Tutorial: How Hostile Takeovers Work

Mergers and acquisitions: These two words represent how companies buy, sell and recombine businesses. They're also the reason why today's corporate landscape is a maze of conglomerations. Insurance companies own breakfast cereal makers, shopping mall outlets are part of military manufacturing groups, and movie studios own airlines, all because of mergers and acquisitions. Not all M&As are peaceful, however. Sometimes, a company can take over another one against its will -- a hostile takeover. How can they do that? In this article, we'll find out how hostile takeovers happen, how to prevent them and why a hostile takeover isn't always a bad thing.

Mergers and Acquisitions
When two companies merge, the boards of directors (or the owners, if it is a privately held company) come to an agreement. The original companies cease to exist, and a new company forms, combining the personnel and assets of the merging companies. Like any business deal, this can be straightforward, or incredibly complex. The key is that both companies have agreed to the merge.
In an acquisition, one company purchases another. The purchased company ceases to exist, or it becomes a part of the buying company. The buying company owns all assets, including the name of the company, their equipment, their personnel and even their patents and other intellectual property. However, just like a merger, the boards or owners of both companies have agreed to the transaction.

A hostile takeover is an acquisition in which the company being purchased doesn't want to be purchased, or doesn't want to be purchased by the particular buyer that is making a bid. How can someone buy something that's not for sale? Hostile takeovers only work with publicly traded companies. That is, they have issued stock that can be bought and sold on public stock markets. (Check out How Stocks and the Stock Market Work for more information.)

A stock confers a share of ownership in the company that issued it. If a company issued 1,000 shares, and you own 100 of them, you own a tenth of that company. If you own more than 500 shares, you own a majority or controlling interest in that company. When the company makes major decisions, the shareholders must vote on them. The more shares you have, the more votes you get. If you own more than half of the shares, you always have a majority of the votes. In many respects, you can control the company.

So a hostile takeover boils down to this: The buyer has to gain control of the target company and force them to agree to the sale.

Going Hostile
There are several reasons why a company might want or need a hostile takeover. They may think the target company can generate more profit in the future than the selling price. If a company can make $100 million in profits each year, then buying the company for $200 million makes sense. That's why so many corporations have subsidiaries that don't have anything in common -- they were bought purely for financial reasons. Currently, strategic mergers and acquisitions are more common. In a strategic acquisition, the buyer acquires the target company because it wants access to its distribution channels, customer base, brand name, or technology.
These purchase factors are the same for friendly acquisitions as well as hostile ones. But sometimes the target doesn't want to be acquired. Perhaps they are a company that simply wants to stay independent. Members of management might want to avoid acquisition because they are often replaced in the aftermath of a buyout. They are simply protecting their jobs. The board of directors or the shareholders might feel that the deal would reduce the value of the company, or put it in danger of going out of business. In this case, a hostile takeover will be required to make the acquisition. In some cases, purchasers use a hostile takeover because they can do it quickly, and they can make the acquisition with better terms than if they had to negotiate a deal with the target's shareholders and board of directors. The two primary methods of conducting a hostile takeover are the tender offer and the proxy fight.

A tender offer is a public bid for a large chunk of the target's stock at a fixed price, usually higher than the current market value of the stock. The purchaser uses a premium price to encourage the shareholders to sell their shares. The offer has a time limit, and it may have other provisions that the target company must abide by if shareholders accept the offer. The bidding company must disclose their plans for the target company and file the proper documents with the Securities and Exchange Commission (SEC). The 1966 Williams Act put restrictions and provisions on tender offers.

Sometimes, a purchaser or group of purchasers will gradually buy up enough stock to gain a controlling interest (known as a creeping tender offer), without making a public tender offer. This bypasses the Williams Act, but is risky because the target company could discover the takeover and take steps to prevent it.

In a proxy fight, the buyer doesn't attempt to buy stock. Instead, they try to convince the shareholders to vote out current management or the current board of directors in favor of a team that will approve the takeover. The term "proxy" refers to the shareholders' ability to let someone else make their vote for them -- the buyer votes for the new board by proxy.

Often, a proxy fight originates within the company itself. A group of disgruntled shareholders or even managers might seek a change in ownership, so they try to convince other shareholders to band together. The proxy fight is popular because it bypasses many of the defenses that companies put into place to prevent takeovers. Most of those defenses are designed to prevent takeover by purchase of a controlling interest of stock, which the proxy fight sidesteps by changing the opinions of the people who already own it.

The most famous recent proxy fight was Hewlett-Packard's takeover of Compaq. The deal was valued at $25 billion, but Hewlett-Packard reportedly spent huge sums on advertising to sway shareholders [ref]. HP wasn't fighting Compaq -- they were fighting a group of investors that included founding members of the company who opposed the merge. About 51 percent of shareholders voted in favor of the merger. Despite attempts to halt the deal on legal grounds, it went as planned.

Who Benefits?
While companies fight tooth and nail to prevent hostile takeovers, it isn't always clear why they're fighting. Because the acquiring company pays for stocks at a premium price, shareholders usually see an immediate benefit when their company is the target of an acquisition. Conversely, the acquiring company often incurs debt to make their bid, or pays well above market value for the target company's stocks. This drops the value of the bidder, usually resulting in lower share values for stockholders of that company.
Some analysts feel that hostile takeovers have an overall harmful effect on the economy, in part because they often fail. When one company takes over another, management may not understand the technology, the business model or the working environment of the new company. The debt created by takeovers can slow growth, and consolidation often results in layoffs.

Another cost of hostile takeovers is the effort and money that companies put into their takeover defense strategies. Constant fear of takeover can hinder growth and stifle innovation, as well as generating fears among employees about job security.

Ultimately, we must measure the costs of mergers and acquisitions on a case-by-case basis. Some have been financial disasters, while others have resulted in successful companies that were far stronger than their predecessors were.