Exam 11: Structuring the Deal:

An earnout agreement is a financial contract whereby a portion of the purchase price of a company is to be paid to the buyer in the future contingent on the realization of a previously agreed upon future earnings level or some other performance measure.

Swiss Pharmaceutical Giant Novartis Takes Control of Alcon Parent firms frequently find it appropriate to buy out minority shareholders to reduce costs and to simplify future decision making. Acquirers may negotiate call options with the target firm after securing a minority position to implement so-called “creeping takeovers.” In December 2010, Swiss pharmaceutical company Novartis AG completed its effort to acquire, for $12.9 billion, the remaining 23% of U.S.-listed eye care group Alcon Incorporated (Alcon) that it did not already own. This brought the total purchase price for 100% of Alcon to $52.2 billion. Novartis had been trying to purchase Alcon’s remaining publicly traded shares since January 2010, but its original offer of 2.8 Novartis shares, valued at $153 per Alcon share, met stiff resistance from Alcon’s independent board of directors, which had repeatedly dismissed the Novartis bid as “grossly inadequate.” Novartis finally relented, agreeing to pay $168 per share, the average price it had paid for the Alcon shares it already owned, and to guarantee that price by paying cash equal to the difference between $168 and the value of 2.8 Novartis shares immediately prior to closing. If the value of Novartis shares were to appreciate before closing such that the value of 2.8 shares exceeded $168, the number of Novartis shares would be reduced. By acquiring all outstanding Alcon shares, Novartis avoided interference by minority shareholders in making key business decisions, achieved certain operating synergies, and eliminated the expense of having public shareholders. In 2008, with global financial markets in turmoil, Novartis acquired, for cash, a minority position in food giant Nestlé’s wholly owned subsidiary Alcon. Nestlé had acquired 100% of Alcon in 1978 and retained that position until 2002, when it undertook an IPO of 23% of its shares. In April 2008, Novartis acquired 25% of Alcon for $143 per share from Nestlé. As part of this transaction, Novartis and Nestlé received a call and a put option, respectively, which could be exercised at $181 per Alcon share from January 2010 to July 2011. On January 4, 2010, Novartis exercised its call option to buy Nestlé’s remaining 52% ownership stake in Alcon that it did not already own. By doing so, Novartis increased its total ownership position in Alcon to about 77%. The total price paid by Novartis for this position amounted to $39.3 billion ($11.2 billion in 2008 plus $28.1 billion in 2010). On the same day, Novartis also offered to acquire the remaining publicly held shares that it did not already own in a share exchange valued at $153 per share in which 2.8 shares of its stock would be exchanged for each Alcon share. While the Nestlé deal seemed likely to receive regulatory approval, the offer to the minority shareholders was assailed immediately as too low. At $153 per share, the offer was well below the Alcon closing price on January 4, 2010, of $164.35. The Alcon publicly traded share price may have been elevated by investors’ anticipating a higher bid. Novartis argued that without this speculation, the publicly traded Alcon share price would have been $137, and the $153 per share price Novartis offered the minority shareholders would have represented an approximate 12% premium to that price. The minority shareholders, who included several large hedge funds, argued that they were entitled to $181 per share, the amount paid to Nestlé. Alcon’s publicly traded shares dropped 5% to $156.97 on the news of the Novartis takeover. Novartis’ shares also lost 3%, falling to $52.81. On August 9, 2010, Novartis received approval from European Union regulators to buy the stake in Alcon, making it easier for it to take full control of Alcon. With the buyout of Nestlé’s stake in Alcon completed, Novartis was now faced with acquiring the remaining 23% of the outstanding shares of Alcon stock held by the public. Under Swiss takeover law, Novartis needed a majority of Alcon board members and two-thirds of shareholders to approve the terms for the merger to take effect and for Alcon shares to convert automatically into Novartis shares. Once it owned 77% of Alcon’s stock, Novartis only needed to place five of its own nominated directors on the Alcon board to replace the five directors previously named by Nestlé to the board. Alcon’s independent directors set up an independent director committee (IDC), arguing that the price offered to minority shareholders was too low and that the new directors, having been nominated by Novartis, should abstain from voting on the Novartis takeover because of their conflict of interest. The IDC preferred a negotiated merger to a “cram down” or forced merger in which the minority shares convert to Novartis shares at the 2.8 share-exchange offer. Provisions in the Swiss takeover code require a mandatory offer whenever a bidder purchases more than 33.3% of another firm’s stock. In a mandatory offer, Novartis would also be subject to the Swiss code’s minimum-bid rule, which would require Novartis to pay $181 per share in cash to Alcon’s minority shareholders, the same bid offered to Nestlé. By replacing the Nestlé-appointed directors with their own slate of candidates and owning more than two-thirds of the Alcon shares, Novartis argued that they were not subject to mandatory-bid requirements. Novartis was betting on the continued appreciation of its shares, valued in Swiss francs, due to an ongoing appreciation of the Swiss currency and its improving operating performance, to eventually win over holders of the publicly traded Alcon shares. However, by late 2010, Novartis’ patience appears to have worn thin. While not always the case, the resistance of the independent directors paid off for those investors holding publicly traded shares. -Why was the price ($181 per share) at which Novartis exercised its call option in 2010 to increase its stake in Alcon to 77 so much higher than what it paid ($143 per share) for an approximate 25 percent stake in Alcon in early 2008?

Sellers may find a sale of assets attractive because they are able to maintain their corporate existence and therefore ownership of tangible assets not acquired by the buyer and intangible assets such as licenses, franchises, and patents.

In a statutory merger, only assets and liabilities shown on the target firm's balance sheet automatically transfer to the acquiring firm.

If the form of acquisition is a statutory merger, the seller retains all known, unknown or contingent liabilities.

Determining Deal Structuring Components BigCo has decided to acquire Upstart Corporation, a leading supplier of a new technology believed to be crucial to the successful implementation of BigCo’s business strategy. Upstart is a relatively recent start-up firm, consisting of about 200 employees averaging about 24 years of age. HiTech has a reputation for developing highly practical solutions to complex technical problems and getting the resulting products to market very rapidly. HiTech employees are accustomed to a very informal work environment with highly flexible hours and compensation schemes. Decision-making tends to be fast and casual, without the rigorous review process often found in larger firms. This culture is quite different from BigCo’s more highly structured and disciplined environment. Moreover, BigCo’s decision making tends to be highly centralized. While Upstart’s stock is publicly traded, its six co-founders and senior managers jointly own about 60 percent of the outstanding stock. In the four years since the firm went public, Upstart stock has appreciated from $5 per share to its current price of $100 per share. Although they desire to sell the firm, the co-founders are interested in remaining with the firm in important management positions after the transaction has closed. They also expect to continue to have substantial input in both daily operating as well as strategic decisions. Upstart competes in an industry that is only tangentially related to BigCo’s core business. Because BigCo’s senior management believes they are somewhat unfamiliar with the competitive dynamics of Upstart’s industry, BigCo has decided to create a new corporation, New Horizons Inc., which is jointly owed by BigCo and HiTech Corporation, a firm whose core technical competencies are more related to Upstart’s than those of BigCo. Both BigCo and HiTech are interested in preserving Upstart’s highly innovative culture. Therefore, they agreed during negotiations to operate Upstart as an independent operating unit of New Horizons. During negotiations, both parties agreed to divest one of Upstart’s product lines not considered critical to New Horizon’s long-term strategy immediately following closing. New Horizons issued stock through an initial public offering. While the co-founders are interested in exchanging their stock for New Horizon’s shares, the remaining Upstart shareholders are leery about the long-term growth potential of New Horizons and demand cash in exchange for their shares. Consequently, New Horizons agreed to exchange its stock for the co-founders’ shares and to purchase the remaining shares for cash. Once the tender offer was completed, New Horizons owned 100 percent of Upstart’s outstanding shares -How would the use of purchase accounting affect the balance sheets of the combined companies?

Which of the following is a disadvantage of balance sheet adjustments?

Employee stock ownership plans cannot be legally used to acquire companies.

Statutory mergers are governed by the statutory provisions of the state in which the surviving entity is chartered.

What are the advantages and disadvantages of a statutory merger?

In a balance sheet adjustment, the buyer increases the total purchase price by an amount equal to the decrease in net working capital or shareholders' equity of the target company.

A holding company may be used as a post-closing organizational structure for all but which of the following reasons?

Acquisition Vehicle and Post Closing Organization In the merger, AirTouch became a wholly owned subsidiary of Vodafone. Vodafone issued common shares valued at $52.4 billion based on the closing Vodafone ADS on April 20, 1999. In addition, Vodafone paid AirTouch shareholders $5.5 billion in cash. On completion of the merger, Vodafone changed its name to Vodafone AirTouch Public Limited Company. Vodafone created a wholly owned subsidiary, Appollo Merger Incorporated, as the acquisition vehicle. Using a reverse triangular merger, Appollo was merged into AirTouch. AirTouch constituted the surviving legal entity. AirTouch shareholders received Vodafone voting stock and cash for their AirTouch shares. Both the AirTouch and Appollo shares were canceled. After the merger, AirTouch shareholders owned slightly less than 50% of the equity of the new company, Vodafone AirTouch. By using the reverse merger to convey ownership of the AirTouch shares, Vodafone was able to ensure that all FCC licenses and AirTouch franchise rights were conveyed legally to Vodafone. However, Vodafone was unable to avoid seeking shareholder approval using this method. Vodafone ADS’s traded on the New York Stock Exchange (NYSE). Because the amount of new shares being issued exceeded 20% of Vodafone’s outstanding voting stock, the NYSE required that Vodafone solicit its shareholders for approval of the proposed merger. Following this transaction, the highly aggressive Vodafone went on to consummate the largest merger in history in 2000 by combining with Germany’s telecommunications powerhouse, Mannesmann, for $180 billion. Including assumed debt, the total purchase price paid by Vodafone AirTouch for Mannesmann soared to $198 billion. Vodafone AirTouch was well on its way to establishing itself as a global cellular phone powerhouse. -What are some of the challenges the two companies are likely to face while integrating the businesses?

Vivendi Universal and GE Combine Entertainment Assets to Form NBC Universal Ending a four-month-long auction process, Vivendi Universal SA agreed on October 5, 2003, to sell its Vivendi Universal Entertainment (VUE) businesses, consisting of film and television assets, to General Electric Corporation's wholly owned NBC subsidiary. Vivendi received a combination of GE stock and stock in the combined company valued at approximately $14 billion. Vivendi would combine the Universal Pictures movie studio, its television production group, three cable networks, and the Universal theme parks with NBC. The new company would have annual revenues of $13 billion based on 2003 pro forma statements. This transaction was among many made by Vivendi in its effort to restore the firm's financial viability. Having started as a highly profitable distributor of bottled water, the French company undertook a diversification spree in the 1990s, which pushed the firm into many unrelated enterprises and left it highly in debt. With its stock plummeting, Vivendi had been under considerable pressure to reduce its leverage and refocus its investments. Applying a multiple of 14 times estimated 2003 EBITDA of $3 billion, the combined company had an estimated value of approximately $42 billion. This multiple is well within the range of comparable transactions and is consistent with the share price multiples of television media companies at that time. Of the $3 billion in 2003 EBITDA, GE would provide $2 billion and Vivendi $1 billion. This values GE's assets at $28 billion and Vivendi's at $14 billion. This implies that GE assets contribute two thirds and Vivendi's one third of the total market value of the combined company. NBC Universal's total assets of $42 billion consist of VUE's assets valued at $14 billion and NBC's at $28 billion. Vivendi chose to receive an infusion of liquidity at closing consisting of $4.0 billion in cash by selling its right to receive $4 billion in GE stock and the transfer of $1.6 billion in debt carried by VUE's businesses to NBC Universal. Vivendi would retain an ongoing approximate 20 percent ownership in the new company valued at $8.4 billion after having received $5.6 billion in liquidity at closing. GE would have 80 percent ownership in the new company in exchange for providing $5.6 billion in liquidity (i.e., $4 billion in cash and assuming $1.6 billion in debt). Vivendi had the option to sell its 20 percent ownership interest in the future, beginning in 2006, at fair market value. GE would have the first right (i.e., the first right of refusal) to acquire the Vivendi position. GE anticipated that its 80 percent ownership position in the combined company would be accretive for GE shareholders beginning in the second full year of operation. -What is the form of acquisition? Why might the parties involved in the transaction have agreed to this form?

Boston Scientific Overcomes Johnson & Johnson to Acquire Guidant—A Lesson in Bidding Strategy Johnson & Johnson, the behemoth American pharmaceutical company, announced an agreement in December 2004 to acquire Guidant for $76 per share for a combination of cash and stock. Guidant is a leading manufacturer of implantable heart defibrillators and other products used in angioplasty procedures. The defibrillator market has been growing at 20 percent annually, and J&J desired to reenergize its slowing growth rate by diversifying into this rapidly growing market. Soon after the agreement was signed, Guidant's defibrillators became embroiled in a regulatory scandal over failure to inform doctors about rare malfunctions. Guidant suffered a serious erosion of market share when it recalled five models of its defibrillators. The subsequent erosion in the market value of Guidant prompted J&J to renegotiate the deal under a material adverse change clause common in most M&A agreements. J&J was able to get Guidant to accept a lower price of $63 a share in mid-November. However, this new agreement was not without risk. The renegotiated agreement gave Boston Scientific an opportunity to intervene with a more attractive informal offer on December 5, 2005, of $72 per share. The offer price consisted of 50 percent stock and 50 percent cash. Boston Scientific, a leading supplier of heart stents, saw the proposed acquisition as a vital step in the company's strategy of diversifying into the high-growth implantable defibrillator market. Despite the more favorable offer, Guidant’s board decided to reject Boston Scientific's offer in favor of an upwardly revised offer of $71 per share made by J&J on January 11, 2005. The board continued to support J&J's lower bid, despite the furor it caused among big Guidant shareholders. With a market capitalization nine times the size of Boston Scientific, the Guidant board continued to be enamored with J&J's size and industry position relative to Boston Scientific. Boston Scientific realized that it would be able to acquire Guidant only if it made an offer that Guidant could not refuse without risking major shareholder lawsuits. Boston Scientific reasoned that if J&J hoped to match an improved bid, it would have to be at least $77, slightly higher than the $76 J&J had initially offered Guidant in December 2004. With its greater borrowing capacity, Boston Scientific knew that J&J also had the option of converting its combination stock and cash bid to an all-cash offer. Such an offer could be made a few dollars lower than Boston Scientific's bid, since Guidant investors might view such an offer more favorably than one consisting of both stock and cash, whose value could fluctuate between the signing of the agreement and the actual closing. This was indeed a possibility, since the J&J offer did not include a collar arrangement. Boston Scientific decided to boost the new bid to $80 per share, which it believed would deter any further bidding from J&J. J&J had been saying publicly that Guidant was already "fully valued." Boston Scientific reasoned that J&J had created a public relations nightmare for itself. If J&J raised its bid, it would upset J&J shareholders and make it look like an undisciplined buyer. J&J refused to up its offer, saying that such an action would not be in the best interests of its shareholders. Table 1 summarizes the key events timeline. Table 1 Boston Scientific and Johnson \& Johnson Bidding Chronology Date Comments December 15,2004 J\&J reaches agreement to buy Guidant for \ 25.4 billion in stock and cash. November 15,2005 Value of J\&J deal is revised downward to \ 21.5 billion. December 5,2005 Boston Scientific offers \ 25 billion. January 11,2006 Guidant accepts a J\&J counteroffer valued at \ 23.2 billion. January 17,2006 Boston Scientific submits a new bid valued at \ 27 billion. January 25,2006 Guidant accepts Boston Scientific's bid when J\&J fails to raise its offer. A side deal with Abbott Labs made the lofty Boston Scientific offer possible. The firm entered into an agreement with Abbott Laboratories in which Boston Scientific would divest Guidant's stent business while retaining the rights to Guidant's stent technology. In return, Boston Scientific received $6.4 billion in cash on the closing date, consisting of $4.1 billion for the divested assets, a loan of $900 million, and Abbott's purchase of $1.4 billion of Boston Scientific stock. The additional cash helped fund the purchase price. This deal also helped Boston Scientific gain regulatory approval by enabling Abbott Labs to become a competitor in the stent business. Merrill Lynch and Bank of America each would lend $7 billion to fund a portion of the purchase price and provide the combined firms with additional working capital. To complete the transaction, Boston Scientific paid $27 billion, consisting of cash and stock, to Guidant shareholders and another $800 million as a breakup fee to J&J. In addition, the firm is burdened with $14.9 billion in new debt. Within days of Boston Scientific's winning bid, the firm received a warning from the U.S. Food and Drug Administration to delay the introduction of new products until the firm's safety procedures improved. Between December 2004, the date of Guidant's original agreement with J&J, and January 25, 2006, the date of its agreement with Boston Scientific, Guidant's stock rose by 16 percent, reflecting the bidding process. During the same period, J&J's stock dropped by a modest 3 percent, while Boston Scientific's shares plummeted by 32 percent. As a result of product recalls and safety warnings on more than 50,000 Guidant cardiac devices, the firm's sales and profits plummeted. Between the announcement date of its purchase of Guidant in December 2005 and year-end 2006, Boston Scientific lost more than $18 billion in shareholder value. In acquiring Guidant, Boston Scientific increased its total shares outstanding by more than 80 percent and assumed responsibility for $6.5 billion in debt, with no proportionate increase in earnings. In early 2010, Boston Scientific underwent major senior management changes and spun off several business units in an effort to improve profitability. Ongoing defibrillator recalls could shave the firm’s revenue by $0.5 billion during the next two years. In 2010, continuing product-related problems forced the firm to write off $1.8 billion in impaired goodwill associated with the Guidant acquisition. At less than $8 per share throughout most of 2010, Boston Scientific’s share price is about one-fifth of its peak of $35.55 on December 5, 2005, the day the firm announced its bid for Guidant. -What might J&J have done differently to avoid igniting a bidding war?

Swiss Pharmaceutical Giant Novartis Takes Control of Alcon Parent firms frequently find it appropriate to buy out minority shareholders to reduce costs and to simplify future decision making. Acquirers may negotiate call options with the target firm after securing a minority position to implement so-called “creeping takeovers.” In December 2010, Swiss pharmaceutical company Novartis AG completed its effort to acquire, for $12.9 billion, the remaining 23% of U.S.-listed eye care group Alcon Incorporated (Alcon) that it did not already own. This brought the total purchase price for 100% of Alcon to $52.2 billion. Novartis had been trying to purchase Alcon’s remaining publicly traded shares since January 2010, but its original offer of 2.8 Novartis shares, valued at $153 per Alcon share, met stiff resistance from Alcon’s independent board of directors, which had repeatedly dismissed the Novartis bid as “grossly inadequate.” Novartis finally relented, agreeing to pay $168 per share, the average price it had paid for the Alcon shares it already owned, and to guarantee that price by paying cash equal to the difference between $168 and the value of 2.8 Novartis shares immediately prior to closing. If the value of Novartis shares were to appreciate before closing such that the value of 2.8 shares exceeded $168, the number of Novartis shares would be reduced. By acquiring all outstanding Alcon shares, Novartis avoided interference by minority shareholders in making key business decisions, achieved certain operating synergies, and eliminated the expense of having public shareholders. In 2008, with global financial markets in turmoil, Novartis acquired, for cash, a minority position in food giant Nestlé’s wholly owned subsidiary Alcon. Nestlé had acquired 100% of Alcon in 1978 and retained that position until 2002, when it undertook an IPO of 23% of its shares. In April 2008, Novartis acquired 25% of Alcon for $143 per share from Nestlé. As part of this transaction, Novartis and Nestlé received a call and a put option, respectively, which could be exercised at $181 per Alcon share from January 2010 to July 2011. On January 4, 2010, Novartis exercised its call option to buy Nestlé’s remaining 52% ownership stake in Alcon that it did not already own. By doing so, Novartis increased its total ownership position in Alcon to about 77%. The total price paid by Novartis for this position amounted to $39.3 billion ($11.2 billion in 2008 plus $28.1 billion in 2010). On the same day, Novartis also offered to acquire the remaining publicly held shares that it did not already own in a share exchange valued at $153 per share in which 2.8 shares of its stock would be exchanged for each Alcon share. While the Nestlé deal seemed likely to receive regulatory approval, the offer to the minority shareholders was assailed immediately as too low. At $153 per share, the offer was well below the Alcon closing price on January 4, 2010, of $164.35. The Alcon publicly traded share price may have been elevated by investors’ anticipating a higher bid. Novartis argued that without this speculation, the publicly traded Alcon share price would have been $137, and the $153 per share price Novartis offered the minority shareholders would have represented an approximate 12% premium to that price. The minority shareholders, who included several large hedge funds, argued that they were entitled to $181 per share, the amount paid to Nestlé. Alcon’s publicly traded shares dropped 5% to $156.97 on the news of the Novartis takeover. Novartis’ shares also lost 3%, falling to $52.81. On August 9, 2010, Novartis received approval from European Union regulators to buy the stake in Alcon, making it easier for it to take full control of Alcon. With the buyout of Nestlé’s stake in Alcon completed, Novartis was now faced with acquiring the remaining 23% of the outstanding shares of Alcon stock held by the public. Under Swiss takeover law, Novartis needed a majority of Alcon board members and two-thirds of shareholders to approve the terms for the merger to take effect and for Alcon shares to convert automatically into Novartis shares. Once it owned 77% of Alcon’s stock, Novartis only needed to place five of its own nominated directors on the Alcon board to replace the five directors previously named by Nestlé to the board. Alcon’s independent directors set up an independent director committee (IDC), arguing that the price offered to minority shareholders was too low and that the new directors, having been nominated by Novartis, should abstain from voting on the Novartis takeover because of their conflict of interest. The IDC preferred a negotiated merger to a “cram down” or forced merger in which the minority shares convert to Novartis shares at the 2.8 share-exchange offer. Provisions in the Swiss takeover code require a mandatory offer whenever a bidder purchases more than 33.3% of another firm’s stock. In a mandatory offer, Novartis would also be subject to the Swiss code’s minimum-bid rule, which would require Novartis to pay $181 per share in cash to Alcon’s minority shareholders, the same bid offered to Nestlé. By replacing the Nestlé-appointed directors with their own slate of candidates and owning more than two-thirds of the Alcon shares, Novartis argued that they were not subject to mandatory-bid requirements. Novartis was betting on the continued appreciation of its shares, valued in Swiss francs, due to an ongoing appreciation of the Swiss currency and its improving operating performance, to eventually win over holders of the publicly traded Alcon shares. However, by late 2010, Novartis’ patience appears to have worn thin. While not always the case, the resistance of the independent directors paid off for those investors holding publicly traded shares. -Alcon and Novartis shares dropped by 5 percent and 3 percent, respectively, immediately following the announcement that Novartis would exercise its option to buy Nestle's majority holdings of Alcon shares. Explain why this happened.

Acquirer stock is a rarely used form of payment in large transactions.

What is the form of payment used in this deal? Why might this form have been selected? What are the advantages and disadvantages of the form of payment used in this deal?

Which of the following is not true of mergers?

Non-U.S. buyers intending to make additional acquisitions may prefer a holding company structure.