Business Law Valuation Mergers and Acquisition Questions

▪ Mergers and Acquisitions (M&A) is a type of corporate strategy, which stands for
all operations related to transfer of property rights in companies, including
formation and restructuring of companies.
▪ M&A simply refer to consolidation of companies (or assets)
▪ M&As are transactions in which the ownership of companies, other business
organizations, or their operating units are transferred or consolidated with other
entities.
▪ M&As can allow enterprises to grow or downsize and change the nature of their
business or competitive position
▪ An acquisition is the purchase of one company by another
▪ A merger is the voluntary consolidation of two or more companies to form one new
entitiy
▪ National Commercial Bank (NCB) and Samba Financial Group
▪ Saudi Aramco and Saudi Basic Industries Corp (SABIC)
▪ Gulf Union Cooperative Insurance Co. and Al-Ahlia Insurance Co.
▪ A mutual decision between acquirer and the target company
▪ A new company is formed and as a result both companies ceased to exit
▪ The size of the companies are generally similar
▪ Can be friendly or hostile
▪ Both companies continue to exist
▪ The acquirer is much bigger than the target company
▪ M&A are part of strategic management of any business.
▪ It involves consolidation of two businesses with an aim to increase market share,
profits and influence in the industry.
▪ Mergers and Acquisitions are complex processes which require preparing,
analysis and deliberation.
▪ There are a lot of parties who might be affected by a merger or an acquisition, like
government agencies, workers and managers.
▪ Before a deal is finalized all party needs to be taken into consideration, and their
concerns should be addressed, so that any possible hurdles can be avoided.
▪ The reasons M&As occur are numerous, and the importance of factors giving rise to
M&A activity varies over time.
▪ Operating Synergy: Improve operating efficiency through economies of sdcale or
scope by acquiring a customer, supplier, or competitor
▪ Financial Synergy: Lower cost of capital
Positioning the firm in higher-growth products or markets
▪ New products/Current Markets
▪ New Products/New Markets
▪ Current Products/New Markets
Acquiring capabilities to adapt more rapidly to environmental changes than could
be achieved if they were developed internally
▪ Technological Change
▪ Regulatory and Political Change
Acquirers believe their valuation of the target is more accurate than the market’s,
causing them to overpay by overestimating synergy
Acquire assets more cheaply when the equity of existing companies is less than the
cost of buying or building the assets
Inrease the size of a company to increase the power and pay of managers
Obtain unused net operating losses and tax credits and asset write-ups, and
substitute capital gains for ordinanry income
Actions taken to boost selling prices above competitive levels by affecting either
supply or demand
Investor overvaluation of acquirers stock encourages M&As
A company might acquire another to get its talented employees. In this situation the
acquirer has to make sure that it will keep the talent following the acquisition. This
type of acquisition usually apear when the target company is a start-up
M&As in the United States have tended to cluster in six multiyear waves since the late
1890s. There are two competing explanations for this phenomenon.
▪ One argues that merger waves occur when firms react to industry “shocks,” such as
from deregulation, the emergence of new technologies, distribution channels,
substitute products, or a sustained rise in commodity prices. Such events often
cause firms to acquire either all or parts of other firms.
▪ The second argument is based on misvaluation and suggests that managers use
overvalued stock to buy the assets of lower-valued firms. For M&As to cluster in
waves, goes the argument, valuations of many firms must increase at the same time.
Managers whose stocks are believed to be overvalued move concurrently to
acquire firms whose stock prices are lesser valued.
Corporate restructuring is often broken into two categories.
▪ Operational Restructuring: entails changes in the composition of a firm’s asset
structure by acquiring new businesses or by the outright or partial sale or spin-off
of companies or product lines. Operational restructuring could also include
downsizing by closing unprofitable or nonstrategic facilities.
▪ Financial Restructuring: describes changes in a firm’s capital structure, such as
share repurchases or adding debt either to lower the company’s overall cost of
capital or as part of an antitakeover defense.
Mergers can be described from a legal perspective and an economic perspective.
▪ A Legal Perspective
▪ An Economic Perspective
▪ A merger is a combination of two or more firms, often comparable in size, in which
all but one ceases to exist legally.
▪ A statutory or direct merger is one in which the acquiring or surviving company
assumes automatically the assets and liabilities of the target in accordance with the
statutes of the state in which the combined companies will be incorporated.
▪ A subsidiary merger involves the target’s becoming a subsidiary of the parent. To
the public, the target firm may be operated under its brand name, but it will be
owned and controlled by the acquirer.
▪ A statutory consolidation—which involves two or more companies joining to form a
new company—is technically not a merger. All legal entities that are consolidated
are dissolved during the formation of the new company, which usually has a new
name, and shareholders in the firms being consolidated typically exchange their
shares for shares in the new company.
▪ Business combinations may also be defined depending on whether the merging
firms are in the same (horizontal) or different industries (conglomerate) and on
their positions in the corporate value chain (vertical).
▪ An acquisition occurs when a company takes a controlling interest in another firm, a
legal subsidiary of another firm, or selected assets of another firm, such as a
manufacturing facility.
▪ They may involve the purchase of another firm’s assets or stock, with the acquired
firm continuing to exist as a legally owned subsidiary. In contrast, a divestiture is
the sale of all or substantially all of a company or product line to another party for
cash or securities.
▪ A spin-off is a transaction in which a parent creates a new legal subsidiary and
distributes shares in the subsidiary to its current shareholders as a stock dividend.
An equity carve-out is a transaction in which the parent issues a portion of its stock
or that of a subsidiary to the public
▪ The term takeover is used when one firm assumes control of another.
▪ In a friendly takeover, the target’s board and management recommend shareholder
approval. To gain control, the acquiring company usually must offer a premium to
the current stock price. The excess of the offer price over the target’s premerger
share price is called a purchase premium or acquisition premium and varies widely
▪ A formal proposal to buy shares in another firm made directly to its shareholders,
usually for cash or securities or both, is called a tender offer.
▪ Tender offers most often result from friendly negotiations (i.e., negotiated tender
offers) between the boards of the acquirer and the target firm.
▪ Cash tender offers may be used because they could represent a faster alternative
to mergers.
▪ Those that are unwanted by the target’s board are referred to as hostile tender
offers.
▪ Self-tender offers are used when a firm seeks to repurchase its stock.
▪ A hostile takeover occurs when the offer is unsolicited, the approach was contested
by the target’s management, and control changed hands.
▪ The acquirer may attempt to circumvent management by offering to buy shares
directly from the target’s shareholders (i.e., a hostile tender offer) and by buying
shares in a public stock exchange (i.e., an open market purchase).
▪ Friendly takeovers are often consummated at a lower purchase price than hostile
deals, which may trigger an auction for the target firm.
▪ Acquirers often prefer friendly takeovers because the postmerger integration
process is usually more expeditious when both parties are cooperating fully and
customer and employee attrition is less.
▪ A holding company is a legal entity having a controlling interest in one or more
companies.
▪ The key advantage is the ability to gain effective control of other companies at a
lower overall cost than if the firm were to acquire 100% of the target’s shares.
▪ Effective control sometimes can be achieved by owning as little as 30% of the
voting stock of another company when the firm’s bylaws require approval of major
decisions by a majority of votes cast rather than a majority of the voting shares
outstanding.
▪ Holding company shareholders may be subject to an onerous tax burden.
▪ In addition to mergers and acquisitions, businesses may combine through joint
ventures (JVs), strategic alliances, minority investments, franchises, and licenses.
The term business alliance is used to refer to all forms of business combinations
other than mergers and acquisitions.
▪ Joint ventures are business relationships formed by two or more separate parties to
achieve common objectives. While the JV is often a legal entity such as a
corporation or partnership, it may take any organizational form desired by the
parties involved.
▪ Each JV partner continues to exist as a separate entity; JV corporations have their
own management reporting to a board of directors.
▪ A strategic alliance generally does not create a separate legal entity and may be an
agreement to sell each firm’s products to the other’s customers or to co-develop a
technology, product, or process. Such agreements may be legally binding or
largely informal.
▪ Minority investments, those involving less than a controlling interest, require little
commitment of management time. A company may choose to assist small
companies in the development of products or technologies it finds useful, often
receiving representation on the board in exchange for the investment.
▪ Licenses enable firms to extend their brands to new products and markets by
licensing their brand names to others or to gain access to a proprietary technology
through the licensing process.
▪ A franchise is a specialized form of a license agreement that grants a privilege to a
dealer from a manufacturer or franchise service organization to sell the franchiser’s
products or services in a given area. Under a franchise agreement, the franchiser
may offer the franchisee consultation, promotional assistance, financing, and other
benefits in exchange for a share of the franchise’s revenue. Franchises represent a
low-cost way for the franchiser to expand.
Key participants in the M&A process can be categorized as follows:
▪ Providers of specialized services
▪ Regulators
▪ Institutional investors and lenders
▪ Activist investors
▪ and M&A arbitrageurs.
Investment Banks
▪ Investment banks provide advice and deal opportunities; screen potential buyers
and sellers; make initial contact with a seller or buyer; and provide negotiation
support, valuation, and deal structuring guidance.
▪ Investment bankers derive significant income from writing so-called fairness
opinion letters—written and signed third-party assertions that certify the appropriateness of the price of a proposed deal involving a tender offer, merger, asset
sale, or leveraged buyout. They are often developed as legal protection for
members of the boards of directors against possible shareholder challenges of
their decisions.
Lawyers
▪ Lawyers help structure the deal, evaluate risk, negotiate the tax and financial terms,
arrange financing, and coordinate the sequence of events to complete the
transaction. Specific tasks include drafting the purchase agreement and other
transaction-related documentation, providing opinion of counsel letters to the
lender, and defining due diligence activities.
Accountants
▪ Accountants provide advice on financial structure, perform financial due diligence,
and help create the optimal tax structure for a deal. Income tax, capital gains, sales
tax, and sometimes gift and estate taxes are all at play in negotiating a merger or
acquisition.
▪ In addition to tax considerations, accountants prepare financial statements and
perform audits.
Proxy Solicitors
▪ Proxy contests are attempts to change the management control or policies of a company by gaining the
right to cast votes on behalf of other shareholders.
▪ The acquiring firm or dissident shareholders hire a proxy solicitor to obtain this information.
▪ The target’s management may also hire proxy solicitors to design strategies for educating shareholders
and communicating the reasons why they should support the board.
Public Relations Firms
▪ Such firms are often hired to ensure that a consistent message is communicated during a takeover
attempt or in defending against takeovers.
▪ In initiating a hostile takeover attempt, the message to target shareholders must be that the acquirer’s
plans for the company will increase shareholder value more than the plans of incumbent management.
▪ The target company’s management will hire a private investigator to develop detailed financial data on
the company and do background checks on key personnel, later using that information in the public
relations campaign in an effort to discredit publicly the management of the acquiring firm.
▪ Regulations that affect M&A activity exist at all levels of government and involve
security, antitrust, environmental, racketeering, and employee benefits laws.
▪ Others are industry specific, such as public utilities, insurance, banking,
broadcasting, telecommunications, defense contracting, and transportation.
▪ State antitakeover statutes place limitations on how and when a hostile takeover
may be implemented.
▪ Approval at both the state and federal levels may be required for deals in certain
industries.
▪ Cross-border transactions may be even more complicated, because it may be
necessary to obtain approval from regulatory authorities in all countries in which
the acquirer and target companies do business.
These financial intermediaries pool funds provided by others and invest or lend
those funds to finance the purchase of a wide array of assets, from securities to real
property to corporate takeovers.
▪ Insurance, Pension, and Mutual Funds
▪ Commercial Banks
▪ Hedge, Private Equity, and Venture Capital Funds
▪ Sovereign Wealth Funds
▪ Angel Investors
Institutions often play the role of activist investors to affect the policies of companies
in which they invest and especially to discipline corporate management.
▪ Mutual Funds and Pension Funds
▪ Hedge Funds and Private Equity Firms
▪ When a bid is made for a target firm, the target’s stock price often trades at a small
discount to the actual bid—reflecting the risk that the deal may not be completed.
Merger arbitrage refers to an investment strategy that attempts to profit from this
spread. Arbs buy the stock and make a profit on the difference between the bid
price and the current stock price if the deal is completed.
▪ On average, the sum of target and acquirer shareholders’ gains around the deal’s
announcement date is positive and statistically significant.
▪ While most of the gain accrues to target shareholders, acquirer shareholders often
experience financial gains in excess of what would have been realized in the
absence of a takeover.
▪ However, in the three to five years after a takeover, it is less clear if shareholders
continue to benefit from the deal.
Positive abnormal or excess shareholder returns may be explained by such factors as
improved efficiency, pricing power, and tax benefits.
Returns High for Target Shareholders
▪ Average abnormal returns to target shareholders during the 2000s averaged 25.1%
as compared to 18.5% during the 1990s
Returns to Acquirer Shareholders Generally Favorable
▪ Recent research involving large samples over lengthy time periods involving U.S.,
foreign, and cross-border deals (including public and private firms) shows that
returns to acquirer shareholders are generally positive except for those involving
large public firms and those using stock to pay for the deal.
▪ The objective of examining postmerger accounting or other performance
measures such as cash flow and operating profit, usually during the three- to fiveyear period following closing, is to assess how performance changed. It is less
clear if shareholders continue to benefit from the deal.
▪ Smaller Acquirers Tend to Realize Higher Returns
▪ Acquirer Returns Often Positive for Privately-Owned or Subsidiary Targets
▪ Relatively Small Deals May Generate Higher Returns
▪ Form of Payment Impacts Acquirer Returns
▪ M&As have little impact on abnormal returns either to the acquirer or to the target
bondholders, except in special situations.
▪ How M&As affect bondholder wealth reflects, in part, the extent to which an
increase in leverage that raises the potential for default is offset by the discipline
imposed on management to improve operating performance
▪ Target firm bondholders, whose debt is below investment grade, experience
positive abnormal returns if the acquirer has a higher credit rating.
▪ Most empirical studies show that M&As result in improved operating efficiencies
and lower product prices than would have been the case without the deal.
▪ M&As create value when more productive firms acquire less productive ones
▪ In your judgment, what are the motivations for NCB and SAMBAs binding
agreement?
The Corporate Takeover
Market
Common Takeover Tactics, Antitakeover Defenses, and Corporate
Governance
Understanding Alternative Takeover Tactics
The Friendly Approach in the Corporate Takeover Market
• In friendly takeovers, a negotiated settlement is possible without the acquirer’s
resorting to aggressive tactics
• The potential acquirer initiates an informal dialogue with the target’s top
management, and the acquirer and target reach an agreement on the key issues
early in the process, such as the long-term business strategy, how they will
operate in the short term, and who will be in key executive positions.
• Often, a standstill agreement is negotiated in which the acquirer agrees not to
make any further investments in the target’s stock for a specific period. This
compels the acquirer to pursue the acquisition on friendly terms, at least for the
period covered by the agreement, and permits negotiations without the threat of
more aggressive tactics, such as those discussed in the following sections.
Understanding Alternative Takeover Tactics
The Hostile Approach in the Corporate Takeover Market
If initial efforts to take control of a target firm are rejected, an acquirer
may choose to adopt more aggressive tactics, including the bear hug,
the proxy contest, and the tender offer.
The Hostile Approach
A-The Bear Hug: Limiting the Target’s Options
• A bear hug is an offer to buy the target’s shares at a substantial premium to its
current share price and often entails mailing a letter containing the proposal to
the target’s CEO and board without warning and demanding a rapid decision.
• It usually involves a public announcement, to put pressure on the board.
Directors voting against the proposal may be subject to shareholder lawsuits.
• Once the bid is made public, the company is likely to attract additional bidders.
• Institutional investors and arbitrageurs add to the pressure by lobbying the board
to accept the offer.
• By accumulating target shares, they make purchases of blocks of stock by the
bidder easier, for they are often quite willing to sell their shares.
The Hostile Approach
B-Proxy Contests in Support of a Takeover
• Activist shareholders often initiate a proxy fight to remove
management due to poor performance, to promote the spin-off of a
business unit or the outright sale of the firm, or to force a cash
distribution to shareholders.
• Proxy fights enable such shareholders to replace board members with
those more willing to support their positions.
• Proxy contests are a means of gaining control without owning 50.1%
of the voting stock, or they can be used to eliminate takeover
defenses, as a precursor of a tender offer, or to oust recalcitrant
target-firm board members.
The Hostile Approach
B.1-Implementing a Proxy Contest
• When the bidder is also a shareholder, the proxy process may begin
with the bidder’s attempting to call a special shareholders meeting
• Alternatively, the bidder may put a proposal to replace the board at a
regularly scheduled shareholders meeting.
• The bidder opens an aggressive public relations campaign.
• The target often responds with its own campaign.
• Once shareholders receive the proxies, they may choose to sign and
send them directly to a designated collection point, such as a
brokerage house or a bank.
The Hostile Approach
B.2-The Impact of Proxy Contests on Shareholder Value
• Proxy fights often result in positive abnormal returns to target
shareholders regardless of the outcome.
• The reasons include the eventual change in management at firms
embroiled in proxy fights, the tendency for new management to
restructure the firm, investor expectations of a future change in
control, and special cash payouts made by firms with excess cash
holdings.
The Hostile Approach
C-The Hostile Tender Offer
• A hostile tender offer circumvents the target’s board and management to reach
the target’s shareholders directly with an offer to purchase their shares.
• While boards often discourage unwanted bids initially, they are more likely to
relent to a hostile tender offer.
• Such offers are undertaken for several reasons:
1.
2.
3.
as a last resort if the bidder cannot get the target’s board and management to relent,
to preempt another firm from making a bid for the target, and
to close a transaction quickly if the bidder believes that time is critical.
• A common hostile-takeover strategy involves the bidder’s acquiring a controlling
interest in the target and later completing the combination through a merger.
The Hostile Approach
C.1-Pretender Offer Tactics: Toehold Bidding Strategies
• Bidders may purchase stock in a target before a formal bid to accumulate
stock at a price lower than the eventual offer price.
• Such purchases are secretive to avoid increasing the average price paid.
• The advantage to the bidder is the potential leverage achieved with the
voting rights associated with the stock it has purchased.
• The bidder can also sell this stock if the takeover attempt is unsuccessful.
• Once a toehold position has been established, the bidder may attempt to
call a special stockholders’ meeting to replace the board of directors or
remove takeover defenses.
The Hostile Approach
C.2-Implementing a Tender Offer
• Tender offers can be for cash, stock, debt, or some combination.
• Unlike mergers, tender offers frequently use cash as the form of payment.
• Securities transactions involve a longer period to complete because of the
need to register with the SEC, to comply with state registration
requirements, and, if the issue is large, to obtain shareholder approval.
• If the offer involves a share-for-share exchange, it is referred to as an
exchange offer.
• Whether cash or securities, the offer is made to target shareholders, is
extended for a specific period, and may be unrestricted (any-or-all offer) or
restricted to a certain percentage or number of the target’s shares.
The Hostile Approach
• Tender offers restricted to purchasing less than 100% of the target’s
outstanding shares may be oversubscribed.
• If the bidder chooses to revise the tender offer, the waiting period is
automatically extended.
• If another bid is made, the waiting period must also be extended by
another ten days.
• Once initiated, tender offers for publicly traded firms are usually successful,
although the success rate is lower if it is contested.
• Federal securities laws impose reporting, disclosure, and antifraud
requirements on acquirers initiating tender offers. Once the tender offer
has been made, the acquirer cannot purchase any target shares other than
the number specified in the offer.
The Hostile Approach
• Multitiered Offers
• A bid can be either a one- or two-tiered offer.
• In a one-tier offer, the acquirer announces the same offer to all target shareholders,
which offers the potential to purchase control of the target quickly and discourage other
potential bidders from attempting to disrupt the deal.
• In a two-tiered offer, the acquirer offers to buy a number of shares at one price and more
at a lower price at a later date.
• The form of payment in the second tier may be less attractive, consisting of securities
rather than cash.
• The intent of the two-tiered approach is to give target shareholders an incentive to
tender their shares early in the process to receive the higher price.
• Since those shareholders tendering their shares in the first tier enable the acquirer to
obtain a controlling interest, their shares are worth more than those who may choose to
sell in the second tier.
WHAT MAKES THE AGGRESSIVE APPROACH
SUCCESSFUL?
• Successful hostile takeovers depend on the size of the offer price
premium, the board’s composition, and the makeup, sentiment, and
investment horizon of the target’s current shareholders.
• Other factors include the provisions of the target’s bylaws and the
potential for the target to implement additional takeover defenses.
OTHER TACTICAL CONSIDERATIONS
• To heighten the chance of a successful takeover, the bidder will include provisions
in a letter of intent (LOI) to discourage the target firm from backing out of any
preliminary agreements.
• The LOI is a preliminary agreement between two companies intending to merge
stipulating areas of agreement between the parties as well as their rights and
limitations.
• It may contain a number of features protecting the buyer; among the most
common is the no-shop agreement, prohibiting the target from seeking other
bids or making public information not currently readily available.
• Contracts often grant the target and acquirer the right to withdraw from the
agreement. This usually requires the payment of breakup or termination fees,
sums paid to the acquirer or target to compensate for their expenses.
OTHER TACTICAL CONSIDERATIONS
• Breakup fees paid by the bidder to the target firm are called reverse breakup fees,
and they have become more common in recent years as buyers, finding it difficult
to finance transactions, have opted to back out of signed agreements.
• The stock lockup, an option granted to the bidder to buy the target firm’s stock at
the first bidder’s initial offer, is another form of protection for the bidder. It is
triggered whenever the target firm accepts a competing bid.
• The initial bidder may also require that the seller agree to a crown jewels lockup,
in which the initial bidder has an option to buy important strategic assets of the
seller, if the seller chooses to sell to another party.
DEVELOPING A BIDDING STRATEGY
• Poorly thought-out strategy can result in unsuccessful bidding for the
target firm, which is costly for the acquiring CEO.
• Common bidding-strategy objectives include winning control of the
target, minimizing the control premium, minimizing transaction costs,
and facilitating post acquisition integration.
• If minimizing the purchase price and transaction costs while
maximizing cooperation between the two parties is critical, the bidder
may choose the “friendly” approach.
UNDERSTANDING ALTERNATIVE TAKEOVER
DEFENSES
• Takeover defenses are designed to slow down an unwanted offer or
to force a suitor to raise the bid to get the target’s board to rescind
the defense.
• They can be grouped in two categories: those put in place before
receiving an offer (preoffer) and those implemented after receipt of
an offer (postoffer).
Preoffer Defenses
• Preoffer defenses are used to delay a change in control, giving the
target firm time to erect additional defenses after the unsolicited
offer has been received.
• Such defenses generally fall into three categories: poison pills, shark
repellents, and golden parachutes.
Preoffer Defenses
Poison Pills
• A poison pill involves a board’s issuing rights to current shareholders,
with the exception of an unwanted investor, to buy the firm’s shares
at an exercise price well below their current market value.
• If a specified percentage (usually 10–20%) of the target’s common
stock is acquired by a hostile investor, each right entitles the holder to
purchase common stock or some fraction of participating preferred
stock of the target firm (a flip-in pill).
• If a merger, consolidation, sale of at least some per- centage (usually
50%) of the target’s assets, or announced tender offer occurs, the
rights holder may purchase acquirer common shares (a flip-over pill).
Preoffer Defenses
Shark Repellents
• Shark repellents are takeover defenses achieved by amending either a
corporate charter or the corporation bylaws.
• Their primary role is to make it more difficult to gain control of the
board through a proxy fight at an annual or special meeting.
• The most typical are staggered board elections, restrictions on
shareholder actions, antigreenmail provisions, differential voting
rights shares, and debt-based defenses.
Preoffer Defenses
Shark Repellents
• Strengthening the Board’s Defenses: Companies sometimes distribute
the election of directors over a number of years to make it harder for
a dissatisfied minority shareholder to gain control of the board.
• Limiting Shareholder Actions: The board can also reinforce its control
by restricting shareholders’ ability to gain control of the firm by
bypassing the board. Limits can be set on their ability to call special
meetings, engage in consent solicitations, and use supermajority rules
Preoffer Defenses
Other Shark Repellents
• Antigreenmail Provisions: Bidders profited by taking an equity
position in a firm, threatening takeover, and subsequently selling their
shares back to the firm at a premium over what they paid for them.
Many firms have since adopted charter amendments, called
antigreenmail provisions, restricting the firm’s ability to repurchase
shares at a premium.
• Fair-Price Provisions: Requirements that any acquirer pay minority
shareholders at least a fair mar- ket price for their stock are called
fair-price provisions
Preoffer Defenses
Other Shark Repellents
• Dual Class Recapitalization: A firm may create more than one class of
stock to separate the performance of individual operating
subsidiaries, compensate subsidiary operating management, maintain
control, or prevent hostile takeovers. The process of creating another
class of stock is called a dual class recapitalization and involves
separating shareholder voting rights from cash flow rights.
• Reincorporation: A potential target may change the state within
which it is incorporated to one where the laws are more favorable for
implementing takeover defenses by creating a subsidiary in the new
state and later merging with the parent.
Preoffer Defenses
Other Shark Repellents
• Golden Parachutes (Change-of-Control Payouts): Employee
severance packages, triggered whenever a change in control takes
place, are called golden parachutes. These arrangements typically
cover only a few dozen employees, who are terminated following the
change in control. They are designed to raise the bidder’s cost of the
acquisition rather than to gain time for the target board.
Postoffer Defenses
Once an unwanted acquirer has approached a firm, a variety of
additional defenses can be introduced.
• Greenmail
• White Knights
• Employee Stock Ownership Plans
• Leveraged Recapitalization
• Share Repurchase or Buyback Plans
• Corporate Restructuring
• Litigation
Postoffer Defenses
• Greenmail: consists of a payment to buy back shares at a premium
price in exchange for the acquirer’s agreement not to initiate a hostile
takeover.
• White Knights: A target may seek a white knight: another firm that is
considered a more appropriate suitor.
• Employee Stock Ownership Plans: ESOPs are trusts that hold a firm’s
stock as an investment for its employees’ retirement program. They
can be quickly set up, with the firm either issuing shares directly to
the ESOP or having an ESOP purchase shares on the open market. The
stock held by an ESOP is likely to be voted in support of management
in the event of a hostile takeover attempt
Postoffer Defenses
• Leveraged Recapitalization: A firm may recapitalize by assuming
substantial amounts of new debt either to buy back stock or to
finance a dividend payment to shareholders. The additional debt
reduces the firm’s borrowing capacity and leaves it in a highly
leveraged posi- tion, making it less attractive to a bidder that may
have wanted to use that capacity to help finance a takeover.
• Share Repurchase or Buyback Plans: When used as a takeover
defense, share buybacks reduce the number of shares that could be
purchased by the potential buyer or by arbitrageurs who will sell to
the highest bidder.
Postoffer Defenses
• Corporate Restructuring: Restructuring may involve taking the
company private, selling attractive assets, undertaking a major
acquisition, or even liquidating the company. “Going private” typically
involves the management team’s purchase of the bulk of a firm’s
shares.
• Litigation: Lawsuits may involve alleged antitrust concerns, violations
federal securities laws, undervaluation of the target, inadequate
disclosure by the bidder as required by the Williams Act, and
fraudulent behavior. Targets often seek a court injunction to stop a
takeover until the court has decided the merits of the allegations. By
preventing a bidder from buying more stock, the target firm is buying
more time to erect additional defenses.
THE IMPACT OF TAKEOVER DEFENSES ON
SHAREHOLDER VALUE
Empirical evidence suggests that on average takeover defenses have a
slightly negative impact on firm value, while those instituted prior to an
IPO or during the early stages of the firm’s development can increase
shareholder value.
The Corporate Takeover
Market
Common Takeover Tactics, Antitakeover Defenses, and Corporate
Governance
Takeover Market
• Corporate takeovers represent a common way to transfer control of a
firm from ineffective to effective management.
• The corporate takeover market in which control is transferred serves
two important functions in a free market economy: the allocation of
resources to sectors in which they can be used most efficiently and as
a mechanism for disciplining failing corporate managers.
• The corporate takeover market can help to promote good corporate
governance, which in turn can improve corporate financial
performance
Takeovers
• When an acquirer makes an offer to buy another company, the
management and the board of directors of target entitiy may accept
or reject the offer
• However, the ultimate decision of a merger or acquisition is made by
the shareholders of the company
• The offer is made by company A to takeover B.
• Company B can accept or reject.
Main types of M&A transactions
Friendly:
• The target company’s management and board of directors accept an
offer to merge with or be acquired by another company and
encourage the shareholders to vote in the favor of the transaction.
• It is usually followed by the approval of transaction in a sharholder
vote
Main types of M&A transactions
Hostile
• The target company’s management and board of directors vote against the favor
of the merger or acquisition. In that case, the acquirer passes on and makes a
direct offer to the target company’s shareholders. If the shareholders vote in the
favor of the transaction, the merger or the acquisition takes place and the current
management and the board will likely be replaced by the acquirer.
• Another alternative for the acquirer is to start and win a proxy fight. In a proxy
fight a group of shareholders, who are in the favor of the transaction, join forces
to get enough shareholder votes to replace the current management, making the
way for the merger or acquisiton.
Corporate Governance
• Corporate governance refers to the rules and processes by which a
business is controlled, regulated, or operated.
• The goal has been to protect shareholder rights.
• This has expanded to encompass additional corporate stakeholders,
including customers, employees, the government, lenders, communities, regulators, and suppliers.
• The corporate takeover market can help to promote good corporate
governance, which in turn can improve corporate financial
performance
Internal Factors
The Board of Directors/Management
• The board hires, fires, sets CEO pay and is expected to oversee management,
corporate strategy, and the firm’s financial reports to shareholders.
• Some board members may be employees or founding family members; others
may be affiliated with the firm through a banking relationship, a law firm retained
by the firm, or someone who represents a customer or supplier.
• Such members may be subject to conflicts of interest causing them to act in ways
not in the shareholders’ best interests.
• This has led some observers to argue that boards should be composed primarily
of independent directors and that different individuals should hold the CEO and
board chairman positions.
Internal Factors (Cont)
Internal Controls and Incentive Systems
• Internal controls are critical in preventing fraud as well as ensuring
compliance with prevailing laws and regulations.
• Financial and legal auditing functions, as well as hiring and firing
policies within the firm, are examples of internal controls.
• Compensation, consisting of base pay, bonuses, and stock options,
underpins incentive systems used to manage the firm in the manner
the board deems appropriate.
Internal Factors (Cont)
• To rectify abuses, the Dodd-Frank Act of 2010 gives shareholders of
public firms the right to vote on executive compensation. Under the
new rules, such votes must occur at least once every three years.
• The Dodd- Frank Act also requires publicly traded firms to develop
mechanisms for recovering compensation based on executive
misconduct.
Internal Factors (Cont)
Managerial and shareholder interests can be aligned in other ways.
• One way is for managers to own a significant portion of the firm’s
outstanding stock or for the manager’s ownership of the firm’s stock
to comprise a substantial share of his or her personal wealth.
• An alternative to concentrating ownership in management is for one
or more shareholders who are not managers to accumulate a large
block of voting shares. So-called “blockholders” may be more
aggressive in monitoring management and more receptive to
takeovers, thereby increasing the risk to managers that they will be
ousted for poor performance.
Internal Factors (Cont)
Antitakeover Defenses
• A firm’s board and management may employ defenses to negotiate a
higher purchase price with a bidder or to solidify their current
position within the firm.
Corporate Culture and Value
• Good governance also depends on an employee culture instilled with
appropriate values and behaviors. Setting the right tone comes from
the board of directors’ and senior management’s willingness to
behave in a manner consistent with what they demand from other
employees.
Internal Factors (Cont)
Bond Covenants
• Legally binding on both the bond issuer and the bond holder,
covenants forbid the issuer from undertaking certain activities, such
as dividend payments, or require the issuer to meet specific
requirements, such as periodic information reporting.
• Strong covenants can motivate managers to pursue relatively low-risk
investments, such as capital expenditures, and avoid higher-risk
investments, such as research and development spending.
External Factors
Legistation and the Legal System
• The 1933 and 1934 Securities Acts underlie U.S. securities legislation and created
the Securities and Exchange Commission, charged with writing and enforcing
securities’ regulations.
• The U.S. Congress has since transferred some enforcement tasks to public stock
exchanges operating under SEC oversight.
• Under the Sarbanes-Oxley Act of 2002, the SEC oversees the Public Company
Accounting Oversight Board, whose task is to develop and enforce auditing
standards.
• State legislation also has a significant impact on governance practices by
requiring corporate charters to define the responsibilities of boards and managers with respect to shareholders
External Factors (Cont)
Regulators
• The SEC, Federal Trade Commission, and Department of Justice can
discipline firms through formal investigations and lawsuits.
• The 2010 Dodd-Frank Act requires listed firms, through new rules
adopted by the stock exchanges, to have fully independent
compensation committees, based on new standards that consider the
source of compensation for the director and whether the director is
affiliated with the company.
External Factors (Cont)
Institutional Activists
• Pension funds, hedge funds, private equity investors, and mutual
funds have become increasingly influential in affecting the policies of
companies in which they invest.
• Shareholders of public firms may submit proposals to be voted on at
annual meetings, but such proposals are not binding, in that the
firm’s board can accept or reject the proposal even if approved by a
majority of shareholders. Nonbinding proposals approved by
shareholders pertaining to takeover defenses, executive
compensation, etc., are more likely to be implemented if there is an
activist investor likely to threaten a proxy fight.
External Factors (Cont)
The Corporate Takeover Market
• Changes in corporate control can occur because of a hostile or
friendly takeover or because of a proxy contest initiated by
shareholders.
• When a firm’s internal management controls are weak, the takeover
market acts as a “court of last resort” to discipline bad management
behavior
• Strong internal governance mechanisms, by contrast, lessen the role
of the takeover threat as a disciplinary factor.
External Factors (Cont)
• The disciplining effect of a takeover threat on a firm’s management
can be reinforced when it is paired with a large shareholding by an
institutional investor.
• Larger firms are more likely to be the target of disciplinary takeovers
than smaller firms, and their CEOs are more likely to be replaced
following a series of poor acquisitions.
External Factors (Cont)
• The management entrenchment theory suggests that managers use takeover
defenses to ensure their longevity with the firm.
• Hostile takeovers or the threat of such takeovers have historically been useful for
maintaining good corporate governance by removing bad managers and installing
better ones.
• An alternative viewpoint is the shareholder interest’s theory, which suggests that
management resistance to takeovers is a good bargaining strategy to increase the
purchase price to the benefit of the target’s shareholders.
• Proxy contests are attempts by a group of shareholders to gain representation on
a firm’s board or to change management proposals by gaining the support of
other shareholders. While those that address issues other than board
representation do not bind the board, boards are becoming more responsive