By purchasing Palm, HP gets access to these patents and therefore can basically enter the touchscreen phone market without having to worry about being sued.

So is this deal a good one? On a valuation standpoint I think HP got a decent deal, but not a great one. It’s all a matter of how much of HP’s resources they put behind Palm to make it all work.

And for those of you looking to see if you can make money on acquisitions such as this, a number of people will short the buyer and buy the seller with the proceeds. But by the time you read this you’ll have missed your chance. M&A news gets priced into the stock faster than you can move.

By The Weakonomist

The Weakonomist is the founder of Weakonomics. Clicking the picture of the puppy will tell you more about him. If you like what you're reading consider subscribing to the blog, following him on Twitter, and checking out the related posts below. Please consider a donation if you really enjoy Weakonomics. Also keep in mind that nothing I say can be construed as financial advice.

categories: business, investing