8 Form of payment I

Form of payment, financing and offer price are linked

Those three decisions are influenced by:

Exogenous factors:
- Economic conditions, such as interest rates (direct factor that influence financing decisions)
- Stock market cycle (relative expensiveness of a stock as a form of payment, eg. In booming
market, stocks are overvalued, its cheaper to pay with stocks)
Endogenous factors
- Perspective to justify merger (is it for cost saving purpose, the total value of total saving
would be the upper limit of the offer, offer price should not be more that the total cost
saving)
- Strategy (hostile or friendly? Hostile would induce a higher offer price)
- Competition (competition leads to higher offer price)
- Shareholders preference
Also includes
- Liquidity
- Control
- Deal strategy
- Irrationality
How bidder justifies motivation for the merger?
- Undervaluation (offer price should never be above the standalone valuation)
- Diversification/financial strategy
- Synergy that is more likely to be realised
Deal strategy impacts
- First mover advantage – may offer higher price - initial premium bid will deter other
competitors away, cash payment a stronger signal
- Hostile bid would impact target management’s reaction

-Have exposure to
the upside
Don’t share in the risks associated potential/value
with realising synergy value, and creation of
don’t share in the risk of the synergy
acquirer’s future share price - maintain
performance investment
exposure to a
thematic company

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 No need to raise
cash through
retained earnigns,
equity raising,
debt,etc

Forms of payment
• Payment received by target shareholders in exchange for their stakes
• Most common is cash (all outs shares are bought in cash), shares (target shareholders
receive pro-rated number of bidder’s shares) or mix (a blended deal), cash underwritten
share offer (shares that can be converted to cash), convertible loan or preference shares
convertible into bidders’ shares, deferred payments and contingent payments
• Considerations of form of payment: shares are not certain, ownership dilution, leverage
position and optima financing costs, exclusion of the part of the synergy to outside party (if
paid in cash), cash is highly certain with the value of consideration,

Exchange ratios
• No of bidder shares offered in exchange for each of a target share
!"#$% '%( )*"(% +, -"(.%-
• Determined by !"#$% '%( )*"(% +, /011%(
For example:
Scenario 1: Without control premium and synergy, bidder: $2, target: $1, exchange ratio:
0.5
Scenario 2: with synergy, the fair value of target is $1.5, bidder: $2, exchange ratio is:
$1.5/$2 = 0.75
• Implied offer price = exchange ratio x value of bidder
• Setting ER too high means allocating a higher proportion of ownership to the target
shareholders, splitting synergies with the target
• A win-win for bidder and target can be achieved by carefully arranging the ER

Risk sharing: There are benefits and risks from different form of payment
- Cash is preferred by target due to price risk (cash offers certainty, when bidder has volatile
market price, cash would be preferred)

Stock market conditions and choice of payments:

- From the bidder’s point of view, overvalued in the market with infor asymmetry à significant
degree of overvaluation and taking adv of it, by raising equity to invest in strategic projects
- When bidder has attractive market prices, target investors might be more willing to accept
scrip
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- Strong market conditions à equity financing
- Tax considerations

Market reaction to forms of payments:

Salami, A (1994) finds that market reacts favourably to cash offer, however, there is bias with
the study, such as 1) size (if the target is a large firm, stocks would preferred, for private
targets, cash would be preferred), 2) type of target (private or public)

Zhang (2001) – use is positively related to friendly deals, while hostile takeovers use stocks
(due to the expectation of conflict between the existing board and target board, so hoping to
cut target shareholders away)

Chang & Mais (2000) – dispersed ownership à shareholders of both bidder and target would
not concerned about ownership dilution

Martin (1996) finds that buoyant stock or when the bidder stock is overvalued in the market,
stocks would be preferred more

Payment forms and accounting practices:

If more than 90% of the deal was paid with stock, bidder use pooling method (no goodwill
recorded)

Payment forms and bidder’s return - Market react negatively to stock offer, regardless of
post-merger performance

Form of financing and considerations:

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 - By retained earnings: cut financial slack, may downgrade credit ratings à higher borrowing
costs
- By stocks: retain borrowing capacity but may signal to market of overvalued stocks,
ownership dilution

Theories of financing forms:

- Pecking order theory (Myer & Majluf, 1984) = retained earnings à debt à stocks
- Overvalued shares (Shleifer, Vishny, 2003) -opportunistic bidders take advantage of
overvalued stocks (taking adv of arbitrage opportunity and not purely value creation)
- Adverse selection (Eckbo, 2018) – protect bidder from adverse selection costs, targets as
sellers are more aware of the state of the firm more the outsiders, the rationale is using
overvalued stocks to pay for overvalued target
- FCF hypothesis (Jensen, 1986) –cash-rich firms tend to do more acquisitions compared to
other firms (they tend to take on negative NPV projects)
- (Merton’s model) – debtholders to benefit at the expense of the shareholders, coinsurance
effect bidder would have a larger asset base that could be used as collaterals.

Financing decisions is also capital structure decisions: esp. when a firm has already
determined an optimal cap structure, the bidder may wish to maintain the same cap structure,
which means that financing decisions for the deal is made to maintain that cap structure

Uysal (2011) finds that overleveraged (limited borrowing capacity) bidder is less likelty to use
cash

Optimal exchange ratio

- Should not cause any earnings dilution/eps dilution
- Max ER depends on the expected post-acquisition earnings growth rate of bidder and target
- Should result in win-win scenario (below maximum and above minimum)
- The maximum ER that can be afforded by the bidder and the minimum that can be accepted by
the target
- Two ways: 1). P/E ratio of the merged entity 2). DCF estimate of the merged equity

ER boundaries is applicable to:

- 1) Given an informed (rational) view about the DCF value or P/E of the merged entity, one can
identify a negotiation range and some likelihood of agreement
- 2) Given a proposed exchange ratio, one can identify P/E or DCF breakeven assumptions
necessary to permit a mutually beneficial deal
- 3) Given both a proposed exchange ratio and view of DCF value or P/E of the merged entity, one
can evaluate the adequacy of a proposal

Bidder’s maximum ER: Golden rule: share price should not declined post-merger
Bidder share price post-merger > pre-announcement price

Exchange ratio: finding the bidder’s maximum ER – any ER below this value would satisfy
bidder

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Target’s minimum ER: Golden rule: post-merger share price must be greater than the post
merger share price

Value of share the target is

Value of consideration per share controlling/value to be given up
received

Exchange ratio: finding the target’s minimum ER – any ER above this value would satisfy
target

ZOPA (Zone For Possible Agreement)

Zone 1 = ZOPA
Zone 2 = bidder wins, target loses, below the min and below max, bidder is happy but targer wont
be happy
Zone 3 = lose lose area
Zone 4 = Target wins, bidder lose

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Exchange ratio: optimal ER with DCF

9 Form of payment II
- Form of payment is used to control/reallocate risk and form of payment is the result of
mutual compromise between bidder and target

Risks involved in a merger

- Deal risk: risks relating to the preventing or delaying the closing of the merger
Price risk: risks relating to the uncertainty of the offer price to be paid, concerns both the
target and bidder
- Value risk: risks relating to the realisation of risks post-merger period

• Risk management involving identifying, measuring and controlling risks

• It’s a trade-off process since the perspectives of sellers and buyers may not match
• Risk management = insurance, rationale: if something happened to the post-merger entity,
who pays?

Risks at different merger stages:

Putting in place transaction structure

which provide a value certainty (cash,
floating ER)

Value uncertainty risk

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• Pre-merger stage – low risk: low commitment of resources, act in advance to reduce
likelihood of risks in post-merger period (eg. Organising selection criteria carefully, reaching out
to regulator to check anti-trust law or industry-specific regulations, taxation implications of the
merger, tax deferral)

Target may impose any-takeover measures to increase bargaining power in later negotiations
to lock in better offer price

Target’s level of risk relates to the form of payment (cash: no risk sharing), accepting any form
of payment at offer must consider these risks

• Merger announcement stage: both bidder and target find out about the merger, both
negotiate terms to be included in the deal negotiations (eg. Termination fees, lockup options or
break fees, exit clauses, due diligence, derivatives as caps, such as floors and collars)

• Post-merger stage - hedge against unexpected discoveries about the target, may impose
escrow accounts (nominate a trustee and transfer all excess earnings if the firm reaches a
performance target) & post-transaction price adjustments, contingent payments (payments
depend on a level of contingent, could be related to govt, R&D, not financial-specific), earnouts
(a contractual provision stating that the seller of a business is to obtain additional compensation
in the future if the business achieves certain financial goals, which are usually stated as a
percentage of gross sales or earnings)l, staged financing (used by VC)

Risks Management Devices:

Definition Adv Disadv
Earnouts: portion of the Alignment of interests Diff to assess at the time of
purchase consideration is between the buyer and the completion what the full
payable after the seller (shifts risks onto the purchase consideration is
completion in future years target0
subject to business
performance but could be Target may be able to
other contingencies negotiate a better purchase
price if the buyer gains
comfort that a material
component is only payable
if business performance is
adequate
Contingent Value Rights Bidder: reduce the upfront Buyer: locked in to
(CVR): financial instruments payments payments per the terms of
structured to provide the CVR
payments in the future if Target: target is able to
certain events occur trade off risk with value. Target: may have to trade
(contingencies are negotiate structure of the off purchase price upfront
satisfied0 CVR such that target is for value attributable to the
comfortable with the total CVR
value to be paid

Target can sell the financial

Fixed ER (Floating value):
Fix ER within certain
boundaries, if the bidder
price falls below a
threshold, ER will increase
instruments
Bidder: Buyer: ER will continue to
-cap the value of the payoff increase to provide a
-provisions of certainty for minimum payoff to the
the seller can be traded seller which is potentially
against value dilutive
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 to maintain a minimum Target: gain certainty Target: max potential value
value payoff or floor is capped

And vice versa when price

rises, maintaining a ceiling
Floating ER (fixed value):
within certain boundaries,
the exchange ratio will float
such that the value
outcome is fixed
Above a certain threshold,
the ER is fixed (no cap to
potential upside)
Bidder: avoid potential
dilution risk if the share
price declines significantly,
while having value certainty
over a range of share price
outcomes
Target: ownership certainty
Buyer: pay more to the
target
Target:
-value outcome is uncertain
-target is exposed to
decrease in the buyer’s
share price

Below a certain threshold,

the ER is fixed such that
there is no cap to the
potential downside to the
deal

Flexible arrangements of payment types

Fixed ER = floating value

!"#$% +, -"(.%-
𝐼𝑚𝑝𝑙𝑖𝑒𝑑 𝑝𝑟𝑖𝑐𝑒 = !"#$% +, /011%( Fixed ER

With fixed ER, implied price of the target is a function of the bidder price
That when the bidder’s value increases, resulting in a higher value of the target

Floating ER = fixed value

!"#$% +, -"(.%-
𝐼𝑚𝑝𝑙𝑖𝑒𝑑 𝑝𝑟𝑖𝑐𝑒 = !"#$% +, /011%( Floating ER

With floating ER, the implied price of the target could be fixed, the ER could as the inverse of the
price = whenever the bidder’s price increases, ER would decrease accordingly, resulting in a fixed
value to be paid to the target

Target’s perspective: floating ER would provide a safety in terms of a constant value to be

paid, but that also means forgoing the upside potential of fixed ER in cases where bidder’s
price rises

Fixed or floating ER à depends on the likeliness of the bidder’s share price

How likely it is going to go up/down before the deal closes

Low pre-closing market risk à fixed-share deal

High pre-closing market risk à fixed-value deal

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Distribution of risks

Pro-rata basis
based on
ownership
structure

Borne by the bidder, diff no.of shares would lock in the value of the
considerations

-9-
 Payment collars
Collars: strategy similar to option trading, hedging against uncertainty

Fixed ER without collar

Fixed value deal or floating ER

Value is fixed at $20

Drawbacks: when share price of the bidder
decreases, the bidder has to offer more shares
to target à ownership dilution
More shares à EPS dilution because
earnings/more shares outs

Payment collars: floating or fixed ER would always expose either party to risks, which leads
to disagreements between the two parties. Payment collars would bridge this agreements by
locking the value at a certain range of the share price

Fixed ER/floating value collars

Area of fixed ER

If the price of the bidder

Bidder share price is declining, increases a lot, bidder
target would not want to would not want to offer
receive junk shares, floating ER too much value to the
is offered as a guarantee of target, bidder can offer
fixed value floating ER

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 Fixed value/floating ER collar

Risks being managed by using the Travolta:

Bidder:
- Protection from dilution risk. If the share price of
bidder falls below XX, the ER is fixed at XX
- Bidder gains certainty over the share of the merged
company which is being given to the target’s
shareholders
- Between the thresholds defined by the collar, the
buyer has value certainty (“cash-like”)

Target:
Fixed ER - Value certainty between XX and XX. Gain certainty
over the minimum share of mergeco
Target is disadv

Fixed value/floating ER collar

Upper bound arrangement is
for the benefit of the bidder

No. of shares issued to

target decrease as the
bidder price increases

When the price is low When the price is high

Bidder avoids issuing a high Bidder issues limited no. of
no. of shares to target shares to target

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Fuller (2003) outlines the wealth effects of different collars
• Target receiving floating ER collars (fixed value) obtain higher abnormal returns
• Returns are similar to those targets received fixed collars offers
• Payments with option-like feature benefit target more
• May be due to cancellation options à this flexibility is a significant value for target
• But bidder is not disadvantaged by the option
• Bidder’ returns is impacted by the inclusion of fixed or floating collars
• Collars are more useful if the size of the merger is small
• Target or bidder has a high inside ownership

Contingent payments à part of payment is related to future performance of the merged

company

Earnouts are more likely when mergers involve:

- In private targets
- Target in industry with high R&D (biotech, pharmaceutical)
- Cross-border deals
- Diversifying M&A
- Earnouts as a financing form for financially constrained bidders
- Firms locating in countries with common legal systems in cross-borders acquisitions

intending to solve:
- Disagreement about target value, future value of target is uncertain
- Realisation of target value may be linked to unique human capital (keeping the existing
management in the target)

How benefits from earnouts?

- Higher premiums are paid to target in earnout deals
- Bidders gain positive abnormal returns in earnout deals (earnout itself is a discount to the
offer price, helps bidder to eliminate uncertainty in target valuation)
- If target is not confident of the future performance, they would not agree to the earnout
clause

Bidders can shift risks by contingent value rights, treated like a financial instrument, while earnouts
are financing arrangement. CVR can be arranged to have options, to buy and sell stocks at a
predetermined price
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 10 Deal Structure
Method of acquisition:
- Takeover
- Scheme of arrangements
- Negotiated contract with a majority of shareholders
- Reduction in capital (buying buy capital of selected group of shareholders, done internally)
- Variation to rights attached to shares (reducing voting power of other groups of
shareholders)

Off-market bids:
- Conditional: A conditional offer refers to a takeover offer which is expressed to be subject to
certain conditions being fulfilled. This means that the offer will only become obligated to
purchase the shares in the target company which have been validly tendered in acceptance
of the offer after the conditions have been fulfilled. If the conditions to the offer are not fulfilled
on or before the closing date of the offer, the offer will lapse and shareholders who have
tendered their shares in acceptance of the offer will have their shares returned to them. A
conditional offer is said to “unconditional” once all the conditions to the offer have been met.
- No differentiation consideration: benefits offer to all shareholders are equal
- Sealing the deal: all offer must be declared unconditional 7 days before the offer closes
otherwise all contracts are void
- Target duties: notify ASX, summarise bid and make preliminary recs

On-market bids:
- Must be cash only and must relate to all shares in the target, not just specific class or
proportion
- Offer must be unconditional and all reg approvals obtained priot to announcement
- Is considered to be less flexible and higher risk than off-market bids
- In the right environment can be effective and quickly achieved

Scheme of arrangement:
- An alternative to takeover for effecting corporate restructures
- Usually a all or nothing outcome
- success requires court approval and approval from either 75% by value or 50% by number
of each class of sec holder
- More flexible than takeover bids, because form of payment, payment differentiation, post-
merger conditions can be arranged
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 - Target role: usually target initiated
- Considered to be friendly, but schemes are used by bidders as a way of dragging reluctant
targets to enter into discussion

Schemes are more likely, when:

• Ownership in the target firm is more concentrated
• Bidder toehold stake is small
• Highly levered bidder
• Larger target
• Premiums of schemes < takeover à takeover usually involves hostile takeover, in which
competitors are present, thus premium is higher

To achieve inorganic growth: alternatives to M&A:

M&A may not work because of:
- Overpayment
- Difficulties in post-merger integration
- Regulatory limits
- Cost and financing limits
- Merger may not be desirable by bidder because remaining independent is more valuable

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 Strategic alliance:
A contractual arrangement where two corporations agree to commit resources or support common
initiatives. A new entity is not created. To maintain financial flexibilities

Two parties may:

- Gain capabilities from partner
- Leverage co-specialised resources
- Create a sustatinable competitive adv

Middle ground ways: by forming strategic alliances, such as:

- Supply and purchase agreement
- Marketing and distribution agreement
- Agreement to provide technical services
- Management contract
- Licensing of method, tech, design, process, patent
- Franchising
- Joint ventures, partnership on a project together

Independent operations Outright integration

Strategic alliance is a real option:

- Provides opportunity to learn about a particular capability without committing resources to
developing that capability upfront
- It is exploratory arrangement
- Small upfront investment
- May transition into a larger arrangement
- There is the option to abandon

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Motives for alliances:
• Exploratory: refers to the degree to which a firm can create new skills, knowledge, and
processes that are distinct from those of the past, eg. Learning alliance, awareness
building,
• Exploitative: refers to the extent to which a firm continually refines and extends its
resources, skills and knowledge. Alliances coordinate to share resources, capabilities,

Inter-firm partnership linking different capabilities, eg. Starbucks and airlines

Inter-firm partnership growing common capabilities:

Economic content classification:

- Pre-competitive firms in unrelated industries collaborating on new product and technology
- Competitive: competitor firms in a strategic alliance
- Pro-competitive: vertical value chain
- Non-competitive: non-competitor firms in same industry but diff markets

Joint venture:
- two or more distinct firms invest In the venture and participate in the management
- the venture is a distint legal entity

Non-equity joint venture:

- distinct firms contribute resources but no equity investment
- no separate entity

Reasons for divestures:

• The divested division is underperforming in relation to its industry competitors or other
divestor businesses
• The divested part is performing reasonably well, but it is not well positioned within its
industry to give it long-term competitive advantage
• The divested part has a poor fit with new strategy, parent wants to concentrate on area with
the greatest competitive strengths
• The parent is too widely diversified, causing difficulties in monitoring the performance of
divisional managers
• The parent is experiencing financial distress, and needs to raise cash to mitigate this and
avoid eventual liquidation
• Unbundling to preserve focus - The diversified business has been bough as part of an
acquired company and the parent has no desire to keep it
- 16 -
 • Unbundling to raise finance - The divested business has been bought as part of an
acquisition, and the parent needs to raise money to pay for the acquisition
• Buy low sell high strategy - The divested business has been bought as part of a bust up
takeover in which unbundling and selling the target piecemeal to strategic buyers is the
value creation strategy of the bidder
• Buy operate sell strategy – acquisition and subsequent divestiture are part of a coherent
strategy to buy an underperforming company, turn it around and sell at a profit

Spin-off: ownership of the subsidiary business is transferred to the parent company shareholders,
who will then own the spun out subsidiary directly as a separate company

Corporate sell-off: outright sale or divestment of a business unit to another firm

Corporate restructuring

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11 Hostile Takeover
- Maintain independence
Managers may believe that remaining independent is the best way to serve interests of their
shareholders, employees and local communities
– Self interest
Target management fear the likely loss of job from the takeover (as well as status, power
prestige etc)
- Tactics
Bid resistance may be a tactical move to extract a higher bid premium from the bidder
Bid resistance also delays the deal and increases uncertainty where the bidder wants
certainty

Hostile takeover:
Shivdasani (1993) finds that higher level of inside ownership decreases the likelihood of a
successful takeover and reduce the probability of a takeover offer

Mikkelson & Partch (1989) find that when firms with high insider ownership receive a
takeover offer, the deal is more likely to succeed

Defence based on timing:

- Proactive: precautionary measures
- Reactive: after the announcement is made

Defence strategies:
- Financial measures: strengthen financial position
- Poison pills: tactics to discourage hostile takeover attempts, allow existing shareholders the
right to purchase additional shares at a discount, effectively diluting ownership interest of a
new, hostile party.
- Pac-man: target firm tries to acquire the bidder
- White knight: riendly' individual or company that acquires a corporation at fair
consideration that is on the verge of being taken over by an 'unfriendly' bidder or
acquirer, who is known as the black knight. Although the target company does not
remain independent, acquisition by a white knight is still preferred to the hostile
takeover.

Pre-bid defences:

- Increase firm value, share price, EPS to make the hostile takeover more expensive
- Create hurdles, such as new class shares with voting power
- Offering share buybacks from unfriendly shareholders
- Seeking board of directors’s support by enganging with shareholders, analysts, media,
investors, etc
- Restructure capital structure by including more debt component, for LBO with strict debt
covenants, they would be reluctant
- Anti-takeover amendments: changing the firm charter to control transfer
- Golden parachutes: lucrative employment contracts compensating managers if they lose
their jobs

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Types of poison pills:

- Flip over plans: shareholders of the target are given rights to buy the bidder’s shares at a
discount à purpose to dilute the share price of the targeted company
- Flip over plan: target shareholders ae allowed to buy more shares of the bidders at a
discounted price à encourages existing shareholders of the target to dilute its shares

Post-offer defences:

- pac-man defence
- corporate restructuring: improve efficiency, sell off main asset (which is the bidder is most
interested in, ruin opportunities for synergies
- Greenmail/targeted share repurchase: targets buy back large block of stock from bidder at
a premium

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