Deal Design P.V. Viswanath Class Notes for FIN 648: Mergers and Acquisitions

P.V. Viswanath2 Deal Design  What is deal design?  In essence, it is a solution to an economic problem between two players

P.V. Viswanath3 Elements of M&A Deal Design  Create Value Value Transfer Value Destruction  Improve reported financial results; avoid EPS dilution Accounting Dilution (reduction in reported EPS following a stock- for-stock acquisition) Economic Dilution (reduction in stockholder wealth) Voting dilution (reduction in voting power) (cf. Arcelor/Mittal)  Improve control Voting control by stockholders Control by lenders and preferred stockholders through covenants Control can be thought of as an option on the strategy of the firm.

P.V. Viswanath4 Elements of M&A Deal Design  Build financial flexibility Cash deals draw down cash balances or require the issuance of debt securities – reduce debt capacity. Stock-for-stock deals entail equity issuance; may not be possible to issue equity again in the near future Financial flexibility is like a call option on future financing (Revco drug stores – find other examples; RJR Nabisco?)  Manage risk Possibility of adverse movements in security prices; M&A transactions take long from deal design to consummation and security prices can move in the interim. If the deal spans international borders, exchange rate fluctuations may matter.

P.V. Viswanath5 Elements of M&A Deal Design  Preserve and improve competitive standing Retain good retail locations, customer relatinoships, assets and talent – these lay the foundation for strategic success.  Manage signals to the capital markets Share-for-share deals tell the market that the acquirer is overpriced.  Manage incentives The resulting capital structure can provide more or less incentives to the managers to do better. For example, increased debt can reduce free cashflow and put pressure on managers to produce – 1980s hostile mergers.

P.V. Viswanath6 Elements of M&A Deal Design  Enhance the governance and management structure Can affect the composition of the shareholder group, board of directors or management team. Research shows that acquisition of small private targets in stock-for- stock deals can create monitoring shareholder block.  Shape impact on employees and communities Provide continuity of employment for employees Protect pension assets Minimize impact of plant closings Build employee morale (Arcelor/ Mittal merger)

P.V. Viswanath7 Terms  Price  Form Fixed Payments: cash and senior debt securities Little uncertainty about value conveyed; resolves uncertainty Contingent payments: mezzanine debt securities, preferred stock, common stock Value less certain than cash/senior debt Earnouts, warrants, convertible bonds, contingent value rigths, puts, guarantees, caps, collars, floors – used to resolve disagreements regarding firm value. Contingent payments are often structured so that if the target performs well in the future, the targeted shareholders receive some extra payoff. Contingent payments are also used to hedge risk for one or both sides of the transaction.

P.V. Viswanath8 Terms  Form Side payments: payments to parties other than owners of the target firm. Examples: golden parachutes, warrantes, bonuses, buyouts of employment contracts, consulting commitments to managers of the target firm. Guarantees of work rules, job, training to unions Guarantees against plant closing to governments/municipalities. Bribes  Financing  Timing and Deadlines Time Value of Money Deferring payments grants the payer an option to renege on the deal.

P.V. Viswanath9 Terms  Commitments: Options granted by seller to buyer – greater the uncertainty, greater the value of the option. Assumption by seller of various liabilities Environmental Product Liabilities from lawsuits in progress Product Warranties Seller required to maintain and hand over at closing items that affect the value of the firm as a going concern. Brand names Patents Trademarks Customer lists Noncompete clauses for executives

P.V. Viswanath10 Terms  Control and Governance (Agency problem resolution) Composition of new Board Limitations on voting power (through standstill agreements) Financial covenanats Creation of fixed income securities (reducing free cashflow)  Risk Management Likelihood that the value of compensation offered can change due to market circumstances Possible entry of a competing bidder The parties could change their mind Can be mitigated by walk-away fees and guarantees to pay counterparty’s costs.

P.V. Viswanath11 Terms  Accounting Choices  Form of Transaction and Tax Exposure to the parties  Social issues Interplay of titles, compensation and ego in establishing governance and managerial hierarchy of new company.  Social Welfare Branch closings, employee layoffs, headquarters locations In some countries, available choices may be restricted by law.