Mergers and acquisitions: These two words represent how companies buy, sell and recombine businesses. They're also the reason why today's corporate landscape is a maze of conglomerations. Insurance companies own breakfast cereal makers, shopping mall outlets are part of military manufacturing groups, and movie studios own airlines, all because of mergers and acquisitions.
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Not all M&As are peaceful, however. Sometimes, a company can take over another one against its will -- a hostile takeover. How can they do that? In this article, we'll find out how hostile takeovers happen, how to prevent them and why a hostile takeover isn't always a bad thing.
Mergers and Acquisitions
Photo courtesy Amazon
In "Other People's Money," Danny deVito plays a ruthless corporate raider bent on taking over a family-run company.
When two companies merge, the boards of directors (or the owners, if it is a privately held company) come to an agreement. The original companies cease to exist, and a new company forms, combining the personnel and assets of the merging companies. Like any business deal, this can be straightforward, or incredibly complex. The key is that both companies have agreed to the merge.
In an acquisition, one company purchases another. The purchased company ceases to exist, or it becomes a part of the buying company. The buying company owns all assets, including the name of the company, their equipment, their personnel and even their patents and other intellectual property. However, just like a merger, the boards or owners of both companies have agreed to the transaction.
A hostile takeover is an acquisition in which the company being purchased doesn't want to be purchased, or doesn't want to be purchased by the particular buyer that is making a bid. How can someone buy something that's not for sale? Hostile takeovers only work with publicly traded companies. That is, they have issued stock that can be bought and sold on public stock markets. (Check out How Stocks and the Stock Market Work for more information.)
A stock confers a share of ownership in the company that issued it. If a company issued 1,000 shares, and you own 100 of them, you own a tenth of that company. If you own more than 500 shares, you own a majority or controlling interest in that company. When the company makes major decisions, the shareholders must vote on them. The more shares you have, the more votes you get. If you own more than half of the shares, you always have a majority of the votes. In many respects, you can control the company.
So a hostile takeover boils down to this: The buyer has to gain control of the target company and force them to agree to the sale. We'll explain how it's done in the next section.
Reasons for Hostile Takeovers
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The film "Wall Street" epitomized the world of hostile takeovers in the 1980s.
There are several reasons why a company might want or need a hostile takeover. They may think the target company can generate more profit in the future than the selling price. If a company can make $100 million in profits each year, then buying the company for $200 million makes sense. That's why so many corporations have subsidiaries that don't have anything in common -- they were bought purely for financial reasons. Currently, strategic mergers and acquisitions are more common. In a strategic acquisition, the buyer acquires the target company because it wants access to its distribution channels, customer base, brand name, or technology.
These purchase factors are the same for friendly acquisitions as well as hostile ones. But sometimes the target doesn't want to be acquired. Perhaps they are a company that simply wants to stay independent. Members of management might want to avoid acquisition because they are often replaced in the aftermath of a buyout. They are simply protecting their jobs. The board of directors or the shareholders might feel that the deal would reduce the value of the company, or put it in danger of going out of business. In this case, a hostile takeover will be required to make the acquisition. In some cases, purchasers use a hostile takeover because they can do it quickly, and they can make the acquisition with better terms than if they had to negotiate a deal with the target's shareholders and board of directors. The two primary methods of conducting a hostile takeover are the tender offer and the proxy fight.
A tender offer is a public bid for a large chunk of the target's stock at a fixed price, usually higher than the current market value of the stock. The purchaser uses a premium price to encourage the shareholders to sell their shares. The offer has a time limit, and it may have other provisions that the target company must abide by if shareholders accept the offer. The bidding company must disclose their plans for the target company and file the proper documents with the Securities and Exchange Commission (SEC). The 1966 Williams Act put restrictions and provisions on tender offers.
Sometimes, a purchaser or group of purchasers will gradually buy up enough stock to gain a controlling interest (known as a creeping tender offer), without making a public tender offer. This bypasses the Williams Act, but is risky because the target company could discover the takeover and take steps to prevent it.
In a proxy fight, the buyer doesn't attempt to buy stock. Instead, they try to convince the shareholders to vote out current management or the current board of directors in favor of a team that will approve the takeover. The term "proxy" refers to the shareholders' ability to let someone else make their vote for them -- the buyer votes for the new board by proxy.
Often, a proxy fight originates within the company itself. A group of disgruntled shareholders or even managers might seek a change in ownership, so they try to convince other shareholders to band together. The proxy fight is popular because it bypasses many of the defenses that companies put into place to prevent takeovers. Most of those defenses are designed to prevent takeover by purchase of a controlling interest of stock, which the proxy fight sidesteps by changing the opinions of the people who already own it.
The most famous recent proxy fight was Hewlett-Packard's takeover of Compaq. The deal was valued at $25 billion, but Hewlett-Packard reportedly spent huge sums on advertising to sway shareholders [ref]. HP wasn't fighting Compaq -- they were fighting a group of investors that included founding members of the company who opposed the merge. About 51 percent of shareholders voted in favor of the merger. Despite attempts to halt the deal on legal grounds, it went as planned.
Next, we'll see how a company can defend against a hostile takeover.
In a corporate raid, a company purchases another through a hostile takeover (often with an LBO) because their assets are worth more than the value of the company. As soon as the new owners complete the acquisition, they close the company and sell off all the assets. This often takes employees by surprise, since it can happen in a matter of hours. Like LBOs, corporate raids are out of vogue, mainly because stock prices are so high that it is rare to find a company that is undervalued relative to its assets.
Defenses Against Hostile Takeovers
There are several ways to defend against a hostile takeover. The most effective methods are built-in defensive measures that make a company difficult to take over. These methods are collectively referred to as "shark repellent." Here are a few examples:
- The Golden Parachute is a provision in a CEO's contract. It states that he will get a large bonus in cash or stock if the company is acquired. This makes the acquisition more expensive, and less attractive. Unfortunately, it also means that a CEO can do a terrible job of running a company, make it very attractive for someone who wants to acquire it, and receive a huge financial reward.
- The supermajority is a defense that requires 70 or 80 percent of shareholders to approve of any acquisition. This makes it much more difficult for someone to conduct a takeover by buying enough stock for a controlling interest.
- A staggered board of directors drags out the takeover process by preventing the entire board from being replaced at the same time. The terms are staggered, so that some members are elected every two years, while others are elected every four. Many companies that are interested in making an acquisition don't want to wait four years for the board to turn over.
- Dual-class stock allows company owners to hold onto voting stock, while the company issues stock with little or no voting rights to the public. That way investors can purchase stocks, but they can't purchase control of the company.
In addition to takeover prevention, there are steps companies can take to thwart a takeover once it has begun. One of the more common defenses is the poison pill. A poison pill can take many forms, but it basically refers to anything the target company does to make itself less valuable or less desirable as an acquisition:
- The people pill - High-level managers and other employees threaten that they will all leave the company if it is acquired. This only works if the employees themselves are highly valuable and vital to the company's success.
- The crown jewels defense - Sometimes a specific aspect of a company is particularly valuable. For example, a telecommunications company might have a highly-regarded research and development (R&D) division. This division is the company's "crown jewels." It might respond to a hostile bid by selling off the R&D division to another company, or spinning it off into a separate corporation.
- Flip-in - This common poison pill is a provision that allows current shareholders to buy more stocks at a steep discount in the event of a takeover attempt. The provision is often triggered whenever any one shareholder reaches a certain percentage of total shares (usually 20 to 40 percent). The flow of additional cheap shares into the total pool of shares for the company makes all previously existing shares worth less. The shareholders are also less powerful in terms of voting, because now each share is a smaller percentage of the total.
Some of the more drastic poison pill methods involve deliberately taking on large amounts of debt that the acquiring company would have to pay off. This makes the target far less attractive as an acquisition, although it can lead to serious financial problems or even bankruptcy and dissolution. In rare cases, a company decides that it would rather go out of business than be acquired, so they intentionally rack up enough debt to force bankruptcy. This is known as the Jonestown Defense.
In the next section, we'll weigh the costs and benefits of hostile takeovers.
The White Knight is a common tactic in which the target finds another company to come in and purchase them out from under the hostile company. There are several reasons why they would prefer one company to another -- better purchase terms, a better relationship or better prospects for long-term success.
With the Pac-Man Defense, a target company thwarts a takeover by buying stocks in the acquiring company, then taking them over.
Who Benefits from a Hostile Takeover?
While companies fight tooth and nail to prevent hostile takeovers, it isn't always clear why they're fighting. Because the acquiring company pays for stocks at a premium price, shareholders usually see an immediate benefit when their company is the target of an acquisition. Conversely, the acquiring company often incurs debt to make their bid, or pays well above market value for the target company's stocks. This drops the value of the bidder, usually resulting in lower share values for stockholders of that company.
Some analysts feel that hostile takeovers have an overall harmful effect on the economy, in part because they often fail. When one company takes over another, management may not understand the technology, the business model or the working environment of the new company. The debt created by takeovers can slow growth, and consolidation often results in layoffs.
Another cost of hostile takeovers is the effort and money that companies put into their takeover defense strategies. Constant fear of takeover can hinder growth and stifle innovation, as well as generating fears among employees about job security.
Ultimately, we must measure the costs of mergers and acquisitions on a case-by-case basis. Some have been financial disasters, while others have resulted in successful companies that were far stronger than their predecessors were.
For lots more information on hostile takeovers and related topics, check out the links on the next page.
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More Great Links
- The Wacky World of M&As
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- How to Cope With The Threat of Hostile Takeovers
- Alsdorf, Matt. "What is a hostile takeover?" Slate, November 11, 1999.
- Barmash, Isadore. "A Not-So-Tender Offer." Prentice Hall, 1995. 0-13-182312-4.
- "Breaking Off Ties: Firms Selling Off Cross-Held Shares." Japan Information Network, January 11, 2001.
- Cole, Benjamin Mark. "L.A. Was Ground Zero for Leveraged Buyouts in 1980s." Los Angeles Business Journal, June 26, 2000.
- Diamond, Stephen C., ed. Leveraged Buyouts. Dow Jones-Irwin, 1985. 0-87094-579-3.
- Fried, Ian. "Costs Mount in HP Proxy Fight." News.com, March 13, 2002.
- Li, Jin and Wang, Fiona. "Leveraged Buyouts: Inception, Evolution, and Future Trends."
- Real Corporate Lawyer: Proxy
- Surowiecki, James. "Drug-company merger-maniacs need sedation." Slate, November 11, 1999.
- SEC: Tender Offer