Lecture - notes - Professor Edmund Schuster Basic Toolkit for M&A PDF

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LL4F3: Mergers, Acquisitions and Restructurings in EuropeLecture (Week 2)M&A Theory & Deal StructuresTheory of the Firm and M&A Companies vs markets o Our starting point is that there is an interesting question: how do markets generally decide on the right boundaries of the firm? This i...

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LL4F3: Mergers, Acquisitions and Restructurings in Europe Lecture (Week 2) M&A Theory & Deal Structures

Theory of the Firm and M&A 

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Companies vs markets o Our starting point is that there is an interesting question: how do markets generally decide on the right boundaries of the firm? This is a famous question in economics and there is a lot of literature on this. o See the reading on the reading list. o There are some controversies about this topic – how do firms decide the right boundaries? Markets: o Independent firms’ behaviour is “coordinated” through the market  If you look at firms interacting in the market, you can say that these firms interface with each other, they exchange assets and services between each other using the market itself. This means that there is no central coordination – nobody tells the car manufacturer how many cars to produce. So, there is coordination of market activity which takes place using market prices as a coordination mechanism. We don’t need central coordination in a market economy because we can rely on the market itself getting things right and the price mechanism is the core mechanism which leads us to the results that we expect and want. o Main mechanisms: market prices o Interactions between firms through contracts  From a lawyer’s perspective, firms interact by writing contracts, agreeing on legally binding commitments and then these contracts form the basis of the exchanges that we see.  Then contrast this with what is going on within any firm. Within any firm we are on the opposite side of the spectrum. There is no use of market price – this is limited within any form. It is more of a “command and control” economy: Within a firm: “command & control” o Coordination of activities through exercise of authority  So, the coordination really takes place through managers exercising their authority – the CEO decides how to allocate resources. The CEO decides what marketing departments should be focusing on. It is not the case that different departments within the firm try to hire the PR people. It is the exercise of central authority, some manager who gives directions.  There are actually some firms who believe that even within the firm they can benefit from market mechanisms – so, sometimes within a firm we see this market mechanism. Some firms internally built time for activities but the central idea stays the same – you have someone who directs these activities. o CEO directly decides allocation of resources The two systems co-exist – but where do we draw the boundaries? o Many small firms vs few large firms

Changes over time!  On the one hand, we have the system where firms interface with each other through market mechanisms and very large firms (e.g. Volkswagen, Apple) which employ thousands of people, and within these firms we have this command and control structure. One way to formulate the question around the boundaries of the firm is to ask, at what point do firms start and when do they stop merging? When is it good to rely on market mechanisms for these interactions between firms and when is it better to rely on authority? There is no clear answer to this. But transaction costs and economics play a significant part in this.  The idea here is that there are certain advantages coordinating activity through market interactions, through contract, but there are also downsides which are most pronounced in situations where you need your counterparty to make firm specific or relationship specific investment. The basic idea of incomplete contract – no matter how much time you take, you will not manage to get a contract to reflect everything that could potentially happen in the future. At the same time, you need long term relationships with their suppliers and customers, and this creates a tension where one of the parties needs to make investment, which creates a problem. As the situation changes, you may end up in a situation where someone has already made a relationship specific investment and if you rely entirely on the market mechanism, it is possible for one of the parties to take advantage of the other party, by offering a price that is unfairly low.  Market interactions may also be costly, and firms might decide that it is easier to in-house them, to direct these activities directly rather than writing a contract and then inevitably, having to renegotiate this contract over time. You could look at this and say, if the boundaries of the firms depend on these factors then as economic conditions change then so will the right boundaries of the firm. Contracting can get cheaper if products are more standardised, if it is less difficult to write a contract (which leaves less to renegotiation later on), and as this happens, firms will redraw their boundaries and say that this division we have, it doesn’t actually create the synergies that we used to have, so, we might be better off selling off this unit to someone else, and we will actually increase the valuation of our firm because this business unit we will sell is more valuable in the hands of someone else. Similarly, in times of rapid innovation, you may conclude that it is not worth relying on outside firms to provide us with the right inputs, we actually need to own a stake in that in order to overcome some of the contracting and transactional costs which flow from transacting. So, changes over time can create both incentives to acquire the firm but also an incentive to sell-off the firm.  Starburst – company consists of many parts and you take them apart and sell the different parts. Discuss: What could determine the optimal size of a company? Extra task (voluntary): o Find out whether Kellogg grows its own crops for producing cereal.  Do they have any assets relating to farming? Why does Kellogg draw its boundaries in the way it does?  Kellogg’s grows its own crops o Can you explain your finding? o

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Class Hypo – part 2 

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The more Louisa learns about DeliverEats’ business, the more interested she becomes in investing in the company. Sophia tells her that the company’s founder Carol, who holds 50% of the shares, is interested in selling her shares. The remaining shares are held by a range of institutional and retail investors, none of whom owns more than 2% of the shares. Louisa acquires Carol’s shares.  Louisa runs the insurance company and Sophia her delivery business. None of the two CEOs wants to sell any shares, does not want to engage in transactions. What are the solutions? We can create a joint venture and the second solution is not do anything in corporate law, not engage in any restructuring but rather say that one of the two firms runs the call centre for the other firm and then just charges them for the service provided.  But what if they can actually start engaging in corporate control transactions? Take a look at these two questions: 1. Discuss whether this adds new options for structuring the transactions. 2. Does the new ownership structure make it easier to address the key issues you identified before? We can say that there are two types of situations and each comes within its own problems:

Synergies & Mergers -

One situation is where you have some minority shareholders, and you the controller holds the controlling stake in company B and there are synergies which can be realized between the two companies.

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The second situation is the one shown in the diagram below. This is where the controller holds a 100% of the share in those two wholly owned subsidiaries. Legal problems connected to these two situations are different and different problems arise in these situations. In this diagram below there is also this additional element, if you have this situation where two wholly owned subsidiaries can transact and their synergies can be released, this gives rise to questions under tax law. This is because as we saw in the Hypo above (what the contract says between DeliverEats and InsuranceCo, or providing call services), it is not clear what the contract should say between the two wholly owned subsidiaries. o For example, if you say that Starbucks is the controller, and the first subsidiary is Starbucks UK, and the second subsidiary owns all the IP rights connected to

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Starbucks. You can say that there is a synergy between the two subsidiaries because if there are coffee shops in the UK, the ability to slap on the Starbucks name on your cups is valuable. You sell more coffee if your cup and shop says Starbucks. There is synergies, where subsidiary 2 owns the trademarks, IP rights and Subsidiary 1 owns the coffee shops. So, if subsidiary 2 lets Subsidiary 1 use these rights, then there will be a higher profit margin or more revenue. Then the question is how much you can charge for these IP rights. This creates tax problems because the way that Starbucks arranged its affairs, was that the UK subsidiary paid so much for the IP rights so that it didn’t have many profits left and ended up not paying tax in the UK for many years.

Basic Toolkit: Transaction Types 

Many ways to categorise/classify transactions  There isn’t one way to categorise transactions. o Change of control, e.g. control transactions vs. intra-group restructurings  Control transactions are the transactions which economically speaking, someone else will be in control of decisions in Target Company. We can contrast this with:  Intra-group restructurings: some of the legal techniques we will discuss are used almost exclusively in Europe for the purpose of restructuring within a group and in terms of the volume of the work intra-group restructurings are part of major transactions for lawyers. o Type of target, e.g. public vs. private  We distinguish between Public M&A and Private M&A depending on whether or not the target company is listed on any stock exchange, the shares are held by the public as opposed to any company which is held by a small number of people who have some connection with the founders or with the managers.  There are also private companies where you do have a lot of investors were no one controls them. But these are rare.  Most of the companies are controlled by someone who is connected with the managing directors. o Type of acquirer, e.g. strategic, financial/private equity  We distinguish between strategic, financial and private equity acquirers. The boundaries are kind of blurred here.  Strategic acquirers are those whose motive for acquiring a company is to a large extent synergy driven. This can be synergies like saving operational costs, but it

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could also be strategic. It fits into the broad definition of synergies that Shuster uses – you make strategic acquisition because you want to make sure that a competitor doesn’t buy this company, or you want to make sure that the company you buy doesn’t grow into significant competitor to your own operations.  In some cases, you might want to acquire a company because you want to have access to their employees or their knowledge.  You can also have financial investors such as a private equity, who doesn’t have any other related businesses in the portfolio. It could be a combination of recalibrating incentives, restructuring the financial side of the company, so rejigging the mix between equity and debt. o Type of consideration, e.g. cash vs securities o You also distinguish between different types of transactions by looking at the type of consideration paid off. Is it cash deposition or an acquisition where securities (typically shares) of another business are used as consideration. There are many more ways of classifying these transactions. o … Legal techniques? Three main methods:  From a legal perspective, almost all transactions can be put into one of the following three buckets: o Asset deals o Share deals (including takeover bids) o Mergers and merger-like transactions (e.g. schemes of arrangement)  Merger-like –> transactions which involve a restructuring of the entities involved in the transaction.

How common are these transactions? We don’t have a lot of data. For private targets we have some asset deals, a few share deals and a few mergers. For public target in the US, it is primary mergers that are used. In the EU context, mergers are far less popular. This last category here on the table doesn’t exist in most EU jurisdictions for control transactions. Though mergers are used for intragroup restructuring. We have a merger-like transaction, the scheme of arrangement is not quite a merger but not dissimilar to a merger. Schemes of arrangement are a common way of acquiring businesses.

 Asset purchases quite frequently, in private transactions, the vast majority happen through stock purchases. And for public transactions, you don’t have any asset purchases and you end up with takeover offers which are followed up with merger-like transactions.

Basic Toolkit: Transaction Types  This is the legislator’s perspective. From a legislator’s perspective, regulating M&A transactions is not a hard task. From a policy perspective, control transactions that create value through synergies is a good thing because it makes the economy more efficient and more can be produced with less inputs in the case of cost synergy. So, legislators are interested in ensuring that we have an efficient allocation of busines resources. There are additional considerations though. Yes, we need to make sure that transactions happen and have value, but the shareholders may not be protected appropriately through these transactions so, legislators will pay attention to minority shareholders, look after creditors and other stakeholders. For larger transactions, there is additional tension. It is easy to say that if two companies merge it creates value because of synergies and therefore we will be richer. This might be true on worldwide basis. However, it is not always true that this value creation accrues across all jurisdictions on which those companies are active. It may actually create synergies, but these may accrue more in one jurisdiction than another. They make a negative contribution in one country and positive in another. There are also external effects there might be more efficiency in one of these companies. There might also be negative effects in the one jurisdiction’s economy, which makes the government more hesitant to approve this transaction and generally, this can create a more ambivalent attitude of legislators towards M&A transactions. o For example, the acquisition of Arm Holdings creates discussion within UK government, that even if this transaction creates value and there are synergies, shouldn’t we be worried about a foreign entity (e.g. Japanese controlled company) acquiring holdings doesn’t this have the potential of having a negative impact on the UK in terms of cheap manufacturing. Softbank is in the process of selling the company they acquired. So, in this process of the sale, Softbank made commitments to keep the research in the UK. The same discussion is happening now with Arms Holdings. o Whenever a foreign company acquires one of our companies, we want to be notified and have the right to block this transaction, look at the specifics at what they are planning and extract maybe guarantees in relation to its future management of the target company. This gained significance in the past so more countries have introduced foreign investment control rules in EU. US had rules about this already.  Regulating corporate transactions - main considerations of legislators? o Facilitate corporate control transactions / value creation rationale o Efficient allocation of resources o Protection of shareholders (including from own management) o Protection of creditors o Protection of stakeholders o Freedom of contract o Securing taxation rights o Employees  From the viewpoint of a policymaker, lawmaker, the empirical fact that transactions often lead to changes in employment, not very surprising, we have

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synergies between two companies which can produce the same amount of goods using fewer employees. Employees are also voters.  Also, large acquisitions are not very popular with the voting public especially when it affects employment – so this plays a role when shaping your regulatory response. Beyond – e.g. consumers/competition, national security, etc  This is outside the scope of our course.  A transaction may create synergies, but it may also be problematic for consumers because it creates market power for the acquirer who is already in a dominant position. So, in such situation, there may be synergies and value creation apart from the added market power. But even if there is actual value creation (which doesn’t have anything to do with value redistribution). There might also be value redistribution. E.g. if we have Microsoft which decides to acquire Zoom, there may be operating synergies between these two companies, but you would also create a situation where there is significant market power for Microsoft. So, competition regulators are not likely to let this transaction go ahead.

ASSET DEALS Deal Basics

 If you look at an asset deal – we have a seller who owns the Target business (this target business is not a separate company), the seller owns some assets, and these assets amount to an interesting busines which someone else wants to buy. The seller will typically own other busines and assets which the buyer is not interested in. the buyer will acquire the target business. As a consequence, the buyer will directly own the target assets and pay the purchase price to the seller:

Asset Deals  In an asset deal, rather than acquiring a company, we are acquiring a business or an undertaking.  Business/undertaking vs company o There is no legal definition which has universal application for what constitutes a business:  What is a “business”? o Context-specific definitions  Used in specific areas such as: o E.g. accounting, reporting vs transactions  In transactions, a business doesn’t have to comply with these segment definitions.  It could be just a collection of assets.  There is one aspect which is important: the rules that are in place: if a collection of assets has the right degree of autonomy, so it can operate in a business-like fashion, then there are consequences to the type of asset deal we have to do. In particular, if you do have a business and you acquire assets in an asset deal, you will automatically have to take on the employees in that business.  If I want to buy Gorge Pub which is in a separate company – but I don’t want to buy the company, I want to buy the business assets (E.g. the glasses, the lease on the premises), then because this is an independent business, you also have to take on the employees.  Consideration? o In an asset deal, the buyer will pay the consideration to the owner of the business assets. So, where we have company selling the business, the company will get the cash – there are no rules as to what the consideration should be. But if it is cash acquisition here, then the cash will go from the buyer to the seller, and the seller will transfer the business assets. o What problems do we generally have?  General problems with transfers? o Assets  As we transfer all these assets, depending on what these assets are and the law applicable to this transfer, there may be a lot of formalities we need to comply with for handing over these assets. You will have to go through the right procedures/formalities – this may be an additional cost and a problem though. o Liabilities

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Will there always be liabilities that I also want to acquire in an asset deal?  There may be some bank loans, financing, in the company which are related to the business assets. For example, the Gorge Pub may have taken out a loan to acquire the glasses and chairs. So, if you look at these liabilities, these are business-connected and what will happen to them in an asset deal. What other liabilities connected to the business might I want to acquire?  If we look at an asset deal from a b...