7) FORM OF PAYMENT - PART 2 Flashcards
Target risk prior to deal being launched + management of this
unwanted takeover –> strengthen financial position
Acquirer risks prior to deal being launched and management of these:
1) target price rises –> gain toe hold position
2) Roadblocks (eg, antitrust, regulatory issues) –> comprehensive target identification strategy
Target risk during deal negotiations + management of this
price risk in scrip deals –> alternate forms of payment (Cash, floating ER, or collar)
Acquirer risk during deal negotiations + management of this
Purchase price increase because of target resistance, competing bidder etc –> there’s no real way to manage this
Target risk after deal closes + management of this
scrip consideration decreasing in value –> contingent value rights
Acquirer risk after deal closes + management of this
target assets underperforming –> use earnouts
Earnout
arrangement in the M&A payment that defers a portion of the consideration until a contingency is resolved
Advantage of earnout for buyer vs for target
Buyer: partially shifts risk to the target
Target: potential negotiating point for higher price
Disadvantage of earnout for buyer vs for target
Buyer: difficulty in valuing, identifying when performance targets met
Target: increased uncertainty in final value of deal
Contingent value rights
financial instrument structured to provide additional payments at some point in the future based on a trigger or contingency
main dif between earnout adn CVR
the CVR is a tradeable instrument, while earnouts are typically not transferrable
Advantage of CVR for buyer vs for target
Buyer: minimises upfront payment, more efficient use of capital. Structures vary from deal to deal.
Target: can be structured to guarantee minimum value of consideration for period after deal close.
Disadvantage of CVR for buyer vs for target
Buyer: locked in to paying a minimum amount
Target: May receive a lower overall purchase price in return for CVR
What are collars in MandA?
not financial instruments,
they are structured agreements in SCRIP BASED TRANSACTIONS (total or partial) that allow for more tailored payments than simple fixed or floating ERs, typically where the resulting payment to the target is determined by the value of the acquirer’s share price.
Fixed ER collar
Egyptian (floating price collar) = ER fixed within the collar bounds (floor and ceiling)
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Fixed ER collar - if the acquirer’s price FALLS below lower bound, then:
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ER increases to preserve the value of the payoff to the target (a floor)
Fixed ER collar - if the acquirer’s price RISES above upper bound, then:
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ER decreases forming a cap on the value of the payout to the target (a ceiling)
Advantages of fixed ER buyer vs target
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Buyer: Caps the value of the payout; may be able to negotiate lower overall payment
Target: Floor on minimum value of scrip payment
Disadvantages of fixed ER buyer vs target
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Buyer: Dilution risk in falling share price to maintain payoff floor to target
Target: Value of payoff capped; may concede on overall value of deal for risk management
Floating ER
Travolta (fixed price/value collar)
= fixes payoff to targets within the collar boundaries by allowing the ER to float
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Floating ER - If the acquirer’s share price FALLS below the collar bound, then:
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the payoff to the target decreases as the ER is fixed at this point.
Floating ER - If the acquirer’s share price RISES above the collar bound, then:
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payoff to the target increases linearly with the acquirer’s share price at the fixed ER
Advantages of floating ER buyer vs target
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Buyer: Can give target a cash-like payoff within collar though keep financing flexibility; Avoids increasing dilution risk if share price falls
Target: Will receive fixed number of shares and % ownership in merged entity if acquirer’s share price falls
Disadvantages of floating ER buyer vs target
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Buyer: May pay higher deal value
Target: Exposed to falls in deal value if acquirer’s share price falls
What is the impact of paying with cash? (ie paying with cash on hand, issuing new debt)
it consumes financial slack - may decrease debt rating, increase cost of debt
What is the impact of paying with stock? (ie paying with issue of stock or shares in treasury)
increases financial slack - may improve debt rating, reduce cost of debt (paying with new stock the most common in Australia)
what is form of payment related to?
DEAL Size - cash is king in most deals.
- smaller deals more likely to use cash (cash offers higher abnormal returns, equity has lower abnormal returns)
- larger deals - usually equity based
economic conditions matter
(stock use in high bull market or when equity more likely to be overvalued)
Stock is usually used when: 4) things
1) deal is friendly
2) buyer’s stock price is buoyant (overvaluation hypothesis)
3) ownership isn’t concentrated (for buyer and seller)
4) deals are larger in size
What are the 3 types of risk that the form of payment tries to manage?
1) DEAL executing risk (factors that could prevent deal closing)
2) PRICE at which deal executives
3) VALUE risk (post deal risk) - eventual value to buyer and seller –> was value actually created
what is risk management?
it’s insurance –> comes at a cost which should be incorporated into the bid value
FIXED ER: fixed share deal (no shares stays the same) –> use where:
pre-closing market risk is low (how likely it is that the acquirer’s share price will drop)
FLOATING ER: floating share deal (shares float to ensure deal value stays constant) –> use where:
pre-closing market risk is high (how likely it is that the acquirer’s share price will drop)
In a fixed ER deal, the seller faces the risk that the buyer’s share price will fall –> a floating ER may overcome this issue BUT
could expose the buyer to unwanted risk of dilution from increased ER. Way to manage this is to use a collar
What is a collar?
way of hedging against uncertainty in the value of the acquirer (useful when acquirer and target disagree as to the direction of share price)
Fixed ER without a collar is a
direct linear relationship (normal share deal) –> this is an issue for target as there no min amount for them
Fixed ER without a collar is a
a direct linear relationship - dollar amount fixed and ER moves to conform to the fixed payment.
Risky bc w/o a collar there’s no limit to how many more or less shares need to be issued
for a floating ER (Egyptian) ,,,,,/`````` in between the floor and ceiling the ER is
fixed. (it’s a diagonal line to reflect how it is constant)
Outside the floor and ceiling there’s a VARYING ER that delivers the min or max fixed value
what is the idea behind a floating ER
(Egyptian) ,,,,,/`````` ?
both parties willing to bear a price rise within a range (the 45-degree line) but outside that range there are guarantees of the value to be delivered of a min and max fixed value (staying constant as ER floats)
for floating ER (Egyptian) ,,,,,/`````` to minimise value exposure, what do targets want?
they will try to negotiate for a narrow width (whereas bidders want wider collars)
For a floating ER collar (Fixed value collar),
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what happens between upper and lower bound?
there is a fixed value of the deal (ie, ER floats to ensure the value stays fixed).
For a floating ER collar (Fixed value collar),
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what happens outside the upper and lower bound?
the ER stays constant such that share price movements dictate the value received
for fixed value collars (floating ER collars) ‘Travolta’
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the wider the collar, the less price
uncertainty for the target’s shareholders
• The closer the buyer’s price to the lower limit the greater the target shareholders uncertainty
• For max protection of value, the target will negotiate for a wider collar
What is a contingent payment + eg
part of the payment is related to future performance of the merged company –> help resolve dif views of future performance.
Eg, earnouts - most common contingent deal technique!!
when are earnouts likely?
where value risk (uncertainty is greater)
o May be paid as bonuses, escrow funds stock options etc
Earnout structure
1) Deal is completed –> upfront consideration payable
2) Contingency period (often 2-3yrs)
- revenue, EBITDA targets, share price,
product sales, milestones, development
and commercialisation milestones,
external factors (oil prices eg)
3) Earn-out payable if contingencies met
Advantages of earnouts 5)
1) shifts risk from bidder to target (avoid winner’s curse)
2) retain management (can assist integration process)
3) drive performance (keep management motivated for earnout period)
4) bridge value gap (assists where can’t agree on $)
5) efficient use of capital (not immediately tied up, may be used in present more efficiently)
Disadvantages of earnouts 4)
1) Post-acquisition integration (more likely to be valuable where integrated into the buyer’s operations)
2) Complexity of definition (what/which measure is optimal - so many to choose)
3) overall aggressive performance goals (can be demotivating for target management)
4) size of earn-out claim (what’s the optimal point?)
best way to value earnouts
1) valuing them as real options (could used DCF tools but this ignores the added value of optionality and would underestimate the earnout)
2) then use simulation process to model value of the optionality (monte carlo simulation)
what’s the other main way a buyer can shift risk?
contingent value rights (CVRs)
= a financing instrument (vs earnouts which are a financing arrangement)
egs of CVRs
additional contingent payments, guarantees of some floor value, options to receive/purchase additional buyer stock
Collars are another more advanced method of managing
pre-deal close risk
o Provide further ways of managing share price movements, depending on the volatility and risk preferences of the participants
