Assuming we have our maximum willingness to pay or warranted value conditional on beliefs about the future growth of the target firm, how do we actually implement the deal? For example, how should we finance it? Should we use cash, debt, stock, or a combination? What are the potential consequences for each type of financing? The purpose of this lecture is to briefly discuss 1) the different approaches to strategically acquire a firm, 2) the regulatory environment that may be relevant to those approaches, and 3) the tax consequences of those approaches. Again, our focus here will be U.S. firms, but you should think about the corresponding issues in your home countries.
Ways to Acquire
There are 3 basic ways to acquire a firm. The first way is the negotiated deal, which is the most typical. In a merger deal, managers from both sides meet and agree on how the deal should be financed or paid for. Both sides do their modeling to find their warranted value of the transaction. Hopefully the target’s minimum willingness to sell is above the acquirer’s maximum willingness to pay and the merger goes through. This transaction can involve the purchase of the stock or assets directly. The latter occurs most often when the target is being liquidated.
The second method to acquire the firm is through direct stock purchases from shareholders. This is usually called a tender offer. Some tender offers are friendly, and other times they are hostile. The acquiring company can do this many ways. They can make announcements through advertisements in newspapers and buy directly from the open market. They can buy shares from large blockholders or institutions or individuals that hold a significant size of the firm. They can use cash or exchange stock for stock.
The last method to acquire a firm is through what is called proxy contests. You would usually use this method if the regulatory environment is not friendly towards hostile takeovers. The strategy involves replacing the board of directors with your own slate in order to gain control of the firm. Once the board is secured, you can sell the firm to the acquiring firm.
I will go over each of these methods separately.
Mergers
Negotiated deals are the most common type of M&A transaction (over 90 percent of recorded deals are negotiated). They are negotiated directly with the target firm’s managers and approved by the board of directors before going to vote by shareholders. The two main features of this transaction are 1) the acquiring firm assumes all assets and liabilities of the target and 2) the target firm ceases as a separate corporate entity. In the end, the acquiring firm has full control over the target firm, even though less than 100% of the shareholders voted for it.
Negotiated Merger Transactions
This is a visual representation of the negotiated merger deal during the exchange and after the exchange. The target firm transfers its assets and liabilities to the acquiring firm in exchange for part of the acquirer’s stock, cash and or other property. The target exchanges its shares for the the payment it receives to its shareholders and the target dissolves. Thus, after the reorganization, the target corporation no longer exists. If stock was used as payment, the target’s shareholders are now shareholders of the acquiring company.
Tender Offers
A tender offer for a target firm is an offer that is made directly to the shareholders. This is different from negotiated mergers because managers of the acquiring firm are not approaching the managers of the target firm first. It is up to the shareholders individually whether or not to sell their sales to the bidding firm. This method is particular effective if it is clear that shareholders cannot coordinate well to collectively bargain for a higher price. We will talk about this coordination failure in more detail later. The two main features of this transaction are 1) that the acquiring firm only assumes control over the target firm’s assets, but not the the target’s liabilities, since the tender offer is only for the target’s stock and 2) the target firm remains a separate corporate entity. In most cases, tender offers are followed by a formal merger, which is often called a back-end merger.
Tender offer Transactions
This is a visual representation of the a tender offer. The Target’s shareholders exchange the target’s stock for cash, stock, or some combination. The target becomes the acquirer’s subsidiary and the target’s former shareholders become the acquirer shareholders and if they receive stock as payment for the target’s shares.
Pros and Cons of Tender Offers
So, why would you prefer to use tender offers over the something less hostile such as a negotiated merger deal? If your intentions is to eventually integrate the target firm into your core business, then the target firm can’t operate as a subsidiary forever. In other words, tender offers can become more expensive than a negotiated merger if you eventually have to do a complete merger eventually. Additionally, you have less information about the target firm. In fact the information about the target firm could be inaccurate so much that you may end up overpaying anyway. In those cases, you can’t sue the target managers for your own misinformation.
However, if you believe that timing is important and that there is a high possibility of other bidders, then perhaps a tender offer can be a good short term solution to gain control of the firm. No shareholder meetings are required and less disclosures are needed for government agencies in general.
As an aside, let me talk briefly about acquisitions through assets. This type of transaction usually takes place when the target firm is going bankrupt and is going to be liquidated. The target transfers its assets in exchange for acquirer’s cash or other property in rare cases. Neither the target firm’s shareholders are involved in any transaction or in any vote. The Acquirer gets asset and losses cash. The target gets cash and losses assets.
Regulatory Considerations in the U.S.
How well each of these acquisition methods depends partly on the regulatory environment. For this course, we will focus on the regulatory conditions in the U.S. M&A transactions are governed by both local and national laws. Local law are administered at the state level. Most public companies are registered in Delaware, for example, because are they are friendly to corporations in a legal sense. Under Delaware law, merger deals can be delayed three years if the bidder is unable to acquire at least 85% of the total shares outstanding from its initial tender offer. This requirement is much less in other states, probably around 60%. We will talk more about corporate antitakeover laws in detail in the next lecture.
Securities registration laws are enforced both at the state and federal level. “Blue sky laws” is a name for state level securities registration laws because securities issued in the past were only backed the “blue sky” or nothing. Securities registration gives investors more protection. This is similar to the Securities Act of 1933.
The Securities Exchange Act of 1934, the Williams Act of 1968, and the Hart-Scott-Rodino Antitrust Act of 1976 are disclosure laws. The Securities Exchange Act of 1934 requires disclosure of information that may affect stocks traded on a public exchange. The Williams Act of 1968 deals with disclosure requires under tender offers. Lastly the HSR requires firms, both target and acquirer, to disclose information about a possible merger or acquisition to government agencies. Lastly, not all acquisitions are possible. There are many laws that restrict foreign acquisitions, particularly concerning firms that may jeopardize national security.
I will talk briefly about the disclosure laws to inform shareholders (i.e., the Securities Exchange Act of 1934 and the WIlliams Act of 1968).
Transaction Disclosure Requirement
The Securities Exchange Act of 1934 requires disclosure of any material information that can affect stock prices, which includes M&A deals and potential transactions. This basically means they can do two things: 1) if there is a deal that will occur, they have to make sure all parties on both sides keep everything a secret. If anyone leaks this information, then managers will have willfully denied relevant information to their shareholders and will have violated their fiduciary duties. 2) They can disclose merger information accurately.
Williams Act 1968
The Williams Act of 1968 regulates tender offers. Specifically, it offers protection to the shareholders of the target firm. If a bidder, for example, acquires more than 5% of a stock or company, either through the open market or through a private sale from a blockholder, the bidder needs to disclose this information with regulators and the public, specifically, the identities of all parties, the purpose of the purchase, the source of financing of the purchase, and business plans if the ultimate goal is to acquire the company.
In order to let new information be priced into the stock and to give target shareholders sufficient time to decide whether to tender, the Williams Act requires that the tender offer be available for at least 20 days. Shareholders can also withdraw those tendered shares until the offer closes, in case new information is revealed and priced into the stock price. The Williams Act also gives target firms the right to sue bidding firms if the bidding firm manipulates the stock price of the target firm (i.e., lowering the stock price via false information).
Prisoners’ Dilemma and Coercive Two-Tier Offers
Even with all this investor protection from hostile takeovers, bidding firms can still exploit the dispersed ownership structure of target firms through coercive two-tier offers. When ownership of the firm is concentrated, majority of the shares are owned by only a few institutions or individuals. In the case of concentrated ownership, large shareholders can talk to each other and use their collective bargaining power to improve the tender offer price. However, when ownership is dispersed, majority of the shareholders only own a little piece of the firm. In the case of dispersed ownership, it is extremely difficult or expensive for shareholders to coordinate and cooperate to collective bargain. Bidding firms can take advantage of this situation through a two-tier offer:
- In the first tier, the bidding firm tenders an offer at a particular price
- If the offer is successful, the acquirer will gain control and drive the market price of he remaining shares down. The acquirer reduces the stock price by transferring asset from the target firm to the acquiring firm by buying assets from the target below market values.
- In the second tier, the acquiring firm will tender an offer at the much lower price given that stockholders cannot act collectively.
This is practice is usually called corporate raiding.
Proxy Contest
The last method to acquire the target firm is through the change of its leadership. The board of directors is the one that vote and decide on whether to accept or reject an offer. Therefore, if you control the board, you control the firm’s future. However, replacing directors internally in general is fairly difficult since it is the board that decides on the slate of directors that should be on the ballot. If you disagree with that slate, what you have to do is issue your own slate of directors and let shareholders decide which ballot to cast. So, first you have to file your own ballot or proxy statement with the securities exchange commission. Once that is done, you then have to mail or send ballots to all shareholders with your own money. As you can see, this can become very expensive since most shareholders won’t actually know there are more than 1 proxy statement or ballot that can be cast or filled out. If you decide to wage a proxy contest, you have to use your own money. Managers on the other hand, can use firm resources to fight your proxy contest.
How Effective are Proxy Contests?
Are proxy contests effective? Although difficult to succeed, proxy contests usually disrupts the rank and order of the leadership of the firm with positive shareholder returns. About one third of proxy contests end up with some board representation.One fourth of them lead to the sale of the firm. In cases in which dissidents do not obtain board control, 50% of managements resigned within 3 years of the proxy contest. Less than 20% of the firms will have the same top management. If you look at stock returns around the announcement of proxy contests, one study finds that the market on average view proxy contests as firm value improving. In other words, proxy contests seem to be a healthy tool to improve corporate governance.
M&A Tax Issues in the U.S.
So, we have talked about how to determine a firm’s warranted price. We have also talked about how to implement a merger or acquisition and its various consequences as well. The last thing we need to talk about is tax treatment of M&A transactions and why it could affect the structure of your deal. From the target’s perspective, the most important tax question you should be asking is how do I avoid paying taxes? From the acquirer’s perspective, the most important tax question is are there any tax benefits I can gain from this transaction?
- Is the gain or loss received by selling stockholders recognized immediately for tax purposes? In other words, do the selling stockholders need to pay tax immediately? Can we delay those payments?
- Is the selling corporation taxed on any gain over book value? If so, is it possible for me to increase my book value and pay less taxes on my gains?
- Can the acquired assets be written up for tax depreciation purposes by the acquirer? Recall that depreciation is tax deductible.
- Will any net operating loss (or other tax attributes) of the target be transferred to the acquirer? Can a firm gain any tax benefits from tax-loss carryforwards of the target firm?
(see lecture 2 slides) - Lastly, will the deal increase the acquirer’s interest tax shield? If the acquisition is financed by debt, then yes.
Note that this is from the U.S. perspective, but I presume most tax laws internationally should be about the same.
How to tell if a Transaction is Tax Exempt
So, how can you tell if a transaction is tax exempt? In general, it is simple. If you are ending an investment and selling an asset, you will be taxed. You, the seller, have three options: 1) you can pay the capital gains multiplied by the tax rate and set your taxable basis to purchase price. We will talk about taxable basis in the next slide). 2) find a law that says you are exempt, or 3) hope you don’t get caught, but if you do you go to jail.
So the big question is how to win tax exemption. In most cases, tax exemption occurs when the seller receives mostly stock in buyer’s firm, and (2) buyer achieves “statutory control” of the seller firm. That means that the buyer only has control over the firm on paper, but in practice, that may not be true.
Taxable Basis and Capital Gains
Let us talk about what a taxable basis is first. Every asset that a person or firm owns has a taxable basis. To be more precise, it is the price you paid for that asset in the past. So, for example, if you bought a stock for price B, then the stock’s taxable basis is B. If you decide to sell the asset in the future, it most likely will be taxable. If somehow you find a law that make your sale tax-exempt, you will pay no taxes. If it is taxable, then you pay tax equal to the Sale Price minus the taxable basis all multiplied by the tax rate. Note that if you sell at a loss, then you pay no taxes.
The buyer pays no tax, but gain a taxable basis B equal to the sale price if the transaction is taxable. If not, then the taxable basis is just the pre-transaction taxable basis.
Is Winning a Tax Exemption Valuable?
Is winning a tax exemption valuable? The short answer here is yes, but I want to show you why.This graph shows the net cash flow consequences of losing tax exemption. Two things occur. First, you have to pay taxes on your capital gains up front. Second, you get a higher taxable basis that you can use to depreciate over time. I assumed a straight line depreciation here. I assumed that if you win tax exemption, you can still depreciate your asset, but at a lower pre-purchase level. So, this graph shows net cost minus benefits of losing tax exemption. I will go over the math in the next slide, but the sum of each periods tax depreciation is equal to the capital gains tax you pay. But because of the time value of money or a discount rate greater than 0, losing a tax exemption will always be negative NPV.
Asset with 10-year Straight Line Depreciation
What does the math look like? First, let’s look at the net cost of failing to get tax exemption. You pay capital gains up front, but you also gain the ability to depreciate your assets at a higher taxable basis. On other hand, if you gained tax exemption, you don’t pay any taxes up front, but your depreciate your assets at a lower rate. So the net cost of losing tax exemption is simply adding the cash flows from losing tax exemption to the cash flows from gaining tax exemption. Note that the net gain in higher depreciation rate will sum to the capital gains you pay up front, but because of the time value of money or a positive discount rate, losing tax exemption will yield a negative NPV.
Transaction Type Matters for Tax Exemption
Back to M&A. What kind of transactions can trigger tax exemption? In general, the necessary conditions for tax exemption is that the seller receives mostly stock in the buyer’s firm and if the buyer only achieves statutory control. We will talk about these two attributes in 3 broad types of acquisitions as seen by the IRS:
- A type reorganizations (merger): The target ceases to exist and the suriving firm gets all liabilities in addition to assets.
- B type reorganizations (acquisition of stock): The target firm remains as a separate entity. Its liabilities are also separate from the acquiring firm.
- C type reorganizations (acquisition of assets): Acquirer buys assets only