Chapter 11
Structuring the Deal
Payment and Legal Considerations
If you can't convince them, confuse them.
—Harry S. Truman
Inside M&A: pfizer acquires wyeth labs despite tight credit markets
Pfizer and Wyeth began joint operations on October 22, 2009, when Wyeth shares stopped trading and each Wyeth share was converted to $33 in cash and 0.985 of a Pfizer share. Valued at $68 billion, the cash and stock deal was first announced in late January of 2009. The purchase price represented a 12.6% premium over Wyeth's closing share price the day before the announcement and a 29% premium over the same day the prior month. Investors from both firms celebrated as Wyeth's shares rose 12.6% and Pfizer's 1.4% on the news. The announcement seemed to offer the potential for profit growth, despite storm clouds on the horizon.
As is true of other large pharmaceutical companies, Pfizer expects to experience serious erosion in revenue due to expiring patent protection on a number of its major drugs. Pfizer faces the expiration of patent rights in 2011 to the cholesterol-lowering drug Lipitor, which accounted for 25% of the firm's 2008 $52 billion in revenue. Pfizer also faces 14 other patent expirations through 2014 on drugs that, in combination with Lipitor, contribute more than one-half of the firm's total revenue. Pfizer is not alone in suffering from patent expirations. Merck, Bristol-Myers Squibb, and Eli Lilly are all facing significant revenue reduction due to patent expirations during the next five years as competition from generic drugs undercuts their pricing. Wyeth will also be losing its patent protection on its top-selling drug, the antidepressant Effexor XR.
Pfizer's strategy appears to have been to acquire Wyeth at a time when transaction prices were depressed because of the recession and tight credit markets. Pfizer anticipates saving more than $4 billion annually by combining the two businesses, with the savings being phased in over three years. Pfizer also hopes to offset revenue erosion due to patent expirations by diversifying into vaccines and arthritis treatments.
By the end of 2008, Pfizer already had a $22.5 billion commitment letter in order to obtain temporary or “bridge” financing and $26 billion in cash and marketable securities. Pfizer also announced plans to cut its quarterly dividend in half to $0.16 per share to help finance the transaction. However, there were still questions about the firm's ability to complete the transaction in view of the turmoil in the credit markets.
Many transactions that were announced during 2008 were never closed because buyers were unable to arrange financing and would later claim that the purchase agreement had been breached due to material adverse changes in the business climate and would renege on contracts. Usually, such contracts contained so-called reverse termination fees, in which the buyer would agree to pay a fee to the seller if they were unwilling to close the deal. This is called a reverse termination or breakup fee because traditionally breakup fees are paid by a seller that chooses to break a contract with a buyer in order to accept a more attractive offer from another suitor.
Negotiations, which had begun in earnest in late 2008, became increasingly contentious, not so much because of differences over price or strategy but rather under what circumstances Pfizer could back out of the deal. Under the terms of the final agreement, Pfizer would have been liable to pay Wyeth $4.5 billion if its credit rating dropped prior to closing and it could not finance the transaction. At about 6.6% of the purchase price, the termination fee was about twice the normal breakup fee for a transaction of this type.
What made this deal unique was that the failure to obtain financing as a pretext for exit could be claimed only under very limited circumstances. Specifically, Pfizer could renege only if its lenders refused to finance the transaction because of a credit downgrade of Pfizer. If lenders refused to finance primarily for this reason, Wyeth could either demand that Pfizer attempt to find alternative financing or terminate the agreement. If Wyeth had terminated the agreement, Pfizer would have been obligated to pay the termination fee.
Chapter overview
Once management has determined that an acquisition is the best way to implement the firm's business strategy, a target has been selected, the target's fit with the strategy is well understood, and the preliminary financial analysis is satisfactory, it is time to consider how to properly structure the transaction. A deal structure is an agreement between two parties (the acquirer and target firms) defining the rights and obligations of the parties involved. The way in which this agreement is reached is called the deal-structuring process. In this chapter, the deal-structuring process is described in terms of seven interdependent components. These include the acquisition vehicle, the postclosing organization, the form of payment, the legal form of the selling entity, the form of acquisition, and accounting and tax considerations.
This chapter briefly addresses the form of the acquisition vehicle, postclosing organization, and the legal form of the selling entity because these are discussed in some detail elsewhere in this book. The chapter also discusses the interrelatedness of payment, legal, and tax forms by illustrating how decisions that are made in one area affect other aspects of the overall deal structure. The focus in this chapter is on the form of payment, form of acquisition, and alternative forms of legal structures in which ownership is conveyed. The implications of alternative tax structures for the deal-structuring process, how transactions are recorded for financial reporting purposes, and how they might affect the deal-structuring process are discussed in detail in Chapter 12.
A review of this chapter (including practice questions and answers) is available in the file folder entitled “Student Study Guide” on the companion site to this book (www.elsevierdirect.com/companions/9780123854858). The companion site also contains a Learning Interactions Library, which gives students the opportunity to test their knowledge of this chapter in a “real-time” environment.
The deal-structuring process
The deal-structuring process is fundamentally about satisfying as many of the primary objectives (or needs) of the parties involved and determining how risk will be shared. Common examples of high-priority buyer objectives include paying a “reasonable” purchase price, using stock in lieu of cash (if the acquirer's stock is believed to be overvalued), and having the seller finance a portion of the purchase price by carrying a seller's note. Buyers may also want to put a portion of the purchase price in an escrow account, defer a portion of the price, or make a certain percentage of the purchase price contingent on realizing some future event to minimize risk. Common closing conditions desired by buyers include obtaining employee retention and noncompete agreements.
Sellers, who also are publicly traded companies, commonly are driven to maximize purchase price. However, their desire to maximize price may be tempered by other considerations, such as the perceived ease of doing the deal, a desire to obtain a tax-free transaction, or a desire to obtain employment contracts or consulting arrangements for key employees. Private or family-owned firms may be less motivated by price than by other factors, such as protecting the firm's future reputation and current employees, as well as obtaining rights to license patents or utilize other valuable assets. A buyer may determine the highest-priority needs of the seller by determining the average age of the primary owners, their basis in the stock of the firm, the extent to which the firm is paternalistic toward its employees, whether it is family owned, and if there are issues around who will succeed the current owner.
Risk sharing refers to the extent to which the acquirer assumes all, some, or none of the liabilities, disclosed or otherwise, of the target. The appropriate deal structure is that which satisfies, subject to an acceptable level of risk, as many of the primary objectives of the parties involved as necessary to reach overall agreement. The process may be highly complex in large transactions involving multiple parties, approvals, forms of payment, and sources of financing. Decisions made in one area inevitably affect other areas of the overall deal structure. Containing risk associated with a complex deal is analogous to catching a water balloon. Squeezing one end of the balloon simply forces the contents to shift elsewhere.
Key Components of the Deal-Structuring Process
Figure 11.1 summarizes the deal-structuring process. The process begins with addressing a set of key questions shown on the left-hand side of the exhibit. Answers to these questions help define initial negotiating positions, potential risks, options for managing risk, levels of tolerance for risk, and conditions under which the buyer or seller will “walk away” from the negotiations.
Figure 11.1 Mergers and acquisitions deal-structuring process.
The acquisition vehicle refers to the legal structure created to acquire the target company. The postclosing organization, or structure, is the organizational and legal framework used to manage the combined businesses following the consummation of the transaction. Commonly used structures for both acquisition vehicle and postclosing organization include the corporate, division, holding company, joint venture (JV), partnership, limited liability company (LLC), and employee stock ownership plan (ESOP) structures. Although the two structures are often the same before and after completion of the transaction, the postclosing organization may differ from the acquisition vehicle, depending on the acquirer's strategic objectives for the combined firms.
The form of payment, or total consideration, may consist of cash, common stock, debt, or a combination of all three types. The payment may be fixed at a moment in time, contingent on the future performance of the acquired unit, or payable over time. The form of payment influences the selection of the appropriate form of acquisition and postclosing organization. The form of acquisition reflects what is being acquired (stock or assets). Accounting considerations refer to the potential impact of financial reporting requirements on the earnings volatility of business combinations due to the need to periodically revalue acquired assets to their fair market value as new information becomes available.
Tax considerations entail tax structures and strategies that determine whether a transaction is taxable or nontaxable to the seller's shareholders and influence the choice of postclosing organization, which affects the potential for double taxation and the allocation of losses to owners. The form of acquisition also defines how the ownership of assets will be conveyed from the seller to the buyer, either by rule of law, as in a merger, or through transfer and assignment, as in a purchase of assets. The legal form of the selling entity (i.e., whether it is a C or S chapter corporation, LLC, or partnership) also has tax implications. These considerations are explored in greater detail later in this chapter.
Common Linkages
For simplicity, many of the linkages or interactions that reflect how decisions made in one area affect other aspects of the deal are not shown in Figure 11.1. Common linkages or interactions among various components of the deal structure are illustrated through examples, described next.
Payment's Form Influences Acquisition Vehicle and Postclosing Organization Choice (Figure 11.1, Arrows 1 and 2)
If the buyer and seller agree on a price, the buyer may offer a purchase price that is contingent on the future performance of the target. The buyer may choose to acquire and operate the acquired company as a wholly-owned subsidiary within a holding company during the term of the “earn-out.” This facilitates monitoring the operation's performance during the earn-out period and minimizes the potential for post-earn-out litigation initiated by earn-out participants.
Form of Acquisition Effects (Figure 11.1, Arrows 3–6)
Choice of acquisition vehicle and postclosing organization. If the form of acquisition is a statutory merger, all known and unknown or contingent liabilities are transferred to the buyer. Under these circumstances, the buyer may choose to change the type of acquisition vehicle to one better able to protect the buyer from the liabilities of the target, such as a holding company arrangement. Acquisition vehicles and postclosing organizations that facilitate a sharing of potential risk or the purchase price include JV or partnership arrangements.
Form, timing, and amount of payment. The assumption of all seller liabilities through a merger also may induce the buyer to change the form of payment by deferring some portion of the purchase price to decrease the present value of the cost of the transaction. The buyer also may attempt to negotiate a lower overall purchase price.
Tax considerations. The transaction may be tax free to the seller if the acquirer uses its stock to acquire substantially all of the seller's assets or stock in a stock-for-stock or stock-for-assets purchase. See Chapter 12 for a discussion of M&A-related tax issues.
Tax Considerations Effects (Figure 11.1, Arrows 7 and 8)
Amount, timing, and composition of the purchase price. If the transaction is taxable to the target's shareholders, it is likely that the purchase price will be increased to compensate the target's shareholders for their tax liability. The increase in the purchase price may affect the form of payment. The acquirer may maintain the present value of the total cost of the acquisition by deferring some portion of the purchase price by altering the terms to include more debt or installment payments.
Selection of the postclosing organization. The decision as to what constitutes the appropriate organizational structure of the combined businesses is affected by these tax-related factors: the desire to minimize taxes and pass through losses to the owners. The S corporation, LLC, and the partnership eliminate double-taxation problems. Moreover, current operating losses, loss carryforwards or carrybacks, or tax credits generated by the combined businesses can be passed through to the owners if the postclosing organization is a partnership or a LLC.
Legal Form of Selling Entity Affects the Form of Payment (Figure 11.1, Arrow 9)
Because of the potential for deferring shareholder tax liabilities, target firms that qualify as C corporations often prefer to exchange their stock or assets for acquirer shares. In contrast, owners of S corporations, LLCs, and partnerships are largely indifferent as to whether the transaction is taxable or nontaxable because 100% of the proceeds of the sale are taxed at the shareholder's ordinary tax rate.
Accounting Considerations Affect the Form, Amount, and Timing of Payment (Figure 11.1, Arrow 10)
Earn-outs and other forms of contingent considerations are recorded at fair value on the acquisition date under recent changes in financial reporting guidelines (i.e., SFAS 141R and SFAS 157) effective December 15, 2009, and subsequently adjusted to fair value as new information becomes available. Such changes can increase or decrease reported earnings. Since earn-outs must be recorded at fair value on the acquisition date and subsequently adjusted, the potential for increased earnings volatility may make performance-related payouts less attractive as a form of payment. Furthermore, the use of equity securities to pay for target firms may be less attractive due to recent changes in financial reporting requirements.1 Finally, the requirement to review periodically the book or carrying value of such assets as goodwill for impairment (e.g., fair market value is less than book value) may discourage acquirers from overpaying for a target firm due to the potential for future asset write-downs. These financial reporting requirements are discussed in more detail in Chapter 12. Table 11.1 provides a summary of these common linkages.
Table 11.1. Summary of Common Linkages within the Deal-Structuring Process
| Component of Deal-Structuring Process | Influences choice of |
| Form, Amount, and Timing of Payment | Acquisition vehicle Postclosing organization Accounting considerations Tax structure (taxable or nontaxable) |
| Form of Acquisition | Acquisition vehicle Postclosing organization Form, amount, and timing of payment Tax structure (taxable or nontaxable) |
| Tax Considerations | Form, amount, and timing of payment Postclosing organization |
| Legal Form of Selling Entity | Tax structure (taxable or nontaxable) |
Form of acquisition vehicle and postclosing organization
Present in all transactions, the acquisition vehicle is the legal or business structure employed to acquire a target firm, and the postclosing organization is that used to operate the new company following closing. There are various options, as the following examples illustrate, and making the right choices for both is integral to the negotiation process.2
On July 9, 2000, in a share-for-share exchange valued at $41 billion, the boards of JDSU (a fiber-optic components manufacturer) and SDL (a pump laser producer) unanimously approved an agreement to merge SDL with a newly formed entity: K2 Acquisition, Inc., a wholly-owned subsidiary of JDS Uniphase created as a shell corporation to be the acquisition vehicle to complete the merger. K2 Acquisition Inc. was merged into SDL, with SDL as the surviving entity. The postclosing organization consisted of SDL as a wholly-owned subsidiary of JDS Uniphase.
In another deal, Rupert Murdoch's News Corp.—a holding company (the acquisition vehicle)—acquired a controlling interest in Hughes Electronics Corporation (a subsidiary of General Motors Corporation and owner of DirecTV) on April 10, 2003. News Corp. subsequently transferred its stake in Hughes to its Fox Entertainment Group subsidiary (the postclosing organization), in which it owned an 81% interest at the time, to strengthen Fox's competitive position while retaining control over DirecTV.
More recently, the Tribune Corporation announced on April 2, 2007, that the firm's publicly traded shares would be acquired in a multistage transaction valued at $8.2 billion. The acquisition vehicle was an employee stock ownership plan (ESOP), and the postclosing organization was a Subchapter S corporation. Converting the Tribune into a Subchapter S corporation eliminated the firm's current annual tax liability of $348 million. Such entities pay no corporate income tax but must pay all profit directly to shareholders, who then pay taxes on these distributions. Since the ESOP is the sole shareholder, the restructured Tribune would be largely tax exempt, since ESOPs are not taxed.
Finally, in a cross-border transaction, the biggest banking deal on record was announced on October 9, 2007, resulting in the dismemberment of one of Europe's largest and oldest financial services firms: ABN Amro (ABN), which was at the time the largest bank in the Netherlands. The acquisition vehicle was a buyer partnership comprising The Royal Bank of Scotland, Spain's Banco Santander, and Belgium's Fortis Bank, which won control of ABN in a buyout valued at $101 billion. The acquisition partners agreed in advance who would retain which ABN assets, and these were merged into the respective buyers' corporate subsidiaries (the postclosing organizations).
Choosing the Appropriate Form of Acquisition Vehicle
The decision about which legal entity to use as an acquisition vehicle requires consideration of a host of practical, financial, legal, and tax issues, which could include the cost and formality of organization, ease of transferability of ownership interests, continuity of existence, management, control, ease of financing, method of distribution of profits, extent of personal liability, and taxation. Each form of legal entity has markedly different risk, financing, tax, and control implications for the acquirer. The various forms of potential acquisition vehicles and their specific advantages and disadvantages are discussed in considerable detail in Chapter 14. The selection of the appropriate entity can help to mitigate risk associated with the target firm, maximize financing flexibility, and minimize the net cost of the acquisition to the acquiring firm.
The corporate structure or some variation is the most commonly used acquisition vehicle. This legal form tends to offer most of the features acquirers desire, including limited liability, financing flexibility, continuity of ownership, and deal flexibility (e.g., option to engage in a tax-free deal). Moreover, the corporate structure enables the acquirer to retain control over the implementation of the business plan and the acquisition process, something that may not be possible under partnership arrangements. When using a corporate structure as the acquisition vehicle, the target company typically is integrated into an existing operating division or product line within the corporation.
The corporate structure may also be appropriate for those situations where there is a desire to share the risk of acquiring the target or because the partner has skills and attributes viewed as valuable in operating the target after closing. Used as an acquisition vehicle, the JV corporation or partnership offers a lower level of risk than a direct acquisition of the target firm by one of the JV corporate owners or individual partners. By acquiring the target firm through the JV, the corporate investor limits the potential liability to the extent of its investment in the joint venture. The joint venture arrangement also enables the inclusion of partners with a particular skill, proprietary knowledge, intellectual property, manufacturing facility, or distribution channel that offers potential synergy with the target firm.
There are many common motivations for using other legal forms. For small, privately owned firms, an employee stock ownership plan structure may be a convenient vehicle for transferring the owner's interest in the business to the employees, while offering significant tax advantages. Non-U.S. buyers intending to make additional acquisitions may prefer a holding company structure. The advantages of this structure over a corporate merger for both foreign and domestic firms are the ability to control other companies by owning only a small portion of the company's voting stock and to gain this control without getting shareholder approval.
If the form of acquisition is a statutory merger, all known and unknown or contingent liabilities are transferred to the buyer. Under these circumstances, the buyer may choose to change the type of acquisition vehicle to one that offers better protection from the target's liabilities, such as a holding company arrangement. By merging the target firm into a subsidiary of the holding company, the acquirer may better insulate itself from the target's liabilities. Again, this risk could be shared under a joint venture or partnership arrangement.
If the buyer and seller cannot agree on a price, the buyer may offer a purchase price that is contingent on the future performance of the target. The buyer may choose to acquire and to operate the acquired company as a wholly-owned subsidiary within a holding company during the term of the earn-out (i.e., deferred payment to target owners upon achievement of certain goals). The holding company framework facilitates monitoring the target's performance during the earn-out period and minimizes the potential for post-earn-out litigation initiated by earn-out participants.
Choosing the Appropriate Postclosing Organization
The postclosing organization refers to the legal or organizational framework used to operate the acquired firm following closing, so it can be the same as that chosen for the acquisition vehicle: corporate, general partnership, limited partnership, and the limited liability company. Common organizational business structures include divisional and holding company arrangements. The choice will depend on the objectives of the acquirer.
A division generally is not a separate legal entity but rather an organizational unit, while a holding company can take on many alternative legal forms. An operating division is distinguishable from a legal subsidiary in that it typically will not have its own stock or board of directors that meets on a regular basis. However, divisions as organizational units may have managers with some of the titles normally associated with separate legal entities, such as a president or chief operating officer. Because a division is not a separate legal entity, its liabilities are the responsibility of the parent firm.
The acquiring firm may have a variety of objectives for operating the target firm after closing, including facilitating postclosing integration, minimizing risk to owners from the target's known and unknown liabilities, minimizing taxes, passing through losses to shelter the owners' tax liabilities, preserving unique target attributes, maintaining target independence during the duration of an earn-out, and preserving the tax-free status of the deal. If the acquirer is interested in integrating the target business immediately following closing, the corporate or divisional structure may be most desirable because it may make it possible for the acquirer to gain the greatest control. In other structures, such as JVs and partnerships, the dispersed ownership may render decision making slower or more contentious, since it is more likely to depend on close cooperation and consensus building that may slow efforts at rapid integration of the acquired company.
In contrast, a holding company structure in which the acquired company is managed as a wholly- or partially owned subsidiary may be preferable when the target has significant known or unknown liabilities, an earn-out is involved, the target is a foreign firm, or the acquirer is a financial investor. By maintaining the target as a subsidiary, the parent firm may be able to isolate significant liabilities within the subsidiary. Moreover, if need be, the subsidiary could be placed under the protection of the U.S. Bankruptcy Court without jeopardizing the existence of the parent.
In an earn-out agreement, the acquired firm must be operated largely independently from other operations of the acquiring firm to minimize the potential for lawsuits. If the acquired firm fails to achieve the goals required to receive the earn-out payment, the acquirer may be sued for allegedly taking actions that prevented the acquired firm from reaching the necessary goals. When the target is a foreign firm, it is often appropriate to operate it separately from the rest of the acquirer's operations because of the potential disruption from significant cultural differences. Finally, a financial buyer may use a holding company structure because they have no interest in operating the target firm for any length of time.
A partnership or JV structure may be appropriate if the risk associated with the target firm is believed to be high. Consequently, partners or JV owners can limit their financial exposure to the amount they have invested. The acquired firm may benefit from being owned by a partnership or JV because of the expertise that the different partners or owners might provide.
A partnership or LLC may be most appropriate for eliminating double taxation and passing through current operating losses, tax credits, and loss carryforwards and carrybacks to owners.3 Cerberus Capital Management's conversion of its purchase of General Motors Acceptance Corporation (GMAC) from General Motors in 2006 from a C corporation to a limited liability company at closing reflected its desire to eliminate double taxation of income while continuing to limit shareholder liability. Similarly, when investor Sam Zell masterminded a leveraged buyout of media company Tribune Corporation in 2007, an ESOP was used as the acquisition vehicle and a Subchapter-S corporation as the postclosing organization. The change in legal structure enabled the firm to save an estimated $348 million in taxes, because S corporation profits are not taxed if distributed to shareholders—which in this case included the tax-exempt ESOP as the primary shareholder.
Legal form of the selling entity
Whether the seller will care about the form of the transaction (i.e., whether stock or assets are sold) may depend on whether the seller is an S, a limited liability company, partnership, or a C corporation. As noted previously, C corporations are subject to double taxation, whereas owners of S corporations, partnerships, and LLCs are not (see Exhibit 11.1).
Exhibit 11.1 How the Seller's Legal Form Affects the Form of Payment
Assume that a business owner starting with an initial investment of $100,000 sells her business for $1 million. Different legal structures have different tax impacts:
1. After-tax proceeds of a stock sale are ($1,000,000 – $100,000) × (1 – 0.15) = $765,000. The S corporation shareholder or limited liability company member holding shares for more than one year pays a maximum capital gains tax equal to 15% of the gain on the sale.a
2. After-tax proceeds from an asset sale are ($1,000,000 – $100,000) × (1 – 0.4) × (1 – 0.15) = $900,000 × 0.51 = $459,000. A C corporation typically pays tax equal to 40% (i.e., 35% federal and 5% state and local), and the shareholder pays a maximum capital gains tax equal to 15%, resulting in double taxation of the gain on sale.
Implications
1. C corporation shareholders generally prefer acquirer stock for their stock or assets to avoid double taxation.
2. S corporation and LLC owners often are indifferent to an asset sale or stock sale because 100% of the corporation's income passes through the corporation untaxed to the owners, who are subject to their own personal tax rates. The S corporation shareholders or LLC members still may prefer a share-for-share exchange if they are interested in deferring their tax liability or are attracted by the long-term growth potential of the acquirer's stock.
Form of payment or total consideration
The form of payment refers to the composition of the purchase price for a target firm and can be structured in many different ways. This section discusses alternative structures that can be used as payment in negotiating with a target firm's board and management and how these various forms of payment can be used to bridge differences between the seller's asking price and the price the acquirer is willing to pay.
Cash
Cash is the simplest and most commonly used means of payment for acquiring shares or assets. Although cash payments generally result in an immediate tax liability for the target company's shareholders, there is no ambiguity about the value of the transaction as long as no portion of the payment is deferred. Whether cash is used as the predominant form of payment depends on a variety of factors, including the acquirer's current leverage, potential near-term earnings per share dilution, the seller's preference for cash or acquirer stock, and the extent to which the acquirer wishes to maintain control.
A bidder may choose to use cash rather than issue voting shares if the voting control of its dominant shareholder is threatened as a result of the issuance of voting stock to acquire the target firm.4 Issuing new voting shares would dilute the amount of control held by the dominant shareholder. The preference for using cash appears to be much higher in Western European countries, where ownership tends to be more heavily concentrated in publicly traded firms, than in the United States. In Europe, 63% of publicly traded firms have a single shareholder who directly or indirectly controls 20% or more of the voting shares; the U.S. figure is 28%.5
Noncash
The use of common equity may involve certain tax advantages for the parties involved—especially shareholders of the selling company. However, using shares is much more complicated than cash because it requires compliance with the prevailing security laws and may result in long-term earnings per share dilution. Using convertible preferred stock or debt can be attractive to both buyers and sellers. These securities offer holders the right (but not the obligation) to convert to common stock at a predetermined “conversion” price. Convertible preferred stock provides some downside protection to sellers in the form of continuing dividends, while providing upside potential if the acquirer's common stock price increases above the conversion point. Acquirers often find convertible debt attractive because of the tax deductibility of interest payments.
The major disadvantage in using securities of any type is that the seller may find them unattractive because of the perceived high risk of default associated with the issuer. When offered common equity, shareholders of the selling company may feel that the growth prospects of the acquirer's stock may be limited or that the historical volatility of the stock makes it unacceptably risky. Debt or equity securities may also be illiquid because of the small size of the resale market for such securities.
Acquirer stock may be a particularly useful form of payment when valuing the target firm is difficult, such as when the target firm has hard to value intangible assets, new product entries whose outcome is uncertain, or large research and development outlays. In accepting acquirer stock, a seller may have less incentive to negotiate an overvalued purchase price if it wishes to participate in any appreciation of the stock it receives. However, a seller could attempt to negotiate the highest price possible for its business and immediately sell its stock following closing.6
Other forms of noncash payment include real property, rights to intellectual property, royalties, earn-outs, and contingent payments. These are discussed later in this chapter.
Cash and Stock in Combination
The bidding strategy of offering target firm shareholders multiple payment options increases the likelihood that more target firm shareholders will participate in a tender offer. It is a bidding strategy common in “auction” environments or when the bidder is unable to borrow the amount necessary to support an all-cash offer or unwilling to absorb the potential earnings per share dilution in an all-stock offer. The multiple-option bidding strategy does, however, introduce a certain level of uncertainty in determining the amount of cash the acquirer ultimately will have to pay out to target firm shareholders, since the number of shareholders choosing the all-cash or cash-and-stock option is not known prior to completion of the tender offer.
Acquirers resolve this issue by including a proration clause in tender offers and merger agreements that allows them to fix—at the time the tender offer is initiated—the total amount of cash they will ultimately have to pay out. For example, assume that the total cost of an acquisition is $100 million, the acquirer wishes to limit the amount of cash paid to target firm shareholders to one-half of that amount, and the acquirer offers the target firm's shareholders a choice of stock or cash. If the number of target shareholders choosing cash exceeds $50 million, the proration clause enables the acquirer to pay all target firm shareholders tendering their shares one-half of the purchase price in cash and the remainder in stock.
Managing risk and closing the gap on price
During the negotiation phase, the buyer and seller maneuver to share the perceived risk and apportion the potential returns. In doing so, substantial differences arise between what the buyer is willing to pay and what the seller believes their business is worth. Postclosing balance sheet adjustments and escrow accounts, earn-outs and other contingent payments, contingent value rights, staging investment, rights to intellectual property, licensing fees, and consulting agreements are all typically used to consummate the deal when the buyer and seller cannot reach agreement on price.
Postclosing Price Adjustments
Postclosing adjustment price mechanisms include escrow or holdback accounts and adjustments to the target's balance sheet. Both mechanisms, most often used in cash rather than stock-for-stock purchases (particularly when the number of target shareholders is large), rely on an audit of the target firm to determine its “true” value and generally are applicable only when what is being acquired is clearly identifiable, such as in a purchase of tangible assets. The buyer and seller typically share the cost of the audit.
With escrow accounts, the buyer retains a portion of the purchase price until completion of a postclosing audit of the target's financial statements. Escrow accounts may also be used to cover and claims that continue beyond a closing. For instance, Google's share-for-share purchase of YouTube involved a holdback of a portion of the purchase price because of the potential for copyright infringement litigation. When Berkshire Hathaway and Leucadia National agreed to buy Capmark Financial Group's mortgage servicing business in 2010 for $490 million, the buyers held back $40 million to cover potential indemnity claims.
Balance sheet adjustments are used most often in purchases of assets when there is a lengthy time between the agreement on price and the actual closing date. This may result from the need to obtain regulatory or shareholder approvals or from ongoing due diligence. During this period, balance sheet items may change significantly—particularly those related to working capital—so the purchase price is adjusted up or down. Balance sheet adjustments can be employed broadly to guarantee the value of the target firm's shareholder equity or, more narrowly, to guarantee the value of working capital.
With a shareholder equity guarantee, both parties agree to an estimated equity value as of the closing date. Target equity value is often calculated by taking the book value of equity on the balance sheet of the target firm at a given point and then increasing (or decreasing) it by the amount of net profit earned (or lost) between that date and closing. The purchase price is then increased or decreased to reflect any change in the book value of equity. A guarantee of this sort protects the buyer from risks such as any distribution of company profits by the seller after the signing date or unusually large salary payments or severance benefits between the contract signing and closing dates. While attractive to the buyer, the equity guarantee can be unattractive to the seller because of the difficulty in forecasting revenue during the period between signing and closing at the signing date. Consequently, sellers often will demand a higher purchase price to compensate them for this increase in risk.
Both parties may more easily reach an agreement with a working capital guarantee, which ensures against fluctuations in the company's current operating assets. It is critical, though, to define clearly what constitutes working capital and equity in the agreement of purchase and sale, since—similar to equity—what constitutes working capital may be ambiguous.
As Table 11.2 indicates, the buyer—to protect the buyer or seller—reduces the total purchase price by an amount equal to the decrease in net working capital or shareholders' equity of the target and increases the purchase price by any increase in these measures during this period.
Table 11.2. Balance Sheet Adjustments ($ million)
Earn-Outs and Other Contingent Payments
Earn-outs and warrants frequently are used whenever the buyer and seller cannot agree on the probable performance of the seller's business over some future period or when the parties involved wish to participate in the upside potential of the business. Earn-out agreements may also be used to retain and motivate key target firm managers. An earn-out agreement is a financial contract whereby a portion of the purchase price of a company is to be paid in the future, contingent on realizing the future earnings level or some other performance measure agreed upon earlier. The terms of the earn-out are stipulated in the agreement of purchase and sale. A subscription warrant, or simply warrant, is a type of security—often issued with a bond or preferred stock—that entitles the holder to purchase an amount of common stock at a stipulated price. The exercise price is usually higher than the price at the time the warrant is issued. Warrants may be converted over a period of many months to many years.
The earn-out typically requires that the acquired business be operated as a wholly-owned subsidiary of the acquiring company under the management of the former owners or key executives. Both the buyer and the seller are well advised to keep the calculation of such goals and resulting payments as simple as possible because the difficulty of measuring actual performance against the goals often creates disputes.
Earn-outs may take many forms. Some are payable only if a certain performance threshold is achieved; others depend on average performance over several periods; and still others may involve periodic payments, depending on the achievement of interim performance measures rather than a single, lump-sum payment at the end of the earn-out period. The value of the earn-out is often capped. In some cases, the seller may have the option to repurchase the company at some predetermined percentage of the original purchase price if the buyer is unable to pay the earn-out at maturity.
Exhibit 11.2 illustrates how an earn-out formula could be constructed reflecting these considerations. The purchase price has two components. At closing, the seller receives a lump-sum payment of $100 million. The seller and the buyer agree to a baseline projection for a three-year period and that the seller will receive a fixed multiple of the average annual performance of the acquired business in excess of the baseline projection. Thus, the earn-out provides an incentive for the seller to operate the business as effectively as possible. Normally, the baseline projection is what the buyer used to value the seller's business. Shareholder value for the buyer is created whenever the acquired business' actual performance exceeds the baseline projection and the multiple applied by investors at the end of the three-year period exceeds the multiple used to calculate the earn-out payment. This assumes that the baseline projection accurately values the business and that the buyer does not overpay. By multiplying the anticipated multiple that investors will pay for operating cash flow at the end of the three-year period by projected cash flow, it is possible to estimate the potential increase in shareholder value.
Earn-outs tend to shift risk from the acquirer to the seller in that a higher price is paid only when the seller has met or exceeded certain performance criteria. Earn-outs may also create some perverse results during implementation. Management motivation may be lost if the acquired firm does not perform well enough to achieve any payout under the earn-out formula or if the acquired firm exceeds the performance targets substantially, effectively guaranteeing the maximum payout under the plan.
Exhibit 11.2 Hypothetical Earn-Out as Part of the Purchase Price
Purchase Price
1. Lump-sum payment at closing: The seller receives $100 million.
2. Earn-out payment: The seller receives four times the excess of the actual average annual net operating cash flow over the baseline projection after three years, not to exceed $35 million.
Earn-out at the end of three yearsa:
Potential increase in shareholder valueb:
Moreover, the management of the acquired firm may have an incentive to take actions not in the best interests of the acquirer. For example, management may cut back on advertising and training expenses to improve the operation's current cash-flow performance or make only those investments that improve short-term profits, while ignoring those that may generate immediate losses but favorably affect profits in the long term. As the end of the earn-out period approaches, managers may postpone investments to maximize their own bonuses under the earn-out plan.
Earn-outs may also be based on share of equity ownership when the business is sold. For example, assume an entrepreneur believes the business is worth $20 million without additional investment, and the private equity investor estimates the business to be worth only $15 million without additional investment. The entrepreneur who wants $5 million in equity investment perceives the market value, including the equity infusion, to be $25 million (i.e., $20 million stand-alone plus $5 million in equity). The implied ownership distribution is 80/20, with the entrepreneur receiving 80% (i.e., $20/$25) and the equity investor receiving 20% (i.e., $5/$25).
However, the equity investor sees the value of the business, including the equity investment, to be only $20 million (i.e., $15 million stand-alone plus $5 million equity investment). The implied ownership is 75/25, with the entrepreneur receiving only 75% ownership (i.e., $15/$20) and the equity investor 25% ownership (i.e., $5/$20). The ownership gap of 5 percentage points can be closed by the entrepreneur and equity investor agreeing to the 80/20 distribution if certain cash-flow or profit targets can be reached prior to exiting the business sufficient to justify the $25 million net present value (see Exhibit 11.3).
Exhibit 11.3 Earn-Outs Based on Ownership Distribution
Distribution of ownership equity if average annual free cash flow is less than $5 million in years 3 to 5a:
Distribution of ownership equity if average annual free cash flow is greater than $5 million in years 3 to 5:
To avoid various pitfalls associated with earn-outs, also known as contingent payouts, it may be appropriate to establish more than one target. For example, it may be appropriate to include a revenue, income, and investment target, although this adds to the earn-out's complexity. Earn-outs are included in about 3% of total transactions. Earn-outs are more commonly used when the targets are small, private firms or subsidiaries of larger firms, rather than for large, publicly traded firms. Such contracts are more easily written and enforced when there are relatively few shareholders.7 Earn-outs tend to be most common in high-tech and service industries, when the acquirer and target firms are in different industries, when the target firm has a significant number of assets not recorded on the balance sheet, when buyer access to information is limited, and when little integration will be attempted.
Earn-outs on average account for 45% of the total purchase price paid for private firms and 33% for subsidiary acquisitions, and target firm shareholders tend to realize about 62% of the potential earn-out amount. In transactions involving earn-outs, acquirers earn abnormal returns of 5.39% around the announcement date, in contrast to transactions not involving contingent payments in which abnormal returns to acquirers tend to be zero or negative. Positive abnormal returns to acquiring company shareholders may be a result of investor perception that with an earn-out the buyer is less likely to overpay and more likely to retain key target firm talent.8
New IRS rules may make earn-outs less attractive than in the past. Under revisions that took effect on January 1, 2009, earn-outs and other contingent payments must be revalued as new information becomes available that could introduce greater volatility into a firm's earnings.9
Contingent Value Rights
In M&A transactions, contingent value rights (CVRs) are commitments by the issuing company (i.e., the acquirer) to pay additional cash or securities to the holder of the CVR (i.e., the seller) if the share price of the issuing company falls below a specified level at some future date. CVRs provide a guarantee of future value of one of various forms of payment made to the seller—such as cash, stock, or debt—as of a given time. While relatively rare, CVRs are sometimes granted when the buyer and seller are far apart on the purchase price or when the target firm wants protection for any remaining minority shareholders fearful of being treated unfairly by the buyer.10
Whereas earn-outs represent call options for the target representing claims on future upside performance and are employed when there is substantial disagreement between the buyer and seller on price, CVRs are put options limiting downside loss on the form of payment received by sellers. CVRs may be traded on public exchanges.
The following examples illustrate the use of CVRs. In Tembec Inc.'s acquisition of Crestbrook Forest Products Ltd., each Crestbrook shareholder received a contingent value right, enabling the shareholder to receive a one-time payment on March 31, 2000, the size of which (up to a maximum of $1.50 per share) depended on the amount that the average price of wood pulp for 1999 exceeded $549 per ton. In 2008, French utility EDF overcame resistance from certain British Energy shareholders by offering a combination of cash and a CVR that enabled investors to share in future profits whenever electrical output and energy prices rose. The amount of future payouts to shareholders would depend on the amount of the increase in profits. In 2011, French pharmaceutical giant Sanofi-Aventis clinched a deal to acquire U.S.-based Genzyme Corporation by offering a CVR to bridge the wide gap in the two firms' expectations for a newly introduced Genzyme drug, Lemitrada. Genzyme forecasted peak annual sales of $3.5 billion versus Sanofi's estimate of only $700 million. By some estimates, the value of the contingent value rights could be worth as much as $12 to $15 per share paid out over as long as eight years to Genzyme shareholders, depending on the eventual annual revenues produced by the drug.
Distributed or Staged Payouts
The purchase price payments can be contingent on the target satisfying an agreed-on milestone, such as achieving a profit or cash-flow target, successfully launching a new product, obtaining regulatory or patent approval, and so on. Distributing the payout over time manages risk to the acquirer by reducing some of the uncertainty about future cash flows. An acquirer could also avoid having to finance the entire cash purchase price in a large transaction at one time.
Rights, Royalties, and Fees
The rights to intellectual property, royalties from licenses, and fee-based consulting or employment agreements are other forms of payment that can be used to close the gap between what the buyer is willing to offer and what the seller expects. The right to use a proprietary process or technology for free or at a rate below that prevailing in the market may interest former owners considering business opportunities in which it would be useful. Note that such an arrangement, if priced at below market rates or free to the seller, would represent taxable income to the seller. Obviously, such arrangements should be coupled with reasonable agreements not to compete in the same industry as their former firm. Table 11.3 summarizes the advantages and disadvantages of these various forms of payment.
Table 11.3. Evaluating Alternative Forms of Payment
| Form of Payment | Advantages | Disadvantages |
| Cash (including highly marketable securities) | Buyer: Simplicity. Seller: Ensures payment if acquirer's creditworthiness questionable. |
Buyer: Must rely solely on protections afforded in contract to recover claims. Seller: Creates immediate tax liability. |
| Stock – Common – Preferred – Convertible Preferred |
Buyer: High P/E relative to seller's P/E may increase value of combined businesses. Seller: Defers taxes and provides potential price increase. Retains interest in the business. |
Buyer: Adds complexity; potential EPS dilution. Seller: Potential decrease in purchase price if the value of equity received declines. May delay closing because of SEC registration requirements. |
| Debt – Secured – Unsecured – Convertible |
Buyer: Interest expense tax deductible. Seller: Defers tax liability on principal. |
Buyer: Adds complexity and increases leverage. Seller: Risk of default. |
| Performance-Related Earn-Outs |
Buyer: Shifts some portion of risk to seller. Seller: Potential for higher purchase price. |
Buyer: May limit integration of businesses. Seller: Increases uncertainty of sales price. |
| Purchase Price Adjustments | Buyer: Protection from eroding values of working capital before closing. Seller: Protection from increasing values of working capital before closing. |
Buyer: Audit expense. Seller: Audit expense. (Note that buyers and sellers often split the audit expense.) |
| Real Property – Real Estate – Plant and Equipment – Business or Product Line |
Buyer: Minimizes use of cash. Seller: May minimize tax liability. |
Buyer: Opportunity cost. Seller: Real property may be illiquid. |
| Rights to Intellectual Property – License – Franchise |
Buyer: Minimizes cash use. Seller: Gains access to valuable rights and spreads taxable income over time. |
Buyer: Potential for setting up new competitor. Seller: Illiquid; income taxed at ordinary rates. |
| Royalties from – Licenses – Franchises |
Buyer: Minimizes cash use. Seller: Spreads taxable income over time. |
Buyer: Opportunity cost. Seller: Income taxed at ordinary rates. |
| Fee-Based – Consulting Contract – Employment Agreement |
Buyer: Uses seller's expertise and removes seller as potential competitor for a limited time. Seller: Augments purchase price and allows seller to stay with the business. |
Buyer: May involve demotivated employees. Seller: Limits ability to compete in same line of business. Income taxed at ordinary rates. |
| Contingent Value Rights | Buyer: Minimizes upfront payment. Seller: Provides for minimum payout guarantee. |
Buyer: Commits buyer to minimum payout. Seller: Buyer may ask for purchase price reduction |
| Staged or Distributed Payouts | Buyer: Reduces amount of upfront investment. Seller: Reduces buyer angst about certain future events. |
Buyer: May result in underfunding of needed investments. Seller: Lower present value of purchase price. |
Using collar arrangements to preserve shareholder value
Unlike what happens with all-cash deals, significant fluctuations in the acquirer's share price can threaten to change the terms of the deal or even to derail it altogether. Parties may need to renegotiate price as they approach closing. A solution is for the acquirer and target firms to agree on a range or collar within which the stock price can change. By setting floors and caps on the stock portion of an acquisition's price, a collar gives both sides some assurance that the deal will retain its value despite share price fluctuations. Whereas fixed share exchange ratios are most common, some transactions do allow the share exchange ratio to fluctuate within limits to compensate for the uncertain value of the deal. These limits often are referred to as the “collar” around the purchase price; such arrangements have become more common in recent years, with about 20% of stock mergers employing some form of collar.
A fixed share exchange agreement fixes the share exchange ratio (i.e., the number of acquirer shares exchanged for each target share) between the signing of the agreement of purchase and sale and closing. However, the value of the buyer's share price is allowed to fluctuate due to changes in the value of the acquirer's share price. While the buyer will know exactly how many shares will have to be issued to consummate the transaction, both the acquirer and the target will be subject to significant uncertainty about the final purchase price. The acquirer may find that the transaction will be much more expensive than anticipated if the value of its shares rises; in contrast, the seller may be greatly disappointed if the acquirer's share price declines. Fixed share exchange ratios are more common in share-for-share exchanges because they involve both firms' share prices and allow both parties to share in the risk or benefit of fluctuating share prices.
A fixed value (offer price) agreement fixes the value of the offer price per share by allowing the share exchange ratio to change. For example, an increase in the value of the acquirer's share price (ASP) would result in the issuance of fewer acquirer shares to keep the value of the deal unchanged, while a decrease would require that new shares be issued.
Buyers often argue that a collar arrangement to the seller is like buying insurance because it tends to reduce the seller's uncertainty about the purchase price at closing. In these cases, such buyers expect sellers to accept a lower purchase price as payment of a “premium” for such insurance.
Offer prices based on collar arrangements can be constructed as follows:
where ASPU > ASPL and SERU < SERL; subscripts L and U refer to lower and upper limits.
Case Study 11.1 illustrates the use of both fixed value and fixed share exchange ratio collar agreements. Within the first collar (fixed value), the purchase price is fixed by allowing the share exchange ratio to vary, giving the seller some degree of certainty inside a narrow range within which the acquirer share price can fluctuate; the second collar (fixed share exchange) allows the acquirer's share price to vary within a stipulated range resulting in both the buyer and seller sharing the risk. Finally, if the acquirer's share price rises above a certain level, the purchase price is capped; if it falls below a predetermined price, the seller can walk away.
If the acquirer's share price has historically been highly volatile, the target may demand a collar to preserve the agreed-on share price. Similarly, the acquirer may demand a collar if the target's share price has shown great variation in the past in order to minimize the potential for overpaying if the target's share price declines significantly relative to the acquirer's share price.
Case Study 11.1
Flextronics Acquires International DisplayWorks Using Fixed Value and Fixed Share Exchange Collars
Flextronics, a manufacturer of camera modules, TV tuners, and Wi-Fi module assemblies, acquired International DisplayWorks (IDW), a designer and manufacturer of LCDs and other components for handheld and industrial products, in a share-for-share deal valued at approximately $300 million in late 2009. The share exchange ratio used at closing was calculated using the Flextronics average daily closing share price for the 20 trading days ending on the fifth trading day immediately preceding the closing.1 Transaction terms included the following three collars:
1. Fixed Value Agreement: The offer price was calculated using an exchange ratio floating inside a 10% collar above and below a Flextronics share price of $11.73 and a fixed purchase price of $6.55 per share for each share of IDW common stock. The range in which the exchange ratio floats can be expressed as follows:2
0.6209 shares of Flextronics' stock issued for each IDW share (i.e., $6.55/$10.55) if Flextronics' stock price declines by as much as 10%0.5078 shares of Flextronics' stock issued for each IDW share (i.e., $6.55/$12.90) if Flextronics' stock price increases by as much as 10%
2. Fixed Share Exchange Agreement: The offer price was calculated using a fixed exchange ratio inside a collar 11% and 15% above and below $11.73, resulting in a floating purchase price if the average Flextronics' stock price increases or decreases between 11% and 15% from $11.73 per share.
3. IDW has the right to terminate the agreement if Flextronics's share price falls by more than 15% below $11.73. If Flextronics' share price increases by more than 15% above $11.73, the exchange ratio floats based on a fixed purchase price of $6.85 per share.3 See Figure 11.2 for an illustration of the collar ranges and Case Study Table 11.4 on 432 for the calculation of the effects of 1% changes in Flextronics' share price on the offer price.
Figure 11.2 Multiple price collars around the share price of Flextronics' stock.↑ indicates increase; ↓ indicates decrease. aSee Table 11.4 for the calculation of upper ($6.85) and lower ($6.18) bounds of offer price.
Table 11.4. Flextronics–IDW Fixed Value and Fixed Share Exchange Agreements for Case Study 11.1
a Percent change in Flextronics' share price. All changes in the offer price based on percent change from $11.73.
The boards of directors of both the acquirer and target have a fiduciary responsibility to demand that merger terms be renegotiated if the value of the offer made by the bidder changes materially relative to the value of the target's stock or if there has been any other material change in the target's operations. Merger contracts routinely contain “material adverse effects clauses” that provide a basis for buyers to withdraw from or renegotiate the contract. The existence of collars reduces the likelihood of having to renegotiate the terms of a merger agreement due to unanticipated changes in share prices.11
Form of acquisition
Acquirers may purchase the stock or assets of a target firm; what is being acquired and the mechanism for transferring ownership of assets or stock and associated liabilities from the target to the acquirer is called the form of acquisition. Each form affects the negotiation and deal structuring process differently, and each has a number of advantages and disadvantages depending on the point of view—whether buyer or seller.12 The most commonly used methods are discussed next.
An asset purchase involves the sale of all or a portion of the assets of the target to the buyer or its subsidiary in exchange for buyer stock, cash, debt, or some combination. The buyer may assume all, some, or none of the target's liabilities. The purchase price is paid directly to the target firm. A stock purchase involves the sale of the outstanding stock of the target to the buyer or its subsidiary by the target's shareholders. Unlike in an asset purchase, the purchase price in a stock purchase is paid to the target firm's shareholders. This is the biggest difference between the two methods, and has significant tax implications for the seller's shareholders (see Chapter 12).
A statutory merger involves the combination of the target with the buyer or a subsidiary formed to complete the merger. The corporation surviving the merger can be the buyer, the target, or the buyer's subsidiary. The assets and liabilities of the corporation that ceases to exist are merged into the surviving firm as a “matter of law” governed by the statutes of the state in which the combined businesses will be incorporated. State statutes typically address the percentage of total voting stock required for approval of the transaction, who is entitled to vote, how the votes are counted, and the rights of dissenting voters. In a statutory merger, dissenting or minority shareholders are required to sell their shares, although some state statutes grant them the right to be paid the appraised value of their shares. Stock-for-stock or stock-for-assets transactions represent alternatives to a merger. Table 11.5 highlights the primary advantages and disadvantages of these alternative forms of acquisition.
Table 11.5. Advantages and Disadvantages of Alternative Forms of Acquisition
| Alternative Forms | Advantages | Disadvantages |
| Cash Purchase of Assets | Buyer:
• Allows targeted purchase of assets • May renegotiate union and benefits agreements in absence of successor clausea in labor agreement |
Buyer:
• Lose NOLsb and tax credits • Lose rights to intellectual property • May require consents to assignment of contracts • Exposed to liabilities transferring with assets (e.g., warranty claims) |
| Cash Purchase of Stock | Buyer:
• Assets/liabilities transfer automatically • May avoid need to get consents to assignment for contracts • NOLs and tax credits pass to buyer • May insulate from target liabilities if kept as subsidiary • No shareholder approval if funded by cash or debt • Enables circumvention of target's board in hostile tender offer |
Buyer:
• Responsible for known and unknown liabilities • No asset write-up unless 338 election adopted by buyer and sellerc • Union and employee benefit agreements do not terminate • Potential for minority shareholdersd • Loss of NOLs and tax credits • Favorable tax treatment lost if buyer and seller adopt 338 electionc |
| Statutory Merger | Buyer: | Buyer: |
| Statutory Merger (cont'd) | Seller: | Seller: |
| Stock-for-Stock Transaction | Buyer: Seller: See purchase of stock on previous page | Buyer: Seller: See purchase of stock earlier in this table |
| Stock-for-Assets Transaction | Buyer: Seller: See purchase of assets on previous page | Buyer: Seller: See purchase of assets on previous page |
| Staged Transactions |
a If the employer and union negotiated a “successor clause” into their collective bargaining agreement covering the workforce in the target firm, the terms of the agreement may still apply to the workforce of the new business.
b Net operating loss carryforwards or carrybacks.
c In Section 338 of the U.S. tax code, the acquirer in a purchase of 80% or more of the stock of the target may elect to treat the acquisition as if it were an acquisition of the target's assets. The seller must agree with the election.
d Minority shareholders in a subsidiary may be eliminated by a so-called “back-end” merger following the initial purchase of target stock. As a result of the merger, minority shareholders are required to abide by the majority vote of all shareholders and sell their shares to the acquirer. If the acquirer owns more than 90% of the target's shares, it may be able to use a short-form merger, which does not require any shareholder vote.
Purchase of Assets
In an asset purchase, a buyer acquires all rights a seller has to an asset for cash, stock, or some combination. Many state statutes require shareholder approval of a sale of “substantially all” of the target's assets. An asset purchase may be the most practical way to complete the transaction when the acquirer is interested only in a product line or division of the parent firm with multiple product lines or divisions that are not organized as separate legal subsidiaries. The seller retains ownership of the shares of stock of the business. The buyer must either create a new entity or use another existing business unit as the acquisition vehicle for the transaction. Only assets and liabilities specifically identified in the agreement of purchase and sale are transferred to the buyer.
In a cash-for-assets acquisition, the acquirer pays cash for the seller's assets and may choose to accept some or all of the seller's liabilities.13 The seller shareholders must approve the transaction whenever the seller's board votes to sell all or “substantially all” of the firm's assets. For example, when Valero Oil and Gas purchased substantially all of the assets of bankrupt ethanol manufacturer VeraSun for $280 million in early 2009—five refineries and one under construction—it required VeraSun shareholder approval. Even though the purchase was fewer than half of VeraSun's total number of refineries, it represented about three-quarters of the firm's assets.14
When substantially all of the selling firm's assets are acquired, the selling firm's shares are extinguished if shareholders approve the liquidation of the firm. After paying for any liabilities that are not assumed by the buyer, the assets remaining with the seller and the cash received from the acquiring firm are transferred to the seller's shareholders in a liquidating distribution.
In a stock-for-assets transaction, once approved by the seller's board and shareholders, the seller's shareholders receive buyer stock in exchange for the seller's assets and assumed liabilities. In a second stage, the seller dissolves the corporation following shareholder ratification of such a move, leaving its shareholders with buyer stock. Consequently, the shareholders of the two firms have effectively pooled their ownership interests in the buyer's corporation, which holds the combined assets and liabilities of both firms.
Advantages and Disadvantages from the Buyer's Perspective
The advantages from the buyer's perspective include being selective as to which assets of the target to purchase. The buyer is generally not responsible for the seller's liabilities unless specifically assumed under the contract. However, the buyer can be held responsible for certain liabilities such as environmental claims, property taxes, and, in some states, substantial pension liabilities and product liability claims. To protect against such risks, buyers usually insist on indemnification that holds the seller responsible for payment of damages resulting from such claims. Of course, this is of value only as long as the seller remains solvent. Indemnification is explained in more detail later in this chapter.15
Another advantage is that asset purchases also enable buyers to revalue acquired assets to market value on the closing date under the purchase method of accounting (a form of financial reporting of business combinations detailed in the next chapter) This increase, or step-up, in the tax basis of the acquired assets to fair market value provides for higher depreciation and amortization expense deductions for tax purposes. Buyers are generally free of any undisclosed or contingent liabilities. Absent successor clauses in the contract, the asset purchase results in the termination of union agreements if less than 50% of the workforce in the new firm is unionized, thereby providing an opportunity to renegotiate agreements viewed as too restrictive. Benefits plans may be maintained or terminated at the acquirer's discretion. Buyers, though, may be reluctant to terminate contracts and benefits plans because of the potential undermining of employee productivity.
Even with all these advantages, there are still several disadvantages to a purchase of assets from the buyer's perspective. The buyer loses the seller's net operating losses and tax credits. Rights to assets such as licenses, franchises, and patents cannot be transferred to buyers. Such rights are viewed as belonging to the owners of the business: the target shareholders. These rights can be difficult to transfer because of the need to obtain consent from the U.S. Patent Office or other agency issuing the rights. The buyer must seek the consent of customers and vendors to transfer existing contracts to the buyer. The transaction often is more complex and costly, because acquired assets must be listed in appendices to the definitive agreement, the sale of and titles to each asset transferred must be recorded, and state title transfer taxes must be paid. Moreover, a lender's consent may be required if the assets to be sold are being used as collateral for loans.
The acquisition by Cadbury Schweppes plc (a confectionery and beverage company headquartered in London, England) of Adams Inc. from Pfizer in 2003 illustrates the potential complexity of an asset purchase. Cadbury bought 100% of Adams' assets for $4.2 billion. Many Adams employees had positions with both the parent and the operating unit, and the parent supplied numerous support services to its subsidiary. Adams also operated in 40 countries, representing 40 different legal jurisdictions—quite typical in the purchase of a unit of a larger company, but no less complicated.
Advantages and Disadvantages from the Seller's Perspective
Among the advantages, sellers are able to maintain their corporate existence and thus ownership of tangible assets not acquired by the buyer and of intangible assets such as licenses, franchises, and patents. The seller retains the right to use the corporate identity in subsequent marketing programs unless ceded to the buyer as part of the transaction. The seller also retains the right to use all tax credits and accumulated net operating losses, which can be used to shelter future income from taxes. Such tax considerations remain with the holders of the target firm's stock.
The disadvantages for the seller include several issues related to taxes. Taxes also may be a problem because the seller may be subject to double taxation. If the tax basis in the assets or stock is low, the seller may experience a sizable gain on the sale. In addition, if the corporation subsequently is liquidated, the seller may be responsible for the recapture of taxes deferred as a result of the use of accelerated rather than straight-line depreciation. If the number of assets transferred is large, the amount of state transfer taxes may become onerous. Whether the seller or the buyer actually pays the transfer taxes or they are shared is negotiable. If substantially all of the target's assets are to be sold, approval must be obtained from the target's shareholders.
In late 2007, the largest banking deal in history was consummated through a purchase of the assets of one of Europe's largest financial services firms (see Case Study 11.2). The deal was made possible by a buyer group banding together to buy the firm after reaching agreement as to which of the target's assets would be owned by the each member of the consortium.
Case Study 11.2
Buyer Consortium Wins Control of ABN Amro
The biggest banking deal on record was announced on October 9, 2007, resulting in the dismemberment of one of Europe's largest and oldest financial services firms, ABN Amro (ABN). A buyer consortium consisting of The Royal Bank of Scotland (RBS), Spain's Banco Santander (Santander), and Belgium's Fortis Bank (Fortis) won control of ABN, the largest bank in the Netherlands, in a buyout valued at $101 billion.
European banks had been under pressure to grow through acquisitions and compete with larger American rivals to avoid becoming takeover targets themselves. ABN had been viewed for years as a target because of its relatively low share price. However, rival banks were deterred by its diverse mixture of businesses, which was unattractive to any single buyer. Under pressure from shareholders, ABN announced that it had agreed, on April 23, 2007, to be acquired by Barclay's Bank of London for $85 billion in stock. The RBS-led group countered with a $99 billion bid consisting mostly of cash. In response, Barclay's upped its bid by 6% with the help of state-backed investors from China and Singapore. ABN's management favored the Barclay bid because Barclay had pledged to keep ABN Amro intact and its headquarters in the Netherlands. However, a declining stock market soon made the Barclay's mostly stock offer unattractive.
While the size of the transaction was noteworthy, the deal is especially remarkable in that the consortium had agreed prior to the purchase to split up ABN among the three participants. The mechanism used for acquiring the bank represented an unusual means of completing big transactions in the amidst of the subprime-mortgage-induced turmoil in the global credit markets at the time. The members of the consortium were able to select the ABN assets they found most attractive. The consortium agreed in advance of the acquisition that Santander would receive ABN's Brazilian and Italian units; Fortis would obtain the Dutch bank's consumer lending business, asset management, and private banking operations, and RBS would own the Asian and investment banking units. Merrill Lynch served as the sole investment advisor for the group's participants. Caught up in the global capital market meltdown, Fortis was forced to sell the ABN Amro assets it had acquired to its Dutch competitor ING in October 2008.
Discussion Questions
1. In your judgment, what are likely to be some of the major challenges in assembling a buyer consortium to acquire and subsequently dismember a target firm such as ABN Amro? In what ways do you think the use of a single investment advisor might have addressed some of these issues?
2. The ABN Amro transaction was completed at a time when the availability of credit was limited due to the subprime-mortgage-loan problem in the United States. How might the use of a group rather than a single buyer have facilitated the purchase of ABN Amro?
3. The same outcome could have been achieved if a single buyer had reached agreement with other banks to acquire selected pieces of ABN before completing the transaction. The pieces could then have been sold at the closing. Why might the use of the consortium been a superior alternative?
Answers to these questions are given in the Online Instructors' Guide for instructors using this textbook.
Purchase of Stock
Stock purchases often are viewed as the purchase of all of a target firm's outstanding stock. In effect, the buyer replaces the seller as owner, the business continues to operate without interruption, and the seller has no ongoing interest in, or obligation with respect to, the assets, liabilities, or operations of the business.
In cash-for-stock or stock-for-stock transactions, the buyer purchases the seller's stock directly from the seller's shareholders. If the target is a private firm, the purchase is completed by a stock purchase agreement signed by the acquirer and the target's shareholders, if they are few in number. For a public company, the acquiring firm making a tender offer to the target firm's shareholders would consummate the purchase. A tender offer is employed because public company shareholders are likely to be too numerous to deal with individually. The tender offer would be considered friendly or hostile depending on whether it was supported by the board and management of the target firm.
This is in marked contrast to a statutory merger, in which the boards of directors of the firms involved must first ratify the proposal before submitting it to their shareholders for approval. Consequently, a purchase of stock is the approach most often taken in hostile takeovers. If the buyer is unable to convince all of the seller's shareholders to tender their shares, then a minority of seller shareholders remains outstanding. The target firm would then be viewed not as a wholly-owned but rather as a partially owned subsidiary of the buyer or acquiring company. No seller shareholder approval is required in such transactions as the seller's shareholders are expressing approval by tendering their shares.
Advantages and Disadvantages from the Buyer's Perspective
When it comes to the purchase of stock, there are a number of advantages for the buyer. All assets are transferred with the target's stock, resulting in less need for documentation to complete the transaction. State asset transfer taxes may be avoided with a purchase of shares and net operating losses and tax credits pass to the buyer. The right of the buyer to use the target's name, licenses, franchises, patents, and permits also is preserved. Furthermore, the purchase of the seller's stock provides for the continuity of contracts and corporate identity, which obviates the need to renegotiate contracts and enables the acquirer to employ the brand recognition that may be associated with the name of the target firm. However, the consent of some customers and vendors may be required before a contract is transferred; this may apply as well to some permits.
While the acquirer's board normally approves any major acquisition, approval by shareholders is not required if the purchase is financed primarily with cash or debt. If stock that has not yet been authorized is used, shareholder approval is likely to be required. Neither the target's board nor shareholders need to approve a sale of stock; however, shareholders may simply refuse to sell their stock.
Among the disadvantages, the buyer is liable for all unknown, undisclosed, or contingent liabilities. The seller's tax basis is carried over to the buyer at historical cost;16 consequently, there is no step-up in the cost basis of assets, and no tax shelter is created. Dissenting shareholders in many states have the right to have their shares appraised, with the option of being paid the appraised value of their shares or of remaining minority shareholders. The purchase of stock does not terminate existing union agreements or employee benefits plans.
The existence of minority shareholders creates significant administrative costs and practical concerns. The parent incurs significant additional expenses to submit annual reports, hold annual shareholder meetings, and conduct a formal board election process. Furthermore, implementing strategic business moves may be inhibited. See Case Studies 6.5 and 11.4 for an illustration of the challenges posed by minority investors.
Advantages and Disadvantages from the Seller's Perspective
Sellers generally prefer a stock purchase rather than an asset purchase because of its advantages. First, it allows them to step away from the business and be completely free of future obligations. The seller is able to defer paying taxes if the form of payment is primarily buyer stock. All obligations, disclosed or otherwise, transfer to the buyer.17 Finally, the seller is not left with the problem of disposing of assets that the seller does not wish to retain but that were not purchased by the acquiring company.
There are, though, disadvantages for the seller. For instance, the seller cannot pick and choose the assets to be retained. Furthermore, the seller loses all net operating losses, tax credits, potential tax savings, and rights to intellectual property.
Mergers
When a merger is used to consummate the transaction, the legal structure may take one of many forms. In a merger, two or more firms combine, and all but one legally cease to exist. The combined organization continues under the original name of the surviving firm. Shareholders of the target firm exchange their shares for those of the acquiring firm after a shareholder vote approving the merger, with minority shareholders required to exchange their shares for acquirer shares.
Statutory and Subsidiary Mergers
In a statutory merger, the acquiring company assumes 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 becoming a subsidiary of the parent. To the public, the target firm may be operated under its brand name, but will be owned and controlled by the acquirer.
Most mergers are structured as subsidiary mergers in which the acquiring firm creates a new corporate subsidiary that merges with the target. By using a reverse triangular merger in which the target survives, the acquirer may be able to avoid seeking approval from its shareholders. While merger statutes require approval by shareholders of both the target and acquiring firms, the parent of the acquisition subsidiary is the shareholder. Just as in a stock purchase, an assignment of contracts is generally not necessary because the target survives. In contrast, an assignment is required in a forward triangular merger because the target is merged into the subsidiary with the subsidiary surviving.
Statutory Consolidations
Although the terms merger and consolidation often are used interchangeably, this is not always accurate. Technically, a statutory consolidation, which involves two or more companies joining to form a new company, is not a merger. All legal entities that are consolidated are dissolved as the new company is formed, usually with a new name, whereas in a merger either the acquirer or the target survives. The new corporate entity created as a result of consolidation, or the surviving entity following a merger, usually assumes ownership of the assets and liabilities of the merged or consolidated organizations. Stockholders in merged companies typically exchange their shares for shares in the new company. The 1999 combination of Daimler-Benz and Chrysler to form DaimlerChrysler is an example of a consolidation.
Mergers of Equals
A merger of equals is a merger structure usually applied whenever the participants are comparable in size, competitive position, profitability, and market capitalization—which can make it unclear whether one party is ceding control to the other and which party provides the greatest synergy. Consequently, target firm shareholders rarely receive any significant premium for their shares. It is common for the new firm to be managed by the former CEOs of the merged firms as coequals and for the new firm's board to have equal representation from the boards of the merged firms.18 In such transactions, it is relatively uncommon for the ownership split to be equally divided.19 The 1998 formation of Citigroup from Citibank and Travelers is an example of a merger of equals.
Tender Offers
Tender offers refer to solicitations to buy stock. When a firm extends an offer to its own shareholders to buy back stock, it is called a self-tender offer. A hostile tender offer is a takeover tactic in which the acquirer bypasses the target's board and management and goes directly to the target's shareholders with an offer to purchase their shares. Unlike a merger, the tender offer specifically allows for minority shareholders to approve or deny the merger.
An alternative to a traditional merger, which accomplishes the same objective, is the two-step acquisition. In the first step, the acquirer buys, through a stock purchase, the majority of the target's outstanding stock from its shareholders in a tender offer and then follows up in a second step with a squeeze-out merger or back-end merger approved by the acquirer as the majority shareholder. Minority shareholders are required to take the acquisition into consideration in the back-end merger. Usually, minority shareholders are offered a lower price for their shares in the form of cash or debt. Two-step acquisitions sometimes are used to make it more difficult for another firm to make a bid because the merger can be completed quickly.
In March 2009, Merck Pharmaceuticals—seeking to close the deal quickly—acquired much smaller rival Schering-Plough through a two-step merger. Merck wanted to prevent a potential bidding war with Johnson & Johnson and the loss of profits from a joint venture Schering had with Johnson & Johnson. Merck was merged into Schering subsequent to closing. By positioning Schering as the acquirer, Merck wanted to avoid triggering a change of control provision in a longstanding drug distribution agreement between Johnson & Johnson and Schering, under which J&J would be able to cancel the agreement and take full ownership of the drugs (see Case Study 12.2).
In contrast, the Swiss pharmaceutical giant Roche reached agreement on March 12, 2009, to acquire the remaining 44% of Genentech it did not already own, but it was unable to employ the back-end merger approach. Roche was bound by an affiliation agreement between the two firms that governed prior joint business relationships. It required, in the event of a merger with Genentech, that Roche receive a favorable vote from the majority of the remaining Genentech shares it did not already own or offer the remaining Genentech shareholders a price equal to or greater than the average of fair values of such shares as determined by two investment banks appointed by the Genentech board of directors.
Board Approvals
Unlike purchases of target stock, mergers require approval of the acquirer's board and the target's board of directors and the subsequent submission of the proposal to the shareholders of both firms. Unless otherwise required by a firm's bylaws, a simple majority of all the outstanding voting shares must ratify the proposal. The merger agreement must then be filed with the appropriate authorities of the state in which the merger is to be consummated.
There are three exceptions under which no vote is required by the acquirer's (i.e., the surviving firm's) shareholders. The first, the so-called small-scale merger exception, involves a transaction not considered material. The acquiring firm's shareholder cannot vote unless their ownership in the acquiring firm is diluted by more than one-sixth or 16.67% (i.e., the acquirer owns at least 83.33% of the firm's voting shares following closing). This effectively limits the acquirer to issuing no more than 20% of its total shares outstanding.20 The second is when a subsidiary is being merged into the parent and the parent owns a substantial majority (over 90% in some states) of the subsidiary's stock before the transaction. This is referred to as a short-form merger or the parent-submerger exception. The third exception involves use of a triangular merger, in which the acquirer establishes a merger subsidiary in which it is the sole shareholder; the only approval required is that of the board of directors of the subsidiary, which may be essentially the same as that of the parent or acquiring company. However, acquirer shareholders may still be required by the firm's bylaws to vote to authorize creation of new shares of stock offered in the transaction.
Staged Transactions
An acquiring firm may choose to complete a takeover of another firm in stages spread over an extended period of time. Staged transactions may be used to structure an earn-out, enable the target to complete the development of a technology or process, or await regulatory approval of a license or patent.
Special Applications of Basic Structures
The structures discussed previously are sufficiently flexible to accommodate a variety of different transaction types.
Leveraged Buyouts
In a leveraged buyout (LBO), a financial sponsor or equity investor, usually a limited partnership, creates a shell corporation funded by equity provided by the sponsor. In stage one, the shell corporation raises debt by borrowing from banks and selling debt to institutional investors. In the second stage, the shell corporation buys 50.1% of the target's stock, squeezing out minority shareholders with a back-end merger in which the remaining shareholders receive debt or preferred stock.
Single Firm Recapitalization
Firms sometimes recapitalize in order to squeeze out minority shareholders. A firm with minority shareholders creates a wholly-owned shell corporation and merges itself into the shell through a statutory merger. All stock in the original firm is canceled, with the majority shareholders in the original firm receiving stock in the surviving firm and minority shareholders receiving cash or debt.
Some things to remember
The deal structuring process addresses satisfying as many of the primary objectives of the parties involved and determines how risk will be shared. The process begins with addressing a set of key questions, whose answers help define initial negotiating positions, potential risks, options for managing risk, levels of tolerance for risk, and conditions under which the buyer or seller will “walk away” from the negotiations.
As part of the deal structuring process, the acquisition vehicle refers to the legal structure used to purchase the target. The postclosing organization is the legal or organizational framework used to manage the combined businesses following the consummation of the transaction and may differ from the acquisition vehicle, depending on the acquirer's strategic objectives for the combined firms. The form of payment or total consideration may consist of cash, common stock, debt, or some combination. The form of acquisition refers to what is being acquired (stock or assets) and the mechanism for conveying ownership. The form of acquisition affects the form of payment, tax considerations, and the choice of acquisition vehicle and postclosing organization. Tax considerations also are affected by the legal structure of the selling entity. Finally, accounting considerations may affect the form, amount, and timing of payment.
Discussion Questions
11.1 Describe the deal structuring process. Be specific.
11.2 Provide two examples of how decisions made in one area of the deal structuring process are likely to affect other areas.
11.3 For what reasons may acquirers choose a particular form of acquisition vehicle?
11.4 Describe techniques used to “close the gap” when buyers and sellers cannot agree on a price.
11.5 Why do bidders sometimes offer target firm shareholders multiple payment options (e.g., cash and stock)?
11.6 What are the advantages and disadvantages of a purchase of assets from the perspective of the buyer and seller?
11.7 What are the advantages and disadvantages of a purchase of stock from the perspective of the buyer and seller?
11.8 What are the advantages and disadvantages of a statutory merger?
11.9 What are the reasons some acquirers choose to undertake a staged or multistep takeover?
11.10 What forms of acquisition represent common alternatives to a merger? Under what circumstances might these alternative structures be employed?
11.11 Comment on the following statement: A premium offered by a bidder over a target's share price is not necessarily a fair price; a fair price is not necessarily an adequate price.
11.12 In early 2008, a year marked by turmoil in the global credit markets, Mars Corporation was able to negotiate a reverse breakup fee structure in its acquisition of Wrigley Corporation. This structure allowed Mars to walk away from the transaction at any time by paying a $1 billion fee to Wrigley. Speculate as to the motivation behind Mars and Wrigley negotiating such a fee structure.
11.13 Despite disturbing discoveries during due diligence, Mattel acquired The Learning Company, a leading developer of software for toys, in a stock-for-stock transaction valued at $3.5 billion. Mattel had determined that TLC's receivables were overstated because product returns from distributors were not deducted from receivables and its allowance for bad debt was inadequate. Also, a $50 million licensing deal also had been prematurely put on the balance sheet. Nevertheless, driven by the appeal of rapidly becoming a big player in the children's software market, Mattel closed on the transaction, aware that TLC's cash flows were overstated. Despite being aware of extensive problems, Mattel proceeded to acquire The Learning Company. Why? What could Mattel have done to better protect its interests? Be specific.
11.14 Describe the conditions under which an earn-out may be most appropriate.
11.15 In late 2008, Deutsche Bank announced that it would buy the commercial banking assets (including a number of branches) of the Netherlands' ABN Amro for $1.13 billion. What liabilities, if any, would Deutsche Bank have to (or want to) assume? Explain your answer.
Answers to these Chapter Discussion Questions are found in the Online Instructor's Manual for instructors using this book.
Chapter business cases
Case Study 11.3
Boston Scientific Overcomes Johnson & Johnson to Acquire Guidant—A Lesson in Bidding Strategy
Johnson & Johnson, the behemoth American pharmaceutical company, announced an agreement in December 2004 to acquire Guidant for $76 per share for a combination of cash and stock. Guidant is a leading manufacturer of implantable heart defibrillators and other products used in angioplasty procedures. The defibrillator market has been growing at 20% annually, and J&J desired to reenergize its slowing growth rate by diversifying into this rapidly growing market. Soon after the agreement was signed, Guidant's defibrillators became embroiled in a regulatory scandal over failure to inform doctors about rare malfunctions. Guidant suffered a serious erosion of market share when it recalled five models of its defibrillators.
The subsequent erosion in the market value of Guidant prompted J&J to renegotiate the deal under a material adverse change clause common in most M&A agreements. J&J was able to get Guidant to accept a lower price of $63 per share in mid-November. However, this new agreement was not without risk.
The renegotiated agreement gave Boston Scientific an opportunity to intervene with a more attractive informal offer on December 5, 2005, of $72 per share. The offer price consisted of 50% stock and 50% cash. Boston Scientific, a leading supplier of heart stents, saw the proposed acquisition as a vital step in the company's strategy of diversifying into the high-growth implantable defibrillator market.
Despite the more favorable offer, Guidant's board decided to reject Boston Scientific's offer in favor of an upwardly revised offer of $71 per share made by J&J on January 11, 2005. The board continued to support J&J's lower bid, despite the furor it caused among big Guidant shareholders. With a market capitalization nine times the size of Boston Scientific, the Guidant board continued to be enamored with J&J's size and industry position relative to Boston Scientific.
Boston Scientific realized that it would be able to acquire Guidant only if it made an offer that Guidant could not refuse without risking major shareholder lawsuits. Boston Scientific reasoned that if J&J hoped to match an improved bid, it would have to be at least $77, slightly higher than the $76 J&J had initially offered Guidant in December 2004. With its greater borrowing capacity, Boston Scientific knew that J&J also had the option of converting its combination stock and cash bid to an all-cash offer. Such an offer could be made a few dollars lower than Boston Scientific's bid, since Guidant investors might view such an offer more favorably than one consisting of both stock and cash, whose value could fluctuate between the signing of the agreement and the actual closing. This was indeed a possibility, since the J&J offer did not include a collar arrangement.
Boston Scientific decided to boost the new bid to $80 per share, which it believed would deter any further bidding from J&J. J&J had been saying publicly that Guidant was already “fully valued.” Boston Scientific reasoned that J&J had created a public relations nightmare for itself. If J&J raised its bid, it would upset J&J shareholders and make it look like an undisciplined buyer. J&J refused to up its offer, saying that such an action would not be in the best interests of its shareholders. Table 11.6 summarizes the key events timeline.
Table 11.6. Boston Scientific and Johnson & Johnson Bidding Chronology
| Date | Comments |
| December 15, 2004 | J&J reaches agreement to buy Guidant for $25.4 billion in stock and cash. |
| November 15, 2005 | Value of J&J deal is revised downward to $21.5 billion. |
| December 5, 2005 | Boston Scientific offers $25 billion. |
| January 11, 2006 | Guidant accepts a J&J counteroffer valued at $23.2 billion. |
| January 17, 2006 | Boston Scientific submits a new bid valued at $27 billion. |
| January 25, 2006 | Guidant accepts Boston Scientific's bid when J&J fails to raise its offer. |
A side deal with Abbott Labs made the lofty Boston Scientific offer possible. The firm entered into an agreement with Abbott Laboratories in which Boston Scientific would divest Guidant's stent business while retaining the rights to Guidant's stent technology. In return, Boston Scientific received $6.4 billion in cash on the closing date, consisting of $4.1 billion for the divested assets, a loan of $900 million, and Abbott's purchase of $1.4 billion of Boston Scientific stock. The additional cash helped fund the purchase price. This deal also helped Boston Scientific gain regulatory approval by enabling Abbott Labs to become a competitor in the stent business. Merrill Lynch and Bank of America each would lend $7 billion to fund a portion of the purchase price and provide the combined firms with additional working capital.
To complete the transaction, Boston Scientific paid $27 billion, consisting of cash and stock, to Guidant shareholders and another $800 million as a breakup fee to J&J. In addition, the firm is burdened with $14.9 billion in new debt. Within days of Boston Scientific's winning bid, the firm received a warning from the U.S. Food and Drug Administration to delay the introduction of new products until the firm's safety procedures improved.
Between December 2004, the date of Guidant's original agreement with J&J, and January 25, 2006, the date of its agreement with Boston Scientific, Guidant's stock rose by 16%, reflecting the bidding process. During the same period, J&J's stock dropped by a modest 3%, while Boston Scientific's shares plummeted by 32%.
As a result of product recalls and safety warnings on more than 50,000 of Guidant's cardiac devices, the firm's sales and profits plummeted. Between the announcement date of its purchase of Guidant in December 2005 and year-end 2006, Boston Scientific lost more than $18 billion in shareholder value. In acquiring Guidant, Boston Scientific increased its total shares outstanding by more than 80% and assumed responsibility for $6.5 billion in debt, with no proportionate increase in earnings. In early 2010, major senior management changes occurred at Boston Scientific and it spun off several business units in an effort to improve profitability. Ongoing defibrillator recalls could shave the firm's revenue by $0.5 billion during the next two years.21 In 2010, continuing product-related problems forced the firm to write off $1.8 billion in impaired goodwill associated with the Guidant acquisition. At less than $8 per share throughout most of 2010, Boston Scientific's share price is about one-fifth of its peak of $35.55 on December 5, 2005, the day the firm announced its bid for Guidant.
Discussion Questions
1. What were the key differences between the two firms' bidding strategies? Be specific.
2. What might J&J have done differently to avoid igniting a bidding war?
3. What evidence is given that J&J may not have seen Boston Scientific as a serious bidder?
4. Explain how differing assumptions about market growth, potential synergies, and the size of the potential liability related to product recalls affected the bidding.
Answers to these questions are provided in the Online Instructor's Manual for instructors using this book.
Case Study 11.4
Swiss Pharmaceutical Giant Novartis Takes Control of Alcon
In December 2010, Swiss pharmaceutical company Novartis AG completed its drawn-out effort to acquire the remaining 23% of U.S.-listed eye care group Alcon Incorporated (Alcon) that it did not already own for $12.9 billion. This brought the total purchase price for 100% of Alcon to $52.2 billion. Novartis had been trying to purchase Alcon's remaining publicly traded shares since January 2010, but its original offer of 2.8 Novartis shares, valued at $153 per Alcon share met stiff resistance from Alcon's independent board of directors, which had repeatedly dismissed the Novartis bid as “grossly inadequate.”
Novartis finally relented, agreeing to pay $168 per share, the average price it had paid for the Alcon shares it already owned, and to guarantee that price by paying cash equal to the difference between $168 and the value of 2.8 Novartis shares immediately prior to closing. If the value of Novartis shares were to appreciate before closing such that the value of 2.8 shares exceeded $168, the number of Novartis shares would be reduced accordingly. By acquiring all outstanding Alcon shares, Novartis avoided any interference by minority shareholders in making major business decisions, achieved certain operating synergies, and eliminated the expense associated with having public shareholders.
In 2008, a year in which global financial markets were in turmoil due to the worst global recession since the 1930s, Novartis acquired only a minority position in global food giant Nestlé's wholly-owned subsidiary Alcon for cash. Nestlé had acquired 100% of Alcon in 1978 and retained that position until 2002, when it undertook an initial public offering of 23% of its shares. In April 2008, Novartis acquired 25% of Alcon for $143 per share from Nestlé. As part of this transaction, Novartis and Nestlé received a call and a put option, respectively, which could be exercised at $181 per Alcon share from January 2010 to July 2011.
On January 4, 2010, Novartis exercised its call option to buy Nestlé's remaining 52% ownership stake in Alcon that it did not already own. By doing so, Novartis increased its total ownership position in Alcon to about 77%. The total price paid by Novartis for this position amounted to $39.3 billion ($11.2 billion in 2008 plus $28.1 billion in 2010). On the same day, Novartis also offered to acquire the remaining publicly held shares that it did not already own in a share exchange valued at $153 per share in which 2.8 shares of its stock would be exchanged for each Alcon share.
While the Nestlé deal seemed likely to receive regulatory approval, the offer to the minority shareholders was assailed immediately as too low. At $153 per share, the offer was well below the Alcon closing price on January 4, 2010, of $164.35. The Alcon publicly traded share price may have been elevated by investors anticipating a higher bid. Novartis argued that without this speculation the publicly traded Alcon share price would have been $137, and the $153 per share price Novartis offered the minority shareholders would have represented an approximate 12% premium to that price. The minority shareholders, who included several large hedge funds, argued that they were entitled to $181 per share, the amount paid to Nestlé. Alcon's publicly traded shares dropped nearly 5% to $156.97 on the news of the Novartis takeover. Novartis' shares also lost 3%, falling to $52.81.
On August 9, 2010, Novartis received approval from European Union regulators to buy the stake in Alcon, making it easier for it to take full control of Alcon. The acquisition's approval was conditioned on Novartis divesting several ophthalmology and pharmaceutical products sold in the EU's consumer vision care market. The transaction had also received approval from the Canadian and Australian antitrust regulators pending certain divestitures by Novartis in their countries. The last required regulatory approval was received on October 1, 2010, when the U.S. Federal Trade Commission approved the deal.
With the buyout of Nestlé's stake in Alcon completed, Novartis was now faced with acquiring the remaining 23% of the outstanding shares of Alcon stock held by the public. Under Swiss takeover law, Novartis needed a majority of Alcon board members and two-thirds of shareholders to approve the terms for the merger to take effect and for Alcon shares to automatically convert into Novartis shares. Once it owned 77% of Alcon's stock, Novartis only needed to place five of its own nominated directors on the Alcon board to replace the five directors previously named by Nestlé to the board.
However, Alcon's independent directors set up an independent director committee (IDC), arguing that the price offered to the minority shareholders was too low and that the new directors, having been nominated by Novartis, should abstain from voting on the Novartis takeover because of their conflict of interest. The IDC preferred a negotiated merger to a “cram down” or forced merger in which the minority shares automatically convert to Novartis shares at the 2.8 share exchange offer.
Provisions in the Swiss takeover code require a mandatory offer whenever a bidder purchases more than 33.3% of another firm's stock. In a mandatory offer, Novartis would also be subject to the Swiss code's minimum bid rule, which would require Novartis to pay $181 per share in cash to Alcon's minority shareholders, the same bid offered to Nestlé. By replacing the Nestlé-appointed directors with their own slate of candidates and owning more than two-thirds of the Alcon shares, Novartis argued that they were not subject to mandatory bid requirements.
Novartis was betting on the continued appreciation of its shares, valued in Swiss francs, due to an ongoing appreciation of the Swiss currency and its improving operating performance, to eventually win over holders of the publicly traded Alcon shares. However, by late 2010, Novartis' patience appears to have worn thin. While not always the case, the resistance of the independent directors paid off for those investors holding publicly traded shares.
Discussion Questions
1. Speculate as to why Novartis acquired only a 25% ownership stake in Alcon in 2008.
2. Why was the price ($181 per share) at which Novartis exercised its call option in 2010 to increase its stake in Alcon to 77% so much higher than what it paid ($143 per share) for an approximate 25% stake in Alcon in early 2008?
3. Alcon and Novartis shares dropped by 5% and 3%, respectively, immediately following the announcement that Novartis would exercise its option to buy Nestlé's majority holdings of Alcon shares. Explain why this may have happened.
4. How do Swiss takeover laws compare to comparable U.S. laws? Which do you find more appropriate and why?
5. Discuss how Novartis may have arrived at the estimate of $137 per share as the intrinsic value of Alcon shares. What are the key underlying assumptions? Do you believe the minority shareholders should receive the same price as Nestlé? Explain your answer.
Answers to these case study discussion questions are available in the Online Instructor's Manual for instructors using this book.
1 The value of the transaction is not known until the closing, since the value of the transaction is measured at the close of the deal rather than at the announcement date. If the length of time between announcement and closing is substantial due to the need to obtain regulatory approval, the value of the deal may change significantly.
2 References to business structures throughout the chapter refer to such arrangements as joint ventures and strategic business alliances (which may or may not involve legal entities). For example, the joint venture routinely is used to describe a collaboration among partners. The JV can be a corporation, partnership, or some other form of legal entity, or the JV can be an informal, non–legally binding agreement involving multiple parties collaborating in an effort to achieve specific business objectives.
3 It is important to maintain the existence of the target firm to preserve the tax-free status of the transaction. Preserving the tax-free status of a deal results from satisfying conditions such as maintaining continuity of ownership, which requires previous target firm shareholders to receive a significant percentage of the purchase price in acquirer stock, and continuity of business enterprise, which requires that the acquirer retains a significant share of the target's assets after closing. These concepts are detailed in Chapter 12.
a This is the current capital gains tax rate as of the time of this writing.
6 In a sample of 735 acquisitions of privately held firms between 1995 and 2004, Officer et al. (2007) found that acquirer stock was used as the form of payment about 80% of the time. The unusually high (for acquirers) 3.8% abnormal return earned by acquirers in this sample around the announcement suggests that sellers willing to accept acquirer stock were more likely to see significant synergies in merging with the acquiring firm.
a The cash-flow multiple of 4 applied to the earn-out is a result of negotiation before closing.
b The cash-flow multiple of 10 applied to the potential increase in shareholder value for the buyer is the multiple the buyer anticipates that investors would apply to a three-year average of actual operating cash flow at the end of the three-year period.
a A three-year average cash-flow figure is used to measure performance to ensure that the actual performance is sustainable as opposed to an aberration.
7 Srikant, Frankel, and Wolfson, 2001
9 Revisions to accounting standards (Statement of Financial Accounting Standards 141R) that apply to business combinations went into effect on January 1, 2009. The fair value of earn-outs and other contingent payouts must be estimated and recorded on the acquisition closing date. Changes in fair value resulting from changes in the likelihood or amount of the contingent payout must be recorded as charges to the income statement at that time. Under earlier accounting standards, contingent payments were charged against income only when they were actually paid.
10 Chatterjee and Yan (2008) argue that CVRs are issued most often when the acquiring firm issues stock to the target firm's shareholders that it believes are undervalued—in what is often called information asymmetry, where one party has access to more information than others. The CVR represents a declaration by the acquirer that its current share price represents a floor and that it is confident it will rise in the future. Firms offering CVRs in their acquisitions tend to believe their shares are more undervalued than those acquirers using cash or stock without CVRs as a form of payment. The authors found that most CVRs are issued in conjunction with either common or preferred stock. Acquirers offering CVRs experience announcement period abnormal returns of 5.3%. Targets receiving CVRs earn abnormal announcement period returns of 18.4%. The size of the abnormal announcement period return is greater than that of firms not offering CVRs. The authors argue that investors view acquirers who offer CVRs as having knowledge of the postmerger performance of the acquired business not available to the broader market. Hence, the issuance of the CVR expresses buyer confidence in the future success of the transaction.
1 Calculating the acquirer share price as a 20-day average ending five days prior to closing reduces the chance of using an aberrant price per share and provides time to include the final terms in the purchase agreement.
2 The share exchange ratio varies within a range of plus or minus 10% of the Flextronics' $11.73 share price.
3 IDW is protected against a potential “free fall” in the Flextronics' share price, while the purchase price paid by Flextronics is capped at $6.85.
11 From an evaluation of 1,127 stock mergers between 1991 and 1999, approximately one-fifth of which had collar arrangements, Officer (2004) concluded that collars are more likely to be used the greater the volatility of the acquirer share price compared to that of the target share price. He further concluded that the use of collars reduces substantially the likelihood that merger terms will have to be renegotiated—a costly proposition in terms of management time and legal and investment banking advice.
12 For more information on this topic, see DePamphilis (2010b), Chapter 11.
13 In cases where the buyer purchases most of the assets of a target firm, courts have ruled that the buyer is also responsible for the target's liabilities.
14 Selling “substantially all” assets does not necessarily mean that most of the firm's assets have been sold; rather, it could refer to a relatively small percentage of the firm's total assets that are critical to the ongoing operation of the business. Hence, the firm may be forced to liquidate if a sale of assets does not leave the firm with “significant continuing business activity”—that is, at least 25% of total pretransaction operating assets and 25% of pretransaction income or revenue. Unless required by the firm's bylaws, the buyer's shareholders do not vote to approve the transaction.
15 Note that in most agreements of purchase and sale, buyers and sellers agree to indemnify each other from claims for which they are directly responsible. Liability under such arrangements usually is subject to specific dollar limits and is in force only for a specific period.
16 This is true unless the seller consents to take a 338 tax code election, which can create a tax liability for the seller. Consequently, such elections are used infrequently.
17 This advantage for the seller usually is attenuated by the buyer's insistence that it be indemnified from damages resulting from any undisclosed liability. However, as previously noted, indemnification clauses in contracts generally are in force for only a limited time.
18 Research by Wulf (2004) suggests that the CEOs of target firms often negotiate to retain a significant degree of control in the merged firm for both their board and management in exchange for a lower premium for their shareholders.
19 According to Mallea (2008), only 14% have a 50/50 split.
20 For example, if the acquirer has 80 million shares outstanding and issues 16 million new shares (i.e., 0.2 × 80), its current shareholders are not diluted by more than one-sixth (i.e., 16/(16 + 80) equals one-sixth or 16.67%). More than 16 million new shares would violate the small-scale merger exception.
21 Source: The Street.com, Boston Scientific's Cash Crunch, April 1, 2010.