**Section V FINANCIAL MANAGEMENT

In this part, we will examine the issues an investment banker deals with on a daily basis when assisting a company in its strategic decisions, which include:

  • organising a group;
  • launching an IPO (initial public offering);
  • selling assets, a subsidiary or the company;
  • merging or demerging;
  • restructuring and more.

We do hope that our readers will not spend whole nights on these topics, unlike investment bankers!

This section also sets out some ideas on the financing of start-ups. This might not be what investment bankers like doing most, unless they have to reinvent themselves as an entrepreneur, investor, or business angel!

As you will soon realise, financial engineering raises and solves many questions of corporate governance.

A really big adventure!

All groups were once upon a time start-ups, and some were even set up in such improbable places as a maid’s room (NRJ), a garage (HP) or a university dormitory (Facebook). The most talented of entrepreneurs, the luckiest, the hardest working, with the ability to learn from failures and with vision, will succeed in creating a group that survives, but the vast majority will fail. Fortunately, this fact does not prevent new entrepreneurs, every year, from embarking on this adventure. We’ve written this chapter for them so that they can avoid making bad financial choices that could put their entrepreneurial adventure in danger. As for anyone else who reads it, we hope that we’ll have sown a tiny seed which perhaps one day will grow into something bigger.

Section 40.1 FINANCIAL PARTICULARITIES OF THE COMPANY BEING SET UP

In our view, there are five:

1/ THE EXTREME VOLATILITY OF CAPITAL EMPLOYED, WHICH MEANS VERY HIGH RISK

Many entrepreneurs1 who launch businesses have an idea or a product or a service but do not yet have an economic model that would enable them to cover their costs and get a reasonable return on their capital invested. When Larry Page and Sergey Brin developed their algorithms that were to give rise to Google, their aim was to come up with a more efficient search engine than those already in existence. They were not sure that they would succeed and they had no idea of how they could make this tool pay. It was only some years later that the idea of associating advertising with searches was born, resulting in a particularly efficient economic model.

This fundamental uncertainty about the relevance of a concept and the ability to find a money-earning demand for it is not specific to the Internet sector. The same situation can be found in the fields of biotechnology, industrial innovation and new services, as well as in commerce.

This is the reason why only 34% of companies created in the US survive 10 years after their inception.

Source: Business Employment Dynamics Report, Bureau of Labor, 2021

Far from being linear, the development of a start-up2 goes through successive stages, which are all possible occasions for failure and/or a change in direction. An entrepreneur has an idea. Will they be able to raise the funds necessary for creating the prototype? If so, will it be possible to create functions that will give the product a competitive advantage? If so, will the entrepreneur find customers prepared to acquire the product at a price that more than covers costs? If so, will it be possible to shift to a mass-production phase without losing the quality of the prototype? If so, etc.

A “no” does not necessarily mean the end of the story, but perhaps a departure in a new direction after specific corrections have been made, or possibly having to go back to the drawing board. So new entrepreneurs have to be psychologically strong and have solid finances!

2/ THE CRUCIAL ROLE OF THE FOUNDER

An enterprise is often set up by one person (Marcel Dassault, Elon Musk, Richard Branson) or a small group of individuals who personally bear a very high level of risk, giving up a situation in which they are well established or renouncing the possibility of such a situation, for what for many of them will in the end turn out to be nothing more than a pipe dream. But they bring a project, a vision and a charisma that is indispensable for facing the unknown, adversity and challenges, and indispensable for convincing others (employees, investors) to follow them. Without the founder, the company would simply not exist.

From a financial point of view, a person starting up a company is the polar opposite of the ideal investor described by the CAPM in Chapter 19. The entrepreneur focuses on a single asset and takes all of the risks. The concept of diversification means nothing to them – it is all or nothing. They have a tiny chance of taking home the big prize and a huge risk of losing everything. But the entrepreneur does not reason in terms of probability like the financial manager does. Their aim is not financial (personal enrichment), but rather, and above all, humanistic (to create). They live in a completely different world.

The entrepreneur generally feels very passionate about their company – it is their creation – which is a far cry from the cold detachment of the financial manager for whom everything is just a question of risk and return. As we will see, this character trait of the entrepreneur is not without danger when their desire to control pushes them to take on too much debt or to put the brakes on the company’s growth.

3/ THE NEED FOR EXTERNAL FINANCING

Very few start-ups immediately generate positive cash flow. Most often, they initially make losses and some have to wait several years before they are able to record their first euro of sales. And when they do start recording positive earnings, investments (in fixed assets and working capital) are rarely fully covered by cash flows.

Since their free cash flow is negative, it is imperative that they find external financing, as generally the entrepreneur does not have sufficient assets to finance their adventure on their own.

4/ A MORE ACTIVE ROLE FOR INVESTORS

Investors hope that they have invested in the next unicorn (valuation greater than $1bn), centaur (valuation greater than $100m), or at the very least pony (valuation greater than $10m), while remaining aware that out of 10 investments that they make, seven to eight will yield nothing, one or two will earn a reasonable return and the tenth could earn 10 or 100 times the investment, saving all of the rest.

According to Cambridge Associates, the post-fee IRR of US venture capital funds is between 10 to 15% per year. Funds created in 2009 yield 20% in the upper quartile and only 5% in the lower quartile. The standard deviation is 12%.

Given that they are taking very high risks, they will monitor their investments very closely, providing the entrepreneur with advice and contacts to help steer the company in the right direction. The entrepreneur is very much in favour of a high level of involvement by investors as they bring what the entrepreneur lacks – experience, contacts, distance, advice on taking difficult decisions and … capital. The loneliness of the entrepreneur is not a myth.

Since the company will raise funds several times before it succeeds in generating positive cash flows, investors have every interest in ensuring that the company follows its road map so as to be able to form an opinion before it takes any decision to reinvest. Their close involvement alongside the manager is thus not disinterested. It is made a lot easier by the fact that, generally, there are not very many of them.

5/ A HIGHLY SPECULATIVE VALUATION WHICH IS THUS VOLATILE

Unsurprisingly, the extreme volatility of capital employed can be seen in the share price, even without the leverage effect, with very sharp share price variations. These variations are the sign of high risk that is specific to this stage of the company’s development. This is illustrated by the share price performances of Innate Pharma, a biotechnology start-up, and Sanofi, one of the world leaders in the pharmaceutical sector.

Innate Pharma was created in 1999 and has since then raised around €305m through ten capital increases. In June 2021, its market capitalisation stood at €234m, compared with €107bn for Sanofi.

Source: Euronext

The sudden changes in Innate Pharma’s share price indicate disappointing results or breakthroughs in its medical research programme.

Section 40.2 SOME BASIC PRINCIPLES FOR FINANCING A START-UP

1/ EQUITY CAPITAL, MORE EQUITY CAPITAL AND EVEN MORE EQUITY CAPITAL

When the economic model of the company is not clearly established and its exploitation does not require assets to be held which have a value that is independent of the activity (real estate, commercial lease), the only reasonable way for a company to finance itself is with equity capital.

Debt, because of the regular payment of interest and the repayment of capital, is quite unsuitable when cash flow is unpredictable and negative over an undetermined period. Entrepreneurs need time to test their products or services, correct errors, make adaptations in line with feedback from the first customers, drop 80% of what’s been done if necessary and head off in another direction. Entrepreneurs are completely wrapped up in their adventures and cannot allow themselves to be distracted or have their timeframes dictated by debt, ticking away like a time bomb.

We have seen too many talented entrepreneurs seeking to avoid being diluted in the capital of their companies by issuing too much debt too early. At this stage of the company’s development, the challenge is not to avoid dilution or to minimise it, but to demonstrate that the company is viable. Better to have a small stake in a company that has had the time it needs to prove that it is viable, than a large stake in a company that is heading for bankruptcy or whose liabilities have to be restructured, as in this case the entrepreneur dilution will be massive.

We cannot stress this point enough.

Once the economic model has been found and its viability has been more or less assured, the company can then take out debt.

It is only if the start-up uses assets whose value is independent of its activity – such as vehicles or equipment with a secondary market – that it can finance them partially using debt. This is the case in sectors like retail, transport and restaurants where business models are proven. The initial investment is often higher than in the Internet or personal services sectors. Debt then makes it possible to get sufficient financing together, which would be difficult using only equity. If this is the case, it should be as long-term as possible, ideally through a leasing agreement so as to avoid putting pressure on the entrepreneur.

This can also be the case for a company that needs to finance a large working capital for its growth. Thus, the use of factoring or discounting of receivables can enable a start-up to finance its growth.

2/ ONE OR SEVERAL ROUNDS OF FINANCING?

Between 1999 and 2020, Innate Pharma, the biotechnology start-up mentioned above, raised €305m in equity from venture capital funds or the public (it has been listed since 2006) in ten capital increases. One every two years. Wouldn’t it have been simpler to carry out a single capital increase of €305m in 1999, thus giving the company peace of mind with regard to its financing?

No. This would not have been in the interests of either the investors or the entrepreneur.

The former because they are reluctant to give the entrepreneur a blank cheque and will only give the financial resources necessary for getting to the next step of the entrepreneurial adventure: development of a prototype, opening and operation for a few months of the first store, reaching 100,000 members for a social network, etc. If the step is successfully reached, a new round of financing will be organised with the same investors and/or new ones, giving the company the financial resources necessary for reaching the next step. Here again, investors will most often only consider committing to a new round of financing if this new step is reached.

If the next step is not reached, investors will step in and decide whether any corrective measures introduced by the entrepreneur look like they are sufficiently solid to warrant continuing the adventure in this new direction and participating in a new (last?) round of financing. If not, the adventure will probably stop there.

This system using several rounds of financing enables investors to control the entrepreneur, to resolve potential conflicts of interest and to allocate their funds to the most promising projects. The interest for entrepreneurs, after an initial failure, is to persevere, come what may, as long as the funds that are being used are not being provided by them. The fear for investors would be that entrepreneurs get themselves into more and more difficulties, wasting funds that could be better used on other projects run by other teams. Here we can see the mechanisms of agency theory, discussed in Chapter 26.

For the entrepreneur, massive fundraising for forecasted financing requirements over several years of activities is not a panacea either. As the company has not yet proved anything – or very little – the issue price of shares is likely to be very low and the entrepreneur will be significantly diluted. On the other hand, in a succession of financing rounds, since each one marks the success of a step, the entrepreneur and the investors in the previous rounds will be in a good position to negotiate a higher share price at each round, thus limiting the dilution of the shareholders and also the entrepreneur.

3/ GOODWILL AT THE START OR AT THE EXIT?

Goodwill is the difference between the value of equity and the amount of equity invested. Its conceptual basis is the ability of the firm to generate, over a certain period, returns that are higher than those required by investors, given the risk (see Chapter 31).

The entrepreneur often considers that they are contributing the idea, the ability to implement the idea, and funds (although not a lot). Investors, for their part, only contribute funds. Accordingly, it will only seem logical to the entrepreneur to receive better treatment than the investors when shares and voting rights are being allocated, enabling them to retain a majority of voting rights in the project. This is why often, during the first round of financing, there is a higher issue price for shares for investors than for the founders. The difference is often considerable, especially if there is a lot of buzz around this new company. We’ve seen investors pay 100 times more for their shares than the entrepreneurs, which is a lot for a company that has yet to prove itself!

This practice is not without danger. As soon as the emerging company, after a few quarters of activity, is unable to stick to its roadmap and fails to meet its first targets, the question of a second round of financing is raised very quickly, while the funds raised in the first round are in the process of being totally depleted.

The relationship between the entrepreneur and the investors could deteriorate rapidly. The investors have made a capital loss because of the entrepreneur who has not delivered what was promised in the business plan, while the entrepreneur has made a capital gain thanks to the goodwill paid by the investors, who discover that there was no real foundation for this goodwill. Although all of the shareholders will have to get together to study how to get things back on track, and to correct or call into question all or part of the strategy implemented until now, there is the risk that any such meeting will be marred by a poisonous atmosphere. This can result in a deadlock at a time when it is vital that things keep moving.

The initial investors, unhappy with the situation, will then find it very difficult to agree to participate in a second round of financing, even though the subscription of new shares will enable them to lower the average cost price of their shares. They often prefer to accept their losses and dilution and move on to other opportunities, rather than go back to their investment committees to explain that they were wrong the previous time about the relevance of the concept and the price paid, but that this time, they’re right, even though the entrepreneur has just acknowledged a first failure. We are now no longer in the realm of pure rationality but have moved into the realm of behavioural finance! (See Section 15.6.)

Since our entrepreneur probably doesn’t have the resources to finance the new direction of the company, new investors will have to be found. The task of convincing them will be particularly arduous, as the signal sent by the failure of the initial investors to participate in this new round of financing is extremely negative. There is a high probability of this search for financing ending in failure. If the search for funds is fruitful, the shares in the second round of financing will be issued at a lower price than the initial round and the entrepreneur will then be massively diluted.

This is the lesser of two evils, because if the search for new investors yields no results, the entrepreneur will be forced to sell the company in very bad conditions, or to liquidate it, which is what happens most frequently.

We could consider, in order to avoid such situations, not asking investors to pay goodwill at the start during the first rounds of financing, but getting them to pay it when they exit, on the basis of the results achieved. Concretely, the shares would be issued when the company is set up, at the same price for all shareholders. Entrepreneurs will get investors to give them call options on a part of their new shareholding at a symbolic exercise price, or stock options, or warrants which will enhance the value of their shares in the future.

But there will be conditions to this enhancement – a given level of investor returns (IRR achieved in the event of sale or a new round of financing). Goodwill will then be paid by investors in the form of dilution of their rate of return, only if it is effectively delivered.

In the very likely event of something going wrong along the way, the situation can be looked at coolly and calmly by the initial shareholders who, since they have all paid the same price for their shares, will have the same interests at heart.

However, we won’t hide the fact that this will be difficult to accept for a passionate entrepreneur, who sees himself as a new Louis Vuitton or Jack Ma (Alibaba) and who hasn’t necessarily given the subject much thought.

More fundamentally, it raises the issue of the motivation and the incentive of the entrepreneur whose role in “their” company risks being symbolic, while the accretive instruments are not exercised, which will only happen in a few years. The risk is that they may consider themselves more as an employee than as an entrepreneur, and that would mean certain death for the emerging company! An entrepreneur should never behave like an employee. They should always be thinking about their project, night and day, like a soul possessed! Yes, we’re still in the realm of behavioural finance!

The whole question can be summed up as follows: “Goodwill, yes, but not too much”, so as to retain potential for enhancement of the share, capital increase after capital increase, and to avoid deadlocks or the implementation of ratchet clauses with disastrous effects for the entrepreneur. In the end, an overly optimistic business plan is not in the interests of entrepreneurs, who could find themselves sitting on a hand grenade from which they themselves have pulled the pin!

It should be noted that the creation of shares with multiple voting rights for founders makes it possible to raise large sums of money by circumventing this problem of dilution of power, whilst distinguishing it from goodwill.

Section 40.3 INVESTORS IN START-UPS

1/ INVESTORS IN EQUITY CAPITAL

The first among them is the entrepreneur, with their life savings, sometimes topped up by a bank loan that is secured by their home. They can spend the first months of the adventure with an incubator which will provide them with premises and services remunerated by a few percentage points of capital. The idea then becomes a project.

Friends and family are often among the initial investors, probably less motivated by the idea of making money, but more by loyalty! This type of investment is referred to as love money, which usually raises a few tens of thousands of euros.

Crowdfunding can be used by the entrepreneur to raise funds through specialised Internet platforms from a very large number of private investors, the most motivated of whom will invest a few hundred or a few thousand euros each. This will enable the entrepreneur to test the concept on a large scale. However, they will be lucky to raise a few hundred thousand euros in this way and struggle to raise more.

Business angels are often former company managers and shareholders. They invest a few tens or hundreds of thousands of euros per project, often called “seed money”. They also provide advice to the entrepreneur and give them access to their networks.

Venture capital funds can provide the entrepreneur with larger amounts of financing, from €0.5m to several tens of millions of euros (sometimes hundreds of millions), if the project has very high development potential.

Source: Business Employment Dynamics Report, Bureau of Labor, 2021

Some industrial groups have created internal investment funds (or joint funds for several groups in the same industry sector) with the dual aim of financing innovation and keeping a strategic watch on developments in their sector, such as Novartis, Intel, Pfizer, Orange, GE or Danone. In such cases, we refer to corporate venture.

The first round of financing from financial or industrial venture capital funds is called Series A, the second round is called Series B, the third round is called Series C, and so on.

Raising funds on the stock market by listing a company is a real possibility for companies, especially in the high-tech, Internet, biotech and medtech sectors.

Each type of investor plays a role at the different stages of the development of the young company:

Most often investors subscribe to shares, sometimes preferred shares, given the different rights that may be granted to them, as we shall see. While waiting for a financing round that is overdue, they may be led to subscribe to a bridge financing, often taking the form of bonds redeemable in shares based on a price that will be that of the next expected financing round, minus a more or less significant discount (15 to 30%) to encourage subscription when the value of the company is unclear. Paradoxically, these bonds are often called convertible bonds, which is an abuse of language since they cannot be redeemed in cash. Alternatively, warrants are sometimes issued for the same amount, giving the right to subscribe to the nominal amount of a variable number of shares at a discount when the financing round is completed.

2/ INVESTORS IN DEBT

There are practically no investors in debt prepared to finance start-ups and, as we saw in Section 40.2, it is not in the interest of the entrepreneur to take out debt until they have demonstrated the validity of their business model.

It is only if the start-up uses or generates assets that have a value that is independent of its operations (vehicles, real estate, business) that it can make use of leasing (see Chapter 21). If it generates sales, it can finance its working capital using discounting or factoring (Chapter 21). Companies with significant R&D expenses may factor their research tax credits. An unallocated bank loan (i.e. financing the company in general rather than specific assets) will only be found if the entrepreneur provides guarantees with a value that is independent of the project. In some countries, state bodies can guarantee loans granted by commercial banks to start-ups.

3/ OTHER SOURCES OF FINANCING

These are more marginal and are often a form of supplementary financing, like subsidies, repayable advances in the event of success, honour loans granted by associations or foundations, competitions for start-ups organised by local authorities or foundations, grants by local authorities, research tax credits, etc.

Section 40.4 THE ORGANISATION OF RELATIONSHIPS BETWEEN THE ENTREPRENEUR AND THE FINANCIAL INVESTORS

The relationship over time between the investors and the entrepreneur(s) is set out in the shareholders’ agreement signed at the time when the funds are handed over. See Chapter 41 for standard clauses of a shareholders’ agreement which are not used in the case of a start-up.

A shareholders’ agreement is the result of a negotiation and sets out the balance between demand for and supply of venture capital at the time that it is signed. It also reflects the power of attraction of a given start-up project or of a given entrepreneur.

1/ CLAUSES BINDING THE FOUNDER-MANAGERS

Any investor in a start-up will tell you that the main motivation behind the investment is the quality of the founding team. Accordingly, it is not surprising that investors set, as a condition for investing, the condition that the managers commit themselves fully and over the long term to this adventure. We also find clauses preventing the founders from holding other positions in other companies or from selling their shares during a certain period (lock-up); clauses that make provision for the loss of their shares and other incentives if they leave the company before a certain period (vesting), along with agreements not to compete; and clauses that give the company the intellectual property rights created by the founders.

Over and above the shareholders’ agreement, we also see mechanisms that create incentives for the founding managers, in such a way that even if they are heavily diluted by several capital increases, they remain highly motivated – stock options, call options, warrants, multiple voting rights, etc.

2/ CLAUSES THAT ARE THE CONSEQUENCE OF GOODWILL BEING PAID AT THE START

If goodwill was paid at the start, the investors will want to prevent the founders from selling the young company too soon, on the basis of a valuation that enables them to recover only a part of their investment while the founders could make a comfortable capital gain (see Exercise 2 for an illustration). In order to avoid this situation, provision can be made that the income from the sale of the company goes first to the investors, in the amount of their investment (sometimes capitalised using a minimum rate of return), and is then shared out between investors and founders whose interests are then aligned.

This provision, known as the preferential liquidity clause, is also used in the event of a resale or liquidation several years after the first round, to protect the most recent investors who have normally paid the highest price. A sale of the company at a price lower than the last round of financing might be convenient for the previous shareholders, including the founders, who have lower cost prices, but would put the most recent investors at a loss. To avoid this situation, and because they agree to pay a higher price thereby reducing the dilution of the current shareholders, the most recent investors will often ask for a preferential liquidity clause. However, in order to allow founders and investors from previous rounds of financing to be able to retrieve their funds even in the event of a low resale price, a partial equal distribution is most often included at the beginning along the following lines:

  • 20% of the price is usually shared pro rata among all shareholders, including the founders (“carve out”).
  • The remainder of the sale’s proceeds are allocated first to investors from the most recent fundraising round, until repayment of their investment, with returns possibly capitalised, and after deducting any amounts received in the first allocation.
  • Finally, the remainder (if any) is distributed to all the other shareholders (including the founders) in due proportion to their holdings.

This clause only comes into play if the sale (or liquidation) price is insufficient to allow the investors of the last round to recover their investment (sometimes with capitalisation), via a normal distribution of the proceeds of the sale in proportion to their holdings.

The preferential liquidity clause is undoubtedly a protection for investors against valuation inflation, at least until the next round of financing. It is also undoubtedly a factor in the valuation inflation of successful start-ups, as investors are less concerned about the level of valuation since they are protected from overvaluation. Current shareholders and founders accept it because it allows for higher, more flattering and less dilutive valuations, and because they hope that the company’s development will lead to a further increase in its value and that this clause will therefore not come into play.

The preferential liquidity clause tends to eliminate the ratchet clause, whose implementation dilutes management too massively. This clause allows investors in the first rounds to receive free shares in subsequent rounds of financing carried out at prices lower than their entry price (an illustration of this is provided in Exercise 4).

3/ CLAUSES RELATED TO THE LIQUIDITY OF THE INVESTMENT

There are different clauses that seek to ensure that investors are able to sell their stakes in such a way as to reap the benefits of their investment. This is, moreover, one of the stated aims of an investment fund, which itself is often required, at the latest when it is wound up, to distribute the income from its investments.

Accordingly, investors can get the founders to agree to the sale of all of their shares in the company after a certain period, if the majority shareholders have not provided them with sufficient liquidity for their investment. A sale of the majority of the shares will enable them to get a better price than if they had only offered a (generally) minority stake for sale (see Section 31.6). Having said that, implementing this clause is very difficult because if the entrepreneur doesn’t want to sell despite having pledged to, they will not be very convincing when trying to get a buyer to make an offer.

Very often, the investors want to be able to sell all or part of their shares before the founders sell theirs, in the case of an IPO or a planned sale by the founders. If they are not given this priority, they may ask for the option to sell the same percentage of their stakes as the founders in the event of a sale (tag-along clause) or if there is a change in control over the company. A drag-along clause is nearly always introduced to provide a group of majority shareholders representing a given percentage of the capital with the option of forcing the other shareholders to sell their shares on the same terms as those offered to them by a buyer. Such a buyer may condition its offer on obtaining all of the capital and in this case, the majority shareholders will not want to have to cope with being blackmailed by a minority shareholder.

4/ CLAUSES RELATED TO CONTROL BY INVESTORS OVER COMPANY DECISIONS

Demonstrating that they are keen to be more closely associated with the running of the young company and the risks that they are prepared to take, investors often require a level of information that is accurate, wide, frequent and adapted to the situation and the activity of the company.

Additionally, provision can be made that certain important decisions (such as modification of the articles of association (by-laws), hiring of key staff, modification of the company’s strategy, investments, acquisitions or disposals, etc.) can only be taken by a qualified majority, giving investors a de facto veto right.

Section 40.5 THE FINANCIAL MANAGEMENT OF A START-UP

There are two principles that underlie the financial management of a start-up: keep a very close watch on the cash position and plan the next round of fundraising very well.

Cash on the assets side of the balance sheet, when there is no monthly cash income, measures the number of months of survival of the company before it is obliged to carry out another round of fundraising. This is called the burn rate. How much time does the company have to reach its next step or to shift from plan A, which has failed, to plan B, which has to be invented and implemented?

Unless the existing shareholders have the financial resources necessary to cover the financing of the next round and agree to do so, the manager of the start-up would be well advised to launch the process of looking for new investors six to nine months at the latest before their cash runs out. Since a round of financing most often covers requirements for the next 12 to 24 months, it comes around quickly. The search for new investors and the conviction needed are very time-consuming, especially for a manager who doesn’t have a financial director to help them.

Launching a new round of financing early is often too early: the company has not yet shown that it has reached a new step in its development since the last round of fundraising. Waiting until later means taking the risk of running out of cash during the final phase of negotiations with investors, at the risk of having to admit defeat.

Section 40.6 THE PARTICULARITIES OF VALUING YOUNG COMPANIES

It is obviously very difficult to value a company that has not yet proved the relevance of its business model, which has a high probability of disappearing in the short term, and for which projections are so uncertain that sometimes one might ask whether they’re worth the paper they’re printed on.

One might thus think that the real option method seen in Chapter 30 is particularly well suited to valuing the young company because the way it works in stages is very similar to the successive stages of development that the young company must go through. In practice, this is not the case at all and it is practically never used in this field. Drawing up a business plan that makes sense and that is also optimistic is complicated, but asking an entrepreneur to draft different versions, including one which leads to bankruptcy, is counter-productive. Do we really want to demoralise and discourage the entrepreneur at a time when they need to be boosted in order to meet the challenges they are facing? Of course not!

Valuation by discounting free cash flows (see Chapter 31) is not very widespread, even though the basic raw material for this method, the business plan, is often available. In order to avoid using this method, investors raise the pretext of the extreme volatility of business plans for start-ups, given that there is very little chance of new companies sticking to them and the fact that they reflect the best of possible outcomes, rather than the most likely. Conceptually, though, there is nothing that prevents this method from being used by looking at the probabilities of several projections.

As for the multiples method (see Chapter 31), given that its use is conditional on the existence of comparable listed companies, it is de facto unusable for valuing very young companies, which are all different from each other and very rarely listed on the stock exchange. Additionally, the fact that most of them have negative earnings would render the operation impossible.

Our reader may be surprised by the very crude nature of the valuation of start-ups, which is more a matter of convention than of calculation. At least for its first rounds of financing, the value of a start-up usually results from a multiple of the amount of funds sought to reach the next level in 12 to 24 months, and/or what amounts to the same thing, the percentage of dilution that the founders agree to.

Practice has shown that a pre-money valuation (i.e. before the capital increase) of 1 to 1.5 times the amount sought is the sign of an unfavourable period for entrepreneurs corresponding to a relative scarcity of capital ready to invest at this stage of company development. In order to finance the next 12 to 24 months, entrepreneurs must be satisfied with 50% to 60% of the company’s capital. They will therefore very quickly lose control, as it is unlikely that there will be just one fund raising. Beyond four times, and the opposite happens and we’re probably in a bubble period. The entrepreneur then succeeds in selling only 20% at most of the share capital during this round of financing.

In normal times we are between 2 and 3, and the founders are diluted from 25% to 33% of the capital.

 Funds raised (m€)
Pre-money value (m€)0.511.522.53
12     
 33%     
1.531.5    
 25%40%    
2421.3   
 20%33%43%   
2.552.51.71.3  
 17%29%38%44%  
3 321.51.2 
  25%33%40%45% 
4 42.72.01.61.3
  20%27%33%38%43%
5 53.32.521.7
  17%23%29%33%38%
7.5  5.03.83.02.5
   17%21%25%29%
10   543.3
    17%20%23%

The table above shows in each box the multiplier coefficient of the fundraising round, and the level of dilution suffered by the founders (which also corresponds to the ownership percentage of investors). We have not filled in the boxes that seem to us to be outliers, where the founders lose control from the first round of investment, or where the valuation bubble stretches to the moon!

We remind our horrified reader that the risk to the investor at this very early stage is not overvaluation, but bankruptcy.

For start-ups that have survived and progressed to an advanced stage of development, venture capital professionals have developed a method that is rather pragmatic and efficient, if a bit simplistic, which they use for valuing young companies, known as the venture capital method. As you will see, it is a hybrid of the multiples and discounted free cash flow methods.

We start by estimating the probable value of the company’s equity in four to seven years, when it will have reached a level of maturity to allow it either to be listed or to be sold to a third party, most frequently an industrial player. This timeframe corresponds to the exit of the venture capitalist and to the fact that the company is no longer a start-up (hopefully) but a developing company. This future value is calculated by applying the P/E ratio today, observed for companies in this stage of development, to net earnings forecast in the business plan at this period (for more on the P/E ratio, see Chapter 22); for example, 15 times net earnings of €8m, i.e. €120m.

Secondly, and in order to determine the present value, this future value of equity is discounted to a value today, using a high discount rate since the company is at an early stage of its development.3 The rates most frequently observed are as follows:

PhaseDiscount rateEquivalent to multiply the investment byOver … years
Start-up (Seed)60%11.27
First round50% 7.65
Second round40% 3.84
Third round30% 2.23
Before IPO20% 1.42

So, for a pure start-up, with a business plan period of seven years, the value today of the equity is €120m / (1 + 60%)7 = €4.5m. This result is post-money as it assumes that the company has found the financing necessary for developing its activities. If today it needs €1.5m, the value of its equity is €4.5 – €1.5 = €3m. The investor who contributes these funds gets 33% (1.5 / 4.5) of the company’s equity. If the company’s capital is made up of a million shares, the investor will have to be issued with 500,000 new shares at a unit price of €3.

The reader will not be surprised at how high these rates are and will have difficulty reconciling them with those provided by the CAPM in Chapter 19 or with the average IRR obtained by venture capital funds (between 15% and 30%), and rightly so, as they are of another order.

If they appear to be high, it is because they integrate the risk of the start-up going bankrupt. They are applied to a level of earnings that does not correspond to the average of different scenarios, but to a business plan that reflects, by construction, the success of the company. However, over a five-year period, at least 40% of companies will have disappeared and out of those that are left, a large number will not have lived up to expectations. Accordingly, the high discount rate takes into consideration the risk that the projections will turn out to have been too optimistic, which is most often the case.

The rate of return required by the investor also takes into account the illiquidity of the investment (see Section 19.4) and also remunerates the non-financial contributions by the investor (operational or managerial advice, network access, etc.).

Our rather simplistic model assumes that a single round of fundraising was necessary before reaching a stage where the company could be sold or listed. Let’s assume that there is a second round of fundraising of €5m in year three. At the time of this fundraising, the post-money valuation of the company made by the second investor, who would require a rate of return of 40%, would be: €120m / (1 + 40%) = €31.2m, which results in a percentage for this second investor of 5 / 31.2 = 16%.

The terminal value remains €120m since it assumes, if it is to be achieved, a second round of fundraising. Our first investor will be diluted by this second capital increase. Accordingly, they thus need to hold a larger part of the capital after their contribution of funds, to set off the dilutive effect of the second capital increase and to obtain their rate of return of 60%. This stake is calculated as follows: 33% / (1 – 16%) = 39.3%. Instead of 500,000 new shares issued in the first round of financing, which would give 33% of the share capital to our first investor, 647,000 new shares4 should be issued. Since the latter is still bringing €1.5m to the table, this means that the shares are issued at a unit price of €1.5m / 0.647m = €2.32, and no longer €3, when there is no subsequent dilution.

If, in seven years’ time, the value of the company’s equity capital is indeed €120m, our first investor, who took a 39.3% stake in the capital when the company was started up, which was then diluted three years later to 33%, can sell their stake for €40m. For an investment of €1.5m made seven years earlier, they have, in fact, obtained their rate of return of 60% per year. As for the second investor who invested €5m in the third year and who got 16% of the capital, the sale of these shares in year seven for 16% × €120m = €19.2m gives them their required rate of return of 40% per year.

The venture capital method is also used backwards. A purchase price of shares is offered to you and you want to find the implicit rate of return of this investment if the business plan is met and given your estimation of the final value of the company. You then compare it with the minimum rate of return that you estimate is justified, given the risk of the investment, in order to take your investment decision. Here we find the IRR of Chapter 17.

Section 40.7 EXAMPLE INSPIRED BY A REAL CASE: EXAMPLE.COM

The simplified joint stock company Example SAS was set up eight years ago by two friends with the aim of developing a new-generation social network around the website Example.com, which offers a very powerful yet simple tool based on complex algorithms that had required years of development.

The first round of financing brought together friends and business angels, who contributed €0.6m. Dilution of capital was only 17% thanks to a high level of goodwill, since the managers only contributed €0.1m. This situation is explained by the following: in addition to the quality of the entrepreneurs, algorithms had been pre-developed, giving a clear idea of the development potential, a worldwide market was being targeted and ambitions were high, and finally the entrepreneurs had declined to be paid a salary during the first two years.

On the basis of the launch of the alpha version of the site Example.com one year later, which demonstrated that the algorithms were correct, Example SAS carried out a second capital increase of €1m, which was followed by the original investors, at a share price that was 50% higher. Because Example SAS was keen to speed up its development, which would involve increasing its losses and its working capital, it made the choice to carry out this capital increase relatively quickly, even though its cash position would have enabled it to defer it for a year. Sometimes it is better to stand fast than to run and to avoid financial stress that could have operational consequences. For example, it is easier to recruit a good IT developer when your cash can cover 24 months of cash burn rather than three!

A third capital increase was carried out one year later, which raised €1.9m. Five new investors (mainly business angels) participated in this capital increase alongside some of the original investors. The launch of the beta version of the site and the development of the community, which was growing at 30% per month, played a determining role in the success of this operation.

Example preferred to wait until the last moment to carry out its fourth capital increase, which at €6m was a large one, nearly double the equity raised previously. When it was finalised, Example SAS only had three months of cash left! The iPad version had just been launched with success and the community had reached 460,000 members, which works out at a monthly growth rate of 18%. The share price could thus be maximised: +40% compared with the capital increase carried out 18 months previously, resulting in dilution of only 30%, but growth in book equity of 1250%. This should be the last capital increase before profits start rolling in.

The funds raised enabled Example to test two revenue models, premium and advertising, which had been partially successful but which failed to lead to equilibrium. Four years later, a final capital increase of €2m was subscribed, at a price per share that was 60% lower than that of the previous capital increase. The challenge for Example will be to break into two new markets that are seen as buoyant markets – the university and the media markets. This is a shift that will require a resizing of the company and a change in profile for a large portion of its workforce. Initial results are promising.

Today, there are 3 million Example users worldwide, with 50% in the USA, 25% in France, and the rest of the world accounting for the last quarter. The two founders, who had brought 1% of the funds raised, hold 35% of the shares and the investors, who brought 99% of the funds, hold 65% of the shares.

SUMMARY

QUESTIONS

EXERCISES

ANSWERS

BIBLIOGRAPHY

NOTES

  1. 1   In this chapter we use the terms founder, creator or manager of a start-up as synonyms for entrepreneurs.
  2. 2   Synonym in this chapter for young company.
  3. 3   For more on discounting, see Chapter 16.
  4. 4   647,000 / (1,000,000 + 647,000) = 39.3%.

What a cast of characters!

Section 41.1 SHAREHOLDER STRUCTURE

Our objective in this section is to demonstrate the importance of a company’s shareholder structure. While the study of finance generally includes a clear description of why it is important to value a company and its equity, analysis of who owns its shares and how shareholders are organised is often neglected. Yet in practice this is where investment bankers often look first.

There are several reasons for looking closely at the shareholder base of a company. Firstly, the shareholders theoretically determine the company’s strategy, but we must understand who really has power in the company, the shareholders or the managers. You will undoubtedly recognise the mark of “agency theory”. This theory provides a theoretical explanation of shareholder–manager problems.

Secondly, we must know the objectives of the shareholders when they are also the managers. Wealth? Power? Fame? In some cases, the shareholder is also a customer or supplier of the company. In an agricultural cooperative, for example, the shareholders are upstream in the production process. The cooperative company becomes a tool serving the needs of the producers, rather than a profit centre in its own right. This is probably why many agricultural cooperatives are not very profitable.

Lastly, disagreement between shareholders can paralyse a company, particularly a family-owned company.

As a last word, do not forget, as seen in Chapter 26, that in the financial world everything has a price, or better, everything can create or destroy value.

1/ DEFINITION OF SHAREHOLDER STRUCTURE

The shareholder structure (or shareholder base) is the percentage ownership and the percentage of voting rights held by different shareholders. When a company issues shares with multiple voting rights or non-voting preference shares or represents a cascade of holding companies, these two concepts are separate and distinct. A shareholder with 33% of the shares with double voting rights will have more control over a company where the remaining shares are widely held than will a shareholder with 45% of the shares with single voting rights if two other shareholders hold 25% and 30%. A shareholder who holds 20% of a company’s shares directly and 40% of the shares of a company that holds the other 80% will have rights to 52% of the company’s earnings but will be in the minority for decision-taking. In the case of companies that issue equity-linked instruments (convertible bonds, warrants, stock options) attention must be paid to the number of shares currently outstanding versus the fully diluted number of potential shares.

Studying the shareholder structure depends very much on the company being listed or not. In unlisted companies, the equilibrium between the different shareholders depends heavily on shareholders’ agreements which are often in place, but rarely public and difficult to gain access to for the external analyst, impacting the relevancy of their analysis. For a listed company, shareholder attendance at previous general meetings should be analysed. If attendance has been low, a shareholder with a large minority stake could have de facto control, like Bolloré at Vivendi, in which it only has 29% of the voting rights.

Lastly, we should mention nominee (warehousing) agreements even though they are rarely used these days. Under a nominee agreement, the “real” shareholders sell their shares to a “nominee” and make a commitment to repurchase them at a specific price, usually in an effort to remain anonymous. A shareholder may enter into a nominee agreement for one of several reasons: transaction confidentiality, group restructuring or deconsolidation, etc. Conceptually, the nominee extends credit to the shareholder and bears counterparty and market risk. If the issuer runs into trouble during the life of the nominee agreement, the original shareholder will be loath to buy back the shares at a price that no longer reflects reality. As a result, nominee agreements are difficult to enforce. Moreover, they can be invalidated if they create an inequality among shareholders. We do not recommend the use of nominee agreements. The modern form for listed companies is the equity swap.1

2/ LEGAL FRAMEWORK

Theoretically, in all jurisdictions, the ultimate decision-making power lies with the shareholders of a company. They exercise it through the assembly of a shareholders’ Annual General Meeting (AGM). Nevertheless, the types of decisions can differ from one country to another. Generally, shareholders decide on:

  • appointment of board members;
  • appointment of auditors;
  • approval of annual accounts;
  • distribution of dividends;
  • changes in articles of association (i.e. the constitution of a company);
  • mergers;
  • capital increases and share buy-backs;
  • dissolution (i.e. the end of the company).

In most countries – depending on the type of decision – there are two types of shareholder vote: ordinary and extraordinary.

At an Ordinary General Meeting (OGM) of shareholders, shareholders vote on matters requiring a simple majority of voting shares. These include decisions regarding the ordinary course of the company’s business, such as approving the financial statements, payment of dividends and appointment and removal of members of the board of directors.

At an Extraordinary General Meeting (EGM) of shareholders, shareholders vote on matters that require a change in the company’s articles of association: share issues, mergers, asset contributions, demergers, share buy-backs, etc. These decisions require a qualified majority. Depending on the country and on the legal form of the company, this qualified majority is generally two-thirds or three-quarters of outstanding voting rights.

The main levels of control of a company in various countries are as follows:

 SupermajorityType of decision
Brazil1/2Changes in the objective of the company
Merger, demerger
Dissolution
Changes in preferred share characteristics
China2/3Increase or reduction of the registered capital
Merger, split-up
Dissolution of the company
Change of the company form
France2/3Changes in the articles of association
Merger, demerger
Capital increase and decrease
Dissolution
Germany3/4Changes in the articles of association
Reduction and increase of capital
Major structural decisions
Merger or transformation of the company
India3/4Merger
ItalyDefined in the articles of association
Netherlands2/3Restrictions in pre-emption rights
Capital reduction
Russia3/4Changes in the articles of association
Reorganisation of the company
Liquidation
Reduction and increase in capital
Purchase of own shares
Approval of a deal representing more than 50% of the company’s assets
SpainDefined in the articles of association
Switzerland2/3Changes in purpose
Issue of shares with increased voting powers
Limitations of pre-emption rights
Change of location
Dissolution
UK3/4Altering the articles of association
Disapplying members’ statutory pre-emption rights on issues of further shares for cash
Capital decrease
Approving the giving of financial assistance/purchase of own shares by a private company or, off market, by a public company
Procuring the winding up of a company by the court
Voluntarily winding up a company
USADefined on a state level and frequently in the articles of association

Shareholders holding less than the blocking minority (if this concept exists in the country) of a company that has another large shareholder with a majority, have a limited number of options open to them. They cannot change the company objectives or the way it is managed. At best, they can force compliance with disclosure rules, or call for an audit or an EGM. Their power is most often limited to being that of a naysayer. In other words, a small shareholder can be a thorn in management’s side, but no more. Nevertheless, the voice of the minority shareholder has become a lot louder and a number of them have formed associations to defend their interests. Shareholder activism has become a defence tool where the law had failed to provide one.

It should be noted that in some countries (Sweden, Norway, Portugal) minority shareholders can force the payment of a minimum dividend. In some countries, all shareholders, irrespective of the number of shares they hold, have the right to ask questions in writing at the General Meeting. The company must answer them publicly at the latest on the day of the meeting.

A shareholder who holds a blocking minority (one-quarter or one-third of the shares plus one share depending on the country and the legal form of the company) can veto any decision taken in an extraordinary shareholders’ meeting that would change the company’s articles of association, company objects or called-up share capital.

A blocking minority is in a particularly strong position when the company is in trouble, because it is then that the need for operational and financial restructuring is the most pressing. The power of blocking minority shareholders can also be decisive in periods of rapid growth, when the company needs additional capital.

The notion of a blocking minority is closely linked to exerting control over changes in the company’s articles of association. Consequently, the more specific and inflexible the articles of association are, the more power the holder of a blocking minority wields.

3/ THE DIFFERENT TYPES OF SHAREHOLDERS

(a) The family-owned company

By “family-owned” we mean that the shareholders have been made up of members of the same family for several generations and, often through a holding company, exert significant influence over management. This is still the dominant model in Europe. The following table shows the shareholder base of the 50 largest companies by market capitalisation in several countries (2021):

ShareholdingGermanySwitzerlandUSAFranceItalyUK
Widely spread50%54%84%43%20%82%
Family (and non-listed)20%32%14%31%38% 6%
State and local authorities10% 8% 0%14%22% 4%
Financial institution 2% 4% 0% 6%12% 6%
Other listed firms18% 2% 2% 6% 8% 2%

Source: Company data, FactSet.

However, this type of shareholder structure is on the decline for several reasons:

  • some new or capital-intensive industries, such as energy/utilities and banks require so much capital that a family-owned structure is not viable over the long term. Indeed, family ownership is more suited to consumer goods, retailing, services, processing, etc.;
  • financial markets have matured and financial savings are now properly rewarded, so that, with rare exceptions, diversification is a better investment strategy than concentration on a specific risk (see Section 18.6);
  • increasingly, family-owned companies are being managed on the basis of financial criteria, prompting the family group either to exit the capital or to dilute the family’s interests in a larger pool of investors that it no longer controls. This trend requires a nuanced view as, in recent years, certain young companies whose founders remain very important shareholders (Contentsquare, Doordash, Iliad, and so on) have taken up a prominent role within the economy.

Family shareholding sometimes reappears in the form of family offices, emanating from large industrial families (Desmarais in Canada, Quandt in Germany, Frère in Belgium, etc.) that invest in financial fundamentals, but with a much longer-term perspective than traditional funds.

Some research has demonstrated that family-owned companies register on average better performance than non-family-owned companies. Having most of your wealth in one single company or group is a strong incentive to properly monitor its managers or to act responsibly as its manager.

(b) Business angels

See Chapter 40.

(c) Private equity funds

Private equity funds, financed by insurance companies, pension funds or wealthy investors, play a major role. In most cases these funds specialise in a certain type of investment: venture capital, development capital, LBOs (see Chapter 47) or turnaround capital, which correspond to a company’s different stages of maturity.

Venture capital funds focus on bringing seed capital, i.e. equity, to start-ups to finance their early developments.

Development capital funds become shareholders of high-growth companies that require substantial funds.

LBO funds invest in companies put up for sale by a group looking to refocus on its core business or by a family-held group faced with succession problems, or help a company whose shares are depressed (in the opinion of the management) to delist itself in a public-to-private (P-to-P) transaction. LBO funds are keen to get full control over a company (but control can be exercised by 2 or 3 funds) in order to reap all of the rewards and also to make it possible to restructure the company as they think best, without having to worry about the interests of minority shareholders. Therefore, they usually prefer the target companies not to be listed (or to be delisted if the target was public), but the fund itself can be listed.

Turnaround funds work with distressed companies, helping them to turn themselves around.

Activist funds have made a speciality of putting public pressure on poorly performing or badly structured groups, proposing corrective measures to improve their value. In 2020, for example, Amber was proposing a complete overhaul of Lagardère’s board of directors, a change of strategy and the abandonment of the limited partnership status that protects the founder’s heir, who has not demonstrated the same qualities. This has been implemented in 2021.

Managed by teams of investment professionals whose compensation is largely linked to performance, these funds have a limited lifespan (no more than 10 years). Before the fund is closed, the companies that the fund has acquired are resold, floated on the stock exchange or the fund’s investments are taken over by another fund.

Some private equity funds take a minority stake in listed companies, a PIPE (private investment in public equity), helping the management to revitalise the company so as to make a capital gain. For example, in 2019, Searchlight Capital took a 26% stake in Latécoère and changed the CEO in 2020. In 2020–2021, the creation of SPACs by private equity funds allowed them to invest in companies on a minority basis when they went public using this technique.

Private equity funds play an important role in the economy and are a real alternative to a listing on the stock exchange. They solve agency problems by putting in place strict reporting from the management, which is incentivised through management packages and the pressure of debt (LBO funds).

They also bring a cash culture to optimise working capital management and limit capital expenditure to reasonably value-creating investments. Private equity funds are ready to bring additional equity to finance acquisitions with an industrial logic. They also bring to management a capacity to listen, to advise and to exchange, which is far greater than that provided by most institutional investors. They are professional shareholders who have only one aim – to create value – and they do not hesitate to align the management of companies they invest in with that objective.

(d) Institutional investors

Institutional investors are banks, asset managers, insurance companies, pension funds and unit trusts that manage money on behalf of private individuals. Most of the time they individually own minor stakes (less than 10%), but they play a much bigger role as they define the stock market price of companies in which they collectively represent the major part of their floating capital.

Because of new regulations on corporate governance (see Chapter 43), they vote at AGMs more frequently, especially to defeat resolutions they do not like, notably regarding excessive compensation.

(e) Financial holding companies

Large European financial holding companies such as Deutsche Bank, Paribas, Mediobanca, Société Générale de Belgique, etc. played a major role in creating and financing large groups. In a sense, they played the role of the (then-deficient) capital markets. Their gradual disappearance or mutation has led to the breakup of core shareholder groups and cross-shareholdings. Today, in emerging countries (Korea, India, Colombia), large industrial and financial conglomerates play their role (Samsung, Tata, Votorantim, etc.).

(f) Employee-shareholders

Many companies have invited their employees to become shareholders. In most of these cases, employees hold a small proportion of the shares, although in a few cases the majority of the shares. This shareholder group, loyal and non-volatile, lends a degree of stability to the capital and, in general, strengthens the position of the majority shareholder, if any, and of the management.

The main schemes to incentivise employees are:

  • Direct ownership. Employees and management can invest directly in the shares of the company. In LBOs, private equity sponsors bring the management into the shareholding structure to minimise agency costs.
  • Employee stock ownership programmes (ESOPs). ESOPs consist in granting shares to employees as a form of compensation. Alternatively, the shares are acquired by shareholders but the firm will offer free shares so as to encourage employees to invest in the shares of the company. The shares will be held by a trust (or employee savings plan) for the employees. Such programmes can include lock-up clauses to maintain the incentive aspect and limit flowback (see Section 25.2). In this way, the shares allocated to each employee will vest (i.e. become available) gradually over time.
  • Stock options. Stock options are a right to subscribe to new shares or shares held by the company as treasury stocks at a certain point in time.

For service companies and fast-growing companies, it is key to incentivise employees and management with shares or stock options, as the key assets of such companies are their people. For other companies, offering stock to employees can be part of a broader effort to improve employee relations (all types of companies) and promote the company’s image internally. The success of such a policy largely depends on the overall corporate mood. In large companies, employees can hold up to 10%. Lehman, the US investment bank, was one of the listed companies with the largest employee shareholdings (c. 25%) when it went into meltdown in 2008.

Regardless of the type of company and its motivation for making employees shareholders, you should keep in mind that the special relationship between the company and the employee-shareholder cannot last forever. Prudent investment principles dictate that the employee should not invest too heavily in the shares of the company that pays their salaries, because in so doing they, in fact, compound the “everyday life” risks they are running.2

Basically, the company should be particularly fast-growing and safe before the employee agrees to a long-term participation in the fruits of its expansion. Most often, this condition is not met. Moreover, just because employees hold stock options does not mean they will be loyal or long-term shareholders. The LBO models we will study in Chapter 47 become dangerous when they make a majority of the employees shareholders. In a crisis, the employees may be keener to protect their jobs than to vote for a painful restructuring. When limited to a small number of employees, however, LBOs create a stable, internal group of shareholders.

(g) Governments

In Europe and the USA, governments’ role as the major shareholders of listed groups is fading, even if they are still majority shareholders of large industry players (Deutsche Bahn, EDF, Enel) or playing a key role in some groups like Deutsche Telekom, Airbus or Eni. State ownership had a period of revival thanks to the economic crisis, as some groups were taken over to avoid collapse (General Motors, RBS) or funds were injected through equity issues to reinforce financial institutions (Citi, ING, etc.).

At the same time, sovereign wealth funds, mostly created by emerging countries and financed thanks to reserves from staples, are gaining importance as long-term shareholders. They are normally very financially minded, but their opacity, their size (often between €50bn and €500bn) and their strong connections with mostly undemocratic states are worrying to some. As of end 2020, they had c. $9,070bn under management, and slowly growing. The most well-known include The Government Pension Fund of Norway, Norges ($1,290bn), China Investment Company (CIC, $1,045bn), SAFE Investment Company and Hong Kong Monetary Authority ($978bn) from China, Abu Dhabi Investment Authority (ADIA, $745bn), GIC and Temasek in Singapore ($710bn), Kuwait Investment Authority (KIA, $562bn), etc. They are majority shareholders of a number of firms (Singapore Airlines, P&O, etc.) and minority shareholders in some listed firms such as the London Stock Exchange, Glencore, KKR, Carlyle, Foncia, etc.

(h) Crossholdings

Crossholdings peaked before the 1990s when capitalism was often capital-less. Today, the very few examples (Renault owns 43% of Nissan, which owns 15% of Renault, Spotify owns 9% of Tencent Music, which owns 7.5% of Spotify) are there to promote industrial synergies, or even to prepare for a closer future relationship, and not for financial or power reasons.

4/ SHAREHOLDERS’ AGREEMENT

Minority shareholders can protect their interests by crafting a shareholders’ agreement with other shareholders.

A shareholders’ agreement is a legal document signed by several shareholders to define their future relationships. It complements the company’s articles of association. Most of the time, the shareholders’ agreement is confidential except for listed companies in countries which require its publication in order for it to be valid.

They mainly contain two sets of clauses:

  • clauses that organise corporate governance: breakdown of directors’ seats, the nomination of the chairperson, of the CEO, of the auditors; how major decisions are taken, including capex; financing, acquisitions, share issues, dividend policy; how to vote during annual general meetings; what kind of information is disclosed to shareholders, etc.;
  • clauses that organise the sale or purchase of shares in the future: lock-up, right of first refusal if one shareholder wants to exit, drag-along (to force the disposal of 100% of the shares if the majority shareholders or several shareholders holding a majority stake between them wish to exit) or tag-along (to allow minority shareholders to benefit from the same transaction conditions if the majority shareholder is selling), caps and floors, etc.
  • For shareholders’ agreement on start-ups, please see Section 40.4.

Section 41.2 HOW TO STRENGTHEN CONTROL OVER A COMPANY

Defensive measures for maintaining control of a company always carry a cost. From a purely financial point of view, this is perfectly normal: there are no free lunches!

With this in mind, let us now take a look at the various takeover defences. We will see that they vary greatly depending on the country, on the existence or absence of a regulatory framework and on the powers granted to companies and their executives. Certain countries, such as the UK and, to a lesser extent, France and Italy, regulate anti-takeover measures strictly, while others, such as the Netherlands and the USA, allow companies much more leeway.

Broadly speaking, countries where financial markets play a significant role in evaluating management performance, because companies are more widely held, have more stringent regulations. This is the case in the UK and France.

Conversely, countries where capital is concentrated in relatively few hands have more flexible regulation. This goes hand in hand with the articles of association of the companies, which ensure existing management a high level of protection. In Germany, half of the seats on the board of directors are reserved for employees, and board members can be replaced only by a 75% majority vote.

Paradoxically, when the market’s power to inflict punishment on companies is unchecked, companies and their executives may feel such insecurity that they agree to protect themselves via the articles of association. Sometimes this contractual protection is to the detriment of the company’s welfare and of free market principles. This practice is common in the US.

Defensive measures fall into four categories:

  • Separate management control from financial control:
    • different classes of shares: shares with multiple voting rights and non-voting shares;
    • holding companies;
    • limited partnerships.
  • Control shareholder changes:
    • right of approval;
    • pre-emption rights.
  • Strengthen the position of loyal shareholders:
    • reserved capital increases;
    • share buy-backs and cancellations;
    • mergers and other tie-ups;
    • employee shareholdings;
    • warrants.
  • Exploit legal and regulatory protection:
    • regulations;
    • voting caps;
    • strategic assets;
    • change-of-control provisions.

In order to defend itself, a company must know who its shareholders are. This is relatively easy for unlisted companies for which shares must be nominative, but a lot more complicated for listed companies, where most of the shares are bearer shares (the identity of the shareholder is unknown to the company). In this way, some companies are able to make provision for the notification obligation, set out in the articles of association, when a minimum threshold (0.5%, for example) of the share capital has been breached, which is in addition to statutory obligations starting at 3 or 5% in most countries (see Section 45.3).

1/ SEPARATING MANAGEMENT CONTROL FROM FINANCIAL CONTROL

(a) Different classes of shares: shares with multiple voting rights and non-voting shares

As an exception to the general rule, under which the number of votes attributed to each share must be directly proportional to the percentage of the capital it represents (principle of one share, one vote), companies in some countries have the right to issue multiple-voting shares or non-voting shares.

In the Netherlands, the USA, Luxembourg, and the Scandinavian countries, dual classes of shares are not infrequent. The company issues two (or more) types of shares (generally named A shares and B shares) with the same financial rights but with different voting rights.

French corporate law provides for the possibility of double-voting shares but, contrary to dual-class shares, all shareholders can benefit from the double-voting rights if they hold the shares for a certain time.

Multiple-voting shares can be particularly powerful; for example, the founders of Alphabet (ex. Google) have 53.1% of voting rights of Alphabet while they hold only 11.6% of the shares. Ford, Snap, Lyft, Facebook, and Roche, have also put in place this type of capital structure. These dual-class shares can appear as unfair and contrary to the principle that the person who provides the capital gets the power in a company. Some countries (Italy, Spain, Belgium and Germany) have outlawed dual-class shares.

(b) Holding companies

Holding companies can be useful but their intensive use leads to complex, multi-tiered shareholding structures. As you might imagine, they present both advantages and disadvantages.

Suppose an investor holds 51% of a holding company, which in turn holds 51% of a second holding company, which in turn holds 51% of an industrial company. Although they hold only 13% of the capital of this industrial company, the investor uses a cascade of holding companies to maintain control of the industrial company.

A holding company allows a shareholder to maintain control over a company, because a structure with a holding disperses the minority shareholders. Even if the industrial company were floated on the stock exchange, the minority shareholders in the different holding companies would not be able to sell their stakes.

Maximum marginal personal income tax is generally higher than income taxes on dividends from a subsidiary. Therefore, a holding company structure allows the controlling shareholder to draw off dividends with a minimum tax bite and use them to buy more shares in the industrial company.

Technically, a holding company can “trap” minority shareholders; in practice, this situation often leads to an ongoing conflict between shareholders. For this reason, holding companies are usually based on a group of core shareholders intimately involved in the management of the company.

A two-tiered holding company structure often exists, where:

  • a holding company controls the operating company;
  • a top holding company holds the controlling holding company. The shareholders of the top holding company are the core group. This top holding company’s main purpose is to buy back the shares of minority shareholders seeking to sell some of their shares.

Often, a holding company is formed to represent the family shareholders prior to an IPO.

(c) Limited share partnerships (LSPs)

A limited share partnership is a company where the share capital is divided into shares, but with two types of partners:

  • several limited partners with the status of shareholders, whose liability is limited to the amount of their investment in the company. A limited share partnership is akin to a public limited company in this respect;
  • one or more general partners, who are jointly liable, to an unlimited extent, for the debts of the company. Senior executives of the company are usually general partners, with limited partners being barred from the executive suite.

The company’s articles of association determine how present and future executives are to be chosen. These top managers have the most extensive powers to act on behalf of the company in all circumstances. They can be fired only under the terms specified in the articles of association. In some countries, the general partners can limit their financial liability by setting up a (limited liability) family holding company. In addition, the LSP structure allows a change in management control of the operating company to take place within the holding company. For example, a father can hand over the reins to his daughter, while the holding company continues to perform its management functions.

Thus, theoretically, the chief executive of a limited share partnership can enjoy absolute and irrevocable power to manage the company without owning a single share. Management control does not derive from financial control as in a public limited company, but from the stipulations of the by-laws, in accordance with applicable law. Several large listed companies have adopted limited share partnership form, including Merck KGaA, Henkel, Michelin and Hermès.

(d) Non-voting shares

Issuing non-voting shares is similar to issuing dual-class shares because some of the shareholders will bring capital without getting voting power. Nevertheless, issuing non-voting shares is a more widely spread practice than issuing dual-class shares. Actually, in compensation for giving up their voting rights, holders of non-voting shares usually get preferential treatment regarding dividends (fixed dividend, higher dividend compared to ordinary shares, etc.). Accordingly, non-voting (preference) shares are not perceived as unfair but as a different arbitrage for the investor between return, risk and power in the company. For more, see Section 24.3.

2/ CONTROLLING SHAREHOLDER CHANGES

(a) Right of approval

The right of approval, written into a company’s articles of association, enables a company to avoid “undesirable” shareholders or shift the balance between shareholders. This clause is frequently found in family-owned companies or in companies with a delicate balance between shareholders. The right of approval governs the relationship between partners or shareholders of the company; be careful not to confuse it with the type of approval required to purchase certain companies (see below).

Technically, the right of approval clause requires all partners to obtain the approval of the company prior to selling any of their shares to a third party, or to another shareholder if explicitly provided for in the approval clause. The company must render its decision within a specified time period. If no decision is rendered, the approval is deemed granted.

If it refuses, the company, its board of directors, executive committee, senior executives or a third party must buy back the shares within a specified period of time, or the shareholder can consummate the initially planned sale.

The purchase price is set by agreement between the parties, or in the event that no agreement is reached, by independent appraisal.

Right of approval clauses might not be applied when shares are sold between a shareholder, their spouse or their immediate family and descendants.

Most of the time, right of approval clauses for listed companies are prohibited as they run contrary to the fluidity implied in being a public company.

(b) Pre-emption rights

Equivalent to the right of approval, the pre-emption clause gives a category of shareholders or all shareholders a priority right to acquire any shares offered for sale. Companies whose existing shareholders want to increase their stake or control changes in the capital use this clause. The board of directors, the chief executive or any other authorised person can decide how shares are divided amongst the shareholders.

Technically, pre-emption rights procedures are similar to those governing the right of approval.

Most of the time, pre-emption rights do not apply in the case of inherited shares, liquidation of a married couple’s community property, or if a shareholder sells shares to their spouse, immediate family or descendants.

Right of approval and pre-emption rights clauses constitute a means of controlling changes in the shareholder structure of a company. If the clause is written into the articles of association and applies to all shareholders, it can prevent any undesirable third party from obtaining control of the company. These clauses cannot block a sale of shares indefinitely, however. The existing shareholders must always find a solution that allows a sale to take place if they do not wish to buy.

3/ STRENGTHENING THE POSITION OF LOYAL SHAREHOLDERS

(a) Reserved share issues

In some countries, a company can issue new shares on terms that are highly dilutive for the existing shareholders. For example, to fend off a challenge from the newspaper group Gannet, the Tribune Publishing group (publisher of The Chicago Tribune and The Los Angeles Times) issued 13% of its share capital in May 2016 to Patrick Soon-Shiong, placing the billionaire as Tribune’s second-largest shareholder.

The new shares can be purchased either for cash or for contributed assets. For example, a family holding company can contribute assets to the operating company to strengthen its control over this company.

(b) Mergers

Mergers are, first and foremost, a method for achieving strategic and industrial goals. As far as controlling the capital of a company is concerned, a merger can have the same effect as a reserved capital increase, by diluting the stake of a hostile shareholder or bringing in a new friendly shareholder. We will look at the technical aspects in Chapter 46.

The risk, of course, is that the new shareholders, initially brought in to support existing management, will gradually take over control of the company.

(c) Share buy-backs and cancellations

This technique, which we studied in Chapter 37 as a financial technique, can also be used to strengthen control over the capital of a company. The company offers to repurchase a portion of outstanding shares with the intention of cancelling them. As a result, the percentage ownership of the shareholders who do not subscribe to the repurchase offer increases. In fact, a company can regularly repurchase shares. For example, Bic and Norilsk Nickel have used this method several times in order to strengthen the control of large shareholders.

(d) Employee shareholdings

Employee-shareholders generally have a tendency to defend a company’s independence when there is a threat of a change in control. A company that has taken advantage of the legislation favouring different employee share-ownership schemes can generally count on a few percentage points of support in its effort to maintain the existing equilibrium in its capital. In 2007, for example, the employee-shareholders of the construction group Eiffage rallied behind management in its effort to see off Sacyr’s rampant bid.

(e) Warrants

The company issues warrants to certain investors. If a change in control threatens the company, investors exercise their warrants and become shareholders. This issue of new shares will make a takeover more difficult, because the new shares dilute the ownership stake of all other shareholders. The strike price of the warrant is usually very attractive but the warrants can only be exercised if a takeover bid is launched on the company.

This type of provision is common in the Netherlands (ING or Philips), France (Peugeot, Bouygues) and the US. In 2018, both Bouygues’ and Peugeot’s AGM authorised their boards to issue such warrants should they find it necessary.

4/ LEGAL AND REGULATORY PROTECTION

(a) Regulations

Certain investments or takeovers require approval from a government agency or other body with vetoing power. In most countries, sectors where there are needs for specific approval are:

  • financial institutions;
  • activities related to defence (for national security reasons);
  • media;
  • etc.

Golden shares are special shares that enable governments to prevent another shareholder from increasing its stake above a certain threshold, or the company from selling certain of its assets (Distrigas, Telecom Italia, Eni are some examples).

(b) Voting caps

In principle, the very idea of limiting the right to vote that accompanies a share of stock contradicts the principle of “one share, one vote”. Nevertheless, in some countries, companies can limit the vote of any shareholder to a specific percentage of the capital. In some cases, the limit falls away once the shareholder reaches a very large portion of the capital (e.g. 50% or 2/3).

For example, Danone’s articles of association stipulate that no shareholder may cast more than 6% of all single voting rights and no more than 12% of all double voting rights at a shareholders’ meeting, unless they own more than two-thirds of the shares. Voting caps are commonly used in Europe, specifically in Switzerland (12 firms out of the 50 largest use them), France, Belgium, the Netherlands and Spain. Nestlé, Total, and Novartis all use voting caps.

This is a very effective defence. It prevents an outsider from taking control of a company with only 20% or 30% of the capital. If they truly want to take control, they have to “up the ante” and bid for all of the shares. We can see that this technique is particularly useful for companies of a certain size. It makes sense only for companies that do not have a strong core shareholder.

(c) Strategic assets (poison pills)

Strategic assets can be patents, brand names or subsidiaries comprising most of the business or generating most of the profits of a group. In some cases the company does not actually own the assets but simply uses them under licence. In other cases these assets are located in a subsidiary with a partner who automatically gains control should control of the parent company change hands. Often contested as misuse of corporate property, poison pill arrangements are very difficult to implement, and in practice are generally ineffective. In 2021, Suez tried to fend off Veolia’s bid by housing its French water business in a foundation in the Netherlands to make it non-transferable.

(d) Change-of-control provisions

Some contracts may include a clause whereby the contract becomes void if one of the control provisions over one of the principles of the contract changes. The existence of such clauses in vital contracts for the company (distribution contract, bank debt contract, commercial contract) will render its takeover much more complex.

Some “golden parachute” clauses in employment contracts allow employees to leave the company with a significant amount of money in the event of a change of control, which consequently has a dissuasive effect.

Section 41.3 STOCK MARKET OR INVESTMENT FUND SHAREHOLDING?

The disenchantment with stock markets and the rise of unlisted investments is a fundamental trend that is not about to stop. While the number of listed companies worldwide has stagnated since 2015 at just over 50,000, in the United States it has been declining since 1997, now less than half the number of the companies listed on the stock exchange as in 1997.

 

Source: Data from World Federation of Exchanges

As nature abhors a vacuum and with companies less attracted by the stock market, investment in unlisted, or private, equity is growing apace. Its precise definition is unclear and differs from one source to another. Let’s say that it covers all investments made through investment funds in unlisted companies or companies that become unlisted on that occasion, or in unlisted assets (such as real estate or natural resources).

Preqin estimates that private equity funds raised in 2020 amounted to $989bn significantly higher than pre-2008 records:

Source: Data from Preqin, quoted in ‘Global private equity report 2021’, Bain & Company

Even if 2020 was a record year for IPOs ($353bn), the funds provided by private equity remain much higher.

1/ THE ORIGIN OF INVESTMENT FUNDS

The origins of unlisted investment in its modern form can be traced back to the United States when, after the Second World War, a Harvard management professor, Georges Doriot, set up the world’s first venture capital company, AR&D, in the Boston area. With funds provided in particular by the John Hancock insurance company and MIT, AR&D financed DEC from its beginnings in 1957, which was a huge success and became the second largest computer manufacturer in the world before its takeover in 1999 by Compaq, which itself merged with HP in 2002.

In the United Kingdom, private equity initially took the form of minority investments to help SMEs or second tier companies to grow and turn into groups. The unlisted, fund-managed sector developed later in continental Europe, where development capital had been pre-empted at the beginning of the 20th century by listed financial companies, the best known of which were Mediobanca, Paribas, Suez, Générale de Belgique, Deutsche Bank, Commerzbank, etc.

Then in the 1980s, a genetic mutation took place in the world of unlisted investing with the appearance and then the development of LBO funds3 taking full control of a target, a new occurrence as unlisted investing had previously limited itself to minority stakes. The refocusing of listed groups, spurred on by the development of the concept of value creation, the end of the large conglomerates (General Electric plc, Saint-Gobain, ITT, etc.), and the succession of family businesses created in the immediate post-war period, provided a breeding ground for the development of this new form of private equity.

The long phase of falling interest rates and the correlative rise in valuation multiples (which favours financial performance), the renewed motivation of the managers of acquired divisions (often managed very loosely) through management packages, and the focus on cash and profitability, combined with the leverage effect of debt, explain the very high returns on investment that attract and retain investors. Over the years, the success of LBOs has been considerable, so much so that for many, private equity has become synonymous with LBO funds. From being a temporary lock between a family shareholder or a division of a group and the stock market or another group, LBOs have become a means of long-term ownership of companies with the development of secondary and tertiary LBOs, etc., such as Optven for example.

Buoyed by their success, some of the historical LBO funds (KKR, Blackstone, Apollo, Ardian, etc.) are expanding their activities to include investments in private debt, infrastructure, development capital, venture capital, real estate, distressed companies, natural resources, minority stakes in listed companies, etc. As a result, McKinsey estimates that in 2019 private equity, in its broadest sense, will manage $6,500bn, up 12% over 2018.

Although it has been growing since 2002 at twice the rate of world market capitalisation, and has multiplied its outstandings by more than seven since then, the unlisted market still represents only around 7% of world market capitalisation ($109,210bn at the end of 2020), compared with half as much in 2000.

Although this share may seem small, we no longer meet investors today who say they are not interested in private equity. On the contrary, most want to increase the proportion of their assets allocated to this type of investment, which has now become mainstream.

So much so that a number of major investors, sovereign wealth funds, family offices and pension funds have developed their own tools and structures for investing in the unlisted market in a traditional manner.

2/ THE GROWING COMPLEXITY OF LIFE ON THE STOCK MARKET

Market windows are periods when the stock market felt able to subscribe to capital increases or to welcome new recruits into its ranks. Outside those ranks, there was no salvation and the only thing to do was wait. Hence sometimes after a few months of preparing a financial transaction, it has to be cancelled on the eve of the launch! All this because a competitor’s quarterly results are 2% below expectations and its share price has fallen 10–15%, or because a central bank has not announced the expected quarter-point drop in its refinancing rate. You have to have nerves of steel and have your plan B ready.

Most listed companies with a market capitalisation below €1bn are not covered by analysts or are only included in studies that paraphrase their publications. The rise of passive management4 (around 20% of assets under management in Europe and 45% in the United States), which simply duplicates an index without basing its investment choices on financial analysis, is the primary reason. The Mifid II Directive, which came into force in Europe in 2018, by seriously reducing the quantity, or even quality, of research published on listed companies, has reinforced this trend. The share of transactions taken by high-frequency trading (HFT), which can exceed 50% of volumes, increases the suspicion that prices are disconnected from companies’ actual performance.

Source: Data from Company data, FactSet

While it seems to us to be completely unjustified to claim that stock markets are affected by short-termism, or that listed companies are affected by propagation of this defect,5 the fact remains that:

  • Business life is often a succession of setbacks, of changes in strategy necessary for survival or of seizing opportunities. When you’re listed, it’s hard to escape a 10–20% drop in price in one day, which is not always justified. It’s hard not to think that some people sell first and think later. While this decline will be corrected over time, managing the effect on employee morale is an extra task.
  • Governance of listed companies has improved significantly over the years6 and is often of better quality than governance of family businesses, cooperatives or subsidiaries of groups. However, it is still often marked by complacency with independent directors chosen de facto and de jure by the majority shareholder or manager. There is not always sufficient debate and challenging of ideas. And poor governance sooner or later has consequences for the company’s operations.
  • There are fewer and fewer shareholders with whom the managers of listed companies can discuss strategy and figures, since some shareholders simply duplicate a stock market index and others often delegate to agencies the task of studying meeting resolutions.
  • The stock market allows you to vote with your feet (by selling your securities) when you disagree with a strategy or with the execution thereof. But sometimes a manager or a team just has to be replaced and this often happens too late in the day when there aren’t any strong voices on the board of directors or among the shareholders of a listed company.
  • A listed company may find it difficult to take on debt beyond the levels accepted on the stock exchange (say more than 3 times EBITDA), and it may not always be the right time for the desired capital increase. In short, the “easy” financing that comes with being listed may be somewhat theoretical.
  • To be listed is to be on a market and to be subject to its fluctuations (market risk), sometimes independently of a company’s actual health.

3/ INVESTMENT FUNDS HAVE TAKEN CARE OF THEIR WEAK POINTS AND KEPT THEIR STRONG POINTS

In recent years, private equity funds have been working on their weak point: the illiquidity of their securities, which corresponds most closely to the maturity of their funds. This is a bit like squaring the circle, because how do you allow investors to exit a fund before it matures, while at the same time allowing the fund to have the time it needs to create value in its holdings by improving margins, digital transformation, acquisition and integration of competitors?

Faced with this need, unlisted funds have specialised in or have created funds specialising in secondary transactions (such as Ardian in Europe) to buy all or part of their shares from private equity investors before the normal maturity of the funds. This provides liquidity to those who need it, in amounts that are constantly increasing and that reached $87bn in 2020.

An investor in an unlisted fund can sell its shares in an LBO fund at a discount of less than 5% of the estimated value, about 10% for a fund invested in real estate and 15–20% for a venture capital fund with much more volatile assets. These levels are well below the discounts we see for listed conglomerates or investment companies.

At the same time, private equity funds have not let their guard down on their strong points:

  • They continue to have their own mode of governance7 which constitutes a real competitive advantage. Unlike investors in listed companies, that hold very small minority stakes in scores (or even hundreds) of listed companies, whose managers they see only occasionally, private equity fund managers monitor only a few investments, which gives them a degree of understanding of these companies that facilitates intense and regular dialogue with their managers – fruitful discussions between informed people. The strategy is then better defined and controlled. In addition, management packages offered to the managers of the companies in which they invest, combine the carrot and the stick to align their interests with the progression of the company’s value that they and their teams will create;
  • They continue to offer risk-adjusted rates of return, after manager compensation, that are on average at least equal to those of listed investments, with the best of them well above. For example, the French private equity industry reports an average rate of return after costs of 11.2% per annum over the last 15 years, and 9.9% over 30 years (i.e. an 18.7-fold increase in value);
  • They continue to be part of an average investment period of five years, which gives management time to implement a strategy, and if the horizon of the managers’ business plans does not correspond to that of a private equity shareholder fund, it is not uncommon for the latter to sell its stake to another fund whose liquidation deadline falls after the end of the business plan.

4/ HOW DOES THE COMPANY POSITION ITSELF IN THIS MATCH BETWEEN LISTED AND UNLISTED COMPANIES?

Today, above a valuation range of around €10–15bn, only the stock market is likely to offer liquidity to investors who want to sell their shares. Admittedly, before 2008, LBOs were valued at around €30bn.8 But that was before 2008, although they will most certainly be back.

It will take some time before private equity funds have the financial means to take an interest in the giants of the stock market, worth more than €50bn or €100bn and which represent the bulk of market capitalisation in value terms. And even if they had these means, current conditions do not suggest significant value creation, with a few exceptions. Most of these groups are currently well managed and difficult to consolidate among themselves, given the antitrust problems involved.

With a valuation below €10–15bn, everything becomes possible again. As an illustration, in 2019, KKR bought the free float of the German media group Axel Springer to take it off the stock market in a transaction that values it at €6.8bn, i.e. 40% above the stock market price. The same controlling shareholder and the same managers are thus moving from listed to unlisted. This example is far from an isolated one as we also have Ahlsell, Wessanen, Merlin, etc.

Under what conditions could such a small company stay and prosper on the stock market? We see several:

  • Run a simple, easily understandable business, with rated peers to facilitate comparisons and avoid discounts;
  • Avoid carrying too much specific risk;
  • Have a free float of at least 30 to 40%, because free float counts more on the stock market than market capitalisation;
  • Have a story to tell investors (equity story), and tell it, whether it is one of growth like Cogelec, consolidation of a sector like Euronext, or dividend yield like Pearson;
  • Seek out several funds and favour a fragmented shareholding structure (the Stock Exchange) in order to remain in charge of your own house, rather than one fund investment, even a minority one, which leads to a certain amount of shared control.

Otherwise, we believe there is a high risk of a discounted valuation, which is not a short- or medium-term problem if control is retained and if there is no need for financing. Given the growing size of asset managers on the stock exchange, the largest of them (Blackrock) manages $7,300bn and the largest European (Amundi) €1,790bn, liquidity is concentrated on large caps with small and mid-caps being neglected. For the latter, valuation multiples are often significantly lower than for large stocks and the required rates of return are higher in view of a growing liquidity premium.9

At the same time, the regulatory constraints of listing are increasing without the cost/benefits balance tilting significantly towards the latter: IFRS standards on turnover and rentals, the MAR Directive, internal insider listings, etc. The aim is to protect investors, specifically private individuals, who are less and less frequently direct shareholders of listed companies (one third of listed companies’ shareholders in the United States, around 10% in France). You have to be really motivated to stay listed when you’re a small or medium-sized company, and you are not likely to carry out an ICO,10 where, in order to attract buyers, the regulatory environment is very light, although not very consistent with the rest!

5/ IN THE END, A POROUS BORDER BETWEEN THE LISTED AND THE UNLISTED

We believe that listed and unlisted companies will continue to coexist in a complementary fashion, with private equity increasing its dominance in the segment up to around €10bn in value, and listed investment prevailing beyond that.

The boundary between these two modes of shareholding and governance is porous and we see a lot of toing and froing. Private equity firms have no qualms about selling companies on the stock market for which they no longer see any significant value-creation potential, especially if the stock market then generously values the companies, or those whose size is testing their limits. But private equity can also have its funds listed on the stock market and even hope one day to have them listed at a discount equal to or lower than that offered by secondary funds. A large listed investment fund controlling SMEs and second tier companies probably makes more sense to investors, and some companies, than a direct listing of the latter.

SUMMARY

QUESTIONS

EXERCISE

ANSWERS

BIBLIOGRAPHY

NOTES

  1. 1   See Section 45.3.
  2. 2   Enron’s and Lehman’s employees can confirm this!
  3. 3   See Section 46.2.
  4. 4   See Section 18.9.
  5. 5   See, for example, Kaplan (2018).
  6. 6   See Chapter 43.
  7. 7   See Section 47.3.
  8. 8   See Section 47.2.
  9. 9   See Section 19.4.
  10. 10  See Section 25.3.

There is nothing immutable or fixed about the organisation of a company. It is capable of adapting to changes in corporate strategy, access to financial resources, and market developments and moods, as well as any ambitions of its controlling shareholders. By way of example, the Schneider Electric group of today focused entirely on energy management and automation, and with 100% control of almost all its subsidiaries worldwide, no longer has anything in common with the Schneider of the early 1980s which was active in the steel industry, the nuclear industry, mechanics, textiles, watchmaking, electricity, and construction to name a few. Most importantly, the old Schneider Electric group (at the time heavily in debt) didn’t always have control of these companies and was itself controlled via a myriad of holding companies, indirectly owned by the Schneider family.

Generally speaking, investors like simplicity and transparency, which allows for better understanding and easier valuation, whilst simplifying everyone’s life and reducing risk (Schneider today). But markets are pragmatic and they can accept complex structures if growth and profitability are present (Alibaba, Liberty Media, Bollore).

A word of caution to our readers: whilst complex structures might solve certain problems or allow for certain opportunities to be seized, they are rarely without additional costs in the form of discounts and undervaluations. Sooner or later, they will have to be reviewed, corrected, and often broken into pieces, especially if the group is listed.

Section 42.1 ORGANISING A DIVERSIFIED COMPANY

The answer to this question depends first of all on the level of sophistication of financial markets. In a debt-ridden economy, financial markets are poorly developed, and it is difficult to finance new activities because equity is scarce. In such economies, it is frequently well-established groups that replace the financial markets; indeed, thanks to their self-financing capabilities, they can finance new activities internally. This can be seen currently in India with Reliance (petrochemicals, media, telecom, health, finance, construction, etc.), in Algeria with Cevital (food processing, supermarkets, electronics and appliances, steel, glass, construction, automotive, services, media) or in Colombia with Argos (cement, insurance, food processing, etc.).

Certain groups from emerging countries resolve the problem of under-sizing and inefficiency in the local equity capital market by going public in Europe or the United States. But this is only possible for the largest and most international companies (such as the Indian Vedanta or the Russian Evraz groups).

When a country moves from a debt-based economy to a financial market economy, the view on diversification of a company’s activities changes: lenders are in favour of it because the diversification of a company’s activities reduces its specific risk and therefore the lenders’ risk.

Equity investors are naturally more sceptical: they know that specific risk is not remunerated (see Section 19.1), reducing it would not be beneficial either, and that there are no financial synergies. Diversification therefore creates value only if the company can use its operational know-how to gain a competitive advantage in a new business, thereby generating synergies. Unfortunately, practice has shown that alongside some brilliant successes – Amazon becoming a web services host (AWS) or Bouygues succeeding in telecoms – there are countless value-destroying failures: Allianz in banking (Dresdner), Murdoch in social networks (MySpace), etc.

If diversification fails, the company will be under pressure to turn the page by selling the division in question (L’Oréal and The Body Shop in 2017). If diversification is successful, the listed company may be perceived as a conglomerate, with the risk of a discount appearing. We see, more often than not, that the market value of a listed conglomerate is lower than the sum of the values of the assets that make it up; the difference represents the conglomerate discount.

The discount generally reflects investors’ fears that resources will be poorly allocated. In other words, the group might support ailing divisions beyond what might be reasonable and in which profitability is mediocre or below their cost of capital, and consequently underinvest in the most promising sectors. Moreover, investors are now keen on “pure play” stocks and prefer to diversify their holdings themselves. Finally, there is the problem of head office costs, which absorb part of the value of the conglomerate.

When a discount persists, and to avoid a hostile takeover bid, four solutions are available:

  • Convince the market of the synergies the diversified strategy creates.
  • Split up the company (demerger by spinning-off an asset, distributing the new shares to existing shareholders of the conglomerate, and listing the new asset1).
  • Piece by piece sale.
  • Demonstrate value by listing a portion of the capital of the undervalued division (Qualtics listed by SAP two years after its acquisition and valued at three times the acquisition price).

There is a very small number of conglomerates that are valued without a discount (Berkshire Hathaway, Amazon) because investors are convinced that they are efficiently managed.

Successful diversification is often a precursor to a change in the group’s line of business, even if it means selling the old business (from the electronics engineer Racal to the telecom group Vodafone), or splitting into two independent entities (FiatChrysler and Ferrari, Dow Dupont and Corteva), or even via a sale/merger, such as the pharmaceutical business of L’Oréal, which was merged with Sanofi.

For family companies, the question remains as to where the diversification takes place: at the level of the shareholders or the operating company.

The family shareholders may only diversify their assets if they can increase dividends from the operating company without penalising it (Quandt, Benetton families), or sell part of its shares without jeopardising family control (J. Ratcliffe).

Otherwise, the operating company will have to be diversified like Bouygues (construction, telecoms, television) to allow for both asset diversification and maintaining family control. However, this supposes that the family’s control is strong enough to dissuade a hostile takeover bid if a conglomerate discount starts to appear. In our example, Bouygues is protected by its strong internal culture and poisons pills such as TF1 broadcasting rights, or Bouygues Télécom telephone licences.

For some families, diversification is a luxury their already reduced control does not allow (e.g. Volkswagen where the Piëch and Porsche families only control 31.3% of the shares through a 50% owned holding company).

Section 42.2 TO BE OR NOT TO BE LISTED

Whether or not to float a company on the stock exchange is a question that concerns, first and foremost, the shareholders rather than the company. But technically, it is the company that requests a listing on the stock exchange.

When a company is listed, its shareholders’ investments become more liquid, but the difference for shareholders between a listed company and a non-listed company is not always that significant. Companies listed on the market gain liquidity at the time of the listing, since a significant part of the equity is floated. But thereafter, for small or medium-sized companies, only a few dozen or hundred shares are usually traded every day, unless the market “falls in love” with the company and a long-term relationship begins.

In addition to real or potential liquidity, a stock market listing gives the minority shareholder a level of protection that no shareholders’ agreement can provide. The company must publish certain information; the market also expects a consistent dividend policy. If the majority shareholders sell their stake, the rights of minority shareholders are protected (see Section 45.3).

Conversely, a listing complicates life for the majority shareholder. It is true that liquidity gives them the opportunity to sell some of their shares in the market without losing control of the company. Listing can also allow the majority shareholder to get rid of a bothersome or restless minority shareholder by providing a forum for the minority shareholders to sell their shares in an orderly manner, or if they are simply looking for an exit. But in return, a majority shareholder will no longer be able to ignore financial parameters such as P/E multiples, EPS, dividends per share, etc. (see Chapter 22) when determining strategy. Researchers2 have shown that listed companies invest less than unlisted companies and are less responsive to investment opportunities because of the short-sightedness of their shareholders.

Once a majority shareholder has taken the company public, investors will judge the company on its ability to create value and communicate financial information properly. Delisting a company to take it private again is a long drawn-out process (see Section 44.6). So, for management, being listed results in a lot more restrictions in terms of transparency and communication.

For the company, a stock market listing presents several advantages:

  • the company becomes widely known to other stakeholders (customers, suppliers, etc.). If the company communicates well, the listing constitutes a superb form of “free” advertising, on an international scale;
  • the company can tap the financial markets for additional funding and acquire other companies, using its shares as currency. This constitutes invaluable flexibility for the company;
  • the company finds it easier to involve employees in the success of the company, incentivising them through stock options, stock-based bonuses, etc.
  • in a group, a parent company can obtain a market value for a subsidiary by listing it (we will then speak of a carve-out) in the hope that the value will be high enough to have a positive impact on the value of the parent company’s shares;

Listing on the stock exchange thus increases the company’s financial flexibility, but this comes at the price of implementing stringent governance measures and adopting IFRS standards, all of which is costly and difficult to fully assess prior to making a decision.

Now for the warning flags: a stock market listing does not guarantee happy shareholders. If only a small percentage of the shares are traded, or if total market capitalisation is low, i.e. less than €1bn, large institutional investors will not be interested, especially if the company is not included in a benchmark index. Volatility on the shares will be relatively high because the presence of just a few buyers (or sellers) will easily drive up (down) the share price significantly.

Section 42.3 HAVING MINORITY SHAREHOLDERS IN SUBSIDIARIES?

It is simpler for a group to own 100% of the subsidiaries it controls outright. In this case, decisions can be taken without the consultation (or even approval) of a third party, legal formalities are reduced, and the benefits of implementing an effective strategy accrue entirely to the sole shareholder group. Moreover, in this case, the management of liquidity within the group is simplified because the dividend payout is made without “leaks” represented by the dividends paid to minority shareholders; the implementation of intra-group loans does not pose a problem either.

1/ THE REASONS

Nevertheless, a group may sometimes bring in (retain) minority shareholders to the capital of some of its subsidiaries. The motivations for welcoming a financial minority shareholder or carrying out an IPO of a subsidiary are generally different from those for bringing in an industrial partner.

Indeed, the affiliation of subsidiaries to another group can generate industrial, commercial or other synergies; and when the benefits identified go beyond mere financial reasons, the sharing of capital can generate tangible benefits.

But all is not rosy since accepting that a subsidiary opens its capital to a partner or in the financial market can generate risks of conflicts of interest (intra-group or partner transfer pricing, level of risk-taking, remuneration of intellectual property, etc.).

(a) Raising funds

Opening up the capital of a subsidiary can enable the group to raise equity capital in an attractive way, especially when it is difficult to find new equity at the level of the parent company. For example, AB Inbev IPOed its Asian subsidiary Budweiser Brewing Company APAC and got $5bn to pay down debts in 2019. Cooperative or mutualist groups may also list a subsidiary to raise equity capital they would struggle to get otherwise.

Groups can also use it to finance an acquisition without carrying out a capital increase (Schneider and a division of Larsen & Toubro). The buyer can also use a vendor loan to acquire the entire capital, or ask the selling shareholder to retain a share of the capital.

Finally, it is a preferred means of growth for family groups whose controlling shareholder does not have the financial means to achieve its strategic ambitions. The result is an organisation chart similar to that of the Frère group in Belgium:

Source: Data from Annual reports

The game consists of finding minority partners (at the different levels of the structure) during the growth phase; then, once the waterfall of subsidiaries have reached maturity and the cash flows have become more consequent, offer them an exit and close the structures.

(b) Externalise the value of an asset and facilitate external growth

Groups sometimes hold particularly prized assets in their midst, whose valuation multiple may be disproportionate to that of the group as a whole. This high valuation is due to the significant anticipated growth of a given activity.

In such a situation, the group may be undervalued if the size and shape of this attractive subsidiary is not properly understood by investors. The simplest way to revalue the entire group is to sell a share of the crown jewels, thereby externalising the value of this nugget.

Moreover, in such a case, it is value destructive for the group to raise equity at the parent company level to finance the subsidiary’s development. This amounts to issuing undervalued shares (those of the parent company) to purchase assets valued at a normal price. It is better to be able to pay in shares of the subsidiary, which is as fairly valued as the target. In 2019, this is what led Volkswagen to open up the capital of its truck subsidiary Traton, in which it retained an 88% stake, to facilitate seizing external growth opportunities (Navistar in 2020).

(c) Sharing significant risk

A controlling shareholder may not want to endanger their group when undertaking an important and risky project. They may then agree to share the profits of the project to relieve themselves of some of the risk. Thus, when the Drahi group expanded into the USA in 2015 by taking over cable operators Cablevision and Suddenlink for $26.8bn, it shared the investment with BC Partner and CPP Investment, which combined held 30% of the capital, before listing it on the stock market in 2017.

(d) Reducing the contribution of a subsidiary to the earnings of the group

Without wishing to proceed with an outright sale, a group may decide to reduce its exposure to any one of its assets by selling a fraction of its capital to third parties. Vivendi sold 20% of the capital of UMG in 2019 and 2020, keeping temporarily 80%.

(e) Preparing for a future divestment

Minority shareholders entering the capital, or better still, initiating an IPO as discussed in the previous paragraph, also makes it possible to impose greater management rigour and specific governance requirements intended for listed companies. This can therefore be a first step towards a divestment by the majority shareholder and independence for the subsidiary.

The listing of a 28% stake in AXA Equitable holdings in 2018 was clearly presented by AXA as a first step towards a complete divestment. This plan was pursued in 2019 with several share sales eventually bringing AXA’s stake in its former US subsidiary bank to below 10%.

(f) Relying on a partner with industrial knowledge or geographic advantages

Accepting an industrial minority partner requires considering multiple facets of the partnership. The partner may contribute more than just capital; it will generally be selected for its ability to contribute to creating value in the subsidiary by facilitating its integration into the economy, improving relations with local authorities, obtaining market share and driving synergies, for example in distribution. The Richemont group purchased 30% of Kering’s eyewear division, which Kering had spent years developing to improve the quality of its Gucci eyewear products. Richemont then gave this division the supply contract for Cartier’s eyewear products.

In a number of countries (China, Indonesia, United Arab Emirates, etc.) and sectors, the creation of wholly owned local subsidiaries is not always possible and a local partner is required, even if it is just a nominee shareholder. To develop its fuel cells business in China, Bosch chose to form a JV with Qingling Motors in 2021

When a local stock exchange exists, authorities can be very sensitive to the local subsidiary being listed (Nexans in Morocco, Nestlé in Côte d’Ivoire, etc.).

(g) Having a tool for motivating employees

Traditional motivational tools for employees in general and management in particular are mostly based on share performance (free shares, performance shares, stock options). In a large group, the specific performance of a subsidiary’s management may be quite largely diluted in the overall performance of the group (e.g. DWS within Deutsche Bank, its asset management arm). The managers of a fast-growing business may then have the impression that they are not being properly compensated when receiving shares in the parent company.

2/ THE HOLDING COMPANY DISCOUNT

By multiplying the number of minority partners and subsidiaries listed on the stock exchange, the group runs the risk of losing its clarity and legibility for analysts and investors, of being assimilated to a holding company and then suffering a holding company discount, which is naturally to be avoided as it leads to a destruction of value due to the group’s structure.

A holding company is a company that owns minority or majority investments in listed or unlisted companies either for purely financial reasons or for the purpose of control. Berkshire Hathaway, Siemens and Exor are examples.

A holding company trades at a discount when its market capitalisation is less than the sum of the investments it holds. For example, a holding company holds assets worth 100, but it only has a market capitalisation of 80. The size of the discount varies with prevailing stock market conditions. In bull markets, holding company discounts tend to contract, while in bear markets they can widen to more than 30%.

Here are four reasons for this phenomenon:

  • the portfolio of assets of the holding company is imposed on investors who cannot choose it;
  • the free float of the holding company is usually smaller than that of the companies in which it is invested, making the holding company’s shares less liquid;
  • administrative inefficiencies: the holding company has its own management costs which, discounted over a long period, constitute a liability to be subtracted from the value of the investments it holds. Imagine a holding company valued at €2bn with administrative costs of €10m p.a. If those costs are projected to infinity and discounted at 8% p.a., their present value is €125m, or 6.25% of the value of the holding company.
  • tax inefficiencies: capital gains on the shares held by the holding company may be taxed twice – first at the holding company level, then at the level of the shareholders. In most countries, but not all, sales of a large stake (above 5%) are often taxed at a low rate to avoid double taxation.

3/ THE EVOLUTION OF THE SHARE STRUCTURE OVER TIME

Any partnership must find its balance. Since the minority position is not the easiest to be in, it is often the case that minority shareholders will sooner or later seek an exit.

  • For “industrial” minority shareholders, their contribution dwindles over time and their disinterest eventually results in a de facto subsidiary wholly controlled and run by the majority group. Sometimes a minority shareholder will adopt counterproductive behaviour to force the majority shareholder to offer it an exit if one has not been contractually provided for.
  • For a financial partner, the need for an eventual exit is obvious. Most of the time, they will require a form of liquidity that is contractualised a priori in a shareholders’ agreement: a put option, a commitment to go public or to perform a joint sale, etc.

Section 42.4 JOINT VENTURES

Most technological or industrial alliances take place through joint ventures, often held 50/50, or through joint partnerships that perform services at cost for the benefit of their shareholders. For example, General Electric and Safran created CFM International in 1972 to produce the CFM56 aircraft engine, and have together become the world leaders in the sector.

Several benefits can be identified: economies of scale, complementary experiences, learning, protection from larger competitors, creating a strategic future opportunity.

The shining example of CFM should not mislead our reader. Most joint ventures are sooner or later unwound, because the reasons that justified their creation and pushed groups to join together on an equal footing disappear over the course of time. Dissolution is then the best solution to avoid boardroom paralysis. Either the joint venture is doing well and one of the shareholders will want to take control of it, or it is doing badly and one of the shareholders will want to get out of it (or will at least refuse to bail out the losses and will therefore be gradually diluted). Thus, in 2019, the Stellantis group (Peugeot-Fiat) bought out the shares of its Chinese partner Changan in the joint venture manufacturing and marketing DS in China. Sales were disappointing and the partners no longer had the same outlook on the brand’s potential. Preparing for the potential future exit of one partner is key when creating a joint venture. Joint venture agreements often have exit clauses intended to resolve conflicts. Some examples are:

  • put and call clauses. These are used in particular if one of the shareholders is likely to be a long-term shareholder (industrial) and the other less long term (financial). The exercise price of the option can either be predetermined, be based on a formula or be determined by an expert independent of the shareholders. The joint venture that Valeo and Siemens created in 2016 foresees a call and a put in 2022, suggesting a potential 100% takeover by Valeo.
  • a buy–sell exit provision, also called a Dutch clause or a shotgun clause. For example, shareholder A offers to sell their shares at price X to shareholder B. Either B agrees to buy the shares at price X or, if they refuse, they must offer their stake to A at the same price X.

Section 42.5 BEING IN THE MINORITY

Although the vocation of a group is not to be a minority shareholder, there are nevertheless several situations where groups hold minority interests. There are several possible reasons for this:

  • the group wants to gain a foothold in a new activity, and starts by taking a minority stake in a company, even if it later takes control once the business model is refined. This is what groups are doing today with digital start-ups (Facebook in Unacademy, Daimler in ChargePoint, etc.);
  • the group wants to “lock in” an asset by taking a stake in a company it wants to eventually take control of (Vivendi in Lagardère, eyeing its Hachette subsidiary). It consequently gets a foot in the door;
  • a legal provision prohibiting in certain sectors of activity holding more than a certain percentage (49% for a television channel in France, for example); Certain countries (such as Algeria or Indonesia) do not allow a foreign group to be a majority owner of a local company;
  • the relative value of the contributions when setting up a joint venture did not allow the group to obtain at least 50%. Thus Diageo holds 34% of the spirits subsidiary Moët Hennessy alongside LVMH at 66%;
  • to seal a strategic or operational partnership between groups through the acquisition or exchange of minority shareholdings in order to give it greater weight. For example, since 2018, Tencent has owned 5% of Ubisoft, whose products it distributes in China;
  • because it is the remnant of a business being divested. Thus L’Oréal owns 9.2% of Sanofi, which is the successor to its 100% ownership of Synthélabo, which has been reduced over time by mergers and sales;
  • because a minority can lead to or determine the control of a group with a very fragmented shareholder base (Mediobanca in Generali) or in the case of a limited partnership (for example, for certain specialist real estate companies, the status of general manager offers a varying degree of control).

From a financial point of view, these minority shareholdings are seldom properly valued. When they are below the equity method threshold (a priori 20%, see Section 6.1), they may be completely forgotten by investors, especially if they do not pay dividends, if their historical cost price is low, or if their strategy is not explained clearly to investors.

The equity method of consolidation is not the holy grail, since the share of profit or loss accounted for by the equity method is not included in EBITDA, nor EBIT or free cash flow, which are aggregates frequently used for valuation purposes (Chapter 31) and in the analysis of indebtedness (Chapter 12). This is in addition to the acquisition of the shareholding reducing the company’s liquidity. Hence the deterioration in value if analysts do not do their job properly. To avoid this problem, it is in the company’s best interest to include the profits accounted for using the equity method in the operating profit as permitted by IFRS.

Our reader will note the asymmetry with the situation where the company disposes of a minority interest in one of its subsidiaries. Operating income and EBITDA are unchanged, but the company’s net debt has been reduced thanks to the cash received, which has a positive impact on the value of the company and its financial situation for those who run their calculations too quickly.

In any case, the value of a minority shareholding will be better protected if a shareholders’ agreement is signed with the majority shareholder and if the minority company is represented on the board.

Section 42.6 THE FINANCIAL STRUCTURE WITHIN THE GROUP

In arranging financing, the CFO must first determine where to situate the net debt within the group, and then which entities will use external financing and which entities will be financed by intra-group loans. These are two separate decisions because a group entity that indebts itself may well have zero net debt if it then lends to other group entities.

With regard to positioning the net debt, it is a good principle of financial management and internal governance to ensure that the surplus cash of subsidiaries systematically flows back to the parent company at least once a year. In this way, it can allocate financial resources between the different units in the best interests of the group, create or acquire new ones, and avoid the formation of internal baronies (based on the principle that the one who has the money has the power). It is therefore not advisable to locate the net debt within the parent company, leading to a poor parent and rich children.

The choice of the internal financing structure will depend on various parameters:

  • Tax aspects that consist of four main variables: the tax rate on profits in the country where they are generated, the tax cost of paying dividends (taxes and withholding taxes) in that country, the tax cost of collecting dividends in the receiving country, and finally the social acceptability of possibly having structures in countries considered as tax havens. Thus, for an American group, until 2017, it was expensive to repatriate dividends from countries where the corporate tax rate was lower than the federal rate of 35%, because it had to pay an additional tax to the Treasury for the difference. This is why Apple’s subsidiary in Ireland (official corporate tax rate of 12.5%) was so cash-rich and Apple Inc. so indebted! Several countries have put into place tax measures to limit intra-group indebtedness of subsidiaries (earning stripping rules in the US, thin capitalisation rules in the UK).

    This will allow cash to accumulate in subsidiaries, thus imposing some form of internal financial structure on the CFO.

  • Legal constraints: These can, particularly currency exchange constraints, handicap the upward flow of liquidity from subsidiaries, forcing the development of wealthy subsidiaries within a group. As an example, even though no law or regulation stops the outflow of capital in China, the financial system (banks in particular) does so when asked by the government. Local subsidiaries are therefore obliged to keep their cash or invest it locally. Thus, since it is generally easier to send interest and loan repayments upwards than dividends, in a constrained legal environment internal debt is preferred.
  • The geography of the assets: if the assets are to be used as collateral for financing (see Section 39.1), the debt capacity will naturally depend on the legal ownership of the assets. The group will then indebt its operating subsidiaries (or possibly the holding companies holding listed securities, if any).
  • The motivation of local management: adopting LBO logic, the group’s management may wish its subsidiaries to be in debt as a matter of principle in order to create a “healthy pressure” for their management to generate cash flows at least sufficient to service the debt. This motivation will be all the more important as the debt will be owed to third parties. It is always possible to make arrangements with the parent company in the event of a default on an inter-company loan, but it is more complicated to do so with one’s bankers.
  • The presence of minority shareholders: it is often simpler to finance subsidiaries in which there are minority shareholders with external debt. Indeed, intra-group financing by debt in proportion to ownership percentages is complicated to implement, while financing solely by the majority shareholder raises the question of the interest rate to be charged in the context of normal governance.

The simplicity of a group’s financial structure generally goes hand in hand with its maturity. Most large groups are financed almost exclusively by bond debt issued by the parent company (Section 39.1), which then finances its subsidiaries through intra-group loans. Bond investors prefer to lend to the highest level of the group, which has access to all the cash flows, since they do not, at least for investment grade issuances, have any security on its assets.

Conversely, SMEs that use bank financing are more likely to use the assets of subsidiaries (receivables, inventories or even real estate assets) to secure lenders and thus obtain more attractive terms: factoring, securitisation of receivables and inventory, leasing of fixed assets.

The quality of the signature also plays an important role in the choices made by the CFO. The more financially sound the group is, the less it needs to secure its financing with assets, allowing the financing to be carried out at the level of the parent company. This makes steering easier for the central finance department.

The more financially strained groups use all available means to obtain financing and therefore use their liquid assets, generally located in the subsidiaries, as much as possible. Although this will make it more complex to monitor financing, the financial directors of subsidiaries have broader and often more motivating roles. At this level, an important and structural decision is whether or not to place non-recourse (on the group’s cash flows) financing with subsidiaries.

If third party indebtedness at the subsidiary level is high, lenders at the parent company level will see a specific risk that the rating agencies will also take into account. The subsidiaries’ lenders will have direct access to the assets in the event of liquidation whilst the parent company’s lenders will be naturally subordinated. They will only be able to recover a share of the value of these assets after the subsidiaries’ lenders have fully recovered their debts. This is structural subordination that worsens rapidly as the risk of bankruptcy increases.

But the CFO’s job does not stop there. Once they have conceived and set up this financial structure within the group, they will have to bring it to life. This means supplementing it with intra-group loans to supply units that do not have sufficient external financing. But also to determine the desirable and achievable dividend payouts from a financial, legal and tax point of view. The intra-group financial structure will live and evolve in line with the subsidiaries’ cash flow generation and the upwards flow of dividend payments.

Section 42.7 THE LEGAL STRUCTURE WITHIN THE GROUP

1/ TAX INFLUENCE

The hot topic in today’s global environment is transfer pricing. As a result of globalisation, it has become extremely rare for a product or service to be designed, manufactured and distributed in a single country, with components coming only from that country. More often than not, a product or service is designed in one country, manufactured in another country, often with components from several countries, and then distributed in a multitude of countries. Hence the ability, thanks to transfer pricing, to locate in any given country (the one with the least burdensome tax regime) the bulk of the value created.

Management fees, trademark and patent licences are other tools used to support this tax strategy for group organisation.

Countries which have seen their tax bases shrink as a result of these practices, have tracked down the most obvious abuses (predominantly the GAFAM), and now require precise, detailed and convincing documentation from any company to justify these schemes and the pricing used.

Schemes aimed at evading part of the tax burden, even perfectly legal ones, are less and less tolerated by citizens and are more and more frequently singled out, which is not without negative consequences to a company’s image and business (see Apple, McDonald’s, Google).

Optimising transfer pricing or the ownership location of intellectual property for trademark or patent royalties is not just a legal and fiscal choice. It requires a real operational change that commits the group to a long-term strategy (even though tax rules may change).

Beyond the tax aspects, these cash flows have the advantage for the majority shareholders not to be earned by the minority shareholders. Thus, it was financially far more effective for Disney to receive management fees from Euro Disney rather than to receive its share of dividends.

To conclude this subject, our reader should be aware that tax optimisation often goes against the very notion of simplicity, and that it is sometimes very complex and costly to unravel a structure set up for tax reasons.

We know of more than one group that has failed to dispose of a business for this reason or has done so with great difficulty.

2/ GEOGRAPHIC OR BUSINESS LINES HOLDINGS?

A group with several types of businesses may consider whether it is better to organise itself legally by having one holding company per country or geographical area, grouping together the companies carrying out each of the group’s businesses in the country or area; or whether it is better to set up vertical internal holding companies for each business, grouping together all the companies carrying out that business worldwide.

The first type of organisation is probably the one that maximises synergies within a group, since these are usually primarily geographical: purchasing power from national suppliers, shared administrative services, etc.

The second type of organisation makes it easier for minority shareholders to enter a given business unit, or even to take it public or sell it, which is more complicated to carry out under a geographical organisation. On the other hand, it is probably more costly, as it makes it more difficult to achieve internal synergies.

SUMMARY

QUESTIONS

EXERCISE

ANSWERS

BIBLIOGRAPHY

NOTES

  1. 1   See Section 46.3.
  2. 2   Asker et al. (2015).

Or on being politically correct

Problems with corporate governance arise as a result of changes in the capital structure and organisation of companies. Corporate governance is not an issue for companies where the manager is the sole shareholder. But gradually the founding shareholder’s stake will be diluted and corporate governance issues will arise between the majority shareholder, who is also usually the manager, and minority shareholders. When a company starts out as family owned and evolves into a company with a fragmented shareholding of institutional and retail investors, new problems of corporate governance will arise. These will relate to control that the shareholders have over the managers, who will have less freedom as a result of the fragmented shareholding structure.

Section 43.1 WHAT IS CORPORATE GOVERNANCE?

1/ DEFINITION

Broadly speaking, corporate governance is the organisation of the control over, and management of, a firm. It covers:

  • the definition of the legal framework of the firm: specifically, the organisation, the functioning, the rights and responsibilities of shareholders attending meetings and the corporate bodies responsible for oversight (board of directors or executive board and supervisory board);
  • the rules for appointing and remunerating managers and directors;
  • management rules and any conflicts of interest;
  • the organisation of control over the management and the running of the company: internal controls, regulatory controls, auditing;
  • the relations between managers and shareholders;
  • the rights and responsibilities of other stakeholders (lenders, customers, suppliers, employees);
  • the disclosure of financial information on the firm and the role and responsibility of external analysts: financial analysts, rating agencies and legal and financial advisors.

In a narrower definition, the term “corporate governance” is used to describe the link that exists between shareholders and management. From this point of view, developments in corporate governance mainly involve the role and functioning of boards of directors or supervisory boards.

We would suggest1 that corporate governance covers all of the mechanisms and procedures surrounding decisions relating to the creation and sharing of value. They concern four main areas: shareholders’ rights, transparency of information, organs of management and control and the alignment of compensation.

2/ RECOMMENDATIONS AND GUIDELINES

It should always be remembered that the organisation of corporate governance is determined, first and foremost, by company law, which defines the field of possibilities:

  • prerogatives of the market regulator;
  • listed companies’ information obligations (shareholders’ agreements, etc.);
  • vote by shareholders on managers’ compensation;
  • composition of the board of directors (maximum number of directorships in public limited companies);
  • possibility of separating the function of chairman of the board of directors from that of CEO;
  • transparency with regard to conditions for preparing and organising the work of the board of directors and internal control procedures.

Over the years, a number of recommendations and guidelines have been added to the purely regulatory and legislative framework, in the form of reports and best practice codes (commissioned and/or drafted by employer bodies, investor associations, governments and government agencies, stock exchanges, etc. in various countries). It is important to note that these codes remain recommendations and guidelines only,2 and are not legally binding laws or regulations.

The main recommendations and guidelines in terms of corporate governance all focus on key issues: transparency in the way that the board and management operate, the role, composition and functioning of the board and the exercise of shareholder power at general meetings.

However, each country has its own category when it comes to companies and their shareholders:

  • employee rights in Germany (and also in Denmark, Austria and Sweden);
  • the role of banks and conglomerates in Japan and South Korea;
  • very widely held shareholdings in the UK or USA;
  • etc.

(a) Transparency

The first recommendation is for transparency in the way the company’s management and supervisory bodies operate.

Transparency surrounding the compensation of managers and directors is also recommended. As we saw in Section 26.3, the way in which firms compensate management plays a key role in reducing conflict between shareholders and managers.

In some countries, shareholders vote on management compensation (say on pay). It is either a consultative vote (Germany, Spain, USA) or a binding one (France, Sweden, the Netherlands, Switzerland, UK).

With the granting of variable compensation or stock options, managers have a financial interest that coincides with that of shareholders, to whom they are accountable. Stock options are not, however, a cure-all, as the short-term vision they encourage may sometimes tempt management to conceal certain facts when disclosing financial information and, in extreme cases, they may even consider committing fraud. This has resulted in the development of alternative products, such as the granting of free shares, the payment of part of their compensation in shares, etc., or by tightening the conditions for exercising stock options and selling the underlying shares, and linking them to criteria that are not only financial, such as ESG criteria.

Source: Willis Towers Watson, PWC

The principle of transparency also applies to transactions carried out by management in the shares of the company. These have to be made public due to the signals that they may give out.

Finally, in reaction to the payments made to managers who had failed (Technip FMC, Sanofi, UBS, etc.), which were, and rightly so, shocking in terms of both the amount and the principle, it is often recommended that these “golden parachutes” only be paid in the event of forced departure and linked to a change in control or strategy and for an amount that does not, in general, exceed one or two years’ salary. Sometimes this compensation is subordinate to performance conditions.

(b) The role of an independent board

Corporate governance codes all recommend that a firm’s corporate strategy be defined by a body (board of directors or supervisory board) which enjoys a certain degree of independence from management.

Independence is achieved by limiting the number of managers who sit on the board, and by setting a minimum number of independent directors.

For example, in the UK the latest recommendation is that at least half of the directors of listed companies should be independent. There are very few companies with no or hardly any independent directors on the board.

The definition of the term “independent director” is the subject of much controversy. As an example, the Bouton report defines an independent director as follows: “Directors are independent when they have no link of any nature whatsoever with the company, the group or management, which could compromise them in the exercise of their free will.” Even though this definition makes it clear that a member of management or a majority shareholder representative would not be considered independent, it allows for a great deal of leeway, which means that deciding whether or not a director is indeed independent is not as easy as it might appear.

The importance given to the need for independent directors on the board tends to overshadow the importance of other more vital matters, such as their competence, their availability and their courage when it comes to standing up to management. These qualities are indispensable throughout the financial year, whereas their independence only becomes an issue in situations of conflict of interest, which fortunately are the exception rather than the rule.

The importance of independent directors is highlighted by the appointment of an independent director to the position of vice chairman of the board or lead independent director (Nike, GSK, Danone, etc.), especially when the roles of Chairman of the Board and Chief Executive Officer are fulfilled by the same individual.

The lead independent director plays a leadership role for the independent directors and has a little more power than the others. They may put up items for discussion on the board’s agenda, call a meeting of the board members without the presence of senior management, or even, if they believe that the CEO is no longer up to the task, take steps to have the latter replaced. They are also often in charge of the dialogue with non-controlling shareholders on governance topics.

Lawyers will surely forgive us for pointing out that the development of corporate governance has brought an end to the idea of the board of directors as an entity invested with the widest of powers, authorised to act in all circumstances in the name of the company. This gives the impression that the board was responsible for running the company, which was quite simply never the case. This erroneous idea put management in a position where it was able to call all of the shots. These days, boards are designed to determine the direction the company will take and to oversee the implementation of corporate strategy. This is a much more modest mandate, but also a lot more realistic. The board is asked to come up with fewer but better goods.

(c) The functioning of the board and of directors’ committees

Corporate governance codes insist on the creation of special committees that are instructed by the board to draw up reports. These committees generally include:

  • an audit committee (inspects the accounts, monitors the internal audit, selects the external auditors);
  • a compensation committee (managers, sometimes directors);
  • a selections or appointments committee (paves the way for the succession of the managing director and/or CEO, puts forward proposals for new directors);
  • a strategic and/or financial committee (large capex plans, mergers and acquisitions, financing issues);
  • a risk committee;
  • an ethics and/or governance and/or social responsibility committee.

(d) The exercise of shareholder power during general meetings

It is clear that anything that stands in the way of the exercise of shareholder power will be an obstacle to good corporate governance. Such obstacles can come in various forms:

  • the existence of shares with multiple voting rights that may enable minority shareholders with only a tiny stake in the capital to impose their views by wielding their extra voting rights (see Section 41.2);
  • the existence of preferred shares with no voting rights attached.3 The control held by the Hoffmann family over the Swiss pharmaceutical group Roche is greatly facilitated by the existence of non-voting shares accounting for 81.5% of the share capital;
  • the restriction of voting rights in meetings by introducing caps on the number of votes cast during general meetings. For example, at Danone, a single investor cannot represent more than 6% or 12%4 of the voting rights;5
  • administrative or material restrictions on exercising voting rights by proxy or by postal vote.

On the other side, making it compulsory for institutional shareholders to vote in general meetings of shareholders, or allowing shareholders to vote without having to freeze their shares a few weeks before the meeting, can clearly improve voting habits and enhance shareholder democracy.

The rise of securities lending may raise the issue of representativeness of general meetings. Shareholders who have lent their securities cannot vote at General Meetings, while still maintaining their economic exposure; the opposite is true for those who have borrowed securities. This is why securities lending exceeding a percentage of voting rights must be declared in some countries.

3/ A ONE-TIER OR A TWO-TIER BOARD: AN UNRESOLVED ISSUE

The way in which power within the board is organised is, in itself, a much debated topic. The need for a body that is independent of the management of the company remains an open question. We can observe three main types of organisation:

  • board of directors with a chief executive officer acting also as chairperson of the board. This means that a great deal of power is concentrated in the hands of one person, who is head of the board and who also manages the company. This is known as a one-tier structure and is in place at groups such as ExxonMobil, Amazon and Telefónica;
  • board of directors with an executive or a non-executive chairperson and a separate chief executive officer. This sort of dual structure has been adopted by Infosys, Sony and Vodafone;
  • supervisory board and executive board: this two-tier structure is in place at Sanofi, BMW and Philips.

Source: Data from Board Governance, International Comparison, Spencer Stuart, 2020

A board on which the control and management roles are exercised by two different people should, in theory, be more effective in controlling management on behalf of the shareholders. Is this always the case in practice? The answer is no, because it all depends on the quality and the probity of the men and women involved. Enron had a chairman and chief executive officer, and L’Oréal has a chief executive officer also acting as chairman of the board. The former went bankrupt in a very spectacular way as a result of fraud and the latter is seen as a model for creating value for its shareholders.

So it is much better to have an outstanding manager, and possibly even compromise a bit when it comes to corporate governance, by giving the manager the job of both running the company and chairing the board, rather than to have a poor manager. Even if extremely well controlled by the chair of the board, a poor manager will remain a poor manager!

An additional question arises when it comes to the choice of the chairperson of the board: can they be the former CEO? Certainly not in the UK. If this were the case, the margin for manoeuvre of the new CEO would be restricted, as the chairperson will be tempted to keep some kind of management role. The chairperson is usually recruited from outside the company, and is often a former CEO of a company in another sector who will spend one or two days a week performing the job of chairperson.

In France or Germany,6 for example, this is often the case, on the basis of the fact that the new chairperson’s experience and knowledge of the company will be highly valuable. The split between the two functions often comes at the time of succession, so that the new CEO can prove their skills. Most of the time, the two functions are generally brought back together (Schneider, Total), but there are exceptions (Sanofi).

It cannot be denied that great strides forward have been taken in the area of corporate governance, even if there is still progress to be made in some emerging countries with less experience in dealing with listed companies and minority shareholders. Associations of minority shareholders, or minority shareholder defence firms, which also provide shareholders with advice on how to vote in general meetings, have often acted as a major stimulus in this regard.

The fact that, in developed countries, many groups have simplified their structures has made this a lot easier: these days, it is usually only the parent company that is listed, which eliminates the possibility of conflicts of interest between the parent company and minority shareholders of its subsidiaries;7 cross-holdings between groups which used to swap directors have been unwound;8 assets used by the group but which belong to the founders have been apportioned to the group.

4/ ESG GOVERNANCE IN THE COMPANY

It is a bit of a mirroring device to talk about ESG governance because the “G” in ESG represents governance. Thus, the purpose of ESG is to ensure good governance of the company.

But structuring actions to improve the company’s impact on the environment and society and maintaining good governance requires the establishment of governance. In some countries, the first link can be integrated into the company’s articles of association, which can adopt a raison d’être allowing the company to commit resources to a goal other than the creation of value for its shareholders and thus set itself precise environmental and social objectives.

To go further, the company may decide to become a B-Corp or similar mission-driven company. The B-Lab provides certification to corporates that meet certain criteria in matters of sustainability and inclusion.

Some people argue that retaining the status of a B-Corp or mission-driven company can act as a poison pill to avoid takeovers. We do not think so; first of all, because those companies must nevertheless take care of their financial performance. Non-performing companies will not be able to ensure their mission in the long term. Moreover, abandoning the mission or the B-Corp status is even easier than adopting it …

Section 43.2 CORPORATE GOVERNANCE AND FINANCIAL THEORIES

1/ THEORY OF MARKETS IN EQUILIBRIUM

The classic theory is of little or no help in understanding corporate governance. What it does is reduce the company to a black box, and draws no distinction between the interests of the different parties involved in the company.

2/ AGENCY THEORY

Agency theory is the main intellectual foundation of corporate governance. The need to set up a system of corporate governance arises from the relationship of agency that binds shareholders and managers. Corporate governance is the main means of controlling management available to shareholders. What corporate governance aims to do is to structure the decision-making powers of management so that individual managers are not able to allocate revenues to themselves at the expense of the company’s shareholders, its creditors and employees and, more generally, society as a whole.

Governance also aims at reducing the natural information asymmetry that exists between management and shareholders, corporate governance also covers financial communication in the very broadest sense of the term, including information provided to shareholders, work done by auditors, etc.

A good system of corporate governance, i.e. a good set of rules, should make it possible to:

  • limit existing or potential conflicts of interest between shareholders and management;
  • limit information asymmetry by ensuring transparency of management with regard to shareholders.

Unsurprisingly, agency theory shows that in firms where there are few potential conflicts of interest between shareholders and management and where information asymmetry is low, i.e. in small and medium-sized companies where, more often than not, the manager and shareholder is one and the same person, corporate governance is not an issue.

3/ ENTRENCHMENT THEORY

Agency theory suggests mechanisms for controlling and increasing the efficiency of management. Entrenchment theory11 is based on the premise, somewhat fallacious but sometimes very real, that mechanisms are not always enough to force management to run the company in line with the interests of shareholders. Some managers’ decisions are influenced by their desire to hold onto their jobs and to eliminate any competition. Their (main) aim is to make it very expensive for the company to replace them, which enables them to increase their powers and their discretionary authority. This is where the word “entrenchment” comes from. Managerial entrenchment and corporate governance do not make good bedfellows.

Section 43.3 VALUE AND CORPORATE GOVERNANCE

An initial response to the question “Does good corporate governance lead to value creation?” is provided by a survey of institutional investors carried out by McKinsey.12 The investors surveyed stated that they would be prepared to pay more for shares in a company with a good system of corporate governance in place. The premium investors are prepared to pay in countries where the legal environment already provides substantial investor protection is modest (12%–14% in Europe and North America), but very high in emerging countries (30% in Eastern Europe and Africa).

The very large number of studies on the subject focus on the problem of coming up with a definition of good corporate governance. Existing studies merely rely on ratings provided by specialised agencies to back up their conclusions, which in our view provides no new insight into the subject.

Their results13 show that good corporate governance does lead to the creation of shareholder value. Bauer, Guenster and Otten have shown that the shares of groups listed on the FTSE 300 that were given a good rating for their corporate governance performed significantly better than groups with “weak” corporate governance. These results tie in with results for US companies put forward by Gompers.

The results are all the more revealing when one considers that local law does not guarantee satisfactory corporate governance. For example, it would appear that a Russian group that adopts (and communicates) an efficient system of corporate governance will create value (Black 2001).

More generally, Anderson and Reeb in the USA and Harbula in France have shown that the financial performance of companies with one main shareholder (for example, a family) is better than average. But the best-performing companies are those with one major shareholder and also a fairly large free float. Ideally, the main shareholder should hold a stake of between 30% and 50% in the company’s share capital. This may seem counterintuitive, in as far as family-owned companies are generally less transparent and comply less willingly with the rules of corporate governance. On the other hand, majority or dominant shareholders are very motivated to ensure that their firms are successful, given that such firms often represent both the tools of their trade and their entire fortune!

Research focuses mostly on the correlation between good corporate governance and high valuations. Very few studies have been able to demonstrate any real correlation between corporate governance and the long-term financial performance of the company. But then nobody has shown that corporate governance has a negative impact on financial performance either!

SUMMARY

QUESTIONS

ANSWERS

BIBLIOGRAPHY

NOTES

  1. 1  Based on the OECD approach.
  2. 2  In some countries, such as the UK and France, listed companies are required to disclose whether or not they implement codes of corporate governance, which is clearly a very strong incentive for them to do so! This is called the “Comply or Explain” principle.
  3. 3  See Section 24.3.
  4. 4  Depending on whether the shares the investor holds carry double voting rights or not.
  5. 5  This restriction will no longer apply if, following a takeover, a third party is in possession of more than 66.7% of the shares.
  6. 6  After a period of two years, unless approved by 25% of shareholders.
  7. 7  Take the example of Allianz, which bought out the minority shareholders of its listed subsidiary Euler Hermes, making it a wholly owned subsidiary.
  8. 8  For example, Deutsche Bank is no longer a large shareholder in large German groups.
  9. 9  See Section 33.2.
  10. 10  See Section 45.3
  11. 11  Initially developed by A. Shleifer and R. Vishny.
  12. 12  McKinsey Investor Opinion Survey, 2002.
  13. 13  See Bibliography.

Welcome to the wonderful world of listed companies!

Theoretically, the principles of financial management that we have developed throughout this book find their full expression in the share price of the company. They apply to unlisted companies as well, but for a listed company, market approval or disapproval – expressed through the share price – is immediate. Being listed enables companies to access capital markets and have a direct understanding of the market value of their companies.

Source: Thomson One Banker, Factset

Being listed enables a company to raise funds in a few weeks or even a few days because:

  • financial analysts periodically publish studies reviewing company fundamentals, reinforcing the market’s efficiency;
  • listing on an organised market enables financial managers to “sell” the company in the form of securities that are bought and sold solely as a function of profitability and risk. Poor management is punished by poor share price performance or worse – from management’s point of view – by a takeover offer which leads to a change in management;
  • listed companies must publish up-to-date financial information and file an annual report (or equivalent) with the market authority.

We refer the reader interested in the reasons for an IPO to Section 42.2 where we discuss this topic.

Section 44.1 PREPARATION OF AN IPO

It usually takes at least six months between the time the shareholders decide to list a company and the first trading in its shares.

This six-month period provides an opportunity for management to revisit some financial decisions made in the past that were appropriate for an unlisted, family-owned company or for a wholly owned subsidiary of a group, but which would not be suitable for a listed company with minority shareholders, such as:

  • preparing accounts in line with accounting standards required for listed companies which may be different from the ones used by private companies, and introduce reporting procedures that cover the whole of the entity to be listed;
  • reviewing the group’s legal structure in order to ensure that vital assets (brands, patents, customer portfolios, etc.) are fully owned by the group and that the group’s legal form and articles of association are compatible with listing (no simplified joint-stock companies and no pre-emptive rights or special agreements in the articles);
  • reviewing the group’s operating structure, ensuring that it is an independent group with its own means of functioning and that it does not retain the structure of a division of a group or a family-run business (terminate employment contracts with non-operational family members, take out necessary insurance policies, draw up management agreements, etc.);
  • drawing up a shareholders’ agreement if needed (see Chapter 41);
  • introducing corporate governance appropriate for a listed company (independent directors, control procedures, board of director committees, etc. – see Chapter 43);
  • reviewing the company’s financial structure in order to ensure that it is similar to that of other listed companies in the same sector. This applies particularly to companies under LBO, which will have to partially deleverage via a share issue, at the latest at the time of listing;
  • adopting a well-thought-out dividend policy that is sustainable over the long term and that will not compromise the group’s development (see Chapter 36);
  • introducing a scheme for providing employees with access to the company’s shares through the allocation of free shares and/or stock options, etc. (see Chapter 42);
  • defining the company strategy in a form that is simple and easy to communicate, which will become the equity story to be told to the market at the time of listing.

From the start of this phase, the company should seek the assistance of an investment bank, which will act as a link between the company and the market. The company will also have to retain the services of a law firm, an accounting firm and possibly a PR agency.

The overall cost of the IPO is between €0.5m and €1m in fixed costs (lawyers, communications agency, roadshows) plus between 5% and 7% of funds raised as fees for the bank syndicate.

Even with this help, the management team will have a very heavy overload of work during these six months because the operational side will not have to be sacrificed for all that!

Section 44.2 EXECUTION OF THE IPO

1/ CHOOSING A MARKET

With rare exceptions, the natural market for the listing is the company’s home country. This is where the company is best known to local investors, who are the most likely to give it the highest value. There are obviously a few exceptions, such as L’Occitane and Prada, which elected for a Hong Kong listing (given that both companies’ activity is highly developed in Asia) and Criteo, which chose New York to facilitate its US expansion and where most of its peers were listed. But only a very small number of companies from major European countries are not listed in their home country.

Having said that, some stock exchanges act as magnets for some sectors, such as New York for technology companies or London for mining groups.

The next question is whether there should be a second listing on a foreign market. Listing on a foreign market generally triggers direct and indirect costs without any guarantee of greater liquidity or a higher valuation of the company.

Only groups from emerging countries, when their local market is underdeveloped (Russia, Latin America, etc.), gain a clear advantage from a listing in New York, London, Paris or Hong Kong. The Nigerian e-commerce group Jumia is a good example, with its listing in New York in 2019. The Swiss-based mining and trading group Glencore chose London (and Hong Kong) as most mining groups are listed in London.

2/ SIZING THE IPO

Over and above the choice of a stock market (or several) for listing, a certain number of parameters will have to be fixed, including the size of the IPO and the choice between a primary offer (share issue), a secondary offer (sale of shares by existing shareholders) or a mix of the two.

These decisions will be made based on the following:

  • whether existing shareholders want to convert all or part of their stakes into cash;
  • whether the company needs funds to finance its growth or to deleverage;
  • the need to put a sufficient number of shares on the market so that the share can offer a certain amount of liquidity;
  • the need to limit the negative signal of the transaction.

These constraints can sometimes turn out to be contradictory. For example, the sale of all of the existing shares on the market by existing shareholders is rarely considered, as this would send a very negative signal to the market. So, when the IPO includes the sale by one or more major shareholders of some of their shares, they will generally be asked to undertake to hold onto the shares that have not been sold for a given period (6–12 months) so as to avoid any heavy impact on the market if they were to sell large volumes of shares immediately after the IPO. This undertaking, or lock-up clause, acts as a reassurance to the market and tempers the negative signal of the operation.

It may also be a good idea to combine the sale of shares by existing shareholders with a capital increase, even if the company has no immediate need of funds. The message sent by an IPO through a capital increase is, by definition, more positive. The newly listed company will be able to speed up its development and to tap a new source of funding, which is why most IPOs are partly primary, whether to a larger or smaller degree.

THE 10 LARGEST IPOS WORLDWIDE OF ALL TIME

RankCompanyStock exchangeSectorProceeds ($bn)Year
 1Saudi AramcoSaudi Arabian stock exchangeOil25.62019
 2AlibabaNew York (NYSE)Ecommerce25  2014
 3Agricultural Bank of China (ABC)Shanghai and Hong KongBank22  2010
 4SoftbankTokyo Stock Exchange (TSE)Conglomerate21.32018
 5Industrial and Commercial Bank of China (ICBC)Shanghai and Hong KongBank19.12006
 6NTT DoCoMoTokyo Stock Exchange (TSE)Telecom and Internet18.11998
 7VisaNew York (NYSE)Financials17.92008
 8AIAHong Kong (HKEx)Insurance17.82010
 9EnelMilan and New York (NYSE)Utility16.51999
10FacebookNew York (NASDAQ)Internet16.02012

Source: Dealogic.

3/ IPO TECHNIQUES

While the classic method of listing remains the constitution of an order book (see Chapter 25), two new techniques have developed strongly in recent years: direct listing and merger with a SPAC (Special Purpose Acquisition Company).

Direct listing is a simple IPO method: a company wishing to become listed simply lists its shares on a regulated market and lets supply (from shareholders wishing to monetise their investment) and demand (from investors wishing to buy shares) set the equilibrium price. In the United States, a reference price is indicated but is not binding. This technique does not therefore require the intervention of a bank as is the case for IPOs by setting up an order book.

This technique is normally less costly than an IPO through the creation of an order book because the company saves the banks’ fees and, above all, the operation is theoretically carried out without any discount for the selling shareholders.

But direct listing does not only have advantages. First of all, the company cannot raise funds by this method, only existing shares are exchanged. Furthermore, the sale of large blocks of shares is not possible or not optimal. Indeed, investor demand may be relatively limited in the absence of a major marketing exercise carried out by the banks in building up the order book (book building with meetings with investors, distribution of analysts’ notes, etc.). Finally, in the absence of a method for price discovery before listing (which is in reality book building), and of mechanisms for limiting price variations (greenshoe, lock up), the volatility of the price during the first few weeks of listing is likely to be significantly higher in the case of a direct listing than in the case of a traditional IPO.

A direct listing is therefore reserved for a certain type of company: one that is already well known to investors (and therefore generally large), with an already large shareholder base (often consisting in part of the company’s employees), wishing to provide liquidity to its shareholders, but not needing to raise funds.

Spotify chose this IPO mode in 2018 followed by Slack in 2019 and Asana and Palentir in 2020. In Europe this technique has been used mainly in the case of spin-offs (e.g. ArcelorMittal/Aperam, HiPay/HiMedia).

SPACs or “blank cheques companies” are shells that get listed with the intention of acquiring and merging within 18–24 months with a private operating company (which will then become a listed company). The shareholders of SPACs have the right to vote for or against the acquisition (known as despacking). This is obviously crucial as it allows the SPAC to fulfil its mission. If the management of a SPAC fails to find a suitable target within 18–24 months, the vehicle is dissolved and the funds returned to the shareholders. At the time of despacking, shareholders may also choose to have their initial investment returned to them. Paradoxically, this latter option actually encourages them to vote for the deal regardless of their views on the transaction. If they think the deal is going well, they vote for it and stay; if not, they vote yes and exit and ask for their shares to be returned. But by asking for the exit, they can jeopardise the operation because if the SPAC does not have enough funds to complete the acquisition, it is cancelled.

It is quite rare that the transaction is completed for an amount less than or equal to the amount raised by the SPAC initially (a few hundred million euros). If the target is larger, either the target’s shareholders remain shareholders (majority or not) in the listed company, or the SPAC raises funds again from institutional investors at the time of the acquisition (this is known as PIPE, Private Investment in Public Equity). This is a second validation by the market of the rationale and price of the acquisition.

The management of SPAC receives almost 20% of the shares for free when SPAC is created and listed. The management invests limited funds (a few million dollars or euros) but they are really at risk, because if SPAC does not despack, the funds are lost (these funds pay for the operating costs of SPAC and the costs of its listing).

When the initial shareholders of the SPAC target are paid in SPAC shares, the operation has the same result as a classical IPO with some differences:

  • For the exiting shareholders, selling to a SPAC means saving the IPO discount since the company is sold privately.
  • For the remaining shareholders, if the company has to raise funds during the operation, the IPO discount must be set against the dilution linked to the free shares of the SPAC’s management and the warrants (issued at the time of the IPO and allowing to subscribe to new shares at a higher price, generally $11.5 for shares issued at $10).
  • For institutional investors, they do not benefit from the IPO discount but they guarantee themselves a place in the operation, which an allocation in a classic IPO would not have allowed.
  • The real losers are the investment banks who receive a much lower fee than in a traditional IPO.

These new methods still suffer from an image problem: direct listing exists in Europe, but mainly for small companies; SPACs are often regarded as the operations of financial pirates. But their institutionalisation in the US, with 219 SPACs raising $79bn (compared with $67bn for traditional IPOs in 2020), may change this image. Although their acceleration at the beginning of 2021 (340 SPACs raising $106.6bn) may give rise to fears of a speculative boom that will deflate, without them falling back into the margins. A few SPACs have gone public in Europe.

Atypically, some small unlisted companies are being absorbed by a listed structure, without operational activities or having previously sold them (a “shell”), in order to access the listing more quickly and at lower cost (AAA in 2021). But in most cases, a free float has to be recreated.

Section 44.4 UNDERPRICING OF IPOS

If statistics are to be believed, the share price of a newly floated company generally – but there are a number of exceptions – sees a small rise over the IPO price in the days following flotation (see Section 25.2). It would also appear that this discount at which shares are sold or issued at the time of an IPO is volatile over time, compared with an equilibrium value – high in the 1960s, lower in the 1970s to 1980s, and then high again in the 2000s before dropping in recent years. Following research, many different explanations for this discount have been put forward. The main ones are:

  • This underpricing is theoretically due to the asymmetry of information between the seller and the investors or intermediaries. The former has more information on the company’s prospects, while the latter have a good idea of market demand. A deal is therefore possible, but price is paramount.
  • Signal theory says that the sale of shares by the shareholders is a negative signal, so the seller has to “leave some money on the table” in return for ensuring that the IPO goes off smoothly and to investors’ satisfaction.
  • Asymmetrical information amongst the different investors. “Informed” investors will only be interested in good deals and will not be tempted by overvalued IPOs. Less well-informed investors, who will thus be involved in all financings, will find that they are better served in unattractive operations. They will not be as present on more attractive deals. In seeking to retain all the investors who provide valuable and necessary liquidity to the market, IPOs are carried out at a discount.
  • There are some who argue (not very convincingly) that underpricing can limit the risk of legal disputes with investors who would feel as if they had been swindled because they’d made a bad investment.

Section 44.5 HOW TO CARRY OUT A SUCCESSFUL IPO

The fact that a number of IPOs are cancelled or postponed (2018–2020 has seen, amongst others, tech start-ups WeWork and Airbnb in the USA, petrochemical company Sibur in Russia) shows that this is a tricky process and that success is not always guaranteed.

A successful IPO is the combination of a number of factors:

  • the intrinsic quality of the company: market share, growth and clarity of the activity, management experience, capital structure, should not be unusual, etc. These factors are assessed on the basis of comparable companies that are already listed, since the listing of the company is offering a new choice to investors within the same investment universe;
  • a clear and convincing explanation of the sellers’ motivations, as the market will always fear that they are selling their shares because their best results have already been achieved. This is why a flotation through a share issue for financing investments is preferable to the sale of shares (signalling theory);
  • agreement on the price, which is much easier to achieve when the stock markets are performing well, and very difficult to achieve when they are performing badly. This is the most frequent reason for cancelling an IPO.

From a tactical point of view, and when the stock markets are performing badly, marketing is crucial. Readers, who have been aware since Chapter 1 that a good financial director is first and foremost a good marketing manager, will not be surprised! Marketing involves:

  • familiarising investors with the stock market candidate a few months before the roadshows themselves begin, through informal meetings (pilot fishing);
  • entry into the company’s capital by investors seen as cornerstone investors a few weeks before the IPO when the regulations allow this, or during the IPO but with a guaranteed allocation, which will encourage other investors to follow suit. This is particularly prevalent in Asia. Thus, Thailand’s largest retailer, Central Retail Corp, welcomed Singapore sovereign wealth fund GIC and funds run by Capital Research Management as international cornerstone investors backing its IPO in January 2020; an anchor investor is an institutional investor placing a large order in the order book, thereby acting as a valuation driving force. The Monetary Authority of Singapore acted as an anchor investor in the March 2020 IPO of SBI Cards.
  • tight management of communication over the envisaged price. For example, Glencore let it be known that it was considering a flotation of over $60bn and when a lower price was announced, this was perceived as good news. This is called behavioural finance! It is true that the difficulty of valuing this complex group made this manoeuvre much easier;
  • a price seen as lower than the equilibrium value, enabling investors to hope for capital gains after a few months. For example, Shurgard fixed its IPO price at the bottom of the indicative bracket. Seven days after listing, the share price stabilised at 13% above the IPO price.

Sometimes the market is a buyers’ market, and these buyers do not hesitate to twist the arm of investors seeking liquidity. It is just as well to be aware of this and not try to play another game if you want to list a company on the stock exchange.

The first days of listing are crucial, because starting a stock market career with a share price that is lower than the IPO price (Uber in May 2019) does not make a very good impression on investors. On the other hand, slightly undervaluing the share when it is listed means that the price will rise by a few percentage points during its first days of listing. This puts everybody in a good mood!

Finally, in the long term the company and its managers will have to learn to live with daily constraints on their behaviour imposed by the periodical distribution of financial information, by managing earnings so as not to disappoint investors and thereby risk lower levels of investment than an unlisted company might face, and because they will be taking fewer risks in general. Furthermore, all shareholders must be treated equally, and managers are going to have to get used to the value of the company being published every day; sometimes this value will be low even though results are good. This can have an impact on the morale of employees and on shareholders’ assets, and it could lead to a change of control in the event of major changes in the capital structure.

That’s just life on the stock exchange!

Section 44.6 PUBLIC TO PRIVATE

A company (or the shareholders) will first start considering a public-to-private move when the reasons why it decided to list its shares in the first place, for the most part, become irrelevant. It has to weigh the cost of listing – direct costs: stock exchange fees, publication of annual reports, meetings with analysts, employment of investor relations staff; and indirect costs: requirement to disclose more information to the public and to competitors, market influence on strategy, management’s time spent talking to the market, etc. – against the benefits of listing when deciding whether the company should remain listed or not. This is especially the case if:

  • the company no longer needs large amounts of outside equity and can self-finance future financing requirements. The company no longer has any ambition to raise capital on the market or to pay for acquisitions in shares;
  • the stock exchange no longer provides minority shareholders with sufficient liquidity (which is often rapidly the case for smaller companies which only really benefit from liquidity at the time of their IPO). Listing then becomes a theoretical issue and institutional investors lose interest in the share;
  • the annual cost of the listing (starting at €200k for a small company and running into millions for larger ones) has become too expensive in comparison with the benefits;
  • the company no longer needs the stock exchange in order to increase awareness of its products or services.

The second type of reason why companies delist is financial. Large shareholders, whether majority shareholders or not, may consider that the share price does not reflect the intrinsic value of the company. Turning a problem into an opportunity, such shareholders could offer minority shareholders an exit, thus giving them a larger share of the creation of future value.

The operation can be complex. Indeed, beyond the technical constraints, it will depend on the ability of the majority shareholder to convince the minority shareholders to sell their shares. Alternatively, for companies with dispersed capital, it will be necessary to find a new investor ready to make an offer, usually with recourse to debt. Delisting is possible if the majority shareholder exceeds a threshold, often 90% or 95%, as it is then obliged to acquire the rest of the shares. This is known as a squeeze-out. In practice, this amounts to forcing minority shareholders to sell any outstanding shares. Because this is a form of property expropriation, the price of the operation is analysed very closely by the market regulator. In most countries, a fairness opinion has to be drawn up by an independent, qualified financial expert.

If investors are below the squeeze-out threshold, they first have to launch an offer on the company’s shares, hoping to go above the squeeze-out threshold so as to be able to take the company private. This is a P-to-P, public-to-private, deal.

Following a change of control, the new majority shareholder who wishes to hold 100% of the capital of its new subsidiary in order to more easily implement the expected synergies will then have to proceed with a delisting through a squeeze-out.

SUMMARY

QUESTIONS

ANSWERS

BIBLIOGRAPHY

A peek behind the scenes of investment banking

At any given time, a company can have several valuations, depending on the point of view of the buyer and the seller and their expectations of future profits and synergies. This variety sets the stage for negotiation but, needless to say, a transaction will take place only if common ground can be found – i.e. if the seller’s minimum price does not exceed the buyer’s maximum price.1

The art of negotiation consists of allocating the value of the anticipated synergies between the buyer and the seller, and in finding an equilibrium between their respective positions, so that both come away with a good deal. The seller receives more than the value for the company on a standalone basis because they pocket part of the value of the synergies the buyer hopes to unlock. Similarly, the buyer pays out part of the value of the synergies, but has still not paid more than the company is worth to them.

Transactions can also result from erroneous valuations. A seller might think the company has reached a peak, for example, and the buyer that it still has growth potential. But generally, out-and-out deception is rarer than you might think. It’s usually only in hindsight that we say we made a killing and that the party on the other side of the transaction was totally wrong!

In this chapter we will focus on the acquisition of one company by another. We will not consider industrial alliances, i.e. commercial or technology agreements negotiated directly between two companies which do not involve a transaction of the equity of either of them. Before examining the various negotiation tactics and the purchase of a listed company, let us first take a look at the merger and acquisition phenomenon and the economic justification behind a merger.

Section 45.1 THE RISE OF MERGERS AND ACQUISITIONS

1/ MERGER AND ACQUISITION WAVES

Acquisitions can be paid for either in cash or in shares. Generally speaking, share transactions predominate when corporate valuations are high, as they were in 1999–2000, because absolute values do not have to be determined.

However, in less propitious times, payment in cash is highly appreciated, both by sellers, who delight in receiving hard cash which will not lose its value on the stock market, and by buyers, who are not keen to issue new shares at a price that to them would seem to be discounted. Between 2007 and 2013, cash was back in fashion!

Conversely, when the market is bearish, cash payments are more attractive to both parties. The seller receives cold, hard cash, which will not lose value as shares might, while the buyer is reluctant to issue new shares at prices they consider to be a discount to their intrinsic value.

Source: Data from Thomson One Deals, Factset

As shown in the above graph, mergers and acquisitions tend to come in waves:

  • In the 1960s, conglomerates were all the rage. ITT, Gulf and Western, Fiat, Schneider and many others rose to prominence during this period. The parent company was supposedly able to manage the acquired subsidiaries better, plus meet their capital needs. Most transactions were paid for with shares.
  • In the 1980s, most acquisitions were paid for in cash. Many of the big conglomerates formed in the 1960s were broken up. They had become less efficient, poorly managed and valued at less than the sum of the values of their subsidiaries.
  • In the 1990s and 2000s, companies within the same sector joined forces, generally in share transactions: Procter & Gamble/Gillette, Pfizer/Wyeth, Arcelor/Mittal, Cadbury/Kraft, etc.
  • In the 2010s, the logic is the same and payments are mostly in cash: Kraft/Heinz, SABMiller/AB Inbev, Lactalis/Parmalat, Air Liquide/Airgas, etc. Since 2014, as the stock market has been regaining momentum, we are seeing more and more payments in shares: Peugeot-FiatChrysler, Lafarge-Holcim, Luxottica-Essilor, Worldline-Ingenico, Sprint-T-Mobile.

It seems to us that there are three main principles that explain the cyclical nature of mergers:

  • when the economic situation is depressed or very bad, companies focus on their operating activities, seeking to cope with problems and to restructure. When the economy improves, they regain confidence, are more open minded and ready to consider mergers and acquisitions, which are always complicated to implement. But because the economic situation is good, they are prepared to take a risk;
  • the availability of equity or debt financing is crucial because an acquisition requires financing. When share prices are low, shareholders are not very keen on being diluted in conditions that are bad for them and it is difficult to carry out capital increases. Also, if share prices are low, this means that it is unlikely that the economy is booming, making it difficult to obtain debt financing. High share prices are often the consequence and the cause of more easily obtainable financing, a clear sign of optimism!;
  • finally, herd behaviour will encourage companies in a given sector to carry out mergers when they see another sector player initiating a merger, so that they will not be the only ones creating cost and/or revenue synergies which could give them a clear competitive advantage. This could be witnessed in 2020 in the payment industry (e.g. Worldline-Ingenico, Nexi-Sia, Rapyd-Korta).

Putting the purely financial elements aside, the determinants of mergers and acquisitions can be macroeconomic, microeconomic or human factors, as we will now see.

2/ MACROECONOMIC FACTORS

There are several determining macroeconomic factors:

  • Periods of innovation and technological change are often followed by merger waves. During the innovation period (computers in the 1970s, the Internet or renewable energies today), many new companies are founded. Inevitably, however, the outlook for the growth and survival of these start-ups will fade, leading to a period of consolidation (Criteo buying Manage). Moreover, start-ups’ heavy financing needs may prompt them to seek the support of a major group that, in turn, can take advantage of the growth in the start-ups’ business (Peugeot buying TravelCar, a carsharing rental platform).
  • Many companies are undergoing a change in market scope. Thirty years ago, their market was national; now they find that they must operate in a regional (European) or more often worldwide context (Syngenta-ChemChina). Adapting to this change requires massive investment in both physical and human capital, leading to much higher financing needs (pharmaceuticals). As competition increases, companies that have not yet merged must grow rapidly in order to keep up with their now larger rivals. Critical mass becomes vital (Occidental Petroleum-Anardako). The policy of creating national champions in the 2000s encouraged this race for size (GDF-Suez becoming Engie).
  • Legislative changes have fostered restructuring in many industries. A broad trend towards deregulation began in the 1980s in the US and the UK, profoundly changing many sectors of the economy, from air transport to financial services to telecommunications. In Europe, a single market was created in conjunction with a policy of deregulation in banking, energy and telecommunications. European governments further scaled back their presence in the economy by privatising a number of publicly held companies. In many cases, these companies then became active participants in mergers and acquisitions (EDF, Orange, ENI).
  • The increasing importance of financial markets has played a fundamental role in corporate restructuring. In the space of 30 years, European companies have evolved from primarily credit-based systems, where banks were the main suppliers of funds, to financial market systems, characterised by disintermediation (see Section 15.1). This structural change took place in conjunction with a shift in power from banks and other financial companies (Mediobanca, Deutsche Bank, Paribas, Générale de Belgique) to investors. Accordingly, shareholders now exert pressure on corporate managers to produce returns in line with their expectations:
    • in the event of a disappointing performance, shareholders can sell their shares and, in doing this, depress the share price. Ultimately, this can lead to a restructuring (Aviva) or a takeover (Monsanto);
    • conversely, companies must convince the market that their acquisitions (Occidental Petroleum-Anadarko) are economically justified.
  • Low population growth in Europe, combined with strict immigration control, has made it more difficult for firms to grow organically. In response, managers in search of new growth drivers will try to find M&A opportunities (Lactalis-Greenland in Egypt).

3/ MICROECONOMIC FACTORS

There are a number of different determining microeconomic factors:

  • By increasing their size and production volumes, companies reduce their unit costs, in particular their R&D, administration and distribution costs (Nestle-Bountiful). Moreover, a higher production volume will put the company in a better position to negotiate lower costs with its suppliers (Tesco-Booker).
  • Mergers can increase a company’s market share and boost its revenues dramatically. To the extent that companies address complementary markets, merging will enable them to broaden their overall scope. There are two forms of complementarity:
    • geographic (Banijay-Endemol). The two groups benefit from their respective presence in different regions;
    • product (SandroMaje-DeFursac). The group can offer a full palette of products to its customers.
  • Although riskier than organic growth, mergers and acquisitions enable a company to save valuable time. In growing sectors of the economy, speed (the first-mover advantage) is a critical success factor. Once the sector matures, it becomes more difficult and more expensive to chip away at competitors’ market share, so acquisitions become a matter of choice (Altice-CableVision). The idea is also to get rid of a competitor (S&P-HIS Markit). When a company is expanding internationally or entering a new business, a strategic acquisition is a way to circumvent barriers to entry, both in terms of market recognition (LVMH-Tiffany) and expertise (Apple-Voysis).
  • By gaining additional stature, a company can more easily take new risks in a worldwide environment. The transition from a domestic market focus to worldwide competition requires companies to invest much more. The financial and human risks become too great for a medium-sized company (oil and gas exploration, pharmaceutical research). An acquisition (paid in shares) instantly boosts the company’s financial resources and reduces risk, facilitating decisions about the company’s future growth (Unilever-Onnit).
  • The need for cash, because groups are in difficulty (Bombardier, ThyssenKrupp), because they need to deleverage (HNA, Wanda in China) or because they regularly need to make capital gains (sale of Deutsche Glasfaser by KKR) are other reasons why M&A deals happen.
  • When groups decide to refocus on their core business, we also see assets being disposed of (Nestlé’s disposal of Haagen-Dazs).
  • In addition to the economic criteria prompting companies to merge, there is also the human factor. Many companies founded between 1955 and 1980, which were often controlled by a single shareholder manager, are now, not surprisingly, encountering problems of succession. In some cases, another family member takes over (ArcelorMittal, Swatch, Benetton, Reliance). In other cases, the company may have to be sold if it is to survive (Norbert Dentressangle).

4/ THE LARGER CONTEXT

Mergers and acquisitions, regardless of how tricky they are to manage, form part and parcel of a company’s life and serve as a useful tool for growth.

Mergers and acquisitions, although tricky to manage, are part of the lifecycle of a company and are a useful growth tool.

Synergies are often overestimated; their cost and time to implement underestimated. For example, making information systems compatible or restructuring staff can be notoriously difficult.

Numerous research works have measured the value created by M&A deals and how this value is shared between shareholders of the buyer and of the target. They demonstrate that value is created for the target’s shareholders because of the control premium paid. For the buyer’s shareholders, the results are more mixed, even if they tend to show a recent improvement since the beginning of the 2000s, when it was widely assumed that two-thirds of mergers were failing. Excluding some resounding failures (acquisition of Alstom’s energy division by GE or the Monsanto by Bayer), which heavily bias the results, M&A deals would appear value-creative because of some largely successful deals such as Sanofi/Genzyme, Office Depot-OfficeMax, Peugeot-Opel. Quality and speediness of the integration process are the key factors for successful M&A deals.

Section 45.2 CHOOSING A NEGOTIATING STRATEGY

A negotiating strategy aims at achieving a price objective set in accordance with the financial value derived from our valuation work presented in Chapter 31. But price is not everything. The seller might also want to limit the guarantees they grant, retain managerial control, ensure that their employees’ future is safe, etc.

Depending on the number of potential acquirers, the necessary degree of confidentiality, the timing and the seller’s demands, there is a wide range of possible negotiating strategies. We present below the two extremes: private negotiation and auction. Academic researchers2 have established that none of these strategies is better than another. Our personal experience tells us the same thing: the context dictates the choice of a strategy.

1/ PRIVATE NEGOTIATION

The seller or their advisor contacts a small number of potential acquirers to gauge their interest. After signing a confidentiality agreement (or non-disclosure agreement, NDA), the potential acquirers might receive an information memorandum describing the company’s industrial, financial and human resource elements. Discussions then begin. It is important that each potential acquirer believes they are not alone, even if in reality they are. In principle, this technique requires extreme confidentiality. Psychological rather than practical barriers to the transaction necessitate the high degree of confidentiality.

To preserve confidentiality, the seller often prefers to hire a specialist, most often an investment banker, to find potential acquirers and keep all discussions under wraps. Such specialists are usually paid a success fee that can be proportional to the size of the transaction. Strictly speaking, there are no typical negotiating procedures. Every transaction is different. The only absolute rule about negotiating strategies is that the negotiator must have a strategy.

The discussion focuses on:

  • how much control the seller will give up (and the status of any remaining minority shareholders);
  • the price;
  • the payment terms;
  • any conditions precedent;
  • representations and warranties; and
  • any contractual relationship that might remain between the seller and the target company after the transaction.

As you might expect, price remains the essential question in the negotiating process. Everything that might have been said during the course of the negotiations falls away, leaving one all-important parameter: price. We now take a look at the various agreements and clauses that play a role in private negotiation.

(a) Memorandum of understanding (MOU) or letter of intent (LOI)

When a framework for the negotiations has been defined, a memorandum of understanding is often signed to open the way to a transaction. A memorandum of understanding is a moral, not a legal, commitment. Often, once the MOU is signed, the management of the acquiring company presents it to its board of directors to obtain permission to pursue the negotiations.

The MOU is not useful when each party has made a firm commitment to negotiate. In this case, the negotiation of the MOU slows down the process rather than accelerating it.

(b) Agreement in principle

The next step might be an agreement in principle, spelling out the terms and conditions of the sale. The commitments of each party are irrevocable, unless there are conditions precedent – such as approval of the regulatory authorities. The agreement in principle can take many forms.

(c) Financial sweeteners

In many cases, specific financial arrangements are needed to get over psychological, tax, legal or financial barriers. These arrangements do not change the value of the company.

Sometimes, for psychological reasons, the seller refuses to go below some purely symbolic value. If they draw a line in the sand at 200, for example, whereas the buyer does not want to pay more than 190, a schedule spreading out payments over time sometimes does the trick. The seller will receive 100 this year and 100 next year. This is 190.9 if discounted at 10%, but it is still 200 to their way of thinking. Recognise that we are out of the realm of finance here and into the confines of psychology, and that this arrangement fools only those who want to be fooled.

This type of financial arrangement is window-dressing to hide the real price. Often companies build elaborate structures in the early stages of negotiation, only to simplify them little by little as they get used to the idea of buying or selling the company. Far from being a magical solution, such sweeteners give each party time to gravitate towards the other. In these cases it is only a stage, albeit a necessary one.

The following techniques are part of the investment banker’s stock in trade:

  • set up a special-purpose holding company to buy the company, lever up the company with debt, then have the seller reinvest part of the funds in the hope of obtaining a second gain (this is an LBO,3 see Chapter 47);
  • have the buyer pay for part of the purchase price in shares, which can then be sold in the market if the buyer’s shares are listed;
  • pay for part of the purchase price with IOUs;
  • link part of the purchase price to the sale price of a non-strategic asset the buyer does not wish to keep, or on the outcome of a significant ongoing litigation;
  • an earnout clause, which links part of the transaction price to the acquired company’s future financial performance. The clause can take one of two forms:
    • either the buyer takes full control of the target company at a minimum price, which can only be revised upwards; or
    • the buyer buys a portion of the company at a fixed price and the rest at a future date, with the price dependent on the company’s future profits. The index can be a multiple of EBIT, EBITDA or pre-tax profit.

Earnout provisions are very common in transactions involving service companies (advertising agencies, M&A boutiques), where people are key assets. Deferral of part of the price will entice them to stay and facilitate the integration process, although it can create management problems during the earnout period.

2/ AUCTION

In an auction, the company is offered for sale under a predetermined schedule to several potential buyers who are competing with each other. The objective is to choose the one offering the highest price. An auction is often private, but it can also be announced in the press or by a court decision.

Private auctions are run by an investment bank in the following manner. Once the decision is taken to sell the company, the seller often asks an audit firm to produce a vendor due diligence (VDD, also called a long form report) to provide a clear view of the weak points of the asset from legal, tax, accounting, environmental, strategic and regulatory points of view. The VDD will be communicated to buyers later on in the process. For the moment, a brief summary of the company is prepared (a “teaser”). It is sent, together with a NDA, to a large number of potentially interested companies and financial investors.

In the next stage (often called “Phase I”), once the potential buyers sign the non-disclosure agreement,4 they receive additional information, gathered in an information memorandum (“info memo”). Then they submit a non-binding offer indicating the price, its financing, any conditions precedent and eventually their intentions regarding the future strategy for the target company.

At that point of time (“Phase II”), a “short list” of up to half a dozen candidates at most is drawn up by the seller and their advisor on the basis of price, other sales conditions, and their confidence in the capability and willingness of the candidates to successfully conclude the sale. Selected buyers receive still more information and possibly a schedule of visits to the company’s industrial sites and meetings with management. Often an electronic data room is set up, where all economic, financial, regulatory, environmental and legal information concerning the target company is available for perusal. Access to the data room is very restricted; for example, no copies can be made. At the end of this stage, potential investors submit binding offers.

At any time, the seller can decide to enter into exclusive negotiations for a few days or a few weeks. For a given period of time, the potential buyer is the only candidate. At the end of the exclusive period, the buyer must submit a binding offer (in excess of a certain figure) or withdraw from the negotiations. Exclusivity is usually granted on the basis of a pre-emptive offer, i.e. a financially attractive proposal.

Together with the binding offers, the seller will ask the bidder(s) to propose a markup (comments) to the disposal agreement (called the share purchase agreement, SPA)5 previously provided by the seller. The ultimate selection of the buyer depends, naturally, on the binding offer, but also on the buyer’s comments on the share purchase.

The seller selecting an auction process to dispose of the company may believe that it will lead to a high price because buyers are in competition with each other. In addition, it makes it easier for the seller’s representatives to prove that they did everything in their power to obtain the highest possible price for the company, be it:

  • the executive who wants to sell a subsidiary;
  • a majority shareholder whose actions might be challenged by minority shareholders; or
  • the investment banker in charge of the transaction.

Competition sometimes generates a price that is well in excess of expectations. Moreover, an auction is faster, because the seller, not the buyer, sets the pace.

However, the auction creates confidentiality problems. Many people have access to the basic data, and denying rumours of a transaction becomes difficult, so the process must move quickly. Also, as the technique is based on price only, it is exposed to some risks, such as several potential buyers teaming up with the intention of splitting the assets among them. Lastly, should the process fail, the company’s credibility will suffer. The company must have an uncontested strategic value and be in sound financial condition. The worst result is that of an auction process which turns sour because financial results are not up to the estimations produced a few weeks before, leaving only one buyer who knows they are now the only buyer.

A well-processed auction can take three to five months between intention to sell and the closing. It is sometimes shorter when an investment fund sells on to another fund.

3/ THE OUTCOME OF NEGOTIATIONS

In the end, whatever negotiating method was used, the seller is left with a single potential buyer who can then impose certain conditions. Should the negotiations fall apart at this stage, it could spell trouble for the seller because they would have to go back to the other potential buyers, hat in hand. So the seller is in a position of weakness when it comes to finalising the negotiations. The principal remaining element is the representations and warranties provisions that are part of the share purchase agreement.

Representations and warranties (“reps & warranties”) are particularly important because they give confidence to the buyer that the profitability of the company has not been misrepresented. It is a way of securing the value of assets and liabilities of the target company as the contract does not provide a detailed valuation.

Representations and warranties are not intended to protect the buyer against an overvaluation of the company. They are intended to certify that all of the means of production are indeed under the company’s control, that the financial statements have been drawn up in accordance with accounting principles and that there are no hidden liabilities.

Well-worded representations and warranties clauses should guarantee to the buyer:

  • the substance of fixed assets (and not their value);
  • the real nature and the value of inventories (assuming that the buyer and the seller have agreed on a valuation method);
  • the real nature of other elements of working capital;
  • the amount and nature of all of the company’s other commitments, whether they are on the balance sheet (such as debts) or not.

They also facilitate the sharing of known risks within the company at the time of the sale (disputes, defaulting customers) between buyer and seller.

The representations and warranties clause is generally divided into two parts.

In the first part (representations), the seller makes commitments related to the substance of the company that is to be sold.

The seller generally represents that the target company and its subsidiaries are properly registered, that all the fixed assets on the balance sheet, including brands and patents, or used by the company in the ordinary course of business, actually exist. As such, representations and warranties do not guarantee the book value of the fixed assets, but their existence.

The seller represents that inventories have been booked correctly, and that depreciation and provisions have been calculated according to GAAP.6 The seller declares that the company is up to date in tax payments, salaries and other accruals and that there are no prejudicial contracts with suppliers, customers or employees. All elements already communicated to the buyer, in particular exceptional items such as special contracts, guarantees, etc., are annexed to the clause and excluded from it because the buyer is already aware of them.

Lastly, the seller represents that during the transitional period between the last statement date and the sale date the company was managed in a prudent manner. In particular, the seller certifies that no dividends were distributed or assets sold, except for those agreed with the buyer during the period, that no investments in excess of a certain amount were undertaken, nor contracts altered, etc.

This is known as the locked-box system, where the price is definitively set on the basis of the latest financial statements provided by the seller and reviewed by the buyer. Otherwise, the company’s accounts will have to be closed at the time of sale and price adjustments will have to be made if the equity (or, to simplify the process, the net debt and working capital) recorded is different from that guaranteed by the seller.

In the second part of the clause (warranties), the selleragrees to cover any additional liabilities that were not disclosed to the buyer (which the buyer was unable to factor in when setting the price), that occurred prior to the sale and come to light after the sale, and to do so for a given period (usually three years). Thresholds and a predetermined cap are set. In some cases, it is possible to set off such liabilities against provisions which then fall away or against income from assets sold at a higher price than expected. Warranties are often accompanied by a holdback (part of the purchase price is put in an escrow account)7 or a bank guarantee.

The representations and warranties clauses are the main addition to the sale agreement but, depending on the agreement, there may be many other additions, so long as they are legally valid – i.e. not contrary to company law, tax law or stock market regulations requiring equal treatment of all shareholders. A non-exhaustive list would include:

  • means of payment;
  • status and future role of managers and executives;
  • audit of the company’s books. On this score, we recommend against performing an audit before the two parties have reached an agreement. An audit often detects problems in the company, poisoning the atmosphere, and can serve as a pretext to abandoning the transaction.
  • minority shareholders’ agreement; etc.

Of course, the parties to the contracts should also call upon legal experts to ensure that each clause is legally enforceable.

The final step is the actual consummation of the deal. It often takes place at a later date, because certain conditions must be met first: accounting, legal or tax audit, restructuring, approval of domestic or foreign competition commissioners, etc.

Sometimes a link-up is not allowed for competition (anti-trust) reasons (Sainbury’s–Asda merger in the UK, Alstom–Siemens in Europe) or control of foreign investments on companies considered as strategic (Carrefour–Alimentation Couche Tard, Broadcom–Qualcomm). Accordingly, these concerns must be anticipated very early on in the merger process and the parties must be assisted by specialised lawyers.

In Europe, the thresholds are €5bn for the combined sales of the parties and €250m for sales made on a combined basis in Europe by at least two parties. An exception exists when all companies concerned generate more than two thirds of their gross revenue within the EU, and within the same single country (the two-thirds rule).

Finally, in the USA, the Hart–Scott–Rodino law allows for notification to be waived if the value of the target is less than $92m. Many types of transactions are, nonetheless, exempted; for example, deals worth less than $368m between companies with sales of less than $184m, target’s sales of less than $18.4m, etc.

4/ THE DUAL-TRACK PROCESS

In order to improve its negotiation position or because the likely outcome of the sale process is unclear, the seller may decide to pursue a dual-track process: it will launch a sale process and the preparation of an IPO in parallel. At the latest possible moment, it will choose to sell to the one offering the best price, be it the stock market or a buyer. This is why in 2018, Delachaux cancelled its IPO and replaced an investment fund (CVC) with a Canadian investor (CDPQ).

Section 45.3 TAKING OVER A LISTED COMPANY

The first idea that comes to mind when buying or taking a significant stake in a listed company would be to pick up shares on the stock market until you are strong enough to negotiate with the other shareholders and the management team. This solution seems attractive since it would allow you to take control without having to buy all the securities. This is why the law and the stock exchange authorities have imposed certain constraints on the purchase of securities on the stock exchange.

First of all, there is an obligation to declare the crossing of thresholds: when a shareholder exceeds a certain percentage of the capital or voting rights of a listed company, a disclosure obligation is imposed on them. Then there is an obligation to launch a public offer on all outstanding shares when certain thresholds are crossed.

These principles governing takeovers of listed companies are found in most countries with various degrees of constraint from one country to another.

1/ STAKE-BUILDING

To succeed in acquiring a listed company, the first step can be to start building a block in the company. This is how Vivendi acquired 30% of Gameloft before launching a full offer on the rest of the shares.

There are three methods available to investors seeking to accumulate shares:

  • gradually buying up shares on the market. Shares are purchased at the market price and the identity of sellers is generally unknown;
  • acquiring blocks of shares, which involves negotiating the purchase of large blocks of shares with identified sellers;
  • an equity swap or total return swap (TRS), which is a contract to swap the stock performance (dividends, capital gains and losses) between a bank (which pays the performance to the investor) and an investor (who wishes to take a risk on the performance of a share without holding it, and who pays interest to the bank) or the opposite. The bank hedges this operation by buying shares on the market. At the end of the swap term, the investor buys the bank’s shares at the price paid by the latter. This is how Elliott acquired a 2% stake (in addition to the 3.75% stake it held in shares) in Telecom Italia in 2018.

The following conditions must be met for an acquisition of an attractive percentage at a reasonable price:

  • the share capital of the target company must be dispersed, with no controlling shareholder actually controlling the company;
  • the operation must be carried out in secret to avoid defensive measures being taken by shareholders opposed to the acquirer of the securities and to prevent the target’s share price from soaring;
  • the volume of daily transactions in the security must be large enough to allow for large purchases without causing a market imbalance.
  • Sometimes the purchase of securities is made by several investors acting in concert (see below) and sometimes over a long period of time.

In order to prevent the acquirer from taking control of a company in that way, most market regulations require investors in a listed company to publicly declare when they pass certain thresholds in the capital of a company. If the acquirer fails to declare these shares, voting rights are lost.

The first threshold is most often 3% (UK, Switzerland, Spain, Germany, Italy, etc.).

Regulatory disclosure requirements allow minority shareholders to monitor stake-building and prevent an acquirer from getting control of a company little by little. These requirements are also helpful for the management to monitor the shareholder structure of the company. By-laws can set additional thresholds to be declared (generally lower thresholds than required by law).

Regulatory threshold disclosure requirements are the following:

China5% and multiples of 5% above
France5%, 10%, 15%, 20%, 25%, 30%, 33.3%, 50%, 66.6%, 90%, 95%
Germany3%, 5%, 10%, 15%, 20%, 25%, 30%, 50%, 75%
India5%, then 2% till 25%, then any share above 25%
Italy3%, 5%, multiples of 5% above up to 30%, then 50%, 66.6%,90%,
Netherlands3%, 5%, 10%, 15%, 20%, 25%, 30%, 40%, 50%, 60%, 75%, 95%
Spain3%, 5%, multiples of 5% thereafter, then 50%, 60%, 70%, 75%, 80%, 90%
Switzerland3%, 5%, 10%, 15%, 20%, 25%, 33.3%, 50%, 66.6%
UK3% and multiples of 1% above
US5% and multiples of 1% above

2/ TYPE OF OFFER

It is very unusual for an acquirer to gain control of a public company without launching a public offer on the target. Such offers are made to all shareholders over a certain period of time (2–10 weeks depending on the country). Public offers can be split between:

  • share offers or cash offers;
  • voluntary or mandatory offers;
  • hostile or recommended offers.

(a) Cash or share offers

The table below summarises the criteria relevant for assessing whether a bidder wants to propose shares or cash in a public offer:

 Payment in cashPayment in sharesComments
Allocation of synergiesTarget company’s shareholders benefit from synergies only via the premium they receiveTarget company’s shareholders participate in future synergiesIn a friendly share exchange offer, the premium might be minimal if the expected synergies are high
Psychological effectsCash lends credibility to the bid and increases its psychological valuePayment in shares has a “friendly” character 
Purchaser’s financial structureIncreases gearingDoes not increase gearingThe size of the deal sometimes requires payment in shares
Shareholder structureNo impact unless the deal is subsequently refinanced through a share issueShareholders of the target become shareholders of the enlarged groupSometimes, shareholders of the target get control of the new group in a share-for-share offer
Impact on purchaser’s share priceAfter the impact of the announcement, no direct link between the purchaser’s and target’s share priceImmediate link between purchaser’s and target’s share price, maintained throughout the bid periodA share exchange offer gains credibility when the two companies’ share prices align with the announced exchange ratio
Signal from buyer’s point of viewPositive: buyer’s stock is undervalued. Debt financing: positive signalNegative: buyer’s stock is overvaluedIf the size of the target only makes possible a share-for-share deal, no signal
Accounting effectsIncreases EPS and its growth rate if the inverse of the target’s P/E ratio including any premium is greater than the after-tax cost of debt of the acquirerIncreases EPS if the purchaser’s P/E ratio is higher than the target’s, premium includedEPS is not a relevant indicator of value creation, see Chapter 27
Purchaser’s tax situationInterest expense deductibleNo impact, except capital gain if treasury shares are usedTaxation is not a determining factor
Seller’s tax situationTaxable gainGain on sale can be carried forward 
Index weightingNo changeHigher weighting in index (greater market capitalisation)In the case of a share exchange, possible re-rating owing to size effect

In practice, the choice is not so black and white. The purchaser can offer a combination of cash and shares (mixed offers), cash as an alternative to shares, or launch a “mix and match” offer, as we will see.

(b) Hostile or recommended offers

The success or failure of an offer can depend largely on the attitude of the target’s management and the board of directors towards the offer.

To maximise the chances of success, the terms of an offer are generally negotiated with the management prior to the announcement, and then recommended by the board of the company. The offer is then qualified as friendly or recommended.

In some cases, the management of the target is not aware of the launch of an offer; it is then called an unsolicited offer. Facing this sudden event, the board has to convene and decide whether the offer is acceptable or not. If the board rejects the offer, it becomes hostile. This does not mean that the offer will not succeed, but just that the bidder will have to fight management and the current board of directors during the offer period to convince shareholders.

Most unsolicited offers end up as recommended offers, but only after the bidder has sweetened the offer in one way or another (generally by offering a higher price).

Around 15% of offers are deemed hostile and large groups such as Pfizer, Sanofi, Diageo, Enel, etc. were created through unsolicited offers.

(c) Voluntary or mandatory offers

The concept of the mandatory offer does not exist in every country. Nevertheless, in most countries, when a buyer passes a certain threshold or acquires the control of the target, they are required by stock exchange regulation to offer to buy back all the shareholders’ shares. It is one of the founding rules of stock exchange regulations. It should be noted that in the US, there is no mandatory offer and an acquirer can theoretically buy a majority of the capital of a listed company without having to launch an offer to the minority shareholders.

Generally, the constraints for a mandatory offer are tighter than for a voluntary offer. For example, in the UK the mandatory offer will be in cash, or at least a cash alternative will be provided. Obviously, the conditions of the offer that the acquirer is allowed to set in a mandatory offer are limited because they are defined by the regulations.

3/ CERTAINTY OF THE OFFER

It would be very disruptive for the market if an acquirer were to launch an offer and withdraw it a few days later. All market regulations try to ensure that when a public offer is launched, shareholders are actually given the opportunity to tender their shares.

Therefore, market regulation requires that a cash offer is fully funded when it is launched. Full funding ensures that the market does not run the risk of a buyer falling short of financing when the offer is a success! This funding usually takes the form of a guarantee by a bank (generally the bank presenting the offer commits that if the acquirer does not have the funds the bank will pay for the shares).

Another principle is that offers should be unconditional. In particular, the bidder cannot set conditions to the execution of the offer that remains in their hands (as an example, an offer cannot be conditional upon board approval of the acquirer). Nevertheless, in most countries, the offer can be subject to a minimum acceptance (which generally cannot be too high) and regulatory approval (including antitrust). In a few countries (the UK, the Netherlands, the US), the offer can be subject to a material adverse change (MAC) clause, which can only be invoked in extreme cases.8

4/ DOCUMENTATION AND MARKET AUTHORITY ROLE

The main role of market authorities is to guarantee the equal treatment of all shareholders and the transparency of the process.

In that regard, market authorities will have a key role in public offers:

  • They set (and often control) the standard content of the offer document. This document must contain all relevant information allowing the target’s shareholders to take a proper decision.
  • They supervise the process timetable.
  • In most countries their green light is necessary for the launch of the offer (they therefore control the price offered).

5/ DEFENSIVE MEASURES

In theory, a company whose shares are being secretly bought up on the stock market generally has a greater variety and number of defensive measures available to it than a company that is the target of a takeover bid. The reason behind this disparity is the secrecy surrounding shares bought up on the market compared with rules of equality and transparency applied to takeover bids.

If a company becomes aware that its shares are being bought up on the market, it is entitled to invoke all of the means of shareholder control described in Chapter 41. It can also get “friendly” investors to buy up its shares in order to increase the percentage of shares held by “friends” and push up its share price, thus making it more expensive for the hostile party to buy as many shares as it needs. Of course, the company will also need to have the time required to carry out all of these transactions, which generally involve waiting periods.

In the case of a takeover bid, there are fewer defensive measures available and they also depend on regulations in force in each country. In some countries (the UK and the Netherlands), all defensive measures taken during a takeover period (excluding attempts to identify other bidders) must be ratified by an EGM held during the offer period. Proxies granted by the general meeting of shareholders to the board prior to the offer period may be suspended. In some countries, any decision taken by the corporate and management bodies before the offer period that has not been fully or partially implemented, which does not fall within the normal course of business and which is likely to cause the offer to fail, must be approved or confirmed by the general meeting of the target’s shareholders.

Furthermore, in some countries, as soon as the takeover bid has been launched, the parties involved are required to ensure that the interests of the target’s employees are taken into account, to ensure that all shareholders are treated equally and that no upheaval on the stock markets is caused, to act in good faith and to comply with all regulations governing takeover bids.

The target company can either defend itself by embarking on an information campaign, explaining to shareholders and to the media how it will be able to create greater value in the future than the premium being offered by the predator, or it can use more active defensive measures, such as:

  • finding a third party ready to launch a competing takeover bid, called a “white knight”;
  • launching its own takeover bid on the hostile bidder;
  • getting “friends” to buy up its shares;
  • carrying out a capital increase or buying or selling businesses;
  • warrants;
  • legal action.

Just how far a board of directors is prepared to go to sabotage a takeover bid is determined by each board facing a predator. It could be depriving its shareholders of a potential capital gain and shareholders may question the responsibility of directors.

A competing takeover bid must be filed a few days before the close of the initial bid. The price offered should be at least a few percentage points higher than the initial bid. There is always the possibility that the initial bidder will make a higher bid, so there is no guarantee that the competing offer will succeed. Likewise, the “white knight” can sometimes turn grey or black when the rescue offer actually succeeds. We saw this in 2019 when Thales came to the “rescue” of Gemalto which was “under attack” by Atos.

A share purchase or exchange offer by the target on the hostile bidder, known as a Pac-Man defence, is only possible if the hostile bidder itself is listed and if its shares are widely held. In such cases, industrial projects are not that different given that an offer by X on Y results in the same economic whole as an offer by Y on X. This marks the start of a communications war (advertisements, press releases, meetings with investors), with each camp explaining why it would be better placed to manage the new whole than the other.

The buying up of shares by “friends” is often highly regulated and generally has to be declared to the market authority, which monitors any acting in concert or which may force the “friend” to file a counter-offer!

A capital increase or the issue of marketable securities is often only possible if this has been authorised by the general meeting of shareholders prior to the takeover bid, because generally there won’t be enough time to convene an EGM to fit in with the offer timetable. In any event, a reserved issue is often not allowed.

Warrants, described in Chapter 41, are a strong dissuasive element. The negative consequences of warrants being issued for the company launching a hostile takeover bid mean that it is generally prepared to negotiate with the target – neutralisation of the warrants in exchange for a higher offer price.

US experience has shown that “poison pill” warrants strengthen the negotiating position of the target’s management, although they don’t ensure its independence. If warrants are, in fact, issued, then the matter of director responsibility will be raised, since the directors will effectively have caused shareholders to lose out on an opportunity to get a higher price for their shares.

The transfer of an important asset into a special structure to prevent its disposal. This is the method used by Suez to try to fend off the Veolia bid.

Legal action could be taken to ensure that market regulations are complied with or on the basis of misleading information if the prospectus issued by the hostile bidder appears to criticise the target’s management. There is also the possibility of reporting the hostile bidder for abuse of a dominant position or insider trading if unusual trades are made before the offer is launched, for failing to comply with the principle of equality of shareholders or for failing to protect the interests of employees if the target has made risky acquisitions during the offer period. The real aim of any legal proceedings is to gain time for the target’s management given that, in general, it takes a few months or quarters for the courts to issue rulings on the facts of a case.

6/ THE LARGER CONTEXT

The various anti-takeover measures generally force the bidder to sweeten their offer, but rarely to abandon it. What can happen is that an initially hostile bid can turn into a friendly merger (SABMiller/AB Inbev, Veolia-Suez). Whether a hostile offer is successful or a white knight comes to the rescue, events invariably lead to the loss of the target company’s independence.

Which, then, are the most effective defensive measures? In recent bids involving large companies, those that have taken the initiative far upstream have been at a clear advantage. A good defence involves ensuring that the company is always in a position to seize opportunities, to anticipate danger and to operate from a position of strength so as to be able to counterattack if need be.

7/ SUMMARY OF SOME NATIONAL REGULATIONS

The EU directive on public offers lays down the principle that a shareholder who has assumed effective control over a company must bid for all equity-linked securities. It is up to individual countries to set a threshold of voting rights that constitutes effective control.

The directive states very specifically the floor price of a mandatory bid: the highest price paid by the new controlling shareholder in the 6–12 months prior to the bid (the exact period is set by national regulations). A mandatory bid can be in either cash or shares (if the shares are listed and are liquid).

So far as defence tactics are concerned, the European directive left European states free to:

  • ban or not ban the boards of target companies from taking anti-takeover defensive measures during the bid, such as poison pills, massive issuing of shares, etc., without approval from an extraordinary general meeting;
  • suspend or not suspend during an offer shareholders’ agreements or articles of association limiting voting rights, transfers of shares, shares with multiple voting rights, rights of approval or of first refusal;
  • authorise targets to put in place anti-takeover measures without the approval of their shareholders if the buyer does not need similar approval from its own shareholders to put in place similar measures at its own level.

Multiple voting rights and/or restrictions on voting rights disappear as of the first general shareholders’ meeting after a bid that has given a bidder a qualified majority of the company. This does not apply to golden shares that have been deemed compatible with European law.9

The table below summarises the principal rules applicable to takeover bids in some countries:

CountryRegulatorThreshold for mandatory bidMinimum percentage mandatory bid must encompassBid conditions allowed?Bid validity after approvalSqueeze-out10 possible?
ChinaChina Securities Regulatory Commission (www.csrc.gov.cn)30%5% 30-60 daysNo. Minority shareholders have the right to sell to the buyer after an offer giving them at least 75% of shares, at the offer price
FranceAMF, Autorité des Marchés Financiers (www.amf-france.org)30% of shares or voting rights, 1% p.a. between 30% and 50% of shares or voting rights100% of shares and equity-linked securitiesUsual suspects.12 None if bid mandatory25–35 trading daysYes, if >90% of voting rights and shares
GermanyBAFin, Bundesanstalt für Finanzdien-stle-istungsauf-sicht (www.bafin.de)30% of voting rights100%Usual supects.12 None if mandatory bid4–10 weeksYes, if >95% of shares
IndiaSecurities and Exchange Board of India (www.sebi.gov.in)25% of shares or voting rights, 5% p.a. beyond, acquisition of control26% at leastMinimum acceptance20 daysYes, if the higher of 90% of shares or stake of the controlling shareholder + 50% of the float is reached
ItalyCONSOB, Commissione Nazionale per le Società e la Borsa (www.consob.it)25% or 30% of shares, 5% p.a. beyond 30% up to 50%100% of voting sharesUsual suspects1215–40 trading daysYes, if >95% of voting rights
NetherlandsAFM, Autoriteit Financiele Markten (www.afm.nl)30% of voting rights100% of shares and equity-linked securitiesMinimum acceptance>8 trading weeks and <10 weeksYes, if >95% of shares
SpainCNMV, Comisión Nacional del Mercado de Valores (www.cnmv.es)30% and 50% or less if right to nominate more than half of the directors or any increase of 5% between 30% and 50%100%Usual suspects123–14 weeksYes, if >90% of the voting rights and higher than 90% success rate for the public offer
SwitzerlandCOPA, Commission des Offres Publiques d’Achat (www.takeover.ch)33.33% of voting rights11100% of sharesUsual suspects1220–40 trading daysYes, if >90% of voting rights
UKTakeover Panel (www.thetakeoverpanel.org.uk)30% of voting rights and any increase between 30% and 50%100% of shares and all instruments convertible or exchangeable into sharesUsual suspects12 and MAC clause that must be approved by regulator21–60 trading daysYes, if >90% of the shares13
USASEC, Securities and Exchange Commission (www.sec.gov)None, except Maine (20%), Pennsylvania (25%) and South Dakota (50%)NoneUsual suspects12 and MAC clause>20 trading daysYes with normal or super-majority

10  That is, possibility for the majority shareholder to force the buy-back of minority shareholders and delist the company if minority shareholders represent only a small part of the capital.

11  No threshold (opt-out) or a threshold up to 49% if the by-laws of the target company permit.

12  Minimum acceptance, antitrust authorisations, authorisation of shareholders to issue shares.

13  The Scheme of Arrangement allows for 75% to agree to an acquisition for it to go through.

SUMMARY

QUESTIONS

ANSWERS

BIBLIOGRAPHY

NOTES

  1. 1   This is known as the ZOPA (zone of possible agreement).
  2. 2    See Boone and Mulherin (2007).
  3. 3   Leveraged buyout.
  4. 4   Implying they will use the information disclosed during the selling process only to make an offer and will not tell a third party they are studying this acquisition.
  5. 5   Or sale and purchase agreement.
  6. 6   Generally Accepted Accounting Principles.
  7. 7   A special bank account for the deposit of funds, to which the beneficiary’s access is subject to the fulfilment of certain conditions.
  8. 8   In a UK takeover bid situation, 9/11 was not deemed to be such a case.
  9. 9   European law strictly limits national government leeway on golden shares. Golden shares are nonetheless still possible in some sectors and special cases, such as the defence industry.

A peek behind the scenes of investment banking

At any given time, a company can have several valuations, depending on the point of view of the buyer and the seller and their expectations of future profits and synergies. This variety sets the stage for negotiation but, needless to say, a transaction will take place only if common ground can be found – i.e. if the seller’s minimum price does not exceed the buyer’s maximum price.1

The art of negotiation consists of allocating the value of the anticipated synergies between the buyer and the seller, and in finding an equilibrium between their respective positions, so that both come away with a good deal. The seller receives more than the value for the company on a standalone basis because they pocket part of the value of the synergies the buyer hopes to unlock. Similarly, the buyer pays out part of the value of the synergies, but has still not paid more than the company is worth to them.

Transactions can also result from erroneous valuations. A seller might think the company has reached a peak, for example, and the buyer that it still has growth potential. But generally, out-and-out deception is rarer than you might think. It’s usually only in hindsight that we say we made a killing and that the party on the other side of the transaction was totally wrong!

In this chapter we will focus on the acquisition of one company by another. We will not consider industrial alliances, i.e. commercial or technology agreements negotiated directly between two companies which do not involve a transaction of the equity of either of them. Before examining the various negotiation tactics and the purchase of a listed company, let us first take a look at the merger and acquisition phenomenon and the economic justification behind a merger.

Section 45.1 THE RISE OF MERGERS AND ACQUISITIONS

1/ MERGER AND ACQUISITION WAVES

Acquisitions can be paid for either in cash or in shares. Generally speaking, share transactions predominate when corporate valuations are high, as they were in 1999–2000, because absolute values do not have to be determined.

However, in less propitious times, payment in cash is highly appreciated, both by sellers, who delight in receiving hard cash which will not lose its value on the stock market, and by buyers, who are not keen to issue new shares at a price that to them would seem to be discounted. Between 2007 and 2013, cash was back in fashion!

Conversely, when the market is bearish, cash payments are more attractive to both parties. The seller receives cold, hard cash, which will not lose value as shares might, while the buyer is reluctant to issue new shares at prices they consider to be a discount to their intrinsic value.

Source: Data from Thomson One Deals, Factset

As shown in the above graph, mergers and acquisitions tend to come in waves:

  • In the 1960s, conglomerates were all the rage. ITT, Gulf and Western, Fiat, Schneider and many others rose to prominence during this period. The parent company was supposedly able to manage the acquired subsidiaries better, plus meet their capital needs. Most transactions were paid for with shares.
  • In the 1980s, most acquisitions were paid for in cash. Many of the big conglomerates formed in the 1960s were broken up. They had become less efficient, poorly managed and valued at less than the sum of the values of their subsidiaries.
  • In the 1990s and 2000s, companies within the same sector joined forces, generally in share transactions: Procter & Gamble/Gillette, Pfizer/Wyeth, Arcelor/Mittal, Cadbury/Kraft, etc.
  • In the 2010s, the logic is the same and payments are mostly in cash: Kraft/Heinz, SABMiller/AB Inbev, Lactalis/Parmalat, Air Liquide/Airgas, etc. Since 2014, as the stock market has been regaining momentum, we are seeing more and more payments in shares: Peugeot-FiatChrysler, Lafarge-Holcim, Luxottica-Essilor, Worldline-Ingenico, Sprint-T-Mobile.

It seems to us that there are three main principles that explain the cyclical nature of mergers:

  • when the economic situation is depressed or very bad, companies focus on their operating activities, seeking to cope with problems and to restructure. When the economy improves, they regain confidence, are more open minded and ready to consider mergers and acquisitions, which are always complicated to implement. But because the economic situation is good, they are prepared to take a risk;
  • the availability of equity or debt financing is crucial because an acquisition requires financing. When share prices are low, shareholders are not very keen on being diluted in conditions that are bad for them and it is difficult to carry out capital increases. Also, if share prices are low, this means that it is unlikely that the economy is booming, making it difficult to obtain debt financing. High share prices are often the consequence and the cause of more easily obtainable financing, a clear sign of optimism!;
  • finally, herd behaviour will encourage companies in a given sector to carry out mergers when they see another sector player initiating a merger, so that they will not be the only ones creating cost and/or revenue synergies which could give them a clear competitive advantage. This could be witnessed in 2020 in the payment industry (e.g. Worldline-Ingenico, Nexi-Sia, Rapyd-Korta).

Putting the purely financial elements aside, the determinants of mergers and acquisitions can be macroeconomic, microeconomic or human factors, as we will now see.

2/ MACROECONOMIC FACTORS

There are several determining macroeconomic factors:

  • Periods of innovation and technological change are often followed by merger waves. During the innovation period (computers in the 1970s, the Internet or renewable energies today), many new companies are founded. Inevitably, however, the outlook for the growth and survival of these start-ups will fade, leading to a period of consolidation (Criteo buying Manage). Moreover, start-ups’ heavy financing needs may prompt them to seek the support of a major group that, in turn, can take advantage of the growth in the start-ups’ business (Peugeot buying TravelCar, a carsharing rental platform).
  • Many companies are undergoing a change in market scope. Thirty years ago, their market was national; now they find that they must operate in a regional (European) or more often worldwide context (Syngenta-ChemChina). Adapting to this change requires massive investment in both physical and human capital, leading to much higher financing needs (pharmaceuticals). As competition increases, companies that have not yet merged must grow rapidly in order to keep up with their now larger rivals. Critical mass becomes vital (Occidental Petroleum-Anardako). The policy of creating national champions in the 2000s encouraged this race for size (GDF-Suez becoming Engie).
  • Legislative changes have fostered restructuring in many industries. A broad trend towards deregulation began in the 1980s in the US and the UK, profoundly changing many sectors of the economy, from air transport to financial services to telecommunications. In Europe, a single market was created in conjunction with a policy of deregulation in banking, energy and telecommunications. European governments further scaled back their presence in the economy by privatising a number of publicly held companies. In many cases, these companies then became active participants in mergers and acquisitions (EDF, Orange, ENI).
  • The increasing importance of financial markets has played a fundamental role in corporate restructuring. In the space of 30 years, European companies have evolved from primarily credit-based systems, where banks were the main suppliers of funds, to financial market systems, characterised by disintermediation (see Section 15.1). This structural change took place in conjunction with a shift in power from banks and other financial companies (Mediobanca, Deutsche Bank, Paribas, Générale de Belgique) to investors. Accordingly, shareholders now exert pressure on corporate managers to produce returns in line with their expectations:
    • in the event of a disappointing performance, shareholders can sell their shares and, in doing this, depress the share price. Ultimately, this can lead to a restructuring (Aviva) or a takeover (Monsanto);
    • conversely, companies must convince the market that their acquisitions (Occidental Petroleum-Anadarko) are economically justified.
  • Low population growth in Europe, combined with strict immigration control, has made it more difficult for firms to grow organically. In response, managers in search of new growth drivers will try to find M&A opportunities (Lactalis-Greenland in Egypt).

3/ MICROECONOMIC FACTORS

There are a number of different determining microeconomic factors:

  • By increasing their size and production volumes, companies reduce their unit costs, in particular their R&D, administration and distribution costs (Nestle-Bountiful). Moreover, a higher production volume will put the company in a better position to negotiate lower costs with its suppliers (Tesco-Booker).
  • Mergers can increase a company’s market share and boost its revenues dramatically. To the extent that companies address complementary markets, merging will enable them to broaden their overall scope. There are two forms of complementarity:
    • geographic (Banijay-Endemol). The two groups benefit from their respective presence in different regions;
    • product (SandroMaje-DeFursac). The group can offer a full palette of products to its customers.
  • Although riskier than organic growth, mergers and acquisitions enable a company to save valuable time. In growing sectors of the economy, speed (the first-mover advantage) is a critical success factor. Once the sector matures, it becomes more difficult and more expensive to chip away at competitors’ market share, so acquisitions become a matter of choice (Altice-CableVision). The idea is also to get rid of a competitor (S&P-HIS Markit). When a company is expanding internationally or entering a new business, a strategic acquisition is a way to circumvent barriers to entry, both in terms of market recognition (LVMH-Tiffany) and expertise (Apple-Voysis).
  • By gaining additional stature, a company can more easily take new risks in a worldwide environment. The transition from a domestic market focus to worldwide competition requires companies to invest much more. The financial and human risks become too great for a medium-sized company (oil and gas exploration, pharmaceutical research). An acquisition (paid in shares) instantly boosts the company’s financial resources and reduces risk, facilitating decisions about the company’s future growth (Unilever-Onnit).
  • The need for cash, because groups are in difficulty (Bombardier, ThyssenKrupp), because they need to deleverage (HNA, Wanda in China) or because they regularly need to make capital gains (sale of Deutsche Glasfaser by KKR) are other reasons why M&A deals happen.
  • When groups decide to refocus on their core business, we also see assets being disposed of (Nestlé’s disposal of Haagen-Dazs).
  • In addition to the economic criteria prompting companies to merge, there is also the human factor. Many companies founded between 1955 and 1980, which were often controlled by a single shareholder manager, are now, not surprisingly, encountering problems of succession. In some cases, another family member takes over (ArcelorMittal, Swatch, Benetton, Reliance). In other cases, the company may have to be sold if it is to survive (Norbert Dentressangle).

4/ THE LARGER CONTEXT

Mergers and acquisitions, regardless of how tricky they are to manage, form part and parcel of a company’s life and serve as a useful tool for growth.

Mergers and acquisitions, although tricky to manage, are part of the lifecycle of a company and are a useful growth tool.

Synergies are often overestimated; their cost and time to implement underestimated. For example, making information systems compatible or restructuring staff can be notoriously difficult.

Numerous research works have measured the value created by M&A deals and how this value is shared between shareholders of the buyer and of the target. They demonstrate that value is created for the target’s shareholders because of the control premium paid. For the buyer’s shareholders, the results are more mixed, even if they tend to show a recent improvement since the beginning of the 2000s, when it was widely assumed that two-thirds of mergers were failing. Excluding some resounding failures (acquisition of Alstom’s energy division by GE or the Monsanto by Bayer), which heavily bias the results, M&A deals would appear value-creative because of some largely successful deals such as Sanofi/Genzyme, Office Depot-OfficeMax, Peugeot-Opel. Quality and speediness of the integration process are the key factors for successful M&A deals.

Section 45.2 CHOOSING A NEGOTIATING STRATEGY

A negotiating strategy aims at achieving a price objective set in accordance with the financial value derived from our valuation work presented in Chapter 31. But price is not everything. The seller might also want to limit the guarantees they grant, retain managerial control, ensure that their employees’ future is safe, etc.

Depending on the number of potential acquirers, the necessary degree of confidentiality, the timing and the seller’s demands, there is a wide range of possible negotiating strategies. We present below the two extremes: private negotiation and auction. Academic researchers2 have established that none of these strategies is better than another. Our personal experience tells us the same thing: the context dictates the choice of a strategy.

1/ PRIVATE NEGOTIATION

The seller or their advisor contacts a small number of potential acquirers to gauge their interest. After signing a confidentiality agreement (or non-disclosure agreement, NDA), the potential acquirers might receive an information memorandum describing the company’s industrial, financial and human resource elements. Discussions then begin. It is important that each potential acquirer believes they are not alone, even if in reality they are. In principle, this technique requires extreme confidentiality. Psychological rather than practical barriers to the transaction necessitate the high degree of confidentiality.

To preserve confidentiality, the seller often prefers to hire a specialist, most often an investment banker, to find potential acquirers and keep all discussions under wraps. Such specialists are usually paid a success fee that can be proportional to the size of the transaction. Strictly speaking, there are no typical negotiating procedures. Every transaction is different. The only absolute rule about negotiating strategies is that the negotiator must have a strategy.

The discussion focuses on:

  • how much control the seller will give up (and the status of any remaining minority shareholders);
  • the price;
  • the payment terms;
  • any conditions precedent;
  • representations and warranties; and
  • any contractual relationship that might remain between the seller and the target company after the transaction.

As you might expect, price remains the essential question in the negotiating process. Everything that might have been said during the course of the negotiations falls away, leaving one all-important parameter: price. We now take a look at the various agreements and clauses that play a role in private negotiation.

(a) Memorandum of understanding (MOU) or letter of intent (LOI)

When a framework for the negotiations has been defined, a memorandum of understanding is often signed to open the way to a transaction. A memorandum of understanding is a moral, not a legal, commitment. Often, once the MOU is signed, the management of the acquiring company presents it to its board of directors to obtain permission to pursue the negotiations.

The MOU is not useful when each party has made a firm commitment to negotiate. In this case, the negotiation of the MOU slows down the process rather than accelerating it.

(b) Agreement in principle

The next step might be an agreement in principle, spelling out the terms and conditions of the sale. The commitments of each party are irrevocable, unless there are conditions precedent – such as approval of the regulatory authorities. The agreement in principle can take many forms.

(c) Financial sweeteners

In many cases, specific financial arrangements are needed to get over psychological, tax, legal or financial barriers. These arrangements do not change the value of the company.

Sometimes, for psychological reasons, the seller refuses to go below some purely symbolic value. If they draw a line in the sand at 200, for example, whereas the buyer does not want to pay more than 190, a schedule spreading out payments over time sometimes does the trick. The seller will receive 100 this year and 100 next year. This is 190.9 if discounted at 10%, but it is still 200 to their way of thinking. Recognise that we are out of the realm of finance here and into the confines of psychology, and that this arrangement fools only those who want to be fooled.

This type of financial arrangement is window-dressing to hide the real price. Often companies build elaborate structures in the early stages of negotiation, only to simplify them little by little as they get used to the idea of buying or selling the company. Far from being a magical solution, such sweeteners give each party time to gravitate towards the other. In these cases it is only a stage, albeit a necessary one.

The following techniques are part of the investment banker’s stock in trade:

  • set up a special-purpose holding company to buy the company, lever up the company with debt, then have the seller reinvest part of the funds in the hope of obtaining a second gain (this is an LBO,3 see Chapter 47);
  • have the buyer pay for part of the purchase price in shares, which can then be sold in the market if the buyer’s shares are listed;
  • pay for part of the purchase price with IOUs;
  • link part of the purchase price to the sale price of a non-strategic asset the buyer does not wish to keep, or on the outcome of a significant ongoing litigation;
  • an earnout clause, which links part of the transaction price to the acquired company’s future financial performance. The clause can take one of two forms:
    • either the buyer takes full control of the target company at a minimum price, which can only be revised upwards; or
    • the buyer buys a portion of the company at a fixed price and the rest at a future date, with the price dependent on the company’s future profits. The index can be a multiple of EBIT, EBITDA or pre-tax profit.

Earnout provisions are very common in transactions involving service companies (advertising agencies, M&A boutiques), where people are key assets. Deferral of part of the price will entice them to stay and facilitate the integration process, although it can create management problems during the earnout period.

2/ AUCTION

In an auction, the company is offered for sale under a predetermined schedule to several potential buyers who are competing with each other. The objective is to choose the one offering the highest price. An auction is often private, but it can also be announced in the press or by a court decision.

Private auctions are run by an investment bank in the following manner. Once the decision is taken to sell the company, the seller often asks an audit firm to produce a vendor due diligence (VDD, also called a long form report) to provide a clear view of the weak points of the asset from legal, tax, accounting, environmental, strategic and regulatory points of view. The VDD will be communicated to buyers later on in the process. For the moment, a brief summary of the company is prepared (a “teaser”). It is sent, together with a NDA, to a large number of potentially interested companies and financial investors.

In the next stage (often called “Phase I”), once the potential buyers sign the non-disclosure agreement,4 they receive additional information, gathered in an information memorandum (“info memo”). Then they submit a non-binding offer indicating the price, its financing, any conditions precedent and eventually their intentions regarding the future strategy for the target company.

At that point of time (“Phase II”), a “short list” of up to half a dozen candidates at most is drawn up by the seller and their advisor on the basis of price, other sales conditions, and their confidence in the capability and willingness of the candidates to successfully conclude the sale. Selected buyers receive still more information and possibly a schedule of visits to the company’s industrial sites and meetings with management. Often an electronic data room is set up, where all economic, financial, regulatory, environmental and legal information concerning the target company is available for perusal. Access to the data room is very restricted; for example, no copies can be made. At the end of this stage, potential investors submit binding offers.

At any time, the seller can decide to enter into exclusive negotiations for a few days or a few weeks. For a given period of time, the potential buyer is the only candidate. At the end of the exclusive period, the buyer must submit a binding offer (in excess of a certain figure) or withdraw from the negotiations. Exclusivity is usually granted on the basis of a pre-emptive offer, i.e. a financially attractive proposal.

Together with the binding offers, the seller will ask the bidder(s) to propose a markup (comments) to the disposal agreement (called the share purchase agreement, SPA)5 previously provided by the seller. The ultimate selection of the buyer depends, naturally, on the binding offer, but also on the buyer’s comments on the share purchase.

The seller selecting an auction process to dispose of the company may believe that it will lead to a high price because buyers are in competition with each other. In addition, it makes it easier for the seller’s representatives to prove that they did everything in their power to obtain the highest possible price for the company, be it:

  • the executive who wants to sell a subsidiary;
  • a majority shareholder whose actions might be challenged by minority shareholders; or
  • the investment banker in charge of the transaction.

Competition sometimes generates a price that is well in excess of expectations. Moreover, an auction is faster, because the seller, not the buyer, sets the pace.

However, the auction creates confidentiality problems. Many people have access to the basic data, and denying rumours of a transaction becomes difficult, so the process must move quickly. Also, as the technique is based on price only, it is exposed to some risks, such as several potential buyers teaming up with the intention of splitting the assets among them. Lastly, should the process fail, the company’s credibility will suffer. The company must have an uncontested strategic value and be in sound financial condition. The worst result is that of an auction process which turns sour because financial results are not up to the estimations produced a few weeks before, leaving only one buyer who knows they are now the only buyer.

A well-processed auction can take three to five months between intention to sell and the closing. It is sometimes shorter when an investment fund sells on to another fund.

3/ THE OUTCOME OF NEGOTIATIONS

In the end, whatever negotiating method was used, the seller is left with a single potential buyer who can then impose certain conditions. Should the negotiations fall apart at this stage, it could spell trouble for the seller because they would have to go back to the other potential buyers, hat in hand. So the seller is in a position of weakness when it comes to finalising the negotiations. The principal remaining element is the representations and warranties provisions that are part of the share purchase agreement.

Representations and warranties (“reps & warranties”) are particularly important because they give confidence to the buyer that the profitability of the company has not been misrepresented. It is a way of securing the value of assets and liabilities of the target company as the contract does not provide a detailed valuation.

Representations and warranties are not intended to protect the buyer against an overvaluation of the company. They are intended to certify that all of the means of production are indeed under the company’s control, that the financial statements have been drawn up in accordance with accounting principles and that there are no hidden liabilities.

Well-worded representations and warranties clauses should guarantee to the buyer:

  • the substance of fixed assets (and not their value);
  • the real nature and the value of inventories (assuming that the buyer and the seller have agreed on a valuation method);
  • the real nature of other elements of working capital;
  • the amount and nature of all of the company’s other commitments, whether they are on the balance sheet (such as debts) or not.

They also facilitate the sharing of known risks within the company at the time of the sale (disputes, defaulting customers) between buyer and seller.

The representations and warranties clause is generally divided into two parts.

In the first part (representations), the seller makes commitments related to the substance of the company that is to be sold.

The seller generally represents that the target company and its subsidiaries are properly registered, that all the fixed assets on the balance sheet, including brands and patents, or used by the company in the ordinary course of business, actually exist. As such, representations and warranties do not guarantee the book value of the fixed assets, but their existence.

The seller represents that inventories have been booked correctly, and that depreciation and provisions have been calculated according to GAAP.6 The seller declares that the company is up to date in tax payments, salaries and other accruals and that there are no prejudicial contracts with suppliers, customers or employees. All elements already communicated to the buyer, in particular exceptional items such as special contracts, guarantees, etc., are annexed to the clause and excluded from it because the buyer is already aware of them.

Lastly, the seller represents that during the transitional period between the last statement date and the sale date the company was managed in a prudent manner. In particular, the seller certifies that no dividends were distributed or assets sold, except for those agreed with the buyer during the period, that no investments in excess of a certain amount were undertaken, nor contracts altered, etc.

This is known as the locked-box system, where the price is definitively set on the basis of the latest financial statements provided by the seller and reviewed by the buyer. Otherwise, the company’s accounts will have to be closed at the time of sale and price adjustments will have to be made if the equity (or, to simplify the process, the net debt and working capital) recorded is different from that guaranteed by the seller.

In the second part of the clause (warranties), the selleragrees to cover any additional liabilities that were not disclosed to the buyer (which the buyer was unable to factor in when setting the price), that occurred prior to the sale and come to light after the sale, and to do so for a given period (usually three years). Thresholds and a predetermined cap are set. In some cases, it is possible to set off such liabilities against provisions which then fall away or against income from assets sold at a higher price than expected. Warranties are often accompanied by a holdback (part of the purchase price is put in an escrow account)7 or a bank guarantee.

The representations and warranties clauses are the main addition to the sale agreement but, depending on the agreement, there may be many other additions, so long as they are legally valid – i.e. not contrary to company law, tax law or stock market regulations requiring equal treatment of all shareholders. A non-exhaustive list would include:

  • means of payment;
  • status and future role of managers and executives;
  • audit of the company’s books. On this score, we recommend against performing an audit before the two parties have reached an agreement. An audit often detects problems in the company, poisoning the atmosphere, and can serve as a pretext to abandoning the transaction.
  • minority shareholders’ agreement; etc.

Of course, the parties to the contracts should also call upon legal experts to ensure that each clause is legally enforceable.

The final step is the actual consummation of the deal. It often takes place at a later date, because certain conditions must be met first: accounting, legal or tax audit, restructuring, approval of domestic or foreign competition commissioners, etc.

Sometimes a link-up is not allowed for competition (anti-trust) reasons (Sainbury’s–Asda merger in the UK, Alstom–Siemens in Europe) or control of foreign investments on companies considered as strategic (Carrefour–Alimentation Couche Tard, Broadcom–Qualcomm). Accordingly, these concerns must be anticipated very early on in the merger process and the parties must be assisted by specialised lawyers.

In Europe, the thresholds are €5bn for the combined sales of the parties and €250m for sales made on a combined basis in Europe by at least two parties. An exception exists when all companies concerned generate more than two thirds of their gross revenue within the EU, and within the same single country (the two-thirds rule).

Finally, in the USA, the Hart–Scott–Rodino law allows for notification to be waived if the value of the target is less than $92m. Many types of transactions are, nonetheless, exempted; for example, deals worth less than $368m between companies with sales of less than $184m, target’s sales of less than $18.4m, etc.

4/ THE DUAL-TRACK PROCESS

In order to improve its negotiation position or because the likely outcome of the sale process is unclear, the seller may decide to pursue a dual-track process: it will launch a sale process and the preparation of an IPO in parallel. At the latest possible moment, it will choose to sell to the one offering the best price, be it the stock market or a buyer. This is why in 2018, Delachaux cancelled its IPO and replaced an investment fund (CVC) with a Canadian investor (CDPQ).

Section 45.3 TAKING OVER A LISTED COMPANY

The first idea that comes to mind when buying or taking a significant stake in a listed company would be to pick up shares on the stock market until you are strong enough to negotiate with the other shareholders and the management team. This solution seems attractive since it would allow you to take control without having to buy all the securities. This is why the law and the stock exchange authorities have imposed certain constraints on the purchase of securities on the stock exchange.

First of all, there is an obligation to declare the crossing of thresholds: when a shareholder exceeds a certain percentage of the capital or voting rights of a listed company, a disclosure obligation is imposed on them. Then there is an obligation to launch a public offer on all outstanding shares when certain thresholds are crossed.

These principles governing takeovers of listed companies are found in most countries with various degrees of constraint from one country to another.

1/ STAKE-BUILDING

To succeed in acquiring a listed company, the first step can be to start building a block in the company. This is how Vivendi acquired 30% of Gameloft before launching a full offer on the rest of the shares.

There are three methods available to investors seeking to accumulate shares:

  • gradually buying up shares on the market. Shares are purchased at the market price and the identity of sellers is generally unknown;
  • acquiring blocks of shares, which involves negotiating the purchase of large blocks of shares with identified sellers;
  • an equity swap or total return swap (TRS), which is a contract to swap the stock performance (dividends, capital gains and losses) between a bank (which pays the performance to the investor) and an investor (who wishes to take a risk on the performance of a share without holding it, and who pays interest to the bank) or the opposite. The bank hedges this operation by buying shares on the market. At the end of the swap term, the investor buys the bank’s shares at the price paid by the latter. This is how Elliott acquired a 2% stake (in addition to the 3.75% stake it held in shares) in Telecom Italia in 2018.

The following conditions must be met for an acquisition of an attractive percentage at a reasonable price:

  • the share capital of the target company must be dispersed, with no controlling shareholder actually controlling the company;
  • the operation must be carried out in secret to avoid defensive measures being taken by shareholders opposed to the acquirer of the securities and to prevent the target’s share price from soaring;
  • the volume of daily transactions in the security must be large enough to allow for large purchases without causing a market imbalance.
  • Sometimes the purchase of securities is made by several investors acting in concert (see below) and sometimes over a long period of time.

In order to prevent the acquirer from taking control of a company in that way, most market regulations require investors in a listed company to publicly declare when they pass certain thresholds in the capital of a company. If the acquirer fails to declare these shares, voting rights are lost.

The first threshold is most often 3% (UK, Switzerland, Spain, Germany, Italy, etc.).

Regulatory disclosure requirements allow minority shareholders to monitor stake-building and prevent an acquirer from getting control of a company little by little. These requirements are also helpful for the management to monitor the shareholder structure of the company. By-laws can set additional thresholds to be declared (generally lower thresholds than required by law).

Regulatory threshold disclosure requirements are the following:

China5% and multiples of 5% above
France5%, 10%, 15%, 20%, 25%, 30%, 33.3%, 50%, 66.6%, 90%, 95%
Germany3%, 5%, 10%, 15%, 20%, 25%, 30%, 50%, 75%
India5%, then 2% till 25%, then any share above 25%
Italy3%, 5%, multiples of 5% above up to 30%, then 50%, 66.6%,90%,
Netherlands3%, 5%, 10%, 15%, 20%, 25%, 30%, 40%, 50%, 60%, 75%, 95%
Spain3%, 5%, multiples of 5% thereafter, then 50%, 60%, 70%, 75%, 80%, 90%
Switzerland3%, 5%, 10%, 15%, 20%, 25%, 33.3%, 50%, 66.6%
UK3% and multiples of 1% above
US5% and multiples of 1% above

2/ TYPE OF OFFER

It is very unusual for an acquirer to gain control of a public company without launching a public offer on the target. Such offers are made to all shareholders over a certain period of time (2–10 weeks depending on the country). Public offers can be split between:

  • share offers or cash offers;
  • voluntary or mandatory offers;
  • hostile or recommended offers.

(a) Cash or share offers

The table below summarises the criteria relevant for assessing whether a bidder wants to propose shares or cash in a public offer:

 Payment in cashPayment in sharesComments
Allocation of synergiesTarget company’s shareholders benefit from synergies only via the premium they receiveTarget company’s shareholders participate in future synergiesIn a friendly share exchange offer, the premium might be minimal if the expected synergies are high
Psychological effectsCash lends credibility to the bid and increases its psychological valuePayment in shares has a “friendly” character 
Purchaser’s financial structureIncreases gearingDoes not increase gearingThe size of the deal sometimes requires payment in shares
Shareholder structureNo impact unless the deal is subsequently refinanced through a share issueShareholders of the target become shareholders of the enlarged groupSometimes, shareholders of the target get control of the new group in a share-for-share offer
Impact on purchaser’s share priceAfter the impact of the announcement, no direct link between the purchaser’s and target’s share priceImmediate link between purchaser’s and target’s share price, maintained throughout the bid periodA share exchange offer gains credibility when the two companies’ share prices align with the announced exchange ratio
Signal from buyer’s point of viewPositive: buyer’s stock is undervalued. Debt financing: positive signalNegative: buyer’s stock is overvaluedIf the size of the target only makes possible a share-for-share deal, no signal
Accounting effectsIncreases EPS and its growth rate if the inverse of the target’s P/E ratio including any premium is greater than the after-tax cost of debt of the acquirerIncreases EPS if the purchaser’s P/E ratio is higher than the target’s, premium includedEPS is not a relevant indicator of value creation, see Chapter 27
Purchaser’s tax situationInterest expense deductibleNo impact, except capital gain if treasury shares are usedTaxation is not a determining factor
Seller’s tax situationTaxable gainGain on sale can be carried forward 
Index weightingNo changeHigher weighting in index (greater market capitalisation)In the case of a share exchange, possible re-rating owing to size effect

In practice, the choice is not so black and white. The purchaser can offer a combination of cash and shares (mixed offers), cash as an alternative to shares, or launch a “mix and match” offer, as we will see.

(b) Hostile or recommended offers

The success or failure of an offer can depend largely on the attitude of the target’s management and the board of directors towards the offer.

To maximise the chances of success, the terms of an offer are generally negotiated with the management prior to the announcement, and then recommended by the board of the company. The offer is then qualified as friendly or recommended.

In some cases, the management of the target is not aware of the launch of an offer; it is then called an unsolicited offer. Facing this sudden event, the board has to convene and decide whether the offer is acceptable or not. If the board rejects the offer, it becomes hostile. This does not mean that the offer will not succeed, but just that the bidder will have to fight management and the current board of directors during the offer period to convince shareholders.

Most unsolicited offers end up as recommended offers, but only after the bidder has sweetened the offer in one way or another (generally by offering a higher price).

Around 15% of offers are deemed hostile and large groups such as Pfizer, Sanofi, Diageo, Enel, etc. were created through unsolicited offers.

(c) Voluntary or mandatory offers

The concept of the mandatory offer does not exist in every country. Nevertheless, in most countries, when a buyer passes a certain threshold or acquires the control of the target, they are required by stock exchange regulation to offer to buy back all the shareholders’ shares. It is one of the founding rules of stock exchange regulations. It should be noted that in the US, there is no mandatory offer and an acquirer can theoretically buy a majority of the capital of a listed company without having to launch an offer to the minority shareholders.

Generally, the constraints for a mandatory offer are tighter than for a voluntary offer. For example, in the UK the mandatory offer will be in cash, or at least a cash alternative will be provided. Obviously, the conditions of the offer that the acquirer is allowed to set in a mandatory offer are limited because they are defined by the regulations.

3/ CERTAINTY OF THE OFFER

It would be very disruptive for the market if an acquirer were to launch an offer and withdraw it a few days later. All market regulations try to ensure that when a public offer is launched, shareholders are actually given the opportunity to tender their shares.

Therefore, market regulation requires that a cash offer is fully funded when it is launched. Full funding ensures that the market does not run the risk of a buyer falling short of financing when the offer is a success! This funding usually takes the form of a guarantee by a bank (generally the bank presenting the offer commits that if the acquirer does not have the funds the bank will pay for the shares).

Another principle is that offers should be unconditional. In particular, the bidder cannot set conditions to the execution of the offer that remains in their hands (as an example, an offer cannot be conditional upon board approval of the acquirer). Nevertheless, in most countries, the offer can be subject to a minimum acceptance (which generally cannot be too high) and regulatory approval (including antitrust). In a few countries (the UK, the Netherlands, the US), the offer can be subject to a material adverse change (MAC) clause, which can only be invoked in extreme cases.8

4/ DOCUMENTATION AND MARKET AUTHORITY ROLE

The main role of market authorities is to guarantee the equal treatment of all shareholders and the transparency of the process.

In that regard, market authorities will have a key role in public offers:

  • They set (and often control) the standard content of the offer document. This document must contain all relevant information allowing the target’s shareholders to take a proper decision.
  • They supervise the process timetable.
  • In most countries their green light is necessary for the launch of the offer (they therefore control the price offered).

5/ DEFENSIVE MEASURES

In theory, a company whose shares are being secretly bought up on the stock market generally has a greater variety and number of defensive measures available to it than a company that is the target of a takeover bid. The reason behind this disparity is the secrecy surrounding shares bought up on the market compared with rules of equality and transparency applied to takeover bids.

If a company becomes aware that its shares are being bought up on the market, it is entitled to invoke all of the means of shareholder control described in Chapter 41. It can also get “friendly” investors to buy up its shares in order to increase the percentage of shares held by “friends” and push up its share price, thus making it more expensive for the hostile party to buy as many shares as it needs. Of course, the company will also need to have the time required to carry out all of these transactions, which generally involve waiting periods.

In the case of a takeover bid, there are fewer defensive measures available and they also depend on regulations in force in each country. In some countries (the UK and the Netherlands), all defensive measures taken during a takeover period (excluding attempts to identify other bidders) must be ratified by an EGM held during the offer period. Proxies granted by the general meeting of shareholders to the board prior to the offer period may be suspended. In some countries, any decision taken by the corporate and management bodies before the offer period that has not been fully or partially implemented, which does not fall within the normal course of business and which is likely to cause the offer to fail, must be approved or confirmed by the general meeting of the target’s shareholders.

Furthermore, in some countries, as soon as the takeover bid has been launched, the parties involved are required to ensure that the interests of the target’s employees are taken into account, to ensure that all shareholders are treated equally and that no upheaval on the stock markets is caused, to act in good faith and to comply with all regulations governing takeover bids.

The target company can either defend itself by embarking on an information campaign, explaining to shareholders and to the media how it will be able to create greater value in the future than the premium being offered by the predator, or it can use more active defensive measures, such as:

  • finding a third party ready to launch a competing takeover bid, called a “white knight”;
  • launching its own takeover bid on the hostile bidder;
  • getting “friends” to buy up its shares;
  • carrying out a capital increase or buying or selling businesses;
  • warrants;
  • legal action.

Just how far a board of directors is prepared to go to sabotage a takeover bid is determined by each board facing a predator. It could be depriving its shareholders of a potential capital gain and shareholders may question the responsibility of directors.

A competing takeover bid must be filed a few days before the close of the initial bid. The price offered should be at least a few percentage points higher than the initial bid. There is always the possibility that the initial bidder will make a higher bid, so there is no guarantee that the competing offer will succeed. Likewise, the “white knight” can sometimes turn grey or black when the rescue offer actually succeeds. We saw this in 2019 when Thales came to the “rescue” of Gemalto which was “under attack” by Atos.

A share purchase or exchange offer by the target on the hostile bidder, known as a Pac-Man defence, is only possible if the hostile bidder itself is listed and if its shares are widely held. In such cases, industrial projects are not that different given that an offer by X on Y results in the same economic whole as an offer by Y on X. This marks the start of a communications war (advertisements, press releases, meetings with investors), with each camp explaining why it would be better placed to manage the new whole than the other.

The buying up of shares by “friends” is often highly regulated and generally has to be declared to the market authority, which monitors any acting in concert or which may force the “friend” to file a counter-offer!

A capital increase or the issue of marketable securities is often only possible if this has been authorised by the general meeting of shareholders prior to the takeover bid, because generally there won’t be enough time to convene an EGM to fit in with the offer timetable. In any event, a reserved issue is often not allowed.

Warrants, described in Chapter 41, are a strong dissuasive element. The negative consequences of warrants being issued for the company launching a hostile takeover bid mean that it is generally prepared to negotiate with the target – neutralisation of the warrants in exchange for a higher offer price.

US experience has shown that “poison pill” warrants strengthen the negotiating position of the target’s management, although they don’t ensure its independence. If warrants are, in fact, issued, then the matter of director responsibility will be raised, since the directors will effectively have caused shareholders to lose out on an opportunity to get a higher price for their shares.

The transfer of an important asset into a special structure to prevent its disposal. This is the method used by Suez to try to fend off the Veolia bid.

Legal action could be taken to ensure that market regulations are complied with or on the basis of misleading information if the prospectus issued by the hostile bidder appears to criticise the target’s management. There is also the possibility of reporting the hostile bidder for abuse of a dominant position or insider trading if unusual trades are made before the offer is launched, for failing to comply with the principle of equality of shareholders or for failing to protect the interests of employees if the target has made risky acquisitions during the offer period. The real aim of any legal proceedings is to gain time for the target’s management given that, in general, it takes a few months or quarters for the courts to issue rulings on the facts of a case.

6/ THE LARGER CONTEXT

The various anti-takeover measures generally force the bidder to sweeten their offer, but rarely to abandon it. What can happen is that an initially hostile bid can turn into a friendly merger (SABMiller/AB Inbev, Veolia-Suez). Whether a hostile offer is successful or a white knight comes to the rescue, events invariably lead to the loss of the target company’s independence.

Which, then, are the most effective defensive measures? In recent bids involving large companies, those that have taken the initiative far upstream have been at a clear advantage. A good defence involves ensuring that the company is always in a position to seize opportunities, to anticipate danger and to operate from a position of strength so as to be able to counterattack if need be.

7/ SUMMARY OF SOME NATIONAL REGULATIONS

The EU directive on public offers lays down the principle that a shareholder who has assumed effective control over a company must bid for all equity-linked securities. It is up to individual countries to set a threshold of voting rights that constitutes effective control.

The directive states very specifically the floor price of a mandatory bid: the highest price paid by the new controlling shareholder in the 6–12 months prior to the bid (the exact period is set by national regulations). A mandatory bid can be in either cash or shares (if the shares are listed and are liquid).

So far as defence tactics are concerned, the European directive left European states free to:

  • ban or not ban the boards of target companies from taking anti-takeover defensive measures during the bid, such as poison pills, massive issuing of shares, etc., without approval from an extraordinary general meeting;
  • suspend or not suspend during an offer shareholders’ agreements or articles of association limiting voting rights, transfers of shares, shares with multiple voting rights, rights of approval or of first refusal;
  • authorise targets to put in place anti-takeover measures without the approval of their shareholders if the buyer does not need similar approval from its own shareholders to put in place similar measures at its own level.

Multiple voting rights and/or restrictions on voting rights disappear as of the first general shareholders’ meeting after a bid that has given a bidder a qualified majority of the company. This does not apply to golden shares that have been deemed compatible with European law.9

The table below summarises the principal rules applicable to takeover bids in some countries:

CountryRegulatorThreshold for mandatory bidMinimum percentage mandatory bid must encompassBid conditions allowed?Bid validity after approvalSqueeze-out10 possible?
ChinaChina Securities Regulatory Commission (www.csrc.gov.cn)30%5% 30-60 daysNo. Minority shareholders have the right to sell to the buyer after an offer giving them at least 75% of shares, at the offer price
FranceAMF, Autorité des Marchés Financiers (www.amf-france.org)30% of shares or voting rights, 1% p.a. between 30% and 50% of shares or voting rights100% of shares and equity-linked securitiesUsual suspects.12 None if bid mandatory25–35 trading daysYes, if >90% of voting rights and shares
GermanyBAFin, Bundesanstalt für Finanzdien-stle-istungsauf-sicht (www.bafin.de)30% of voting rights100%Usual supects.12 None if mandatory bid4–10 weeksYes, if >95% of shares
IndiaSecurities and Exchange Board of India (www.sebi.gov.in)25% of shares or voting rights, 5% p.a. beyond, acquisition of control26% at leastMinimum acceptance20 daysYes, if the higher of 90% of shares or stake of the controlling shareholder + 50% of the float is reached
ItalyCONSOB, Commissione Nazionale per le Società e la Borsa (www.consob.it)25% or 30% of shares, 5% p.a. beyond 30% up to 50%100% of voting sharesUsual suspects1215–40 trading daysYes, if >95% of voting rights
NetherlandsAFM, Autoriteit Financiele Markten (www.afm.nl)30% of voting rights100% of shares and equity-linked securitiesMinimum acceptance>8 trading weeks and <10 weeksYes, if >95% of shares
SpainCNMV, Comisión Nacional del Mercado de Valores (www.cnmv.es)30% and 50% or less if right to nominate more than half of the directors or any increase of 5% between 30% and 50%100%Usual suspects123–14 weeksYes, if >90% of the voting rights and higher than 90% success rate for the public offer
SwitzerlandCOPA, Commission des Offres Publiques d’Achat (www.takeover.ch)33.33% of voting rights11100% of sharesUsual suspects1220–40 trading daysYes, if >90% of voting rights
UKTakeover Panel (www.thetakeoverpanel.org.uk)30% of voting rights and any increase between 30% and 50%100% of shares and all instruments convertible or exchangeable into sharesUsual suspects12 and MAC clause that must be approved by regulator21–60 trading daysYes, if >90% of the shares13
USASEC, Securities and Exchange Commission (www.sec.gov)None, except Maine (20%), Pennsylvania (25%) and South Dakota (50%)NoneUsual suspects12 and MAC clause>20 trading daysYes with normal or super-majority

10  That is, possibility for the majority shareholder to force the buy-back of minority shareholders and delist the company if minority shareholders represent only a small part of the capital.

11  No threshold (opt-out) or a threshold up to 49% if the by-laws of the target company permit.

12  Minimum acceptance, antitrust authorisations, authorisation of shareholders to issue shares.

13  The Scheme of Arrangement allows for 75% to agree to an acquisition for it to go through.

SUMMARY

QUESTIONS

ANSWERS

BIBLIOGRAPHY

NOTES

  1. 1   This is known as the ZOPA (zone of possible agreement).
  2. 2    See Boone and Mulherin (2007).
  3. 3   Leveraged buyout.
  4. 4   Implying they will use the information disclosed during the selling process only to make an offer and will not tell a third party they are studying this acquisition.
  5. 5   Or sale and purchase agreement.
  6. 6   Generally Accepted Accounting Principles.
  7. 7   A special bank account for the deposit of funds, to which the beneficiary’s access is subject to the fulfilment of certain conditions.
  8. 8   In a UK takeover bid situation, 9/11 was not deemed to be such a case.
  9. 9   European law strictly limits national government leeway on golden shares. Golden shares are nonetheless still possible in some sectors and special cases, such as the defence industry.

A peek behind the scenes of investment banking

At any given time, a company can have several valuations, depending on the point of view of the buyer and the seller and their expectations of future profits and synergies. This variety sets the stage for negotiation but, needless to say, a transaction will take place only if common ground can be found – i.e. if the seller’s minimum price does not exceed the buyer’s maximum price.1

The art of negotiation consists of allocating the value of the anticipated synergies between the buyer and the seller, and in finding an equilibrium between their respective positions, so that both come away with a good deal. The seller receives more than the value for the company on a standalone basis because they pocket part of the value of the synergies the buyer hopes to unlock. Similarly, the buyer pays out part of the value of the synergies, but has still not paid more than the company is worth to them.

Transactions can also result from erroneous valuations. A seller might think the company has reached a peak, for example, and the buyer that it still has growth potential. But generally, out-and-out deception is rarer than you might think. It’s usually only in hindsight that we say we made a killing and that the party on the other side of the transaction was totally wrong!

In this chapter we will focus on the acquisition of one company by another. We will not consider industrial alliances, i.e. commercial or technology agreements negotiated directly between two companies which do not involve a transaction of the equity of either of them. Before examining the various negotiation tactics and the purchase of a listed company, let us first take a look at the merger and acquisition phenomenon and the economic justification behind a merger.

Section 45.1 THE RISE OF MERGERS AND ACQUISITIONS

1/ MERGER AND ACQUISITION WAVES

Acquisitions can be paid for either in cash or in shares. Generally speaking, share transactions predominate when corporate valuations are high, as they were in 1999–2000, because absolute values do not have to be determined.

However, in less propitious times, payment in cash is highly appreciated, both by sellers, who delight in receiving hard cash which will not lose its value on the stock market, and by buyers, who are not keen to issue new shares at a price that to them would seem to be discounted. Between 2007 and 2013, cash was back in fashion!

Conversely, when the market is bearish, cash payments are more attractive to both parties. The seller receives cold, hard cash, which will not lose value as shares might, while the buyer is reluctant to issue new shares at prices they consider to be a discount to their intrinsic value.

Source: Data from Thomson One Deals, Factset

As shown in the above graph, mergers and acquisitions tend to come in waves:

  • In the 1960s, conglomerates were all the rage. ITT, Gulf and Western, Fiat, Schneider and many others rose to prominence during this period. The parent company was supposedly able to manage the acquired subsidiaries better, plus meet their capital needs. Most transactions were paid for with shares.
  • In the 1980s, most acquisitions were paid for in cash. Many of the big conglomerates formed in the 1960s were broken up. They had become less efficient, poorly managed and valued at less than the sum of the values of their subsidiaries.
  • In the 1990s and 2000s, companies within the same sector joined forces, generally in share transactions: Procter & Gamble/Gillette, Pfizer/Wyeth, Arcelor/Mittal, Cadbury/Kraft, etc.
  • In the 2010s, the logic is the same and payments are mostly in cash: Kraft/Heinz, SABMiller/AB Inbev, Lactalis/Parmalat, Air Liquide/Airgas, etc. Since 2014, as the stock market has been regaining momentum, we are seeing more and more payments in shares: Peugeot-FiatChrysler, Lafarge-Holcim, Luxottica-Essilor, Worldline-Ingenico, Sprint-T-Mobile.

It seems to us that there are three main principles that explain the cyclical nature of mergers:

  • when the economic situation is depressed or very bad, companies focus on their operating activities, seeking to cope with problems and to restructure. When the economy improves, they regain confidence, are more open minded and ready to consider mergers and acquisitions, which are always complicated to implement. But because the economic situation is good, they are prepared to take a risk;
  • the availability of equity or debt financing is crucial because an acquisition requires financing. When share prices are low, shareholders are not very keen on being diluted in conditions that are bad for them and it is difficult to carry out capital increases. Also, if share prices are low, this means that it is unlikely that the economy is booming, making it difficult to obtain debt financing. High share prices are often the consequence and the cause of more easily obtainable financing, a clear sign of optimism!;
  • finally, herd behaviour will encourage companies in a given sector to carry out mergers when they see another sector player initiating a merger, so that they will not be the only ones creating cost and/or revenue synergies which could give them a clear competitive advantage. This could be witnessed in 2020 in the payment industry (e.g. Worldline-Ingenico, Nexi-Sia, Rapyd-Korta).

Putting the purely financial elements aside, the determinants of mergers and acquisitions can be macroeconomic, microeconomic or human factors, as we will now see.

2/ MACROECONOMIC FACTORS

There are several determining macroeconomic factors:

  • Periods of innovation and technological change are often followed by merger waves. During the innovation period (computers in the 1970s, the Internet or renewable energies today), many new companies are founded. Inevitably, however, the outlook for the growth and survival of these start-ups will fade, leading to a period of consolidation (Criteo buying Manage). Moreover, start-ups’ heavy financing needs may prompt them to seek the support of a major group that, in turn, can take advantage of the growth in the start-ups’ business (Peugeot buying TravelCar, a carsharing rental platform).
  • Many companies are undergoing a change in market scope. Thirty years ago, their market was national; now they find that they must operate in a regional (European) or more often worldwide context (Syngenta-ChemChina). Adapting to this change requires massive investment in both physical and human capital, leading to much higher financing needs (pharmaceuticals). As competition increases, companies that have not yet merged must grow rapidly in order to keep up with their now larger rivals. Critical mass becomes vital (Occidental Petroleum-Anardako). The policy of creating national champions in the 2000s encouraged this race for size (GDF-Suez becoming Engie).
  • Legislative changes have fostered restructuring in many industries. A broad trend towards deregulation began in the 1980s in the US and the UK, profoundly changing many sectors of the economy, from air transport to financial services to telecommunications. In Europe, a single market was created in conjunction with a policy of deregulation in banking, energy and telecommunications. European governments further scaled back their presence in the economy by privatising a number of publicly held companies. In many cases, these companies then became active participants in mergers and acquisitions (EDF, Orange, ENI).
  • The increasing importance of financial markets has played a fundamental role in corporate restructuring. In the space of 30 years, European companies have evolved from primarily credit-based systems, where banks were the main suppliers of funds, to financial market systems, characterised by disintermediation (see Section 15.1). This structural change took place in conjunction with a shift in power from banks and other financial companies (Mediobanca, Deutsche Bank, Paribas, Générale de Belgique) to investors. Accordingly, shareholders now exert pressure on corporate managers to produce returns in line with their expectations:
    • in the event of a disappointing performance, shareholders can sell their shares and, in doing this, depress the share price. Ultimately, this can lead to a restructuring (Aviva) or a takeover (Monsanto);
    • conversely, companies must convince the market that their acquisitions (Occidental Petroleum-Anadarko) are economically justified.
  • Low population growth in Europe, combined with strict immigration control, has made it more difficult for firms to grow organically. In response, managers in search of new growth drivers will try to find M&A opportunities (Lactalis-Greenland in Egypt).

3/ MICROECONOMIC FACTORS

There are a number of different determining microeconomic factors:

  • By increasing their size and production volumes, companies reduce their unit costs, in particular their R&D, administration and distribution costs (Nestle-Bountiful). Moreover, a higher production volume will put the company in a better position to negotiate lower costs with its suppliers (Tesco-Booker).
  • Mergers can increase a company’s market share and boost its revenues dramatically. To the extent that companies address complementary markets, merging will enable them to broaden their overall scope. There are two forms of complementarity:
    • geographic (Banijay-Endemol). The two groups benefit from their respective presence in different regions;
    • product (SandroMaje-DeFursac). The group can offer a full palette of products to its customers.
  • Although riskier than organic growth, mergers and acquisitions enable a company to save valuable time. In growing sectors of the economy, speed (the first-mover advantage) is a critical success factor. Once the sector matures, it becomes more difficult and more expensive to chip away at competitors’ market share, so acquisitions become a matter of choice (Altice-CableVision). The idea is also to get rid of a competitor (S&P-HIS Markit). When a company is expanding internationally or entering a new business, a strategic acquisition is a way to circumvent barriers to entry, both in terms of market recognition (LVMH-Tiffany) and expertise (Apple-Voysis).
  • By gaining additional stature, a company can more easily take new risks in a worldwide environment. The transition from a domestic market focus to worldwide competition requires companies to invest much more. The financial and human risks become too great for a medium-sized company (oil and gas exploration, pharmaceutical research). An acquisition (paid in shares) instantly boosts the company’s financial resources and reduces risk, facilitating decisions about the company’s future growth (Unilever-Onnit).
  • The need for cash, because groups are in difficulty (Bombardier, ThyssenKrupp), because they need to deleverage (HNA, Wanda in China) or because they regularly need to make capital gains (sale of Deutsche Glasfaser by KKR) are other reasons why M&A deals happen.
  • When groups decide to refocus on their core business, we also see assets being disposed of (Nestlé’s disposal of Haagen-Dazs).
  • In addition to the economic criteria prompting companies to merge, there is also the human factor. Many companies founded between 1955 and 1980, which were often controlled by a single shareholder manager, are now, not surprisingly, encountering problems of succession. In some cases, another family member takes over (ArcelorMittal, Swatch, Benetton, Reliance). In other cases, the company may have to be sold if it is to survive (Norbert Dentressangle).

4/ THE LARGER CONTEXT

Mergers and acquisitions, regardless of how tricky they are to manage, form part and parcel of a company’s life and serve as a useful tool for growth.

Mergers and acquisitions, although tricky to manage, are part of the lifecycle of a company and are a useful growth tool.

Synergies are often overestimated; their cost and time to implement underestimated. For example, making information systems compatible or restructuring staff can be notoriously difficult.

Numerous research works have measured the value created by M&A deals and how this value is shared between shareholders of the buyer and of the target. They demonstrate that value is created for the target’s shareholders because of the control premium paid. For the buyer’s shareholders, the results are more mixed, even if they tend to show a recent improvement since the beginning of the 2000s, when it was widely assumed that two-thirds of mergers were failing. Excluding some resounding failures (acquisition of Alstom’s energy division by GE or the Monsanto by Bayer), which heavily bias the results, M&A deals would appear value-creative because of some largely successful deals such as Sanofi/Genzyme, Office Depot-OfficeMax, Peugeot-Opel. Quality and speediness of the integration process are the key factors for successful M&A deals.

Section 45.2 CHOOSING A NEGOTIATING STRATEGY

A negotiating strategy aims at achieving a price objective set in accordance with the financial value derived from our valuation work presented in Chapter 31. But price is not everything. The seller might also want to limit the guarantees they grant, retain managerial control, ensure that their employees’ future is safe, etc.

Depending on the number of potential acquirers, the necessary degree of confidentiality, the timing and the seller’s demands, there is a wide range of possible negotiating strategies. We present below the two extremes: private negotiation and auction. Academic researchers2 have established that none of these strategies is better than another. Our personal experience tells us the same thing: the context dictates the choice of a strategy.

1/ PRIVATE NEGOTIATION

The seller or their advisor contacts a small number of potential acquirers to gauge their interest. After signing a confidentiality agreement (or non-disclosure agreement, NDA), the potential acquirers might receive an information memorandum describing the company’s industrial, financial and human resource elements. Discussions then begin. It is important that each potential acquirer believes they are not alone, even if in reality they are. In principle, this technique requires extreme confidentiality. Psychological rather than practical barriers to the transaction necessitate the high degree of confidentiality.

To preserve confidentiality, the seller often prefers to hire a specialist, most often an investment banker, to find potential acquirers and keep all discussions under wraps. Such specialists are usually paid a success fee that can be proportional to the size of the transaction. Strictly speaking, there are no typical negotiating procedures. Every transaction is different. The only absolute rule about negotiating strategies is that the negotiator must have a strategy.

The discussion focuses on:

  • how much control the seller will give up (and the status of any remaining minority shareholders);
  • the price;
  • the payment terms;
  • any conditions precedent;
  • representations and warranties; and
  • any contractual relationship that might remain between the seller and the target company after the transaction.

As you might expect, price remains the essential question in the negotiating process. Everything that might have been said during the course of the negotiations falls away, leaving one all-important parameter: price. We now take a look at the various agreements and clauses that play a role in private negotiation.

(a) Memorandum of understanding (MOU) or letter of intent (LOI)

When a framework for the negotiations has been defined, a memorandum of understanding is often signed to open the way to a transaction. A memorandum of understanding is a moral, not a legal, commitment. Often, once the MOU is signed, the management of the acquiring company presents it to its board of directors to obtain permission to pursue the negotiations.

The MOU is not useful when each party has made a firm commitment to negotiate. In this case, the negotiation of the MOU slows down the process rather than accelerating it.

(b) Agreement in principle

The next step might be an agreement in principle, spelling out the terms and conditions of the sale. The commitments of each party are irrevocable, unless there are conditions precedent – such as approval of the regulatory authorities. The agreement in principle can take many forms.

(c) Financial sweeteners

In many cases, specific financial arrangements are needed to get over psychological, tax, legal or financial barriers. These arrangements do not change the value of the company.

Sometimes, for psychological reasons, the seller refuses to go below some purely symbolic value. If they draw a line in the sand at 200, for example, whereas the buyer does not want to pay more than 190, a schedule spreading out payments over time sometimes does the trick. The seller will receive 100 this year and 100 next year. This is 190.9 if discounted at 10%, but it is still 200 to their way of thinking. Recognise that we are out of the realm of finance here and into the confines of psychology, and that this arrangement fools only those who want to be fooled.

This type of financial arrangement is window-dressing to hide the real price. Often companies build elaborate structures in the early stages of negotiation, only to simplify them little by little as they get used to the idea of buying or selling the company. Far from being a magical solution, such sweeteners give each party time to gravitate towards the other. In these cases it is only a stage, albeit a necessary one.

The following techniques are part of the investment banker’s stock in trade:

  • set up a special-purpose holding company to buy the company, lever up the company with debt, then have the seller reinvest part of the funds in the hope of obtaining a second gain (this is an LBO,3 see Chapter 47);
  • have the buyer pay for part of the purchase price in shares, which can then be sold in the market if the buyer’s shares are listed;
  • pay for part of the purchase price with IOUs;
  • link part of the purchase price to the sale price of a non-strategic asset the buyer does not wish to keep, or on the outcome of a significant ongoing litigation;
  • an earnout clause, which links part of the transaction price to the acquired company’s future financial performance. The clause can take one of two forms:
    • either the buyer takes full control of the target company at a minimum price, which can only be revised upwards; or
    • the buyer buys a portion of the company at a fixed price and the rest at a future date, with the price dependent on the company’s future profits. The index can be a multiple of EBIT, EBITDA or pre-tax profit.

Earnout provisions are very common in transactions involving service companies (advertising agencies, M&A boutiques), where people are key assets. Deferral of part of the price will entice them to stay and facilitate the integration process, although it can create management problems during the earnout period.

2/ AUCTION

In an auction, the company is offered for sale under a predetermined schedule to several potential buyers who are competing with each other. The objective is to choose the one offering the highest price. An auction is often private, but it can also be announced in the press or by a court decision.

Private auctions are run by an investment bank in the following manner. Once the decision is taken to sell the company, the seller often asks an audit firm to produce a vendor due diligence (VDD, also called a long form report) to provide a clear view of the weak points of the asset from legal, tax, accounting, environmental, strategic and regulatory points of view. The VDD will be communicated to buyers later on in the process. For the moment, a brief summary of the company is prepared (a “teaser”). It is sent, together with a NDA, to a large number of potentially interested companies and financial investors.

In the next stage (often called “Phase I”), once the potential buyers sign the non-disclosure agreement,4 they receive additional information, gathered in an information memorandum (“info memo”). Then they submit a non-binding offer indicating the price, its financing, any conditions precedent and eventually their intentions regarding the future strategy for the target company.

At that point of time (“Phase II”), a “short list” of up to half a dozen candidates at most is drawn up by the seller and their advisor on the basis of price, other sales conditions, and their confidence in the capability and willingness of the candidates to successfully conclude the sale. Selected buyers receive still more information and possibly a schedule of visits to the company’s industrial sites and meetings with management. Often an electronic data room is set up, where all economic, financial, regulatory, environmental and legal information concerning the target company is available for perusal. Access to the data room is very restricted; for example, no copies can be made. At the end of this stage, potential investors submit binding offers.

At any time, the seller can decide to enter into exclusive negotiations for a few days or a few weeks. For a given period of time, the potential buyer is the only candidate. At the end of the exclusive period, the buyer must submit a binding offer (in excess of a certain figure) or withdraw from the negotiations. Exclusivity is usually granted on the basis of a pre-emptive offer, i.e. a financially attractive proposal.

Together with the binding offers, the seller will ask the bidder(s) to propose a markup (comments) to the disposal agreement (called the share purchase agreement, SPA)5 previously provided by the seller. The ultimate selection of the buyer depends, naturally, on the binding offer, but also on the buyer’s comments on the share purchase.

The seller selecting an auction process to dispose of the company may believe that it will lead to a high price because buyers are in competition with each other. In addition, it makes it easier for the seller’s representatives to prove that they did everything in their power to obtain the highest possible price for the company, be it:

  • the executive who wants to sell a subsidiary;
  • a majority shareholder whose actions might be challenged by minority shareholders; or
  • the investment banker in charge of the transaction.

Competition sometimes generates a price that is well in excess of expectations. Moreover, an auction is faster, because the seller, not the buyer, sets the pace.

However, the auction creates confidentiality problems. Many people have access to the basic data, and denying rumours of a transaction becomes difficult, so the process must move quickly. Also, as the technique is based on price only, it is exposed to some risks, such as several potential buyers teaming up with the intention of splitting the assets among them. Lastly, should the process fail, the company’s credibility will suffer. The company must have an uncontested strategic value and be in sound financial condition. The worst result is that of an auction process which turns sour because financial results are not up to the estimations produced a few weeks before, leaving only one buyer who knows they are now the only buyer.

A well-processed auction can take three to five months between intention to sell and the closing. It is sometimes shorter when an investment fund sells on to another fund.

3/ THE OUTCOME OF NEGOTIATIONS

In the end, whatever negotiating method was used, the seller is left with a single potential buyer who can then impose certain conditions. Should the negotiations fall apart at this stage, it could spell trouble for the seller because they would have to go back to the other potential buyers, hat in hand. So the seller is in a position of weakness when it comes to finalising the negotiations. The principal remaining element is the representations and warranties provisions that are part of the share purchase agreement.

Representations and warranties (“reps & warranties”) are particularly important because they give confidence to the buyer that the profitability of the company has not been misrepresented. It is a way of securing the value of assets and liabilities of the target company as the contract does not provide a detailed valuation.

Representations and warranties are not intended to protect the buyer against an overvaluation of the company. They are intended to certify that all of the means of production are indeed under the company’s control, that the financial statements have been drawn up in accordance with accounting principles and that there are no hidden liabilities.

Well-worded representations and warranties clauses should guarantee to the buyer:

  • the substance of fixed assets (and not their value);
  • the real nature and the value of inventories (assuming that the buyer and the seller have agreed on a valuation method);
  • the real nature of other elements of working capital;
  • the amount and nature of all of the company’s other commitments, whether they are on the balance sheet (such as debts) or not.

They also facilitate the sharing of known risks within the company at the time of the sale (disputes, defaulting customers) between buyer and seller.

The representations and warranties clause is generally divided into two parts.

In the first part (representations), the seller makes commitments related to the substance of the company that is to be sold.

The seller generally represents that the target company and its subsidiaries are properly registered, that all the fixed assets on the balance sheet, including brands and patents, or used by the company in the ordinary course of business, actually exist. As such, representations and warranties do not guarantee the book value of the fixed assets, but their existence.

The seller represents that inventories have been booked correctly, and that depreciation and provisions have been calculated according to GAAP.6 The seller declares that the company is up to date in tax payments, salaries and other accruals and that there are no prejudicial contracts with suppliers, customers or employees. All elements already communicated to the buyer, in particular exceptional items such as special contracts, guarantees, etc., are annexed to the clause and excluded from it because the buyer is already aware of them.

Lastly, the seller represents that during the transitional period between the last statement date and the sale date the company was managed in a prudent manner. In particular, the seller certifies that no dividends were distributed or assets sold, except for those agreed with the buyer during the period, that no investments in excess of a certain amount were undertaken, nor contracts altered, etc.

This is known as the locked-box system, where the price is definitively set on the basis of the latest financial statements provided by the seller and reviewed by the buyer. Otherwise, the company’s accounts will have to be closed at the time of sale and price adjustments will have to be made if the equity (or, to simplify the process, the net debt and working capital) recorded is different from that guaranteed by the seller.

In the second part of the clause (warranties), the selleragrees to cover any additional liabilities that were not disclosed to the buyer (which the buyer was unable to factor in when setting the price), that occurred prior to the sale and come to light after the sale, and to do so for a given period (usually three years). Thresholds and a predetermined cap are set. In some cases, it is possible to set off such liabilities against provisions which then fall away or against income from assets sold at a higher price than expected. Warranties are often accompanied by a holdback (part of the purchase price is put in an escrow account)7 or a bank guarantee.

The representations and warranties clauses are the main addition to the sale agreement but, depending on the agreement, there may be many other additions, so long as they are legally valid – i.e. not contrary to company law, tax law or stock market regulations requiring equal treatment of all shareholders. A non-exhaustive list would include:

  • means of payment;
  • status and future role of managers and executives;
  • audit of the company’s books. On this score, we recommend against performing an audit before the two parties have reached an agreement. An audit often detects problems in the company, poisoning the atmosphere, and can serve as a pretext to abandoning the transaction.
  • minority shareholders’ agreement; etc.

Of course, the parties to the contracts should also call upon legal experts to ensure that each clause is legally enforceable.

The final step is the actual consummation of the deal. It often takes place at a later date, because certain conditions must be met first: accounting, legal or tax audit, restructuring, approval of domestic or foreign competition commissioners, etc.

Sometimes a link-up is not allowed for competition (anti-trust) reasons (Sainbury’s–Asda merger in the UK, Alstom–Siemens in Europe) or control of foreign investments on companies considered as strategic (Carrefour–Alimentation Couche Tard, Broadcom–Qualcomm). Accordingly, these concerns must be anticipated very early on in the merger process and the parties must be assisted by specialised lawyers.

In Europe, the thresholds are €5bn for the combined sales of the parties and €250m for sales made on a combined basis in Europe by at least two parties. An exception exists when all companies concerned generate more than two thirds of their gross revenue within the EU, and within the same single country (the two-thirds rule).

Finally, in the USA, the Hart–Scott–Rodino law allows for notification to be waived if the value of the target is less than $92m. Many types of transactions are, nonetheless, exempted; for example, deals worth less than $368m between companies with sales of less than $184m, target’s sales of less than $18.4m, etc.

4/ THE DUAL-TRACK PROCESS

In order to improve its negotiation position or because the likely outcome of the sale process is unclear, the seller may decide to pursue a dual-track process: it will launch a sale process and the preparation of an IPO in parallel. At the latest possible moment, it will choose to sell to the one offering the best price, be it the stock market or a buyer. This is why in 2018, Delachaux cancelled its IPO and replaced an investment fund (CVC) with a Canadian investor (CDPQ).

Section 45.3 TAKING OVER A LISTED COMPANY

The first idea that comes to mind when buying or taking a significant stake in a listed company would be to pick up shares on the stock market until you are strong enough to negotiate with the other shareholders and the management team. This solution seems attractive since it would allow you to take control without having to buy all the securities. This is why the law and the stock exchange authorities have imposed certain constraints on the purchase of securities on the stock exchange.

First of all, there is an obligation to declare the crossing of thresholds: when a shareholder exceeds a certain percentage of the capital or voting rights of a listed company, a disclosure obligation is imposed on them. Then there is an obligation to launch a public offer on all outstanding shares when certain thresholds are crossed.

These principles governing takeovers of listed companies are found in most countries with various degrees of constraint from one country to another.

1/ STAKE-BUILDING

To succeed in acquiring a listed company, the first step can be to start building a block in the company. This is how Vivendi acquired 30% of Gameloft before launching a full offer on the rest of the shares.

There are three methods available to investors seeking to accumulate shares:

  • gradually buying up shares on the market. Shares are purchased at the market price and the identity of sellers is generally unknown;
  • acquiring blocks of shares, which involves negotiating the purchase of large blocks of shares with identified sellers;
  • an equity swap or total return swap (TRS), which is a contract to swap the stock performance (dividends, capital gains and losses) between a bank (which pays the performance to the investor) and an investor (who wishes to take a risk on the performance of a share without holding it, and who pays interest to the bank) or the opposite. The bank hedges this operation by buying shares on the market. At the end of the swap term, the investor buys the bank’s shares at the price paid by the latter. This is how Elliott acquired a 2% stake (in addition to the 3.75% stake it held in shares) in Telecom Italia in 2018.

The following conditions must be met for an acquisition of an attractive percentage at a reasonable price:

  • the share capital of the target company must be dispersed, with no controlling shareholder actually controlling the company;
  • the operation must be carried out in secret to avoid defensive measures being taken by shareholders opposed to the acquirer of the securities and to prevent the target’s share price from soaring;
  • the volume of daily transactions in the security must be large enough to allow for large purchases without causing a market imbalance.
  • Sometimes the purchase of securities is made by several investors acting in concert (see below) and sometimes over a long period of time.

In order to prevent the acquirer from taking control of a company in that way, most market regulations require investors in a listed company to publicly declare when they pass certain thresholds in the capital of a company. If the acquirer fails to declare these shares, voting rights are lost.

The first threshold is most often 3% (UK, Switzerland, Spain, Germany, Italy, etc.).

Regulatory disclosure requirements allow minority shareholders to monitor stake-building and prevent an acquirer from getting control of a company little by little. These requirements are also helpful for the management to monitor the shareholder structure of the company. By-laws can set additional thresholds to be declared (generally lower thresholds than required by law).

Regulatory threshold disclosure requirements are the following:

China5% and multiples of 5% above
France5%, 10%, 15%, 20%, 25%, 30%, 33.3%, 50%, 66.6%, 90%, 95%
Germany3%, 5%, 10%, 15%, 20%, 25%, 30%, 50%, 75%
India5%, then 2% till 25%, then any share above 25%
Italy3%, 5%, multiples of 5% above up to 30%, then 50%, 66.6%,90%,
Netherlands3%, 5%, 10%, 15%, 20%, 25%, 30%, 40%, 50%, 60%, 75%, 95%
Spain3%, 5%, multiples of 5% thereafter, then 50%, 60%, 70%, 75%, 80%, 90%
Switzerland3%, 5%, 10%, 15%, 20%, 25%, 33.3%, 50%, 66.6%
UK3% and multiples of 1% above
US5% and multiples of 1% above

2/ TYPE OF OFFER

It is very unusual for an acquirer to gain control of a public company without launching a public offer on the target. Such offers are made to all shareholders over a certain period of time (2–10 weeks depending on the country). Public offers can be split between:

  • share offers or cash offers;
  • voluntary or mandatory offers;
  • hostile or recommended offers.

(a) Cash or share offers

The table below summarises the criteria relevant for assessing whether a bidder wants to propose shares or cash in a public offer:

 Payment in cashPayment in sharesComments
Allocation of synergiesTarget company’s shareholders benefit from synergies only via the premium they receiveTarget company’s shareholders participate in future synergiesIn a friendly share exchange offer, the premium might be minimal if the expected synergies are high
Psychological effectsCash lends credibility to the bid and increases its psychological valuePayment in shares has a “friendly” character 
Purchaser’s financial structureIncreases gearingDoes not increase gearingThe size of the deal sometimes requires payment in shares
Shareholder structureNo impact unless the deal is subsequently refinanced through a share issueShareholders of the target become shareholders of the enlarged groupSometimes, shareholders of the target get control of the new group in a share-for-share offer
Impact on purchaser’s share priceAfter the impact of the announcement, no direct link between the purchaser’s and target’s share priceImmediate link between purchaser’s and target’s share price, maintained throughout the bid periodA share exchange offer gains credibility when the two companies’ share prices align with the announced exchange ratio
Signal from buyer’s point of viewPositive: buyer’s stock is undervalued. Debt financing: positive signalNegative: buyer’s stock is overvaluedIf the size of the target only makes possible a share-for-share deal, no signal
Accounting effectsIncreases EPS and its growth rate if the inverse of the target’s P/E ratio including any premium is greater than the after-tax cost of debt of the acquirerIncreases EPS if the purchaser’s P/E ratio is higher than the target’s, premium includedEPS is not a relevant indicator of value creation, see Chapter 27
Purchaser’s tax situationInterest expense deductibleNo impact, except capital gain if treasury shares are usedTaxation is not a determining factor
Seller’s tax situationTaxable gainGain on sale can be carried forward 
Index weightingNo changeHigher weighting in index (greater market capitalisation)In the case of a share exchange, possible re-rating owing to size effect

In practice, the choice is not so black and white. The purchaser can offer a combination of cash and shares (mixed offers), cash as an alternative to shares, or launch a “mix and match” offer, as we will see.

(b) Hostile or recommended offers

The success or failure of an offer can depend largely on the attitude of the target’s management and the board of directors towards the offer.

To maximise the chances of success, the terms of an offer are generally negotiated with the management prior to the announcement, and then recommended by the board of the company. The offer is then qualified as friendly or recommended.

In some cases, the management of the target is not aware of the launch of an offer; it is then called an unsolicited offer. Facing this sudden event, the board has to convene and decide whether the offer is acceptable or not. If the board rejects the offer, it becomes hostile. This does not mean that the offer will not succeed, but just that the bidder will have to fight management and the current board of directors during the offer period to convince shareholders.

Most unsolicited offers end up as recommended offers, but only after the bidder has sweetened the offer in one way or another (generally by offering a higher price).

Around 15% of offers are deemed hostile and large groups such as Pfizer, Sanofi, Diageo, Enel, etc. were created through unsolicited offers.

(c) Voluntary or mandatory offers

The concept of the mandatory offer does not exist in every country. Nevertheless, in most countries, when a buyer passes a certain threshold or acquires the control of the target, they are required by stock exchange regulation to offer to buy back all the shareholders’ shares. It is one of the founding rules of stock exchange regulations. It should be noted that in the US, there is no mandatory offer and an acquirer can theoretically buy a majority of the capital of a listed company without having to launch an offer to the minority shareholders.

Generally, the constraints for a mandatory offer are tighter than for a voluntary offer. For example, in the UK the mandatory offer will be in cash, or at least a cash alternative will be provided. Obviously, the conditions of the offer that the acquirer is allowed to set in a mandatory offer are limited because they are defined by the regulations.

3/ CERTAINTY OF THE OFFER

It would be very disruptive for the market if an acquirer were to launch an offer and withdraw it a few days later. All market regulations try to ensure that when a public offer is launched, shareholders are actually given the opportunity to tender their shares.

Therefore, market regulation requires that a cash offer is fully funded when it is launched. Full funding ensures that the market does not run the risk of a buyer falling short of financing when the offer is a success! This funding usually takes the form of a guarantee by a bank (generally the bank presenting the offer commits that if the acquirer does not have the funds the bank will pay for the shares).

Another principle is that offers should be unconditional. In particular, the bidder cannot set conditions to the execution of the offer that remains in their hands (as an example, an offer cannot be conditional upon board approval of the acquirer). Nevertheless, in most countries, the offer can be subject to a minimum acceptance (which generally cannot be too high) and regulatory approval (including antitrust). In a few countries (the UK, the Netherlands, the US), the offer can be subject to a material adverse change (MAC) clause, which can only be invoked in extrem