Ohio State University Advanced topic in Corporate Finance (Spring 2005) Dr. Walkling Slide Set 2: Ohio State University Advanced topic in Corporate Finance (Spring 2005) Dr. Walkling Slide Set 2
Options: Options
Problems with NPV: Problems with NPV May ignore valuable options imbedded in projects
Fundamentals of Option Pricing: Fundamentals of Option Pricing Black Scholes - 1973
Replicating portfolio idea
Types of options: Types of options Call option
Put option
European option
American option
Inputs needed for Black-Scholes Analysis: Inputs needed for Black-Scholes Analysis ?
_________________________
_________________________
_________________________
_________________________
_________________________
Call option: Call option the right to ________________________________
Example: see WSJ
Put option: Put option the right ________________________________
Example: see WSJ
Put option: Put option the right to sell an asset at a specified price for a specified period of time
Example: see WSJ
European option: European option __________________________
__________________________
American option: American option _____________________
_____________________
Inputs needed for Black-Scholes Analysis: Inputs needed for Black-Scholes Analysis ________________________________
________________________________
________________________________
________________________________
________________________________
Intuition behind each of the inputs: Intuition behind each of the inputs
Value of the underlying asset: Value of the underlying asset As value of the underlying asset increases, call values _________________
Intuition
As what you are obtaining becomes more valuable, the option to obtain it __________________________
Variance of the underlying asset: Variance of the underlying asset As variance increases, call values
__________
Intuition:
?
An increase in the variance of the underlying asset, ___________ the chance your option is in the money
Remember - downside risk is _________________________________
Puzzle: Puzzle Don’t we measure risk by volatility?
Isn’t it true that investor’s dislike risk and that we traditionally penalize a project with increased risk by raising its discount rate?
How can an increase in volatility increase the value of an asset?: How can an increase in volatility increase the value of an asset? Because we are measuring risk
_______________________, not risk of the option
An increase in the volatility of the underlying asset, __________________ the chance that it will be in the money.
The downside risk from a call option is ____________
Exercise price of the option: Exercise price of the option As the exercise price of the option increases, call values
____________
Intuition:
The more it costs to exercise the option, the _________ valuable it is
Time to expiration of the option: Time to expiration of the option As the time to expiration of the option increases, call values
______________
Intuition:
?
The longer the option is valid, _______________________ it could be in the money
Risk free rate: Risk free rate As the risk free increases, call values
_____________
Intuition:
The exercise price is not paid until _________. As the rate increases, the present value of the exercise price _____________. This in turn ______________ option value.
SOME Intuition reversed for put options: SOME Intuition reversed for put options
The Black Scholes Model: The Black Scholes Model See Brealey Myers or Comparable text
SP 10:3: SP 10:3 Briefly explain why a call option price rises as stock price increases, exercise price decreases, time to maturity increases, volatility increases, and risk-free rate increases.
*SP 10:8: *SP 10:8 Why can the equity of a firm be viewed as an option on its assets? How would you calculate the value of this option?
*SP 10:9: *SP 10:9 Briefly explain how the option analogy can be used to value loan guarantees and debts.
Real Options: Real Options
Problems with NPV: Problems with NPV May ignore valuable options imbedded in projects
Real Options: Real Options Options embedded in investment decisions
Examples of Real Options: Examples of Real Options Option to delay
Option to expand
Option to abandon
The cost of delay: The cost of delay Equal to the foregone dividends or cash flows
Quantifying the inputs: Quantifying the inputs Exercise price
_____________________________
Risk free rate
Usually measured ___________________
Value of the underlying asset
Usually measured in traditional ways (NPV, etc.)
MeasuringTime to expiration: MeasuringTime to expiration Generally, the time till the option would expire
Estimating variance: Estimating variance Previous experience
Comparables
Estimated probabilites
Simulation
Option to delay: Option to delay As a project’s inputs change, so does its value
Option to expand: Option to expand
Some implications of real options: Some implications of real options More valuable in volatile industries
Barriers to entry can increase the exercise period
e.g. patents
Multi-stage investments: Multi-stage investments Often have added value because of the option to expand
Downside - loss in economies from piecemeal expansion
Option to abandon: Option to abandon
Examples :: Examples : Valuing Natural Resource Options
Valuing a gold mine
Valuing an oil reserve
Valuing a patent
Dangers of Real Options: Dangers of Real Options Can be used to justify bad investments
Try to quantify benefits
Understand ranges of possibilities
Be objective
Valuing Film Studios: Valuing Film Studios Refer to class notes and discussion
Hostile Acquisitions: Takeover Defenses: Hostile Acquisitions: Takeover Defenses
Why does target management resist?: Why does target management resist?
Shareholder welfare
Manager welfare
Takeover defenses: Takeover defenses Maximize your share price
Concentrated ownership
Legal challenges
Pro-active
State anti-takeover laws
Reactive
Miscellaneous defenses : Miscellaneous defenses _______________________
_______________________
_______________________
_______________________
_______________________
Financial characteristics: Financial characteristics
Bid characteristics: Bid characteristics
Significant determinants of the probability of success: Significant determinants of the probability of success __________________________
Payment of a solicitation fee
% of shares held by bidder prior to the offer
% bid premium
“Selling Shareholders face a Prisioners Dilemma: “Selling Shareholders face a Prisioners Dilemma
Corporate Governance: Corporate Governance
Historical developments in corporate governance activity, 1960-Present: Historical developments in corporate governance activity, 1960-Present 1960's: Acquisitions popular
1968: U.S. William's Act
1969-1977: First generation state takeover laws, few hostile acquisitions
1982: Edgar v. MITE strikes down Illinois law
Start of 1980's takeover wave
First poison pills (Bell & Howell, Enstar)
First second generation state takeover law (Ohio)
Moran v. Household Int'l poison pill decision - 1985
1987: CTS v. Dynamics Corp. of America upholds Indiana law
1987-91: Corporate governance proxy proposals gain momentum
1990: Aggressive state antitakeover laws (Pennsylvania), Ohio; widespread use of stakeholder statutes
1992: Large outside shareholders/independent directors flex muscles:
--General Motors
--Sears & Roebuck
1993: "Relational investing”
2002 Sarbanes Oxley
Increase in size and influence of institutional investors: Increase in size and influence of institutional investors 1981 Institutions own 38% of U.S. equities
1991 Institutions own 53% of U.S. equities
Source: Brancato and Gaughan (1991)
Change in institutional voting activity: Change in institutional voting activity Before 1987
institutional investors are generally passive
During 1990’s
Over 80% support shareholder initiated antigreenmail resolutions
Source: Bergin (1988) and Biersach (1990)
Corporate Governance & Performance: Corporate Governance & Performance
A Comparison of Germany, Japan, & the U.S.
Steve Kaplan, The University of Chicago
Outline: Outline Corporate Governance Systems
Germany
Japan
U.S.
Anecdotal Theories
Research & Empirical Evidence
Conclusions
Corporate Governance Systems: Corporate Governance Systems
Corporate Governance Systems: Corporate Governance Systems
Anecdotal Theories: Anecdotal Theories Relationship-oriented systems (Germany/Japan)
Pros
decrease agency costs
banks & S/H have power to make changes
monitoring more effective
avoid costly hostile takeovers & proxy fights
more long-term focus
no short-term earnings pressure
financing more available
banks & S/H have better access to information
Anecdotal Theories: Anecdotal Theories Relationship-oriented systems (Germany/Japan)
Cons
managers become entrenched
banks may charge abnormally high fees & rates
compensation for bailing out poor-performing companies
Research & Empirical Evidence: Research & Empirical Evidence Selected large companies is each country
Focused on the top managers (e.g. CEOs)
What incentives do different systems offer?
Why are managers fired?
Why are managers paid more?
Research & Empirical Evidence: Research & Empirical Evidence Performance Measures
company stock returns
sales growth
change in pre-tax income/total assets
dummy variable of 1 if pre-tax loss
Regression Analysis - dependent variables
probability of losing job
percentage change in compensation
Why are managers fired?: Why are managers fired? Company stock returns
In all 3 countries, poor performance increases likelihood of firing
Sales growth
Except for Germany, slow sales growth increases likelihood of firing
Change in pre-tax income/total assets
In all 3 countries, earnings losses increase the likelihood of firing
When are managers paid more?: When are managers paid more? Japan & U.S. only
% changes since U.S. managers get more $
Mgt compensation is strongly related to:
Company stock returns
Sales growth
Change in pre-tax income/total assets
Conclusions: Conclusions 3 different systems generate similar outcomes
Anecdotal theories do not hold
no long-term focus for Germany & Japan
not more sensitive to sales growth
Successful governance responds to current performance measures (earnings & stock price)
Bank & inter-corporate relationships partially substitute for U.S. market control mechanisms
Conclusions - Explanations: Conclusions - Explanations Successful market economies in all 3 countries
Governance differences are less important when:
product market is competitive
including growing & changing markets
firms require more capital
will not allow for wasteful spending
Sarbanes-Oxley Act – Key Provisions: Sarbanes-Oxley Act – Key Provisions Creates a new oversight board to supervise the accounting profession on standards, discipline, etc.
Fundamentally changes the relationship between auditors, audit committees and management teams
Enhances the role and independence of audit committees
Requires that CEOs and CFOs of public companies certify their financial statements and attest to their internal controls over financial reporting.
Sarbanes-Oxley Act – More Key Provisions: Sarbanes-Oxley Act – More Key Provisions Creates new auditor independence restrictions
Bans a public company’s auditor from also providing financial systems information technology consulting, internal audit services (“outsourcing” the audit function), and from representing the company in Tax Court
Sarbanes-Oxley Act of 2002: Sarbanes-Oxley Act of 2002 The Act’s major provisions include:
Requirement of CEO/CFO certification of financial statements and internal controls.
Requirement of auditor examination of company internal controls
Creation of the Public Company Accounting Oversight Board (PCAOB) to serve as an auditing profession “watchdog.”
Prohibition of certain client services by firms conducting a client’s audit.
Sarbanes-Oxley: Management’s Responsibility For Financial Reporting : Sarbanes-Oxley: Management’s Responsibility For Financial Reporting One of its most important provisions (Section 302) states that the key company officials must certify the financial statements. Certification means that the company CEO and CFO must sign a statement indicating:
They have read the financial statements.
They are not aware of any false or misleading statements (or any key omitted disclosures).
They believe that the financial statements present an accurate picture of the company’s financial condition.
Source: U.S. Congress, Sarbanes-Oxley Act of 2002, Pub. L. 107-204, 116 Stat/ 745 (2002).
Reasons Behind Sarbanes-Oxley : Reasons Behind Sarbanes-Oxley SOX was enacted soon after the significant corporate scandals most popular ones are Enron and WorldCom,
Factors cited as contributing to scandals
Equity compensation linked executives interest to the share price.
Motivations to meet market expectations among concerns.
Long term bull market effect (1994-2000),
The failure of gatekeepers e.g. auditors, lawyers, analyst… in the scandals. (deterrence, bubble)
Enron: Enron
Enron stock price was $90 in August 2000 - America’s 7th largest company,
Chapter 11 (bankruptcy) on December 2, 2001, promptly after restating their financial reports,
The largest bankruptcy reorganization in American history,
Stock price at that time - 60 cents.
The most highlighted event at the collapse of the Enron is its relations with limited partnerships (Special Purpose Entity- SPEs),
- Executives got personal gains being on both sides (Fastow -CFO-more than $ 30 million)
- Enron failed to disclose the extent of these relations (off-balance sheet and related party transaction)
Enron (Cont’d): Enron (Cont’d)
Failures all levels of monitoring within the company including the board.
Gatekeepers such as lawyers (Vinson & Elkins) & rating agencies severely criticized.
Some investment banks charged with aiding and abetting the securities fraud.
Enron’s both internal and outside auditor Arthur Andersen, indicted to obstruction of justice, shredding of Enron-related documents,
The whistle-blower, (Sharon Watkins) vice president of Enron resigned,, letter to the top of Enron highly emphasized by media.
ROGUES GALLERY: ROGUES GALLERY
Common Accounting Tricks : Common Accounting Tricks Revenue Recognition (Qwest, Global Crossing, Dynegy, Merck-Medco)
Understating Loss Reserves
Off-Balance Sheet Activity (Enron, Dynegy)
Expenses being capitalized (WorldCom)
Cookie-jar Accounting – setting reserves for rainy day
Big Bath – Realizing excessive losses when the going is bad to set a lower benchmark
Deal Design: Deal Design Deal design
Form of Reorganization
Form of payment
Factors in deal design: Factors in deal design
The form of reorganization is important because it affects: The form of reorganization is important because it affects ______________
______________
______________
______________
______________
Deal Design: Deal Design You name the price. I’ll name the terms. (And I’ll so better than you every time.)
Old saying
“Deal Structures are Solutions to Economic Problems”: “Deal Structures are Solutions to Economic Problems” Bargaining on many fronts
“First, seek to understand”
Factors in deal design
Form of payment: Form of payment Why does it matter?
Types of payment
Form of payment: Form of payment Choices:
Stock
Cash
Other
Effects
More exotic strategies
Historic Evidence on the Market Reaction to Security Offer Announcements: Historic Evidence on the Market Reaction to Security Offer Announcements Smith 86
Table 1 The Stock Market Response to Announcements of Security Offerings (Source: Smith JFE 86) : Table 1 The Stock Market Response to Announcements of Security Offerings (Source: Smith JFE 86) Types of Issuer
Type of Security Offering Industrial Utility
Common Stock -3.14% -0.75%
(155) (403)
Preferred Stock -0.19% +0.08%
(28) (249)
Convertible Preferred Stock -1.44% -1.38%
(53) (8)
Straight Bonds 0.26% -0.13%
(248) (140)
Convertible Bonds -2.07% n.a.
(73)
Empirical Evidence on Form of Payment in Acquisitions: Empirical Evidence on Form of Payment in Acquisitions Heron - 2002
Characteristics of Stock Deals Additional evidence: Characteristics of Stock Deals Additional evidence As these variables increase/exist
6. Hostile deal
5. Ownership structure % managers own
4. Buyer’s stock price
3. Deal size
2. Buyer Liquidity
1. Bidder avoids dilution of control
The probability of a stock deal:
6. _____________________
5.
4.
3.
2.
1.
Other factors affecting form of payment: Other factors affecting form of payment Perspective – investment vs. financing
Competition
Control
Accounting earnings
Financial Flexibility of parties
Transaction costs
Size – relative and absolute
Information asymmetries
Tips for the deal designer: Tips for the deal designer Listen
Learn
Be creative
Be flexible, but understand the value of your tradeoffs
Bargain on multiple dimensions
Strive towards a ZOPA
Ch 19: Choosing the Form of Acquisitive Reorganization: Ch 19: Choosing the Form of Acquisitive Reorganization Types of Reorganization
See text for varieties including
Purchase of assets for cash or debt
Purchase of stock, substantially with cash or debt
Triangular Cash Mergers
Statutory Merger
etc
Why important?
Contingent Payouts Risk management in M&A: Contingent Payouts Risk management in M&A
Contingent payouts in M&A: Contingent payouts in M&A Contingent payments are options
Extremely useful in negotiations
Extremely useful in motivating and retaining talent
Characteristics of Earnouts: Characteristics of Earnouts As these variables increase/exist
1. Divestitures
2. Acq. of private targets
3. Size of acquiror
4. Non-horizontal combinations
* The probability of an earnout:
1. increases
2. increases
3. decreases
4. increases
Structuring earnouts: Structuring earnouts Avoid excessive complexity
Be realistic
Warning: lack of autonomy creates frustration in striving for earnouts
Exhibit 22.2: Exhibit 22.2 Compares earnout to call option
Interesting comparison of similarities and differences
Example – On Assignment
Speculation Spreads and the Market Pricing of Proposed Acquisitions: Speculation Spreads and the Market Pricing of Proposed Acquisitions
Jan Jindra
And
Ralph A. Walkling
Journal of Corporate Finance
Summer 2004
Example: Example
$40 - Bid price
$20 - Pre-offer stock price
Slide100: Subsequent market price at t+1
Objectives: Objectives Develop & test a simple model of speculation spreads
What determines the
magnitude of the spread?
cross sectional variation?
What factors are priced when the spread is set?
Motivation: Motivation The spread is the foundation of “arbitrage returns”
Better understand
acquisition pricing, acquisition trading, and the arbitrage process.
arbitrage returns
No existing evidence on the spread
Interpreting speculation spreads: Interpreting speculation spreads
SSi = (BP – P1)/P1
Smaller spreads greater market adjustment
Components of Speculative Returns: Components of Speculative Returns
TRi = (PFi – P1 i) / P1i – Hi
where TRi total % return
PFi is the final price received
Hi is the % holding costs
Components of speculative returns: Components of speculative returns Let BPi = first announced bid price
PFi – P1i = (PFi – BPi) + (BPi - P1i)
TRi = SSi + RRi – Hi
where
SSi = (BPi – P1i)/P1i and RRi = (PFi – BPi)/P1i
Expected total return: Expected total return E(TRi) = F ProbFi (PFi – P1i)/P1i – Hi
Or equivalently,
E(TRi) = SSi +Fi ProbFi (PFi – BPi ) / P1i - Hi
where ProbFi is the probability of being able to sell the shares for PFi dollars.
Hypotheses: Hypotheses H1: SS RR
a negative relation
H2: SS deal duration
a positive relation
H3: high abn. volume (arb activity)
stronger effects
Sample Selection: Sample Selection Securities Data Corp. (SDC)
Target firms 1/1/81 to 12/31/95
Cash tender offers > $10 million
Bidder seeks 100%
Target on NYSE, AMEX, or NASDAQ
Covered by Lexis-Nexus.
Financial and public utilities excluded.
Data: Data First formally announced bid.
Ownership - proxy statements, S&P Stock Guide
Managerial attitude - outcome of the offer - SDC, Lexis-Nexus.
Price, return and volume data - CRSP
Probability factors: Probability factors Target Attitude
Distribution of power
shareholdings of officers and directors,
institutions,
blockholders,
bidder toeholds.
volume activity
runups
Rumors
size of the bid premium,
target and industry characteristics
experience of the bidder.
Distribution of speculation spread: Distribution of speculation spread
Emory Handout on Article: Emory Handout on Article
Summary and Conclusions : Summary and Conclusions 362 offers 1981 - 1995,
speculation spreads on average, positive,
considerable cross-sectional variation
Over 23% are negative
Summary and conclusions, cont.: Summary and conclusions, cont. Spreads are significantly associated with
outcome of the offer (revision)
magnitude of revision
duration of the offer
Effects more dramatic in high abn. Vol. offers
A Brief Analysis of M&A Arbitrage : A Brief Analysis of M&A Arbitrage
Risk Arbitrage: Risk Arbitrage “Ivan Boesky They Ain’t”
Arbitrage vs. Risk Arbitrage
How much risk?
Rumor or announcement?
Simple M&A Arb Strategy: Simple M&A Arb Strategy Buy the target (long)
Short the bidder
More exotic strategies
options
Arbitrage examples: Arbitrage examples
Objective: Understand : Objective: Understand Alternate methods of pricing takeover transactions
Techniques of hedging and allocating market risk among participants
Unprotected transactions: Unprotected transactions Fixed exchange ratio
Examples
US West Media& Continental Cablevision
Walt Disney & CapitalCities/ABC
Time Warner & Turner Broadcasting
Reasoning? -
companies operate similar or complementary business
are will to share market risk
Fixed Exchange Rate Pricing: Fixed Exchange Rate Pricing Fixed exchange rate
Bell Atlantic’s $21.34 billion stock swap acquisition of NYNEX Corp
NYNEX shareholders receive 0.768 share of Bell for each share held
Boeing & McDonnell Douglas
$13.34 billion
0.65 share of Boeing for each McD share
Advantages of Fixed Exchange Rate Pricing: Advantages of Fixed Exchange Rate Pricing Certainty?
Acquirer can determine dilution of ownership in advance
Depending on market movements one party gains --
Disadvantages of Fixed Exchange Rate Pricing: Disadvantages of Fixed Exchange Rate Pricing and the other loses!
Both parties may face significant market risk
If Bidder price drops, target may want to cancel
Modest decline in price of LDDS Communications (now WorldCom) caused termination of the agreement to acquire ACC Corp in 1996
Rise in bidder’s price before closing may prompt bidder to terminate
Fixed Value Pricing (floating exchange rate pricing) : Fixed Value Pricing (floating exchange rate pricing) Nominal per share value fixed at inception
Exchange rate altered at closing to deliver fixed value (regardless of the number of shares needed)
Calculations typically involve average market prices
Pricing period - length and timing - may be difficult to negotiate
Pros and Cons of Fixed Rate Pricing: Pros and Cons of Fixed Rate Pricing Target gets known value
Bidder faces uncertainty over share dilution
Hedging and Protection: Hedging and Protection Increasingly used
Deals
IVAX Corp/ Johnson products
Bank of Boston/Multibank Financial
Examples of protective tools
Floors, Caps, Ceilings, Collars, Temination Fees, Contingent Value Rights,
Floors, Caps, Ceilings & Collars: Floors, Caps, Ceilings & Collars May be used separately or in conjunction with fixed exchange or fixed value pricing
Floor - if bidder’s price drops too low the exchange rate is amended
Cap - places a limit on the number of shares the bidder would have to issue
Floor + Cap = Collar
IVAX acquisition of Johnson Products : IVAX acquisition of Johnson Products Fixed exchange rate with a collar
One to One exchange - could be amended if IVAX stock fell below $24.50 or above $29 during the post agreement period
Cancellation Options and Walk Away Rights: Cancellation Options and Walk Away Rights
Target can terminate if bidder’s price drops dramatically
BANC One’s acquisition of First Community Bancorp: BANC One’s acquisition of First Community Bancorp Target will receive $31.96 of BanC One Stock but also had stipulations for a maximum (and minimum) exchange ratio if Banc One drops below $47
If Banc One drops below $43, First Community could cancel
Bidder can also get walk away rights
“As-You-Like-It-Options” and “Top-Up” Rights: “As-You-Like-It-Options” and “Top-Up” Rights As-You-Like-It-Options Used to create exotic takeover derivatives
Top-Up” Rights aka revival rights - induce a target to complete a deal
Contingent Value Rights and Variable Common Rights: Contingent Value Rights and Variable Common Rights CVRs require the bidder to pay additional cash depending on subsequent performance
VCRs give extra compensation to the target if the bidder’s stock drops in a subsequent period
Empirical evidence on types of collars: Empirical evidence on types of collars
M&A Valuation : M&A Valuation
Valuation: Valuation How much should a bidder pay?
Types of value
Methods of valuation
How much should a bidder pay for an acquisition?: How much should a bidder pay for an acquisition? Maximum = ?
Minimum = ?
Some thoughts on maximizing the acquisition price: Some thoughts on maximizing the acquisition price Maximize value
Recognize the bidder’s motivation
Know your bargaining strengths
Enter the negotiations as informed as possible
Merger Valuation: Merger Valuation A capital budgeting perspective
Similar to any other valuation
NPV
Multiples
Comparables
Important Issues in M&A Valuation: Important Issues in M&A Valuation What cash flows do you discount?
Existing?
Under new management?
What discount rate do you use?
Targets?
Bidders?
Important Issues, continued: Important Issues, continued What are the alternatives?
Build vs. buy
Don’t double count cash flows
Allow for needed investment
Bid premium size Reasons for importance:: Bid premium size Reasons for importance: 1. ____________________________
2. ____________________________
3. Provides opportunities for insights into managerial motivations
Significant determinants of bid premiums: Significant determinants of bid premiums As these variables increase (or exist)
1. Debt position of target
2. Market/book ratio
3. % of shares bidder controls prior to bid
4. Offers where control is sought
5. Offers where another bid exists
6. Liquidity of target
7. Offers where management resists
8. Conglomerate vs. nonconglomerate
The % bid premium
1.______________
2. ______________
3. ______________
4. ______________
5. ______________
6. ______________
7. ______________
8. ______________
Experiment: The controller has the power to choose the outcome number without consulting the other participant, but both parties may negotiate to split the total payoff as desired. : Experiment: The controller has the power to choose the outcome number without consulting the other participant, but both parties may negotiate to split the total payoff as desired.
Coase - "The Problem of Social Cost" : Coase - "The Problem of Social Cost" Journal of Law and Economics, 1960
Background - What is the optimal amount of pollution?
Coase's critique of government intervention
The farmer and the rancher
Coase Theorem: : Coase Theorem: The outcome (with regard to externalities) is invariant to
the prior assignment of rights
Cooperative games
Trading pollution permits
Problems with the Coase Theorem. : Problems with the Coase Theorem. It works well when:
There are _____ parties to a bargain
Property rights are ___________
Bargainers have ______________ of one anothers' profit or utility functions
Continued: Continued Bargainers behave competitively
There is ___________ bargaining
Courts will __________ enforce any bargain
Agents strike advantageous bargains and avoid bargaining breakdowns
There are no income effects
Does the Coase Theorem work?: Does the Coase Theorem work? Acid rain
Oil Exploration
Experimental results
Reasons for bargaining breakdowns: Reasons for bargaining breakdowns Transaction costs
Property rights are not well defined
Disagreement over information
Oracle/Peoplesoft timeline through 11/19/2004: Oracle/Peoplesoft timeline through 11/19/2004 June 2, 2003
PeopleSoft announces its intention to acquire J.D. Edwards for $1.7 billion in stock. June 6, 2003
Oracle stuns the world with a hostile offer to buy PeopleSoft for $16 per share in cash, or $5.1 billion. June 12, 2003
PeopleSoft rejects Oracle's offer; J.D. Edwards and PeopleSoft sue Oracle, claiming interference with their merger.
Slide152: June 16, 2003
PeopleSoft, seeking to accelerate the J.D. Edwards deal, amends the agreement to pay about half in cash. June 18, 2003
Oracle raises its PeopleSoft offer to $19.50 per share, or $6.3 billion. PeopleSoft rejects the offer two days later. June 30, 2003
U.S. Department of Justice begins investigating Oracle's offer. July 18, 2003
PeopleSoft completes J.D. Edwards acquisition. Jan. 12, 2004
Larry Ellison splits chairman and CEO roles at Oracle, relinquishes chairman spot to Chief Financial Officer Jeffrey Henley. Safra Catz and Charles Phillips are promoted to co-presidents.
Slide153: Feb. 4, 2004
Oracle raises bid to $26 per share. PeopleSoft rejects the offer five days later. Feb. 26, 2004
U.S. Department of Justice sues Oracle to block proposed PeopleSoft takeover. April 22, 2004
PeopleSoft issues second-quarter guidance well below Wall Street estimates. May 14, 2004
Oracle lowers bid to $21. PeopleSoft rejects offer 12 days later. July 7, 2004
PeopleSoft says it will not meet second-quarter guidance and blames shortfall on publicity surrounding Oracle bid.
Slide154: Sept. 9, 2004
Oracle prevails against Justice Department as big regulatory hurdle is cleared. Oct. 2, 2004
PeopleSoft CEO Craig Conway is fired, having lost confidence of the board. Founder David Duffield, who stepped down from the job five years earlier, is installed. Nov. 1, 2004
Oracle raises bid to $24, sets Nov. 19 deadline for tender of a majority of PeopleSoft shares or it will drop bid. PeopleSoft rejects offer nine days later. Nov. 10, 2004
PeopleSoft provides 2005 guidance that many on Wall Street see as unrealistic and unattainable. Nov. 19, 2004
A majority of PeopleSoft shares are tendered in favor of the takeover. PeopleSoft invokes its poison pill defense, which Oracle seeks to have voided in court or otherwise.
Due Diligence: Due Diligence
The Due Diligence Process: The Due Diligence Process The Deal Process
Stages of the deal
Important factors in due diligence
The Buyer Always Pays!: The Buyer Always Pays! Caveat Emptor
Surprises now or surprises later?!
Be fact based but knowledge oriented
Case Studies – CUC-HFS: Case Studies – CUC-HFS December 1997 Cendant Corp. is created
By merger of HFS, Inc.
Ramada, Days Inn, Howard Johnson, Avis, Coldwell Banker, Century 21
And
CUC International, Inc.
Sold memberships in clubs that offered travel shopping and dining discounts
Advantages – combining databases and cross selling
March 1998: March 1998 Discovered that CUC had been engaging in accounting fraud since 1995
Up to 61% of 1997’s revenues were ficticious
Quote
Due diligence based on public information
Problems discovered after the fact
Due Diligence Different but complimentary perspectives from various sources: Due Diligence Different but complimentary perspectives from various sources
Due Diligence: Due Diligence Last Steps Before Finalizing the Venture or the Business Acquisition
Due Diligence Process: Due Diligence Process “Due diligence” - an examination of the business and legal issues concerning a proposed business partner, venture opportunity or acquisition target.
Process of obtaining reliable information about the proposed venture to uncover facts that would influence the offer or decision to acquire the business or enter the venture.
Due Diligence Process: Due Diligence Process Conduct at an early stage of the transaction.
Address questions and issues that will reveal the true nature, conditions and position of the business.
Factors considered:
price of the deal
perceived risks
urgency of consummating the deal
gaining a level of comfort that makes the opportunity attractive
Internally-Generated Information: Internally-Generated Information To verify seller representations
To assist in determination of value
Assets and liabilities
To uncover problems, issues and concerns
To gain a better understanding of the business and industry
key customers, trends, regulatory requirements
To evaluate management and key employees
Externally-Generated Information: Externally-Generated Information Public information regarding the company, its
principals and key employees
Key customers
Market research to gain a better understanding of the dynamics of the marketplace
Case Studies – Quaker Oats/Snapple: Case Studies – Quaker Oats/Snapple 11/94 Quaker announces acquisition of snapple for $1.7 billion
4/96 Quaker agrees to sell Snapple for $300 million
The Plan: The Plan Grow Snapple as it had done with Gatorade
Integrate Snapple with Gatorade and achieve synergies
Streamline distribution of Snapple
Swap distribution rights
Snapple’s 300 independent distributors would get to deliver Gatorade to convenience stores and Mom & Pop outlets
But give up distributing Snapple to Supermarkets
The Problem: The Problem Apparently, No one asked the distributors
Supermarket business
Established
Twice as profitable as convenience stores
Other problems
Growth of Snapple had been from cramming distributor pipeline full of inventory
Bottling production scheme caused blockages and stockouts
Late in the deal: Late in the deal Snapple discloses plummeting sales and profits and continued expected weaknesses
Snapple’s owners reject stock and cash plan in favor of ‘all cash’ deal
Quaker buys Snapple for $1.7 billion cash
Tips for Conducting a Due Diligence Investigation: Tips for Conducting a Due Diligence Investigation Professional judgement and experience is critical
if you are lacking in certain areas get help
Develop a questionnaire to guide you through the process
questionnaires are available in books and from major accounting and law firms
Tips for Conducting a Due Diligence Investigation: Tips for Conducting a Due Diligence Investigation Document the findings of your investigation
Be aware of how the nature of the information impacts its reliability
internal vs. external
how and from whom it is obtained
Is it independently verifiable?
Tips for Conducting a Due Diligence Investigation: Tips for Conducting a Due Diligence Investigation Look for inconsistencies in verbal representations or
information
Practices, values and reputation of business
Consistent with your approach to doing business?
Ask open ended questions
Rather than asking for the confirmation of a fact, ask a question that leads you to the same answer
Tips for Conducting a Due Diligence Investigation: Tips for Conducting a Due Diligence Investigation Remember that past behavior can be a good predictor of future performance
Crucial in evaluating management's and employee's values, practices and performance
May or may not uncover fraud
Tips for Conducting a Due Diligence Investigation: Tips for Conducting a Due Diligence Investigation Have the seller sign a letter of representation before closing the deal
Confirm the representations the seller has made
That there are no known facts or circumstances that would affect your decision to buy under the terms and conditions agreed upon
Tips for Conducting a Due Diligence Investigation: Tips for Conducting a Due Diligence Investigation Balance cost of investigation against total risk exposure
Undiscovered pending liability could wipe out total investment
Legal remedy is costly and time-consuming
Tech Coast Angel’s Six-Step Process: Tech Coast Angel’s Six-Step Process Submit Application – Register and complete Business Plan Summary form on TCA website
Pre-Screening Assessment – Meet with small team of TCA members; present business plan. TCA members provide same-day assessment: accepted for formal screening, or not
Formal Screening – Present to 20-30 TCA members at meetings in LA, OC, SD
Entrepreneur’s objective – Generate enough interest to advance to due-diligence… at least one person willing to “lead” and at least 20 other “interested” angels
Investors’ objective – Identify promising opportunities: strong management team with a clear, compelling and credible business plan
Due-Diligence – Starts after successful formal screening; ends with funding
Dinner Presentations – Present “tuned” business plan to TCA membership. Firm up funding interest
Funding – Close on equity placement Submit Application Pre-Screening Assessment Formal Screening Dinner Presentations Funding Due-Diligence Process Focus of this talk
What Is Due Diligence? (courtesy of Akin Gump): What Is Due Diligence? (courtesy of Akin Gump) The process by which we discover, review and analyze material information in the context of a transaction
The nature and extent of investigation is dependent on, among other things: the type of transaction
Time constraints
Money constraints
Object: to get the maximum useful information in the minimum time
Why Do It?: Why Do It? Allows investors to:
Value the business
Assess risk exposure
Negotiate agreements to address existing or contingent liabilities through appropriate representations, warranties and indemnifications
Position for negotiation
Allows the company to:
Make full and complete disclosure
Make accurate representations and warranties
Position for negotiation
Top 10 Diligence Subjects: Top 10 Diligence Subjects People
Creation, Development, Ownership and Licensing of Intellectual Property Rights
Ownership of Company Assets and Property
Barriers to Competitive Entry and Third Party Barriers
Market – Pain and Painkiller
Financial – Revenue Model and Projections
Differentiated Story
Equity Ownership
Material Contracts
Litigation and Claims
The People - Often the Most Important Factor: The People - Often the Most Important Factor Consider founders, management and other investors
Probe into backgrounds
Credentials
Prior business background
Reference checks
Background checks
Case Studies – Daimler Chrysler: Case Studies – Daimler Chrysler What's culture got to do with it?
DaimlerChrysler's bumpy post-merger road
Despite significant pre-merger due diligence related to finance and product line offerings, this marriage has failed to deliver promised dividends to shareholders with stock prices still below pre-merger levels.
Despite management changes (Germans now head all divisions) and personnel layoffs of over 30,000, the Chrysler division continues to under perform and drain resources.
The widely acclaimed PT Cruiser was unable to put the company back in the fast lane of automobile traffic.
What's culture got to do with it? : What's culture got to do with it? Both the Germans and Americans anticipated issues related to their respective cultures such as language and lifestyle differences. However, they failed to consider fundamental differences in the operation of their organizations.
While the Germans viewed themselves as the superior partner in what they really believed to be an acquisition, they were surprised to find American management practices that segregated personnel, eg. reserved parking, separate cafeterias for staff and administration, and management compensation packages that were not tied to performance.
Creation, Development, Ownership and Licensing of Intellectual Property Rights: Creation, Development, Ownership and Licensing of Intellectual Property Rights Does the Company own/have proper rights to its intellectual property (patents, copyrights, trademarks, trade secrets)?
Examine source of IP or way in which it is protected (employees, 3rd parties, transfer)
These are "Bet The Company" issues
Solutions might include licensing, transfer for equity, new development
Market: Market What is the relevant market?
Why haven't others attacked it, who might, and how big are the players?
What is the real market size -- not what Jupiter or Forrester project it to be, but what it is now?
How you look for it: Talk to strategic investors. e.g., if the market is broadband wireless, talk to Hughes and TRW. What are their buying and investment plans?
Cost of failure to look: Pets.com -- is the market really $30 billion (i.e. market size over estimated); etoys (big market, overspent); Webvan (does the market care, customer acquisition cost?); EMC (keep eye on market, focused, driven sales team, helped create and drive the market through innovation)
Financial - Revenue Model, Projections and Recognition : Financial - Revenue Model, Projections and Recognition How you look for it: Analyze all of the numbers--take nothing for granted and ask for back up and third party validation (e.g. talk to customers, sales persons; review contract terms and bank records)
Accounting and operational analysts with domain experience
Review accounting procedures and policies
Research SEC and FAS positions on that industry
Consider who built the models (talk to him or her in addition to management)
Cost of failure to look
Due Diligence: Due Diligence
Establishing “Truth”: Establishing “Truth”
VC Due Diligence Basics October 15, 2002 Craig Gomulka Draper Triangle Ventures : VC Due Diligence Basics October 15, 2002 Craig Gomulka Draper Triangle Ventures
Who is Draper Triangle?: Who is Draper Triangle? Located in Pittsburgh, Pennsylvania
PA-based fund of Draper Fisher Jurvetson
First-round, early stage, lead investor
High-tech fund - Education, MEMS, Data, Semiconductor, Advanced Software, Medical Devices, Optical, Automation
The DFJ Network: The DFJ Network Timberline Venture Partners
Vancouver, WA Draper Fisher
Jurvetson
Redwood City, CA Zone Ventures
Los Angeles, CA Wasatch Venture Fund
Salt Lake City, UT Access Venture Partners
Westminister, CO
Austin, TX DFJ Portage
Chicago, IL Draper Atlantic
Reston, VA Draper Triangle
Ventures
Pittsburgh, PA DFJ New England
Cambridge, MA Draper Fisher
Jurvetson Gotham
New York, NY
Draper Triangle Portfolio: Draper Triangle Portfolio
The Funding Timeline: The Funding Timeline Review business plan
Bring in management team to present
Evaluation of opportunity
Internal partners meeting
Term sheet
In-depth due diligence
Legal documentation
Funding 1 to 4 Months
Initial level of due diligence: Initial level of due diligence Level I (after the plan and initial go/no-go)
Meet the team
Prior entrepreneurial experience
Experience in the market place
Would we enjoy working with the team?
High level understanding of
Product, Market size and Exit Potential
Competition and Differentiation
Marketing, Sales, Competitive strategy
Go or no-go decision
Secondary level of due diligence: Secondary level of due diligence Level II (gets more interesting now)
Market research, competitive analysis
Marketing and sales plan validation
Financial validation (numbers make sense?)
Potential/existing customer/partner calls
Independent industry insider/expert calls
IP review, existing patent scan
Better validation of likely exit scenarios
Have we enjoyed working with the team?
Go or no-go decision for term sheet
Final level of due diligence: Final level of due diligence Level III (after term sheet, the boring stuff)
Management team background checks
Corporate and organizational (books in order?)
Capitalization structure, benefit plan
Intellectual property (legal review)
Financials (historical audit/review, tax returns)
Existing contracts and obligations
Properties, leases and insurance
Reps and warranties in the term sheet
The Oracle of Bacon: The Oracle of Bacon
Best Practices in M&A: Best Practices in M&A
Today’s Corporate Environment in Historical Perspective (Jensen - Presidential Address): Today’s Corporate Environment in Historical Perspective (Jensen - Presidential Address) 1st, 2nd and Modern Industrial Revolutions
Change
Forces at work on the Modern Corporation
The first industrial revolution : The first industrial revolution Originated in Britain
Late 18th century
Application of new energy sources to methods of production
The second industrial revolution: The second industrial revolution Middle to end of the 19th century:
birth of modern transportation & communication
railroad, telegraph, steamship, cable systems
High speed consumer packaging technology
Mass production & distribution systems
Innovation and Invention: Innovation and Invention McCormick Reaper - 1830s
Sewing maching - 1844
High volume canning and packaging- 1880s
Interchangable parts for hand-tooled components
Coal replaces wood, water and animals as energy source
Paper industry: wood pulp replaces rags
Innovation and Invention: Innovation and Invention Wire industry: rod rolling - new technology
Wire nails replace cut nails
Woolen textile industry - advances in combing technology -
worsted textiles
Tobacco - Bonsack machine reduces labor cost by 98%
Bessemer process reduces cost of steel rails by 88%
Electrolytic refining reduces the price of aluminum by 96%
Chemicals - mass production of synthetic dyes
The Modern Industrial Revolution: The Modern Industrial Revolution Technology
The internet
PCs
Revolution in Political Economy
Socialist and communist becomes capitalist
Globalization of Trade
The greatest bull market in history
Change = : Change = Crisis?
Sharp decline in production costs and prices
Widespread excess capacity
The necessity of exit
Change = : Change = _____________
_____________
_____________
_____________
Rock and Finance: Rock and Finance
Course Wrapup: Course Wrapup Valuation
Options
Capital Structure
Arbitrage
Financial Analysis
Statistical Modeling
Cumulative Abnormal Returns
Altman’s Z-score
Agency problems
Informational assymetry
Mergers and Acquisitions
Guest speakers
Tim Portland – Scotts’
Moe Modecki – Marathon
Cyndi Richson – Opers
Case Analyses
Conoco-Dupont
Scott’s
Hershey
Yeat’s/TSE