7) FORM OF PAYMENT - PART 2

Question 1

Target risk prior to deal being launched + management of this

Answer 1

unwanted takeover –> strengthen financial position

Question 2

Acquirer risks prior to deal being launched and management of these:

Answer 2

1) target price rises –> gain toe hold position

2) Roadblocks (eg, antitrust, regulatory issues) –> comprehensive target identification strategy

Question 3

Target risk during deal negotiations + management of this

Answer 3

price risk in scrip deals –> alternate forms of payment (Cash, floating ER, or collar)

Question 4

Acquirer risk during deal negotiations + management of this

Answer 4

Purchase price increase because of target resistance, competing bidder etc –> there’s no real way to manage this

Question 5

Target risk after deal closes + management of this

Answer 5

scrip consideration decreasing in value –> contingent value rights

Question 6

Acquirer risk after deal closes + management of this

Answer 6

target assets underperforming –> use earnouts

Question 7

Earnout

Answer 7

arrangement in the M&A payment that defers a portion of the consideration until a contingency is resolved

Question 8

Advantage of earnout for buyer vs for target

Answer 8

Buyer: partially shifts risk to the target

Target: potential negotiating point for higher price

Question 9

Disadvantage of earnout for buyer vs for target

Answer 9

Buyer: difficulty in valuing, identifying when performance targets met

Target: increased uncertainty in final value of deal

Question 10

Contingent value rights

Answer 10

financial instrument structured to provide additional payments at some point in the future based on a trigger or contingency

Question 11

main dif between earnout adn CVR

Answer 11

the CVR is a tradeable instrument, while earnouts are typically not transferrable

Question 12

Advantage of CVR for buyer vs for target

Answer 12

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.

Question 13

Disadvantage of CVR for buyer vs for target

Answer 13

Buyer: locked in to paying a minimum amount

Target: May receive a lower overall purchase price in return for CVR

Question 14

What are collars in MandA?

Answer 14

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.

Question 15

Fixed ER collar

Answer 15

Egyptian (floating price collar) = ER fixed within the collar bounds (floor and ceiling)
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Question 16

Fixed ER collar - if the acquirer’s price FALLS below lower bound, then:
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Answer 16

ER increases to preserve the value of the payoff to the target (a floor)

Question 17

Fixed ER collar - if the acquirer’s price RISES above upper bound, then:
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Answer 17

ER decreases forming a cap on the value of the payout to the target (a ceiling)

Question 18

Advantages of fixed ER buyer vs target

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Answer 18

Buyer: Caps the value of the payout; may be able to negotiate lower overall payment

Target: Floor on minimum value of scrip payment

Question 19

Disadvantages of fixed ER buyer vs target

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Answer 19

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

Question 20

Floating ER

Answer 20

Travolta (fixed price/value collar)
= fixes payoff to targets within the collar boundaries by allowing the ER to float
___ /
/

Question 21

Floating ER - If the acquirer’s share price FALLS below the collar bound, then:

___ /
/

Answer 21

the payoff to the target decreases as the ER is fixed at this point.

Question 22

Floating ER - If the acquirer’s share price RISES above the collar bound, then:

___ /
/

Answer 22

payoff to the target increases linearly with the acquirer’s share price at the fixed ER

Question 23

Advantages of floating ER buyer vs target

___ /
/

Answer 23

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

Question 24

Disadvantages of floating ER buyer vs target
___ /
/

Answer 24

Buyer: May pay higher deal value

Target: Exposed to falls in deal value if acquirer’s share price falls

Question 25

What is the impact of paying with cash? (ie paying with cash on hand, issuing new debt)

Answer 25

it consumes financial slack - may decrease debt rating, increase cost of debt

Question 26

What is the impact of paying with stock? (ie paying with issue of stock or shares in treasury)

Answer 26

increases financial slack - may improve debt rating, reduce cost of debt (paying with new stock the most common in Australia)

Question 27

what is form of payment related to?

Answer 27

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)

Question 28

Stock is usually used when: 4) things

Answer 28

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

Question 29

What are the 3 types of risk that the form of payment tries to manage?

Answer 29

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

Question 30

what is risk management?

Answer 30

it’s insurance –> comes at a cost which should be incorporated into the bid value

Question 31

FIXED ER: fixed share deal (no shares stays the same) –> use where:

Answer 31

pre-closing market risk is low (how likely it is that the acquirer’s share price will drop)

Question 32

FLOATING ER: floating share deal (shares float to ensure deal value stays constant) –> use where:

Answer 32

pre-closing market risk is high (how likely it is that the acquirer’s share price will drop)

Question 33

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

Answer 33

could expose the buyer to unwanted risk of dilution from increased ER. Way to manage this is to use a collar

Question 34

What is a collar?

Answer 34

way of hedging against uncertainty in the value of the acquirer (useful when acquirer and target disagree as to the direction of share price)

Question 35

Fixed ER without a collar is a

Answer 35

direct linear relationship (normal share deal) –> this is an issue for target as there no min amount for them

Question 36

Fixed ER without a collar is a

Answer 36

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

Question 37

for a floating ER (Egyptian) ,,,,,/`````` in between the floor and ceiling the ER is

Answer 37

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

Question 38

what is the idea behind a floating ER

(Egyptian) ,,,,,/`````` ?

Answer 38

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)

Question 39

for floating ER (Egyptian) ,,,,,/`````` to minimise value exposure, what do targets want?

Answer 39

they will try to negotiate for a narrow width (whereas bidders want wider collars)

Question 40

For a floating ER collar (Fixed value collar),
___ /
/
what happens between upper and lower bound?

Answer 40

there is a fixed value of the deal (ie, ER floats to ensure the value stays fixed).

Question 41

For a floating ER collar (Fixed value collar),
___ /
/
what happens outside the upper and lower bound?

Answer 41

the ER stays constant such that share price movements dictate the value received

Question 42

for fixed value collars (floating ER collars) ‘Travolta’
___ /
/
the wider the collar, the less price

Answer 42

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

Question 43

What is a contingent payment + eg

Answer 43

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!!

Question 44

when are earnouts likely?

Answer 44

where value risk (uncertainty is greater)

o May be paid as bonuses, escrow funds stock options etc

Question 45

Earnout structure

Answer 45

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

Question 46

Advantages of earnouts 5)

Answer 46

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)

Question 47

Disadvantages of earnouts 4)

Answer 47

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?)

Question 48

best way to value earnouts

Answer 48

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)

Question 49

what’s the other main way a buyer can shift risk?

Answer 49

contingent value rights (CVRs)

= a financing instrument (vs earnouts which are a financing arrangement)

Question 50

egs of CVRs

Answer 50

additional contingent payments, guarantees of some floor value, options to receive/purchase additional buyer stock

Question 51

Collars are another more advanced method of managing

Answer 51

pre-deal close risk
o Provide further ways of managing share price movements, depending on the volatility and risk preferences of the participants