Hostile Takeovers

Hostile Takeovers
Even if you see an opportunity to run a firm more profitably, you may not be able to gain
control of the firm by a hostile takeover. Current management often tries to prevent a
takeover attempt. Similarly, shareholders may be hesitant to sell to you, or other
entrepreneurs may compete with you to take over the firm.
Management Defensive Tactics. The current, inefficient managers do not want you to
succeed in taking over the firm and firing them. They may resort to a variety of defensive
tacticsdesigned to prevent an outsider from succeeding in a hostile takeover attempt. Even if
you assure the managers you will not fire them and they want you to take over the firm, they
may thwart you temporarily to force you to raise your bid.
Make the Firm Undesirable. To keep you from wanting to acquire the corporation, the
managers may make taking over the firm unattractive. The managers can legally obligate the
firm to engage in costly actions if you succeed in taking it over. For example, in the event of a
hostile takeover, some unattractive obligations include:
Scorched earth policy: The corporation must sell valuable assets.
Golden parachutes: Key employees (the current managers) receive very high
severance pay.
Poison pill: The corporation must make stock available at bargain prices to original
shareholders (but not someone who takes over the firm) if the firm is taken over,
thereby diluting the value of the new owner's stock.
Firms may change the state in which they incorporate to take advantage of the new state's
strong anti-takeover laws that permit such types of behavior.
Similarly, the current managers may make the assets of the firm illiquid (not easily sold) so as
to raise the cost of borrowing money to take over the firm. Suppose you want to take over the
firm but do not have enough money to buy the firm. You may be able to borrow the money by
issuing junk bonds using the assets and earning potential of the firm as security to guarantee
bond payments. If the firm has a large amount of cash or a liquid asset (one that is easy to
sell quickly), buyers of bonds know that you can easily pay back the bond. If, instead, the
managers invest the firm's cash in real estate, which takes time to resell and whose future
value may be hard to predict, potential bondholders are less inclined to loan you the money.
They will only be willing to buy the bonds (if at all) if you raise the interest payments on the
bonds. Thus, if the firm's assets are illiquid so that your costs of raising money are higher, you
have less of an incentive to try to take over the firm.
Find Another Buyer. When faced with a hostile takeover attempt, the managers may try to find
a friendly firm or individual, known as a white knight, to come to their rescue, obtain control
of the firm, and leave current management in place.
Payoffs. The firm may try to dissuade a particular individual from taking over the firm
using greenmail, in which the firm buys back the shares of the person who is trying to take
over the firm (and only that person's shares) at a premium. Of course, some individuals may
indicate (falsely) that they are interested in taking over in the hopes of receiving greenmail.
Voting Rules. Managers (who often own some stock) can try to enact a shareholder agreement
under which anyone who seeks to gain control of the firm must obtain the approval of a
supermajority (more than 50 percent) of the firm's shareholders. Such a rule makes it easier
for a group of current shareholders to prevent a takeover.
Harassment. By bringing lawsuits alleging fraud or antitrust objections, managers can raise
the cost to someone who is trying to gain control of the firm.
Urge Shareholders to Side with Management. Managers can try to convince stockholders that
their long-run interests are better served by refusing to sell to someone who is trying to take
over the firm (even at a price above the current share price). Shareholders are asked to
believe that the current management will make the company even more profitable than those
trying to take over the company.
Such a claim must have a hollow ring to it. The current share price reflects the market's
valuation of the firm's stock with current management in place. If you are willing to pay
shareholders more than that price, then management's claim that they are more efficient than
you makes sense only if the market incorrectly perceives the profit potential of the current
Other Problems in Gaining Control. Takeover specialists spend large amounts of time and
money looking for firms whose performance they can improve. If they gain control and
improve a firm's performance, they can reap large rewards. Because of those large potential
gains, however, they may have trouble gaining control of the company. Even if, originally, you
were the only one who spent the time and money to learn of this opportunity, others may
recognize the opportunity when you start trying to gain control.
Suppose you try to gain control of the firm by purchasing 51 percent of its stock. Once
shareholders realize that you want control of the firm, they may decide that, because you will
increase profits, it would be better to hold on to their shares rather than sell them to you. If,
however, not enough shareholders are willing to sell to you, you cannot gain control of the
company (Grossman and Hart 1980). To deal with this problem, you might make a twotiered offer, in which you offer to pay a high price (say $120 per share) until you acquire
enough shares to control the company and a lower price ($100) for the remaining shares. In
addition, the offer has a clause that says that if you cannot obtain enough shares for a
controlling interest, you can cancel the offer and return all the shares to their original owners.
This offer creates an incentive to rush to tender shares to you.
You still run the risk, however, that other takeover entrepreneurs will observe what you are
doing and bid against you for control of the firm. You would be justifiably annoyed by a
bidding war because it was your initial hard work that identified the firm as a hot prospect.
The greater the roadblocks that you must face in acquiring control, the less is your initial
incentive to engage in the costly activity of uncovering underperforming firms. If you could
swoop in quickly and buy up all the shares of the firm, you would avoid the problem of having
other investors benefit from your discovery that the firm is underperforming.
Hostile takeover battles were rare prior to 1968 and are, in part, a result of more recent
government legislation. Unfortunately for you, the U.S. government has legislation (such as
the Williams Act of 1968) that requires you to reveal your intentions about a firm in which you
are trying to acquire a controlling interest. The legislation also imposes certain delays on you
that give managers time to try to thwart your attempt to gain control. The result is that you
must often share a large part of your expected gains with the stockholders of the firms you
acquire, which reduces your incentive to engage in such activities.
SOURCE: Grossman, Sanford J., and Oliver D. Hart. 1980. "Takeover Bids, the Free Rider Problem, and
the Theory of the Corporation." Bell Journal of Economics 11:42-64.