Merger & Acquisitions Lecture 3 Flashcards
Which factors are important in the choice of payment methods in mergers?
- Information asymmetry > biggest determinant in cash-and-stock deals
- Capital structure > how to finance the deal
- Voting control > important when you pay with stock, as you do not want to give up control
- Overvaluation of equity
- Target size in absolute and relative terms
- Transaction costs
Note on cash-and-stock deals
Buyers pay with just enough stock that they fall below the 20% threshold of shareholder dilution. Otherwise shareholders have to vote!
When is a stock payment more likely?
- Overvaluation of equity
- Overlevered
- Target has high relative size
- Large deals/targets
When is a cash payment more likely?
- Unused debt capacity
- Concentrated ownership > don’t want to give up control
- Hostile deals
When paying with stock, the buyer can make 2 types of offers
- Fixed exchange ratio offer = number of shares issued to the target shareholders is fixed but the value of deal may fluctuate between deal announcement and closing depending on movements in buyer stock price > target shareholders are exposed to the risk of a fall in buyer stock price.
// - Fixed value offer = buyer adjusts the exchange rate so as to make sure that the dollar value of proceeds received by the target shareholders is a constant > buyer shareholders bear the risk of greater dilution of their ownership should the acquirer stock price fall between deal announcement and closing.
What are the 2 types of collars, and when are they used?
- Spread collar _/– > fixed exchange ratio offer: allows for some uncertainty for either firm on the value realised/paid within a range of bidder share price. For target shareholders, the downside losses are limited if the price falls below the pre-designated floor. Upside gains for target shareholders are also capped, which pleases the bidder shareholders. If the stock price would increase a lot, you’re technically overpaying for the target. With a spread collar, that’s capped.
// - Local collar /–/ > fixed value offer: leaves no uncertainty for either party as long as the buyer’s share price is within a range. If the price falls below a pre-designated floor price or rises above the cap, the gains and losses are shared by both the buyer and target. Within the range, the buyer is willing to accept the dilution!
What are the motives of using contingent payments in M&A?
- Contingent payments are generally used when the buyer and the target disagree about the value of the target. The contingent payment is used to bridge the gap between their valuations.
> Buyer may only be willing to meet seller’s price if certain milestones are met.
> Seller may be more willing to accept less payment upfront if it is confident on achieving post-performance goals.
// - Contingent payments may be used by buyers to reduce the risk of overpayment and to retain and motivate key personnel of the target after the deal is closed.
// - It can also be used as a risk-management device –in case new liabilities emerge in the target or if closing conditions are not met.
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Generally: in an all-cash deal, the risk is borne by the buyer alone. But this is a way to share the risk while still paying with cash!!!
What are the forms of contingent payments?
- Holdback allowance or escrow funds
- Targeted or tracking stock
- Stock options
- Earn-outs
- Contingent value rights (CVRs)
What is a holdback allowance? And what is an escrow fund?
Holdback allowance: it is based on an event happening. Part of the total payment for the target is withheld until some agreed upon condition is satisfied by the target such as completion of a new product or getting approval for a new drug.
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Escrow fund: it is based on an event not happening. Buyer will claw-back funds from the escrow if any problems emerge or if closing conditions are violated (i.e., representations are inaccurate or warranties are breached).
What is the difference between a representation and a warrant?
Representations and warranties are statements of facts regarding a company’s business, assets, liabilities, and operations. They can relate to the past, present or future, and are included as one of several critical clauses in a purchase agreement.
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Representation is a statement of fact. If a representation is untrue, it is “INACCURATE”
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A warranty is an assurance. If a warranty is untrue, it is “BREACHED”
What are targeted / tracking shares? Explain what is explicitly necessary here.
The buyer issues shares to the target shareholders or management. The dividends of these shares are indexed to the performance of the target.
IMPORTANT: target must be operated as a separate division; all the expenses and revenue of the division are separated from the financial statements of the acquirer > long-term performance of tracking stock is not tied to the financials of the acquirer!
What are stock options?
Allows the target shareholders to acquire shares in the buyer > exercise price of the option is set based on the expected gain from the acquisition of the target.
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But you can also use this to retain key personnel. If they have common shares, they can just sell it in the market and depart.
What is an earn-out? And what is it tied to?
A contractual arrangement between a buyer and seller in which a portion of the purchase price is paid out contingent upon the target firm achieving predefined financial and/or operating or regulatory milestones post transaction-close.
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Part of the payment to the target shareholders is indexed to the realization of some specific metric or outcome such as revenues, gross margin, pre-tax profit, EBITDA.
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Used to bridge gaps in valuation between seller and buyer; retain and elicit cooperation from target management post-deal.
When/where are earn-outs common among?
- Acquisitions of private targets
- Deals in high-tech industry
- Targets with smaller group of shareholders
- Smaller acquirers
- Deals involving buyers and sellers from different industries
Important point of earn-outs…
The target usually exists as a subsidiary of the buyer. So it has to operate separately. If you mix the financials, you cannot measure the performance of the target.
