Transcript BA Section 6a: Equity finance

Mergers & acquisitions
Section 3a:
Equity finance
Prof. Amitai Aviram
[email protected]
University of Illinois College of Law
Copyright © Amitai Aviram. All Rights Reserved
S15D
Equity finance
Overview of Section 3a
1. Capital markets
–
–
–
Capital market terminology
Capital market efficiency
Investment strategies
2. Types of claims
3. Inter-SH conflicts
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Capital market terminology
What is capital?
• Capital: a set of claims on a firm’s assets & future profits, given in
return for the money it raises
– Capital is used to mean both sides of this deal: the sets of claims (“securities”)
& the money that is raised issuing them
• Corporate finance is a set of practices (and laws that regulate these
practices) that have three goals:
– Raise money for a firm’s business activities
– Facilitate exit-type “agency solutions” for the firm’s SHs & creditors
– Set governance balance between the firm’s SHs & creditors
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Capital market terminology
Arch-types of capital
• The firm receives money in return for a –
– Claim to the remainder of the firm’s assets, after paying all other obligations
(Equity)
– Claim to a predetermined stream of money, unrelated to the firm’s
performance (Debt)
• Debt can be further divided:
– Is collateral offered to secure the debt (senior/secured debt), or not
(junior/unsecured debt)?
– Can claim be exercised immediately by the owner?
– Can claim be easily transferred to a third party?
Exercised (almost) immediately
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Not exercised immediately
Claim is publicly traded (easy to “Cash”: checks, commercial paper,
transfer to 3rd party)
notes
Bonds
Claim is not publicly traded
Long-term loans
Short-term loans
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Capital market terminology
Primary & secondary markets
• Capital markets are the primary source of capital
– Markets in which money is offered in return for securities
• Capital markets are divided into primary & secondary markets
– Primary market – transactions in which issuing firm is a party
• E.g., Acme Corp. issues Acme shares to investor B
– Secondary market – transactions in which issuing firm is not a party
• E.g., Investor B sells to investor C shares in Acme Corp.
– Stock exchanges are a secondary market
• Primary markets allow firms to raise capital for their operations
– What good are secondary markets?
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Capital market terminology
Purpose
Public benefit
• Assesses the value of the company
– More about this benefit later
Private benefits
• Benefit to persons who have money to invest
• Benefit to SHs who want to sell their securities
• Benefit to the company
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Capital market terminology
Understanding risk
• The outcome of most investments is uncertain
– Stock: Not clear how company will perform
– Bonds: Debtor might default
• To evaluate investments, we estimate probabilities of outcomes
– E.g., 90% likelihood of paying the bond in full; 10%: default without
paying anything
– If the estimate is correct, we no longer have uncertainty, but we still
have risk
• Investments are evaluated on two dimensions:
– Return: The average expected profit from the investment
– Risk: The likely deviation from the average
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Capital market terminology
Understanding risk
• Consider 3 investments, all of which offer 10% return
– A - U.S. Treasury Bond: 100% probability of a 10% return
– B - “Blue Chip” stock
• 50%: earn a 0% return
• 50%: earn a 20% return
– C - Start-up stock
• 50%: -100% return (lose entire investment)
• 50%: 120% return
• Risk of each investment:
– A: No deviation from average – Zero risk
– B: ±10% deviation from average
– C: ±110% deviation from average – 11 times the risk of B
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Capital market terminology
Understanding risk
• Review:
– Investment A
• 50% chance: 1% return
• 50% chance: 3% return
– Investment B
• 50% chance: 3% return
• 50% chance: 13% return
Average: 2%
Deviation from Avg. ± 1%
Average: 8%
Deviation from Avg. ± 5%
• Which is the riskier investment?
• Then why do we want to avoid higher risk?
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Capital market terminology
Diversification
• Diversification reduces risk without reducing the return
– Reason: Regression to the mean
– Imagine you are flipping a coin 10 times, counting how often it
falls on heads
– Now imagine you are flipping the coin 1,000 times
– What’s more likely:
• Coin fell on heads between 4 & 6 times out of 10
• Coin fell on heads 400-600 times out of 1,000
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Capital market terminology
Diversification
• Jane owns 10 shares of Acme. Having just heard that she
needs to diversify, she buys another 990 Acme shares. Did
she reduce her risk?
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Capital market terminology
Diversification / correlation
• Additional “bets” diversify only to the extent that they are
not correlated with the existing bets
– Correlation: The observation that when there’s a change
in A, there’s a change in B
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Capital market terminology
Examples – full correlation
• Two Acme shares: whenever there’s a change in the price
of one share, there’s an identical change in the other share
– correlation between the shares is 1 (fully correlated)
– Splitting your funds between these two investments
does not diversify at all
• Acme share & Ajax share: Ajax owns 90% of Acme’s shares,
owns no other assets and has no other business –
correlation is 1
– Again, splitting funds between these two investments offers no
diversification
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Capital market terminology
Examples – some/no correlation
• Microsoft share & a lottery ticket: MS’s share price doesn’t
affect chance of winning lottery or vice versa, so correlation is 0
(not correlated)
– Splitting your funds between these two investments diversifies
• Ford share & General Motors share: Some factors affect both
firms’ prices (e.g., cost of gasoline), but other factors are
independent for each company. In Dec. 2013, WSJ reported the
correlation between the shares was 0.84
– Splitting your funds between these two
investments diversifies somewhat, but
not as well as the previous example
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Capital market terminology
Examples – negative correlation
• Ford share & ExxonMobil share: Exxon rises & Ford drops
when gas prices are high. Correlation is, say, -0.3
(negatively correlated)
– Splitting your funds between these two investments is
called “hedging” (partial protection in case your bet is
wrong)
• Buying a Ford share & shorting a Ford share: Correlation is
-1 (whenever one investment goes up, the other goes
down by the same amount)
– The two investments cancel out each other (if equal amounts
invested in each)
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Capital market efficiency
Purpose of capital markets
Back to the purpose of secondary capital markets…
Public Benefit
• Assesses the value of the company
– Why not rely on the primary market for valuation?
– Why do we care about valuing a company correctly?
– Experts can assess a company’s value
What makes the market better at valuing companies?
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Capital market efficiency
• An important service of capital markets is assessing
companies’ values
– But the assessment is only as good as the information it
incorporates
• How much info is incorporated in the market price?
• There are several competing assumptions. They are called
forms (levels) of market efficiency
– Weak
– Semi-strong
– Strong
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Capital market efficiency
Efficient capital markets hypothesis
Random
prices
Weak-form
efficiency
Semi-strong
form efficiency
Strong-form
efficiency
Prices reflect
no information
Prices reflect
previous price info
Prices reflect
all public info
Prices reflect
all info
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Capital market efficiency
Weak form efficiency
• Weak form efficiency: Current price reflects all information
on historical prices
– If this is true, previous price changes have no effect on
future prices
• I.e., how much a stock has gone up/down in the past doesn’t
matter
– In weak-form efficient capital markets, securities prices
follow a “random walk” – past prices offer no guidance
as to future prices
• If a market is at least weak form efficient, then you cannot
profit from technical analysis
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Capital market efficiency
Weak form efficiency
– Assume a stock exchange is weak-form efficient
– Hypo 1: Acme’s share price has risen by 250% in the past
week
– Is the price now more likely to rise or to drop?
• Hypo 2: In a press release made yesterday, Acme informed
the media that a $30M investment it made is now worth
only $4M
– Does Acme’s price today reflect this information?
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Capital market efficiency
Semi-strong form efficiency
• Semi-strong form efficiency: Current price reflects not only
historical price information, but all public information
• If this is true, an investor cannot profit from studying
available information, because the market already
incorporates this information
– I.e., “experts” can’t earn higher returns than the market average
(unless they have access to private information)
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Capital market efficiency
Semi-strong form efficiency
• Assume a stock-exchange is semi-strong-form efficient
• Hypo 2 (again): In a press release made yesterday, Acme
informed the media that a $30M investment it made is now
worth only $4M
• Does Acme stock price today reflect this information?
• Hypo 3: Acme’s CEO knows that another $30M investment
made by Acme has increased in value to $200M. Only Acme’s
insiders (officers/directors) know this.
• Acme’s CEO secretly buys a few shares of Acme, knowing that
these shares will double in value once the company discloses
the profit on the investment.
– Will he profit from this purchase of Acme stock?
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Capital market efficiency
Strong form efficiency
• Strong form efficiency: Current price reflects all
information, whether publicly available or not
• If this is true, no one can systematically earn higher returns
than the market average
– Not even people with inside information
– Also, prices don’t change when the company announces new
information
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Capital market efficiency
Strong form efficiency
• Assume a stock-exchange is strong-form efficient
• Hypo 3 (again): Acme’s CEO knows that another $30M
investment made by Acme has increased in value to
$200M. Only Acme’s insiders (officers/directors) know this.
• Acme’s CEO secretly buys a few shares of Acme, knowing
that these shares will double in value once the company
discloses the profit on the investment.
– Will he profit from this purchase of Acme stock?
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Capital market efficiency
Who is right?
• Which type of efficiency (weak, semi-strong or strong)
seems typical of stock exchanges?
• Which do we want to have?
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Capital market efficiency
How to explain bubbles?
• If large capital markets tend to be around the semi-strong
level most of the time, how can we explain stock market
bubbles?
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Capital market efficiency
How to explain bubbles?
• Hypothesis: Is it only because
players lack correct information?
• Vernon Smith’s experiment
– A dozen people receive some money
and “shares”
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Capital market efficiency
How to explain bubbles?
• Vernon Smith’s experiment (cont’d)
– Each share pays a dividend to the person holding it at the end of
each round of the experiment
• Dividend has equal chances of being 0, 8, 28 or 60¢/share (average is
24¢)
– Each round, participants have a few minutes to trade their shares
• Trading is done via computer, not face-to-face (no salesmanship)
– Game goes on for 15 rounds
– At end of game, shares are worth zero
– How much is each share worth?
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Capital market efficiency
How to explain bubbles?
• Vernon Smith’s experiment
– Value of the share should be clear
•
•
•
•
In round 1, $3.60 (15 x 24¢)
In round 2, $3.36 (14 x 24¢)
[…]
In round 15, 24¢ (1 x 24¢)
– Yet shares continuously trade above their expected value, then
crash as the last round draws near
• Difference in performance between best and worst trades is about $80
for a 3-hour experiment
• So participants should be motivated to trade wisely
– Why this outcome?
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Capital market efficiency
How to explain bubbles?
• When we buy a good/service for consumption, we compare
its price to the benefit we get from it
• But when we buy investment products, we do not intend to
consume them – we plan to sell them to others later (to
buy a house, finance retirement, etc.)
– So, we compare price to our expectation of what others would
pay in the future
• If we expect prices to go up, we may buy even at a price
higher than we think the investment is worth
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Capital market efficiency
How to explain bubbles?
• Are the buyers irrational?
– Not necessarily; consider 3 categories of participants
• Fundamentalists: Buy is share is priced below fundamental value (24¢ x
# of rounds left); sell if share is priced above
• Early bird speculators: Buy early at a low price, then sell to the
momentum traders
• Momentum traders: Buy when they see that prices keep rising
– In Smith’s experiments, fundamentalists didn’t do as well as the
early birds
• Early birds profited at expense of momentum traders
– So, early birds seem to have acted rationally
• Is there a risk to being an early bird?
• Can you profit as a momentum trader?
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Capital market efficiency
How to explain bubbles?
• Where are the level-headed investors?
– In theory, this trend should be reversed by short sellers – people
making bets that prices will decline
– But in practice, a “short position” is more costly and risky than a
“long position”
• E.g., in Smith’s experiment, people could not bet against the price of a
share; they could only sell (if they still had shares), buy, or neither sell
nor buy
• In real life, economic and political impediments to shorting
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Capital market efficiency
How to explain bubbles?
• So are we doomed to always repeat this?
– Experiments show that people learn from their past
experience of booms and busts
– By the third time the same group goes through a 15round experiment, bubble tends to disappear
• People burned by previous bust start anticipating a
crash earlier and sell earlier, preventing the price
from taking off
• But people still tend to expect the bubble will last
longer and prices will end up higher than they
actually are
– Expectations are based on the previous game
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Capital market efficiency
How to explain bubbles?
• But experience may be overrated…
– Participants who repeat the game several times anticipate the bubble
earlier and therefore limit its magnitude
– But when game rules are changed, even just a bit (e.g., different
dividends, more cash, fewer shares), even experienced traders again
underestimate the bubbles, resulting in a bigger bubble and a bigger
crash
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Investment strategies
Investing in capital markets
• Two common types of securities analysis
– Fundamental analysis
• Value
• Growth
– Technical analysis
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Investment strategies
Fundamental analysis
• Fundamental analysis involves figuring out the “correct”
value of a security by studying:
– available information about the company
– economic factors that affect a given company’s business
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Investment strategies
Fundamental analysis
• Strategies for fundamental investing in stock:
– Value: Identify companies that are much cheaper than the
“correct” value
• Essentially, hunting for bargain prices
– Growth: Identify companies that are likely to have explosive
growth in their business
• Essentially, hunting for “the next big thing”
Now
Disfavored
by market
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Value
Future
Now
Growth
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Future
Favored
by market
Investment strategies
Technical analysis
• Technical analysis involves studying the past
pricing pattern of a security to predict its future price
– Basic idea: All information is already factored into the price, but
the actual info is hard to acquire (“what is more important than
why”)
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Investment strategies
Matching the market (β)
• Bearing in mind the ECMH, how does one rationally invest in capital
markets?
• Jane expects the S&P 500 (a stock market index) to rise 5% in the
coming year
• Is there a way that she can invest her money so that she makes
exactly the same return as the S&P 500?
– Will it work in efficient capital markets?
• To facilitate this kind of investing, there are special type of mutual
funds called index funds
– Index funds try to match the market index, not beat it
– They do not pick the best stocks; they invest in all of them
– Very low fees: <0.1%
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Investment strategies
Matching the market (β)
• Calvin likes to live on the edge. He wants to invest so that
he makes ten times what the S&P 500 does. I.e.:
– If S&P 500 goes up 5%, Calvin profits 50%
– If S&P 500 goes down 5%, Calvin loses 50%
• He borrows $100 from a bank;
buys units in an S&P 500 index fund
– For simplicity, assume 0% interest
• Bank holds as collateral:
– The index fund units
– $10 of Calvin’s own money (margin)
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Investment strategies
Matching the market (β)
• If S&P 500 went up by 5%
– Calvin sells units for $105
– Pays back $100 for loan
– Profit: $5 off of a $10 investment → 50%
• If S&P 500 went down by 5%
–
–
–
–
Calvin sells units for $95
Owes bank $100 for loan
Bank keeps $95 proceeds + $5 out of the margin
Profit: -$5 off of a $10 investment → -50%
• How much does this arrangement cost?
• Will it work in efficient capital markets?
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Investment strategies
Beta
• In finance theory, the relation between RoR on an
investment & RoR of the market is known as beta (β)
• β=1: Investment acts exactly same as the market
– E.g., an index fund aims to have β=1
• β=10: Investment rises & falls 10 times as much as the
market
– E.g., Calvin’s investment
• β=0: Investment’s RoR is not related to market RoR
– E.g., a bank savings account with fixed interest
• β=-1: Investment acts exactly opposite of the market
– E.g., selling short index fund units
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Investment strategies
Alpha & beta
• Colloquially in the financial world, β means the return on
the investment that is explained by what the market as a
whole did, adjusted for the risk of the investment
• In other words, if the S&P 500 went up 5%, then
– the “beta return” for an investment with β=1 is 5%
– the “beta return” for an investment with β=10 is 50%
Beta
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Alpha
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Investment strategies
Alpha & beta
• The portion of the return that is not explained by the
market is called alpha (α) (sometimes called “abnormal
return”)
• A money manager achieved a RoR of 20%. During that time,
the S&P 500 went up 5%. What is her α if –
– the portfolio’s β is 1?
– the portfolio’s β is 10?
• Based on her performance, does she deserve a higher fee
than what an index fund charges?
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Investment strategies
Problems with α
1. To know α, you need to know β (the risk of the
investment)
– Infer β from past behavior
•
•
But investments may act differently in the future
Also, new investments have no past record track
– Calculate β for the past year & pay at end of year
•
But it will come out wrong if the past year is not
representative
– Calculate β for the past 10 years & pay then
•
•
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But no money manager will wait that long to be paid
And few investors will invest for that long
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Investment strategies
Problems with α
2. How do you earn an abnormal return (α)?
– Creating a β return is a commodity; easy & inexpensive
•
How do you create a β return?
– But this means that it’s not enough money for an expert
money manager
– To justify high fees, a money manager needs to create
an α return
•
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Three ways to create α …
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Investment strategies
Creating α
1. Entrepreneurship
• Control the enterprise & make it work better. E.g.
–
–
•
Venture capitalism: take an inventor & idea and turn into
professionally run business
Shareholder activism: buy unpopular (cheap) company, replace
its management with one that the market trusts more, sell when
prices rise
Why aren’t profits competed away?
–
Requires continuous, active involvement
•
–
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Limits manager to a small number of ventures
Requires new ideas
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Investment strategies
Creating α
2. Valuation
• Identify underpriced investments & invest in them
• Requires market efficiency < strong
–
–
•
Less liquid markets (few buyers/sellers); or
Faster trading technology than rivals
Also requires better valuation skills than rivals
–
–
•
Nonpublic information (w/o it, mkt eff must be <semi-strong)
Better analysis skills
Why aren’t profits competed away?
–
Scale of investment
•
–
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Requires significant investment in collecting/analyzing info
Time scope of investment (Harder to exit an illiquid investment)
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Investment strategies
Creating α
3. Financial engineering
• Improve efficiency of firm’s use of capital; or • Create new financial products appealing to investors
–
Example: Mutual funds. Before mutual funds, middle class
investors were unable to diversify, and so bore a higher risk
•
•
Why aren’t profits competed away?
–
Requires constant innovation
•
–
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Investors pay in fees some of the costs the funds save them
Once a new idea becomes known, others copy it
Requires expertise & marketing ability
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Investment strategies
Bottom line – for life
•
Creating α
–
–
–
•
For the rest of us, β is the most we can aspire to
–
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If you have very large investments & can afford to keep the
investments illiquid for many years, you can create α via stock
picking in illiquid markets
If you are an entrepreneur with good business ideas and spare
time to manage a business, you can create α via activism
If you have the expertise, reputation and innovation to create
and market new financial products, you can create α via financial
engineering
Buy index funds that track the market & have very low fees
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Investment strategies
Bottom line – for this course
•
Creating α via entrepreneurship (SH activism)
–
–
•
Diversifying
–
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Explains why SHs are trying to control the firm (rather than defer
to the board)
Most of the law we learn in this course addresses battle between
SHs & board for control of the firm
Explains why both shareholders (in picking investments) and
firms (in deciding which businesses to expand into) often pick
businesses that do not correlate (or negatively correlate) with
existing businesses
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Equity finance
Overview of Section 3a
1. Capital markets
2. Types of claims
3. Inter-SH conflicts
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Types of claims
How does a firm raise money?
• Internal financing (using assets of the firm)
– Retain earnings (cut costs, reduce dividends)
– Sell some of the firm’s assets
• Sell & lease back assets if firm needs them (similar to borrowing)
• Repurchase: sell & promise to re-buy in future date for specified price
(functionally like borrowing)
• External financing (selling claims on the firm)
– Equity financing (issue shares)
• IPO (initial public offering)/follow-on offering/private offering
• Rights issue: offering new shares to existing SHs
– Debt financing (borrow)
• Loan: bilateral contract with creditor (typically, a bank)
• Bonds: securities that are freely transferable (typically, sold to the public &
trade on an exchange)
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– Securitization: a process that turns loans into bonds
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Types of claims
The spectrum
Capital: set of claims to firm’s assets & future earnings
Senior
Bonds
Hybrids
• First claim to assets/earnings
Common
Shares
• Last claim to assets
• Specified return (independent of company performance) • Residual return
• Residual control rights
• Contractual control rights
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Types of claims
Hybrids
Capital: set of claims to firm’s assets & future earnings
Senior
Bonds
Hybrids
Common
Shares
• Hybrids combine features of shares & bonds. Examples:
–
–
–
–
Junior bonds
Convertible bonds
Preferred shares
Warrants
• Firm may have several classes of shares/bonds, with each class
conveying different rights
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Types of claims
Junior bonds
• Bonds with lower priority (claim to assets/earnings) than
senior bonds
– But higher priority than all classes of shares
• Other features similar to senior bonds
– Specified return (independent of
company performance)
– Contractual control rights
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Types of claims
Convertible bonds
• Convertible bond: a bond that may be converted into stock
• Example
– Acme Corp.’s shares are currently selling for $5/share
– It issues a $100 bond, that is convertible to 10 regular shares
• Would it make sense for a bondholder to convert it immediately?
• Would it make sense for a bondholder to convert it if the price of a share
went up to $12/share?
• Benefits
– For bondholders:
• Security of a bond (guaranteed interest & priority over SHs)
• Some of the upside of rising stock prices
• Aligns incentives of bondholders & firm’s management (protects
bondholders from excessive risk-taking by the SH-controlled management)
– For firm: Firm pays a lower interest rate on the bond
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Types of claims
Convertible bonds
• A special type of convertible bonds in know as contingent convertible
bonds (CoCo bonds)
• CoCo bonds are bonds that convert into shares when a certain event
occurs (typically, when the firm is in financial distress)
• Example
– Regulator requires Banks B to have equity of at least 5% of total assets
(otherwise B would be required to raise more equity)
– B has $10B in assets (loans made to others); capital structure: $5B in customer
deposits, $3B in secured bonds, $1B in CoCo bonds (contingency: equity <5% of
total assets) & $1B in equity (10% of assets)
– Borrowers to default on $1B of loans. B now has $9B in assets; capital: $5B
deposits, $3B secured bonds, $1B CoCos, no equity (0% of assets)
– CoCos convert into shares, adding $1B in equity, so capital structure is: $5B
deposits, $3B secured bonds, $1B equity (11% of assets)
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Types of claims
Preferred shares
• A class of shares that has priority over other shares in:
– Receiving dividends; and/or
– Rights to the firm’s assets upon liquidation
• Similar to (but subordinate to) bonds
– Because it has priority, its return (right to dividends) needs to be
specified (unlike common shares)
– Often have limited voting rights
59
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Preferred shares
Participating vs. Non-participating
• Example: Acme has 100 regular shares & 100 preferred
shares w/a $3/share dividend preference
– Board decides to distribute $500 in dividends
– Preferred SHs first receive $3 a share
– This leaves $200. If the preferred shares get part of this
money they are called “participating preferred shares”
• In that case, the $200 are distributed among all 200 shares
(preferred and regular). Each share receives $1
– Result: Each preferred share receives a $4 dividend. Each
regular share receives $1
• If preferred shares were non-participating, each gets $3;
common shares get $2 each
60
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Preferred shares
Cumulative vs. Non-cumulative
• Acme’s board decides it needs to save more money
– Can it suspend payment of interest on its bonds?
– Can it suspend payment of dividends on preferred shares?
• Cumulative P-shares protect their SHs from this
– Amount of preference over common shares accumulates in years
that dividend isn’t paid
• Example: Acme has 100 regular shares & 100 preferred
shares w/a $3/share dividend preference
– In 2005, board does not declare a dividend; P-SHs receive 0
– In 2006, board declares a dividend of $600
– P-SHs accumulated a right to $6/share of dividends, so they
receive entire $600; common SHs receive nothing
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Types of claims
Warrants
• A warrant is a security issued by a firm, giving the holder
the right to purchase a share in the firm, during a specified
period, for a specified price.
• Example
– Acme sells 100 warrants
• Each warrant allows the holder to purchase a share for $5
• The warrant vests (can be exercised) immediately
• The warrant expires 5 years after it is issued
– Assume the market price for a share is $6
• Would it make sense to buy a warrant? At what price?
– Now assume the market price for a share is $4
• Would it make sense to buy a warrant? At what price?
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Types of claims
Warrants
• Warrants are like selling a share in two installment payments, with
the share delivered only if both payments are made, and with the
buyer allowed to cancel the agreement within a certain time, subject
to losing the first payment.
– Like a coupon: “Buy one for $5 with this coupon; offer expires on…”
– Warrants are often issued by the firm in a bundle with bonds or stock
• Like a coupon: “buy one, get another one for $5”
– What are the benefits of warrants to buyers?
– To the firm?
• Don’t confuse a warrant with an option
– Options are issued by third parties (not the firm), and the money paid for
purchasing or exercising them does not go to the firm
– “Stock options” a firm grants to employees are a type of warrant
63
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Equity finance
Overview of Section 3a
1. Capital markets
2. Types of claims
3. Inter-SH conflicts
64
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Intra-shareholder conflicts
Which SH wealth to maximize?
•
•
65
Board expected to maximize SH wealth,
but sometimes interests of holders
of different share classes conflict
Common conflict: common SHs vs.
preferred SHs (with a liquidation
preference) – when firm has fewer
assets than its liquidation preference,
preferred SHs want to liquidate
the firm, while common SHs want
to keep operating the firm
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Intra-shareholder conflicts
Which SH wealth to maximize?
•
Example: Firm A is worth $30M; has 2M common shares & 1M
preferred shares (w/$10 liquidation preference/share)
–
•
A loses $20M (now worth $10M)
–
•
If firm is liquidated now: preferred SHs receive $10M; common SHs receive
nothing
Incentives
–
–
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Liquidation preference: $10M
Common SHs want to continue running company (nothing to lose, something
to gain)
Preferred SHs want to liquidate (they bear 100% of risk for next $10M of
losses, but have to share gains with common SHs)
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Intra-shareholder conflicts
Equity-linked Investors LP v. Adams [Del.Ch. 1997]
•
Genta has 3 businesses:
–
–
–
•
Genta raised capital via preferred shares
–
–
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IP in “antisense” (cancer treatment) – development stage (neg. cashflow)
JBL: generic chemicals & drugs – positive cashflow
JV with SkyePharma: oral drug delivery technology – development stage
(negative cashflow)
About $30M in return for Series A preferred shares
About $10M in return for Series B & C preferred shares: all Series B and most
Series C were converted into common stock
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Intra-shareholder conflicts
Equity-linked Investors LP v. Adams
•
Capital structure
–
–
39.99M shares of common stock
528K shares Series A preferred stock (issued for $50/share)
•
•
•
$50/share liquidation premium
$5/share (10%) cumulative dividend
Put option for $50/share in event of fundamental change (including
delisting of common shares from Nasdaq)
–
Why did preferred SHs negotiate for this?
•
Put option after three years, but Genta may pay in cash or common stock
(if stock, Genta must use best efforts to arrange underwriting)
–
–
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Why did preferred SHs negotiate for this?
Why not require redemption in cash only (or require underwriting)?
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Intra-shareholder conflicts
Equity-linked Investors LP v. Adams
•
As Genta keeps losing money, it becomes more difficult to raise
new funds to develop its business
Genta suggests a plan to keep Genta operating:
•
–
–
Sell JBL & antisense IP
Buy SkyePharma’s 50% in the oral drug delivery JV in return for a controlling
block of Genta stock
•
•
•
•
•
•
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Genta focuses on oral drug delivery technology (1, not 2, development projects)
Cash from JBL & antisense funds future operations of Genta
SkyePharma controls Genta (wealthy/experienced backer?)
Preferred SHs convert into common shares; become MSHs in Genta
Common SHs become MSHs in Genta; stay for the ride
Series A committee rejects the plan. Why?
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Intra-shareholder conflicts
Equity-linked Investors LP v. Adams
•
The real issue: should the board favor preferred SHs’ interests
(liquidate Genta) or common SHs interests (operate Genta, risking
pref SHs’ money but not common SHs’ money)
Court: “The corporation is… required to respect [preferred SHs’
contractual rights]. But… it will be the duty of the board, where
discretionary judgment is to be exercised, to prefer the interests of
common stock…”
Since pref SHs can’t claim board violated their rights as pref SHs,
they claim board violated their Revlon rights as common SHs, by
declining better offers (i.e., pref SHs’ offer)
•
•
–
70
Pref SH’s offer to lend more money ($3.6M vs. $3M), on same terms; is their
offer better for the common SHs?
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Intra-shareholder conflicts
Orban v. Field [Del. Ch. 1997]
•
•
Office Mart runs a chain of office supply stores
Capital structure
–
–
Common stock (owned by Orban, issued for $15,000)
~2.4M Series A preferred stock (issued for ~$3M)
•
•
•
–
~6.8M Series B preferred stock (issued for ~$17M)
•
•
•
•
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Liquidation preference = original investment
Convertible into common stock; votes on as-converted basis (~22.6%)
Anti-dilution rights (what’s that?)
Liquidation preference = original investment + 9% ann. Interest
Convertible into common stock; votes on as-converted basis (~63.2%)
Anti-dilution rights
Orban has ~14.3% of the voting power in OM
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Intra-shareholder conflicts
Orban v. Field
•
OM can’t raise money for outsiders; some B SHs lend
$5.2M in return for:
–
–
•
3 year secured notes paying 13% interest
Warrants to acquire 40% of OM’s equity for $1.39/share
Soon, OM can’t afford to pay interest on this loan. It executes a
recapitalization plan to convert the debt into equity
–
5.2M Series C senior cumulative redeemable preferred stock
•
–
–
•
~2.1M common shares (10% of OM’s fully diluted equity)
Warrant exercise price reduced from $1.39 to $0.75/share
Results
–
–
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Liquidation preference of $7.5M before all other stock, and another $1.5M
after Series A&B received $12M. Why the split preference?
Common SHs’ voting power ~2.5% (A: 10.5%; B: 36.9%; C: 50%)
Total liquidation preference: ~$35M
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Intra-shareholder conflicts
Orban v. Field
•
Orban gains unintended leverage
–
–
–
•
OM plays off Office Depot vs. Staples; Staples agrees to buy OM for
~$32M (< liquidation preference)
–
–
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A & B SHs had anti-dilution rights that were activated by the recapitalization
plan, and gave A&B SHs right to extra shares, so total authorized shares would
be >55M (current authorized shares: 25M)
Series A&B have the votes to modify the charter and they don’t object, but to
save time board decided to proportionately reduce # of shares of each class
Orban asked to surrender ~875K common shares, but stalls (result:
recapitalization not fully implemented; Orban’s voting power hasn’t dropped
from 14.3% to 2.5%)
If this is best price currently possible, should Orban favor the deal?
Staples offer dependent on pooling of interest accounting treatment, which
requires OM SHs to approve deal with >90% vote
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Intra-shareholder conflicts
Orban v. Field
•
Orban tries to use leverage to get $4M payment
–
SHs can easily vote to increase authorized shares, then issue to A&B SHs
shares to comply with their anti-dilution provisions
Problems
–
•
•
•
Board facilitates transaction to remove Orban’s leverage
–
–
–
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# of warrants & exercise prices in recapitalization were based on capital
reduction plan; if capital is not reduced (i.e., A&B SHs get more shares), C SHs
need to get more warrants @ reduced exercise price
Because 40% of the voting power is in warrants (which don’t vote until
converted), Orban might have >10% of voting power unless warrants are
converted, but C SH’s might not have money for that
Amend charter to increase authorized shares
Increase # of warrants & reduce exercise price
Redemption of 2M C shares for $3M, on non-pro-rata basis
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Intra-shareholder conflicts
Orban v. Field
•
Orban’s claim: Need for 90% approval rate gave common SHs
leverage to extract value at expense of preferred SHs
–
•
But isn’t it a technicality, since pref SHs could have easily increased
authorized shares had they known Orban wouldn’t surrender his
shares?
–
•
75
Board acted to take away this value, breaching duties to common SHs
That might permit the board to adjust # of warrants & exercise price, but
financing warrant conversion (by redeeming some C shares) provides
affirmative help to preferred SHs at Orban’s expense
Court applies Unocal standard (deploying corporate power
against SHs to achieve greater good of the firm), and finds that the
board satisfied both prong 1 (quasi-BJR) and prong 2 (reasonable in
relation to threat to the firm)
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Intra-shareholder conflicts
Orban v. Field
•
Prong 1 satisfied, but for prong 2, what is the threat?
–
Violating legal obligations to pref SHs?
•
This may be correct as to warrant adjustment (facilitating rights of
preferred SHs), but the board had no obligation to redeem C shares
selectively to finance the exercise of warrants
–
Saving the Staples deal?
•
This makes sense if the good of the firm means the total good to all SHs;
but Adams says that subject to respecting pref SHs’ contractual rights, in
case of conflict the board should prefer common SHs’ interests
•
Difficult to reconcile Adams & Orban (assuming both are good law)
–
Perhaps court defers to board’s decision as to which SH interests to prefer, as
long as the board was informed & acted in good faith
–
Or perhaps total SH welfare needs to be maximized
76
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