© 2005 Dr Ralph A. Walkling1 Ohio State University Advanced topic in Corporate Finance (Spring...

© 2005 Dr Ralph A. Walkling 1

Ohio State University Advanced topic in Corporate Finance

(Spring 2005) Dr. WalklingSlide Set 2


Options


Problems with NPV

May ignore valuable options imbedded in projects


Fundamentals of Option Pricing

Black Scholes - 1973 Replicating portfolio idea


Types of options

Call option Put option European option American option


Inputs needed for Black-Scholes Analysis

? _________________________ _________________________ _________________________ _________________________ _________________________


Call option

the right to ________________________________

Example: see WSJ


Put option

the right ________________________________

Example: see WSJ


Put option

the right to sell an asset at a specified price for a specified period of time

Example: see WSJ


European option

__________________________ __________________________


American option

_____________________ _____________________


Inputs needed for Black-Scholes Analysis

________________________________

________________________________

________________________________

________________________________

________________________________


Intuition behind each of the inputs


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

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

– 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?

– 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

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

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

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


The Black Scholes Model

See Brealey Myers or Comparable text


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

– 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

Briefly explain how the option analogy can be used to value loan guarantees and debts.


Real Options


Problems with NPV

May ignore valuable options imbedded in projects


Real Options

Options embedded in investment decisions


Examples of Real Options

Option to delay Option to expand Option to abandon


The cost of delay

Equal to the foregone dividends or cash flows


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

Generally, the time till the option would expire


Estimating variance

Previous experience Comparables Estimated probabilites Simulation


Option to delay

As a project’s inputs change, so does its value


Option to expand


Some implications of real options

More valuable in volatile industries Barriers to entry can increase the exercise

period– e.g. patents


Multi-stage investments

Often have added value because of the option to expand

Downside - loss in economies from piecemeal expansion


Option to abandon


Examples :

Valuing Natural Resource Options Valuing a gold mine Valuing an oil reserve Valuing a patent


Dangers of Real Options

Can be used to justify bad investments– Try to quantify benefits– Understand ranges of possibilities– Be objective


Valuing Film Studios

Refer to class notes and discussion


Hostile Acquisitions: Takeover Defenses


Why does target management resist?

Shareholder welfare

Manager welfare


Takeover defenses

Maximize your share price Concentrated ownership Legal challenges

– Pro-active• State anti-takeover laws

– Reactive


Miscellaneous defenses

_______________________ _______________________ _______________________ _______________________ _______________________


Financial characteristics

uncontested offers (n=57)

contested offers (n=38)

total assetstotal salesdebt/assets

mkt equity/debtnwc/t. assetsmkt. value/book value

ROAROEtrend in ROAtrend in ROE

Betadiv. payoutdiv. yield

ro


Bid characteristics

Uncontested offers Contested offers

$ shares controlledby bidder

26.8% 11.4%

solicitation fee $0.23 $0.37

% conglomerateoffers

33% 50%

% successful offers

% bid premium


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

Prisoner B

Prisoner A Don’t Confess Confess

Don’t Confess A gets 5 years

B gets 5 years

A gets 8 years

B gets 3 years

Confess A gets 3 years

B gets 8 years

A and B get 10 years each


Corporate Governance


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

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

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

A Comparison of Germany, Japan, & the U.S.

Steve Kaplan, The University of Chicago


Outline

Corporate Governance Systems

– Germany

– Japan

– U.S. Anecdotal Theories Research & Empirical Evidence Conclusions



Germany

Japan

U.S.

Executive Comp

Moderate Low High

Board of Directors

Management /Supervisory

Primarily Insiders

Primarily Outsiders

Ownership High family, Corporate, &

Bank

High bank, High corp., Low mgt

Diffuse & Non-

corporate



Germany

Japan

U.S.

Capital Markets

Relatively Illiquid

Somewhat Liquid

Very Liquid

Takeover/ Control Markets

Minor

Minor

Major

Banking System

Universal Banking

Main Bank

System

Fragmented


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

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

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

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?

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?

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

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

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

• 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

• 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

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

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:

1. They have read the financial statements.

2. They are not aware of any false or misleading statements (or any key omitted disclosures).

3. 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– 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 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)

•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

Company Share Price % fall (Jan 1st 01- Jun 26th 02)

Enron 99.9 Filed for bankruptcy after fiddling accounts; top management resigned

Global Crossing 99.7 Filed for bankruptcy after fiddling accounts

Adelphia Communications

99.1 Filing for bankruptcy after off-balance sheet loans to directors; CEO resigned

Peregrine Systems 95.8 SEC is investigating accounting practices; CEO and CFO resigned

Qwest Communications

95.6 CEO Joseph Nacchio resigned

Worldcom 93.8 CEO sacked after cover-up of $3.8 billion fraud

Dynegy 88.9 SEC is investigating accounting practices; top management resigned

ImClone 79.4 Former CEO Samuel Waksal charged with insider trading

Tyco International 78.4 CEO Dennis Koslowski resigned after being charged with tax evasion.

Source – The Economist, June 29th 2002


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

Form of Reorganization

Form of payment


Factors in deal design


The form of reorganization is important because it affects

______________ ______________ ______________ ______________ ______________


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”

Bargaining on many fronts

“First, seek to understand”

Factors in deal design


Form of payment

Why does it matter? Types of payment


Form of payment

Choices:

– Stock

– Cash

– Other

Effects

More exotic strategies


Historic Evidence on the Market Reaction to Security Offer

Announcements Smith 86


Table 1The 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

Heron - 2002


Characteristics of Stock DealsAdditional 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

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

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

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 PayoutsRisk management 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 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

Avoid excessive complexity Be realistic Warning: lack of autonomy creates

frustration in striving for earnouts


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

Jan Jindra

And

Ralph A. Walkling

Journal of Corporate Finance

Summer 2004


Example

$40 - Bid price

$20 - Pre-offer stock price


Subsequent market price at t+1


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

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

SSi = (BP – P1)/P1

Smaller spreads greater market

adjustment


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

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

– 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

H1: SS RR

– a negative relation

H2: SS deal duration

– a positive relation

H3: high abn. volume (arb activity)

– stronger effects


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

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

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

-0.4 -0.3 -0.2 -0.1 0.0 0.1 0.2 0.3 0.4 0.5SPREAD

0

100

200

300

Cou

nt

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8P

roportion per Bar


Calendar Portfolio Returns

-1

0

1

2

3

4

5

6

7

8103

11

8203

08

8303

02

8402

27

8502

21

8602

19

8702

13

8802

10

8902

06

9002

01

9101

29

9201

24

9301

20

9401

14

9501

12

Calendar Time

Raw

Ret

urn

0

5

10

15

20

25

# o

f fi

rms

in p

ort

foli

o

Cumulative Target

Cumulative VW

Cumulative EW

# of firms


Emory Handout on Article


Summary and Conclusions

362 offers 1981 - 1995,

speculation spreads on average, positive,

considerable cross-sectional variation

Over 23% are negative


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


Risk Arbitrage

“Ivan Boesky They Ain’t”

Arbitrage vs. Risk Arbitrage

How much risk?

Rumor or announcement?


Simple M&A Arb Strategy

Buy the target (long) Short the bidder More exotic strategies

– options


Arbitrage examples


Objective: Understand

Alternate methods of pricing takeover transactions

Techniques of hedging and allocating market risk among participants


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– 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

Certainty?

Acquirer can determine dilution of

ownership in advance

Depending on market movements one party

gains --


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) 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

Target gets known value

Bidder faces uncertainty over share dilution


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

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

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

Target can terminate if bidder’s price drops dramatically


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 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

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


M&A Valuation


Valuation

How much should a bidder pay?

Types of value

Methods of valuation


How much should a bidder pay for an acquisition?

Maximum = ?

Minimum = ?


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

A capital budgeting perspective Similar to any other valuation

– NPV– Multiples– Comparables


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

What are the alternatives?– Build vs. buy

Don’t double count cash flows– Allow for needed investment


Bid premium sizeReasons for importance:

1. ____________________________

2. ____________________________

3. Provides opportunities for insights into

managerial motivations


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. Outcome Party A Party B

1 $0.00 12.00

2 4.00 10.00

3 6.00 6.00

4 7.50 4.00

5 9.00 2.50

6 10.50 1.00

7 12.00 0.00


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:

The outcome (with regard to externalities) is invariant to

the prior assignment of rights Cooperative games Trading pollution permits


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

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?

Acid rain Oil Exploration Experimental results


Reasons for bargaining breakdowns

Transaction costs Property rights are not well defined Disagreement over information


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.


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.


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.


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


The Due Diligence Process

The Deal Process Stages of the deal Important factors in due diligence


The Buyer Always Pays!

Caveat Emptor Surprises now or surprises later?! Be fact based but knowledge oriented


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

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

Last Steps Before Finalizing the Venture or the Business Acquisition


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 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

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

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

11/94 Quaker announces acquisition of

snapple for $1.7 billion

4/96 Quaker agrees to sell Snapple for $300

million


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

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

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

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



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?



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



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



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



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

1. Submit Application – Register and complete Business Plan Summary form on TCA website

2. 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

3. 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

4. Due-Diligence – Starts after successful formal screening; ends with funding

5. Dinner Presentations – Present “tuned” business plan to TCA membership. Firm up funding interest

6. Funding – Close on equity placement

Submit Application

Pre-Screening Assessment

Formal Screening

Dinner Presentations

Funding

Due-Diligence ProcessFocus of this

talk


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?

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

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

Consider founders, management and other investors

Probe into backgrounds– Credentials– Prior business background– Reference checks– Background checks


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?

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

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 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

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

Learn & Confirm

Protect IntellectualProperty

Time and Cost


Establishing “Truth”

Learn

Term Sheet

Confirm

Reps & Warranties

Remedies


VC Due Diligence Basics

October 15, 2002

Craig Gomulka

Draper Triangle Ventures


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 NetworkTimberline Venture PartnersTimberline Venture Partners

Vancouver, WAVancouver, WA

Draper Fisher Draper Fisher JurvetsonJurvetson

Redwood City, CARedwood City, CA

Zone VenturesZone VenturesLos Angeles, CALos Angeles, CA

Wasatch Venture FundWasatch Venture FundSalt Lake City, UTSalt Lake City, UT

Access Venture PartnersAccess Venture PartnersWestminister, COWestminister, CO

Austin, TXAustin, TXDFJ PortageDFJ PortageChicago, ILChicago, IL

Draper AtlanticDraper AtlanticReston, VAReston, VA

Draper Triangle Draper Triangle VenturesVentures

Pittsburgh, PAPittsburgh, PA

DFJ New EnglandDFJ New EnglandCambridge, MACambridge, MA

Draper Fisher Draper Fisher Jurvetson GothamJurvetson Gotham

New York, NYNew York, NY


Draper Triangle Portfolio


The Funding Timeline1. Review business plan

2. Bring in management team to present

3. Evaluation of opportunity

4. Internal partners meeting

5. Term sheet

6. In-depth due diligence

7. Legal documentation

8. Funding

1 to 4 Months


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 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 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


Best Practices in M&A


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

Originated in Britain

Late 18th century

Application of new energy sources to

methods of production


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

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

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

Technology The internet PCs Revolution in Political Economy

– Socialist and communist becomes capitalist Globalization of Trade The greatest bull market in history


Change =

Crisis?

Sharp decline in production costs and prices

Widespread excess capacity

The necessity of exit


Change =

_____________

_____________

_____________

_____________


Rock and Finance


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 AnalysesConoco-DupontScott’sHersheyYeat’s/TSE

© 2005 Dr Ralph A. Walkling1 Ohio State University Advanced topic in Corporate Finance (Spring...

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Transcript of © 2005 Dr Ralph A. Walkling1 Ohio State University Advanced topic in Corporate Finance (Spring...