Spring 2022 Corporate Finance Final Exams on Acquisitions- Florida International University
During the acquisition of a company, what is the most appropriate method of gaining control?
- Assets of company
- Shares and shareholder loans
- Obtaining control via loans
- Obtaining control by subscription of new shares rather than purchase
- Management control
If the reason for making an acquisition is primarily to control a major asset and not for the business, it may be feasible to purchase that asset rather than the company which owns it.
A private company may well be established with a small share capital and subsequently funded by loans from shareholders or other related parties. This method has the advantage of minimizing any capital duty on the issue of new shares. It is also more flexible as the advance can be repaid without any question of reduction of capital or the need to have sufficient distributable reserves to declare dividends.
If a company capitalized in this way is being considered, it is important to ensure that the entire shareholders’ funds are purchased and not simply the share capital Calculations of value must be carried out on a consistent basis. Very often it is convenient not to charge interest on shareholder loans. This means that if the company is valued on an earnings basis, the valuation will correspond to the entire shareholders' funds, whether they are made up of share capital or loans or both. No question of repayment of loans to shareholders in addition to the purchase price can arise. On the other hand, if the loans have been treated on an arm's length basis and interest charged, then an earnings-based valuation will relate simply to the worth of the issued share capital. The repayment of any shareholder loans and the interest rate which they are to bear are matters to be considered separately.
In some countries, there may be no or a lower rate of transfer tax on the assignment of loans. There may therefore be considerable tax savings available by purchasing shareholder loans in such a way that the value attributed to the share capital of the company being acquired is reduced.
Particular care must be taken when a bank or financial company is being acquired. Part of the funding arrangements and deposit base may be tied to, or depend on, the outgoing management and shareholders. If, as is usual, a premium is being paid over net asset value, partly to reflect the value of the deposit base, it must be clear what deposits are likely to be withdrawn following the change of control. This is not only a question of value but of liquidity. The worst possible start to the acquisition of a financial institution is to suffer a loss of confidence and a run on deposits after a change of control.
It will sometimes be the case that a company's shareholders' funds have become largely irrelevant Where a company has encountered financial difficulty, the lenders to the company may have the effective control due to the erosion of the company's equity has Depending on the terms of the loans, it may be possible to acquire control by buying the benefit of the loan rather than by buying the shares For example, the terms of the loan may give the lender the right to take security over assets through a floating charge and to put in a receiver/manager to run the business. This would allow the prospective purchaser to control the company's affairs while an investigation is carried out as to whether deeper involvement is wise This can substantially reduce the risks involved in a purchase where quick action may be required to prevent liquidation of the company.
The terms of the loan may, by agreement of the board and the shareholders of the company, be amended to include the right of conversion into equity Alternatively, the prospective purchaser may be granted options to subscribe new equity in due course, thus enabling the acquiror to control the share capital if the equity proves to have a value. In the meantime, by purchasing the benefit of a loan, the acquiror can signal to the market that he is not committed to stand behind the obligations of the company. On occasions, a purchaser who becomes a major shareholder of a company is seen as having taken moral responsibility for the company overall. This can lead either to embarrassment if the company is subsequently allowed to fail or to financial loss if the purchaser feels obliged to support it.
If control of a company is available for purchase because of a shortage of capital. it is sensible to consider obtaining that control by an injection of new capital rather than a purchase of existing shares or loans. The company being acquired will no doubt require financial support in any case. It is more attractive for the purchaser to kill two birds with one stone by subscribing for sufficient new shares to obtain majority control while at the same time providing cash to the company. If shares are bought from existing shareholders, cash goes out of the system. The financial position of the company is not improved unless there is an agreement for the shareholders receiving the cash to support the company in some way. Because no existing shares are purchased, the new controlling shareholder may be able to obtain a waiver from making a general offer to all shareholders which would otherwise be required when control passes under the terms of the takeover code, in countries where a code operates. This procedure requires that existing shareholders are willing to retain their shares while being diluted by the new party. This may not be unrealistic as the original shareholders frequently prefer not to sell at a moment they may feel is the nadir of the company's fortunes.
Sometimes control can be obtained at a management level in a way which achieves the acquiror's purpose without any acquisition being made. A majority on the board of directors may be secured through a proxy fight without significant purchases of shares. The mere threat of a takeover bid or proxy fight may persuade the board of a company to accommodate the wishes of a third party.
This method is only really effective if control is desired to achieve a specific objective rather than for the overall financial benefits of owning the majority of the shares in a company. For example, a property developer eyeing a company with a large land bank may be perfectly content to secure a joint venture agreement over the development of that land. To acquire the company and assume responsibility for its business and employees is an unnecessary complication. The whole benefits of control to the developer can be achieved through one agreement.
An acquiror may choose to gain control of the company through its assets. State and explain some of the factors to consider when using this method to gain control.
Exam Solution: The factors to consider include the following:
- Simplicity
- Finance
- Taxation
The complications of acquiring an asset are less than those of acquiring a company. If a company is acquired, it is necessary to investigate all its assets and liabilities, including contracts it may have entered into and other actual or contingent obligations. On the other hand, it is usually possible to buy an asset such as a property or a ship by itself, without any entanglements.
Banks may be prepared to finance a higher percentage of the purchase price where they can take a direct charge over the asset than if their security is at one stage removed, through shares in a company. Interest costs may be lower, reflecting the bank's perception of lesser risk. Security documents are likely to be shorter and in a more standard form, decreasing legal fees and management time required.
Taxation implications may exert a deciding influence on the matter. In some countries, tax on the transfer of an asset is greater than tax on the transfer of shares Negotiations may be complicated, if the purchaser of an asset is table for all the transfer duty. In a transaction involving shares, buyer and seller usually split the duty payments equally.
The vendor's profits or income tax liability may be affected if the asset is sold rather than the company. On the other hand, if the purchaser buys the company. he must be aware that the cost of the asset in the company's books for tax purposes may be much lower (for example, because values have risen with inflation) than the value which is reflected in the price paid for shares. A provision for contingent tax should be included in the calculations of the value of the company This approach will not be possible where the attractiveness of an acquisition depends on the business connections of the company such as its suppliers, customers and other commercial relationships.
Discuss the different levels of control desired by acquirors during the purchase of a company.
Exam Solution: If an acquiror has decided to purchase a company rather than its assets, he should then consider whether he wishes or needs to control all the share capital of a company. On some occasions, a lesser amount will be sufficient.
- 100% control
- Partial control
The major advantage of owning the entire share capital of a company is flexibility in what can be done after the acquisition has been completed. Assets can be transferred or sold without having to consider the interests of minority shareholders. Funds can be channeled more easily to wherever they are needed. Future projects, business and costs can be allocated without the need to be fair to outside equity partners. Banks who have given financial support to fund an acquisition may place proportionately greater security value on the entire share capital of a company than on any lesser percentage.
If the company being acquired is a public company, the retention of minority shareholders may prove particularly burdensome. Some transactions will require the approval of shareholders in general meeting. The report and accounts and other documents have to be published and sent to shareholders. The annual general meeting has to be held in public, allowing questions to be raised by outside parties. Material transactions with the controlling shareholder may be criticized by minorities. The controlling shareholders themselves will be unable to vote on such transactions. If the minorities are hostile or become very small, the outcome of such meetings may be difficult to forecast.
As a consequence, it frequently happens that controlling shareholders eventually decide to buy out small minorities. This is done principally to reduce the level of disclosure required, to minimize administration costs and to consolidate the management of the company fully with its parent.
An an acquiror may not wish to purchase 100% of the share capital of the target company but rather may desire to gain partial control. Partial control usually relates to holdings of over 50% of the share capital.
What are some of the reasons that an acquiror may choose to gain partial control of a company instead of the full 100% control?
Exam Solution:
- Cost
- Commitment of management and other parties
- Gaining or retaining a listing
One obvious advantage of a partial purchase is that the total consideration to be paid is correspondingly lower. In some cases, it may simply not be possible for an acquiror to fund a purchase of 100%.
Even if finance is not a constraint, it may be desirable to leave key parties such as the team with a share in the business in order to provide them with a reason for staying on and an incentive in running the business. A purchaser may be particularly concerned at the prospect of losing senior executives soon after a takeover when its own capacity to replace them is likely to be low. The retention of a shareholding in outside hands also helps to preserve the image of independence. This may be desirable in the case of a group with a long tradition and a loyal customer base.
If the target company is publicly quoted, its listing may have been one attraction in making the acquisition. To retain the listing, it will be necessary to demonstrate that there remains a sufficient spread of shareholdings in public hands to ensure an adequate degree of marketability. In this case, it is advantageous if certain shareholders agree from the outset not to accept an offer or not to accept it for the entirety of their holdings.
The new controlling shareholder of a listed company may wish to retain the listing for essentially the same reasons as persuade shareholders to take a company public in the first place. The most relevant reasons in the context of an acquisition are to be able to use paper for future acquisitions through the newly acquired vehicle and to raise loans against the security of the shares. Unlisted shares are unlikely to be as acceptable to vendors of companies as consideration or to banks as security.
Partial control usually relates to holdings of over 50% of the share capital. The issue of voting at general meetings is not in doubt at least on matters which require a simple majority. In the case of a company with a wide spread of passive shareholders, effective control may be gained at a much lower shareholding level than 50%, provided that the new shareholder is able to obtain board representation and the appointment of key executives. This is reflected in the takeover codes of countries where such codes operate. The level of shareholding at which a general offer for a public company is required varies considerably but can be as low as 20% Partial control may be backed up by an option to purchase further shares (possibly all the remaining shares) at some later date. The attraction to a purchaser is that further time is allowed for investigation and increased familiarity with the company before a commitment to go the whole hog is made An option can also serve as a method of deferred purchase while eliminating the possibility that the vendors will sell their remaining shares to a third party In such cases, the option price may be subject to increase (or decrease).