Defence Mechanisms

Takeovers are announced practically every day, but announcing them doesn’t necessarily mean everything will go ahead as planned. In many cases the target company does not want to be taken over. What does this mean for investors? Everything! There are many strategies that management can use during M&A activity, and almost all of these strategies aim at affecting the value of stock in some way. Let’s take a look at some more popular ways that companies can protect themselves from an unruly predator. These are all types of what is referred to as “shark repellent”:

Golden Parachute

This measure discouraging an unwanted takeover offers lucrative benefits to top executives, who lose their job once their company is taken over by another firm. Benefits include items such as stock options, bonuses, severance pay, etc. Golden parachutes can be worth millions of dollars and can cost the firm a lot of money. This clause of payment is designed to counter the hostile takeover, by making it more expensive, as it involves paying more than what is usually a lump sum payment to such executives of target company.

The strategy is usually implemented in combination with other takeover defense strategies. The Golden Parachute’s primary function in a hostile takeover is to align incentives between shareholders and the executives of the target company, as generally there are concerns about executives who face a hostile takeover while risking loss of their jobs, oppose the bid even when it increases the value for shareholders.

Greenmail

A spin-off of the term blackmail, greenmail occurs when an unfriendly company holds a large block of stock, who then forces the target company to repurchase the stock at a substantial premium to prevent the takeover.

Macaroni Defense

This is a defensive strategy by which the target company issues a large number of bonds that come with the guarantee that they will be redeemed at a high price if the company is taken over. Why is it called Macaroni Defense? Because if a company is in danger, the redemption price of the bonds expands, kind of like Macaroni in a pot! This is a highly useful tactic, but the target company must be careful it doesn’t issue so much debt that it cannot make interest payments.

People Pill

Here, management threatens that in the event of a takeover, the entire management team will resign. This is especially useful if they are a good management team; losing them could seriously harm the company.

Poison Pill

With this strategy, the target company aims at making its own stock less attractive to the acquirer. There are two types of poison pills. The first is the “flip-in,” which allows existing shareholders (except the acquirer) to buy more shares at a discount. The second is the “flip-over,” which allows stockholders to buy the acquirer’s shares at a discounted price after the merger. If investors fail to take part in the poison pill by purchasing stock at the discounted price, the outstanding shares will not be diluted enough to ward off a takeover.

Sandbag

A “sandbagging” provision in a M&A agreement (asset purchase agreement, stock purchase agreement, or merger agreement) states that a buyer’s remedies against the seller under the agreement will not be impacted by whether or not the buyer had knowledge, prior to closing the deal, of the facts or circumstances giving rise to the claim. In other words, even if the buyer knew of the problem at hand―whether it be the company’s non-compliance with applicable laws, a breach of a customer contract, or other breach of a representation, warranty or covenant―it could decide to complete the acquisition with that knowledge, and then proceed against―or “sandbag”―the seller for recourse under the agreement.

Busted Takeover

A busted takeover is a highly leveraged corporate buyout that is contingent upon the selling off of some of the acquired company’s assets. A busted takeover occurs when an acquired company’s assets are sold in order to meet the cost of acquisition. The assets of the company being acquired may be used as collateral for the financing required for the deal to go through. Once the target company is acquired, some of its assets are sold in order to pay back a portion of the funds that the acquiring company used to finance the initial buyout. The acquiring company must properly evaluate the target company’s assets to confirm that the sale of the assets will adequately cover the debt.

Leveraged Buyout-LBO

A strategy involving the acquisition of another company using borrowed money (bonds or loans). The acquiring company uses its own assets as collateral for the loan in hopes that the future cash flows will cover the loan payments.

There is usually a ratio of 90% debt to 10% equity. Because of this high debt/equity ratio, the bonds are usually not investment grade and are referred to as junk bonds.

Debt Reckoning

Debt-leveraged companies have the hard task of paying their interest obligations out of a flat or declining level of income. Those firms that are unable to pay for their debt go bankrupt. Those that struggle to pay lose credit-worthiness and face further financing troubles down the road. Shrinking profits make debts that are otherwise manageable look horribly burdensome.

The debt-to-equity ratio offers one of the best pictures of a company’s leverage. The formula is straightforward – Total liabilities divided by total shareholders’ equity. Quite simply, the higher the figure, the higher the leverage the company employs. Notice that this ratio uses all liabilities (short-term and long-term), and all owners’ equity (both invested capital and retained earnings).

Here is one final warning to you : although the debt-to-equity ratio is a valuable number to examine, investors cannot focus only on it and without any other indicators. There are a number of frequently used debt ratios that show how much a company relies on debt financing. These include the debt ratio, the current ratio, interest coverage, etc. Together they vividly show how the amount of debt leverage can vary between healthy firms with low debt levels and plenty of cash to service it and troubled companies that are heavily leveraged and cash-poor.