Mergers, Acquisitions, and Investment Banking: Payment Issues in Deal Structuring

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This knol discusses how to structure fixed and variable share for share exchange ratios to preserve value in M&A deals.


 

Source: For more about M&A deal structuring, see Chapters 11 and 12 of Mergers, Acquisitions, and Other Restructuring Activities, 6th edition, 2011 by Donald M. DePamphilis. To learn more about this book or to order online, click here.


 

Share Exchange Ratios

A share exchange ratio is the number of shares of acquirer stock offered for each share of target stock. A fixed or constant share exchange agreement is one in which the number of acquirer shares exchanged for each target share is unchanged between the signing of the agreement of purchase and sale and closing.  However, the value of the buyer’s share price is allowed to fluctuate. While the buyer will know exactly how many shares will have to be issued to consummate the transaction, both the acquirer and the target will be subject to significant uncertainty about what the final purchase price will be. The acquirer may find that the transaction will be much more expensive than anticipated if the value of its shares rises; in contrast, the seller may be greatly disappointed if the acquirer’s share price declines.

In a fixed value agreement, the value of the price per share is fixed by allowing the number of acquirer shares issued to vary to offset fluctuations in the buyer’s share price. For example, an increase in the value of the acquirer’s share price would result in the issuance of fewer acquirer shares to keep the value of the deal unchanged; a decrease in the acquirer’s share price would require more new shares to be issued.  Because of potential dilution to acquirer shareholders if more new shares than originally anticipated had to be issued, the buyer would usually want to ask for a reduction in the purchase price in exchange for a collar arrangement.
 

Alternative Collar Arrangements

 
Most stock mergers have a fixed share exchange ratio. To compensate for the uncertain value of the deal, some transactions allow the share exchange ratio to fluctuate within limits or boundaries. Such limits are referred to as a collar. Collar arrangements have become more common in recent years, with about 20 percent of stock mergers employing some form of collar as part of the bid structure.  Collar agreements provide for certain changes in the exchange ratio contingent on the level of the acquirer’s share price around the effective date of the merger. This date is often defined as the average acquirer share price during a 10-20 day period preceding the closing date. The two primary types of collar arrangements are the floating (also called variable) and fixed collar agreement.
 
A floating collar agreement may involve a fixed exchange ratio as long as the acquirer’s share price remains within a narrow range, calculated as of the effective date of merger.  For example, the acquirer and target may agree that the target would receive .5 shares of acquirer stock for each share of target stock, as long as the acquirer’s share price remains between $20 and $24 per share during a 10-day period just prior to closing. This implies a collar around the bid price of $10 (i.e., .5 x $20) to $12 (i.e., .5 x $24) per target share. The collar arrangement may further stipulate that if the acquirer price falls below $20 per share the target shareholder would receive $10 per share; if the acquirer share price exceeds $24 per share, the target shareholder would receive $12 per share. Therefore, the acquirer and target shareholders can be assured that the actual bid or offer price will be between $10 and $12 per target share.
 
A fixed payment or value collar agreement guarantees that the target firm shareholder receives a certain dollar value in terms of acquirer stock as long as the acquirer’s stock remains within a narrow range, and a fixed exchange ratio if the acquirer’s average stock price is outside the bounds around the effective date of the merger.  For example, the acquirer and target may agree that target shareholders would receive $40 per share, as long as the acquirer’s share price remains within a range of $30 to $34 per share.  This would be achieved by adjusting the number of acquirer shares exchanged for each target share (i.e., the number of acquirer shares exchanged for each target share increases if the acquirer share price declines toward the lower end of the range and decreases if the acquirer share price increases).  If the acquirer share price increases above $34 per share, target shareholders would receive 1.1765 shares of acquirer stock (i.e., $40/$34); if the acquirer share price drops below $30 per share, target shareholders would receive 1.333 shares of acquirer stock (i.e., $40/$30) for each target share they own.
 
The following table identifies the advantages and disadvantages of various types of collar arrangements.
 

Advantages and Disadvantages of Alternative Collar Agreements

Agreement Type

Advantages

Disadvantages

Fixed Share Exchange Agreement

Buyer: Number of acquirer shares to be issued known with certainty; minimizes potential for overpaying

Seller: Share exchange ratio known with certainty

Buyer: Actual value of transaction uncertain until closing; may necessitate renegotiation

 Seller  Same

Fixed Value Agreement

Buyer: Transaction value known; protects acquirer from overpaying

Seller: Transaction value known; prevents significant reduction in purchase price due to acquirer share price variation

Buyer: Number of acquirer shares to be issued uncertain

 
Seller: May have to reduce purchase price to get acquirer to fix value

Floating Collar Agreement

Buyer: Number of acquirer shares to be issued known within a narrow range

Seller: Greater certainty about share exchange ratio;

Buyer: Actual value of transaction subject to some uncertainty

 Seller: May have to reduce purchase price to get acquire to float exchange ratio

Fixed Payment Collar Agreement

Buyer: Reduces uncertainty about transaction value and potential for renegotiation

Seller: Same

Buyer: May still result in some overpayment

 
Seller: May still result in some underpayment
 

Collars May Preclude Renegotiation

 
Both the acquirer and target boards of directors have a fiduciary responsibility to demand that the merger terms be renegotiated if the value of the offer made by the bidder changes materially relative to the value of the target’s stock or if there has been any other material change in the target’s operations.  Merger contracts routinely contain “material adverse effects clauses,” which provide a basis for buyers to withdraw from or renegotiate the contract. For example, in 2006, Johnson and Johnson (J&J) demanded that Guidant Corporation, a leading heart pacemaker manufacturer, accept a lower purchase price than that agreed to in their merger agreement.  J&J was reacting to news of government recalls of Guidant pacemakers and federal investigations that could materially damage the value of the firm.
 

Renegotiation can be expensive for either party due to the commitment of management time and the cost of legal and investment banking advice.  Collar agreements protect the acquiring firm from ‘‘overpaying’’ in the event that its share price is higher or the target firm’s share price is lower on the effective date of the merger than it was on the day agreement was reached on merger terms. Similarly, the target shareholders are protected from receiving less than the originally agreed to purchase price if the acquirer’s stock declines in value by the effective date of the merger. If the acquirer’s share price has historically been highly volatile, the target may demand a collar to preserve the agreed upon share price. Similarly, the acquirer may demand a collar if the target’s share price has shown great variation in the past in order to minimize the potential for overpaying if the target’s share price declines significantly relative to the acquirer’s share price.

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