L1 - EJ: ITT Corporation

Once a company is generating free cash flows, what should management do with that cash? Should managers invest that cash in new projects? Should they acquire companies? Or should
they dis- tribute the cash to their shareholders? In recent years, we’ve seen a large increase in share buybacks, sometimes called repurchases These questions determine the capital
allocation process
DECISION TREE FOR CAPITAL ALLOCATION
The first question a manager must address involves the availability of positive net present value (NPV) projects to spend money on. If positive NPV projects are available to you, then you
should undertake them. Those projects may involve organic growth—say, introducing new products or buying new property, plant, and equipment—or inorganic growth via mergers and
acquisitions. If there aren’t value-creating opportunities—that is, projects with positive NPVs—then a manager should distribute the cash to shareholders through dividends or share
buybacks.
RETAINING CASH:
Make investments: you need to calculate the net present values of a few options in order to identify the best value-creation (organic or inorganic). there are several trade-offs to consider
(problems to consider when undergoing mergers and acquisitions, which can complicate present value assessments)
THE PERILS OF INORGANIC GROWTH
The lure of mergers and acquisitions as opposed to organic investment is often the apparent speed of buying existing as- sets instead of taking the time to build those assets. Moreover, the
M&A logic also implies that buying assets, as opposed to building them, is also safer, as the risk of completion has been resolved.
BEFORE THE MERGER
diligence is such an important part of the M&A process. Buyers need to understand the assets they are acquiring. But, in the end, they must remember that the seller has a large
informational advantage.
What might sellers do in approaching a sale? They might underinvest in assets to understate the capital intensity of the business. They might accelerate revenues and delay costs. And
they might bury problems such as bankrupt customers who owe them by declaring those receivables still open. Intermediaries, like consultants and investment banks, can help buyers with
these problems, and the buyer’s own deal teams can find out where the bodies are buried. If you’re not careful, it's easy to be swayed by their enthusiasm and end up paying too much. So,
the notion that M&A is safer than organic investment is far from well-grounded, and the data on the failure rates of mergers directly contradicts their supposed safety
AFTER THE MERGER
Although the rationale of synergies can be tantalizing when assessing a merger, realizing those synergies is no trivial task. The time it takes to realize the synergies can have a massive
impact on the value creation of the merger.
Cultural issues in bringing two organizations together must be considered. The issues raised by cultural differences are paramount and have significant financial consequences. These issues
also signal why the seeming speed and safety of mergers and acquisitions versus organic growth can be illusory.
Conglomerates → *Aggressive M&A strategies can also lead to conglomerates, or multidivisional companies with diversified holdings with little shared between the holdings. *These are an
opportunity to revisit some important finance intuitions. *2 finance justifications for becoming a conglomerate: 1 - a cost- of-capital argument. By doing the diversifying acquisition, I will bring
my cost of capital to that target. This reasoning is flawed, as the correct cost of capital to use is a function of that business. You can’t export your cost of capital. 2 - to manage risk. By
owning different types of companies in different industries, shareholders are thought to benefit from diversification. Equates acquisitions to stock portfolios. This line is faulty and ignores
that managers are undertaking diversification, while shareholders could arguably achieve that risk management themselves. *The logic of finance is: you shouldn’t do something for your
shareholders that they can do for themselves. *Those that appear to destroy value rather than create it, often trade at a discount, which means that their combined value is less than if the
businesses were traded separately, because capital allocation within a conglomerate is distorted by the pressure to treat all divisions equally. *In the process, capital is distributed equally
rather than allocated toward the best opportunities The divisions would be worth more apart than together. *But those aren’t always problematic. In some emerging markets, those can be
powerful because they overcome market imperfections in capital markets and labor markets by internalizing activity inside that conglomerate.
Distributing Cash to Shareholders → *Assuming a company doesn’t have worthwhile projects to pursue, it should distribute cash to shareholders. *How? There are 2 primary options: 1 -
The more intuitive way to distribute cash is to pay a dividend, simply pay cash to its shareholders on a pro rata basis. Those can be part of a predictable flow, or they can be larger, one-off
events— special dividends. 2 - a share buy- back is less intuitive. Buys back its own shares in the open market and then retires them. Investors who choose not to sell their shares will own a
larger fraction, and cash has been distributed. Share buybacks have become popular over the last decade. *Which is the better method? There is no right answer, but it is useful to begin by
debunking some misconceptions so you can develop some better intuitions on this decision. To clarify the nature of the decision, whether a company chooses to distribute cash shouldn’t
matter. The choice is irrelevant, but each method potentially sends a different signal to the market, and that can matter. Value arises from pursuing positive NPV projects. keeping nor
distributing cash results in changed value
Distributing Cash
There are two ways to distribute cash:
The more intuitive way to distribute cash is through dividends. A company simply pays cash to its shareholders on a pro rata basis. Dividends can be part of a predictable flow, or they can be
larger on-off events (special dividends).
The second way is through share buyback. The company buys back its own share in the market and then retires them. Therefore, investors who choose not to sell their shares will own a
slightly larger fraction of the company and cash has been distributed.

So, which option is better? There is no right answer, but we will debunk some myths to make a better decision. Some argue stock prices rise after buyback because the remaining
shareholders own more of the company afterwards. Others argue that dividends are bad because their shares will be worth less. To clarify this, we will show whether a company decides to
distribute cash shouldn't matter.

The company distributes $70 of the cash as dividends. Given that there are 100 shares outstanding, that is $0.7 per share. Cash reduces to $30 but operating assets remain the same.
Because debt remains the same, equity also has to drop $70, so the price per share falls from $1.40 to $0.7. As a Shareholder you might seem to be taking a hit but when you factor in the
$0.7 in cash you received, you are left with $1.4 (same position as before).

The company buys back $70 worth of shares. Again, cash drops and OA remains the same. The equity drops $70. Given the price of $1.4, with $70 you can buy 50 shares. The total value
of the equity is now $70 and there are 50 shares outstanding that provides a 1.4 share price. The shareholders who sold to the company are left with 1.4 and the ones who stayed have a
share worth of $1.4 (nothing has changed). Conclusion: value does not arise from taking cash from one pocket and putting it to another. Instead, it arises from pursuing positive NPV
projects.

Decision to distribute cash

The value neutrality of keeping or distributing cash is true under the M&M conditions (no taxes, perfect information, and no transaction costs).
Real world considerations do have an impact.
● Taxes may affect the value. For example, during a share buyback, investors must sell their shares and incur a capital gain that may be taxed at a lower rate while a dividend can be taxed at
a higher rate. There is asymmetric information and incentives. All actions are judged by the information they are thought to reveal. If people with all the information are buying back shares,
they must think the firm is undervalued and are willing to put real money under that sentiment.
● Dividends give an opposite idea. People believe that paying dividends means that there are no projects to invest in and they don´t think the firm is undervalued so that is why they are giving
it back to you. It is possible to also interpret dividends positively, because as a company starts to pay dividends it is hard to stop so it signals that the management has faith in the ongoing
profitability of the enterprise.
● The principal-agent problem is also a common factor. Managers can use cash to pursue their own agendas.
● Adopting agency perspective can explain the share buyback phenomenon. Let's say a manager is a penny short on Earnings Per Share for a given quarter and knows he will be punished for
the error. He can manufacture the EPS by doing a buy back as it will reduce the number of shares outstanding.

Myths and Realities in facing financial decisions

The notion of value neutrality can help us understand a variety of financial transactions, as well as the illusions and mistakes they give rise to.
Equity Issuance: many believe this is problematic because of dilution. Specifically, equity issuance is thought to lead to stock price declines because investors end up with a smaller piece of
the company. As shares are worth $1.4, raising $70 in equity will mean the firm has to issue 50 shares. That leaves 150 shares outstanding to split the $210 in equity. Price of the shares did
not vary. Investors end up with a smaller percentage but of a larger pie.
 Stock Splits: let’s say a company decides to split its stocks two-for-one. there will be no changes for the market-based balance sheet is the same and as equity remains $140 and you now
have 200 shares each one will be $0.7. Investors did not lose value, only now they have two shares that are worth $1.4 in total. Some companies do this to attract smaller investors.
According to Warren Buffet, these splits are meaningless and only encourage short term interest in a stock through a seemingly cheaper price.

Leverage recapitalization: it is a large dividend funded by the issuance of debt. The company will borrow an additional $60 and combine it with $40 of cash to pay out a special $100 cash
dividend. This means that now 100 shares are now worth $0.4 per share but shareholders have also received a $100 dividend split across those shares or $1 each. As a result, the value of
the share is $1.40. Now the equity is riskier and that is associated with higher expected returns.

Venture financing: Let's imagine a brand-new enterprise. Before the first round of external financing the balance sheet is ambiguous as founders’ own equity and the assets are their ideas.
The founders have allocated a hundred shares of company stock to themselves, but the company is still entirely private. The company needs $100 to invest in a new project and goes to a
venture capitalist to find that funding. If the venture agrees to give the money in exchange of a percentage of the company in return, he has implicitly valued the company. 25 shares are
issued to the capitalist (20% of 125 shares).

Now the company goes for another series of investments. They are asking for $1000, and the investors request 50% of the company in return. If 50% represents $1000 then the equity
is worth $2000. This means that the company now is worth $1000 ($2000 (total asset value) - $1000 cash).The founders have 100 shares, and the series A investors have 25. These 125
shares are worth $1000 or $8 each. Finally, 125 shares are issued to the series B investors to represent the 50%.

The founders have gone from owning 100% to 80% after Series A to 40% after Series B. With each round, their equity is diluted but their stakes grow in value because the pie is growing
larger as well.
CASH ON BALANCE SHEETS
Six Major Mistakes in Capital Allocation
It’s useful to emphasize the precise places where things can go wrong. These are six of the biggest mistakes that happen during the capital allocation process.
1. Delaying decision making: Not making capital allocation decisions results in rising cash levels on corporate balance sheets. These rising cash levels typically frustrate shareholders as they
question why managers are unable to deploy capital.
2. Trying to create value through share buybacks: In fact, value can’t be created through share buybacks. At best, share buybacks transfer value across shareholders, depending on the
buyback prices for shares. Managers can only create value by investing in positive NPV projects.
3. Preferring acquisitions over organic investment because acquisitions are faster and safer: the informational problems between sellers and buyers, it can be risky to acquire
companies, and the integration issues associated with acquisitions can offset any purported gains.
4. Preferring buybacks over dividends because buybacks are discretionary while dividends are not: Shareholders can become just as accustomed to a steady stream of buybacks as
they do with dividends. Shareholders value a company's commitment to pay dividends, which can result in gains to shareholders. Special dividends are a simple way to distribute cash that
explicitly will not generate expectations for future dividends.
5. Preferring to reinvest cash to build a larger business. Building empires can become a major objective for managers that can contradict their mandate to be good stewards of capitals.
6. Excessive distribution of cash to satisfy short- term shareholders: Overlooking positive NPV projects is as problematic as pursuing size over value creation. Short- term earnings goals
and pressure from shareholders who care only about these short- term earnings metrics can cause a manager to overlook good investments.
Biogen’s Acquisition of Convergence Pharmaceuticals - Risks of integration
● In January 2015, Biogen announced the acquisition of Convergence Pharmaceuticals, a company working on developing drug therapies for neuropathic pain.
● For a small acquisition like this, Biogen started by examining the science, assessing the probability of the therapy going to market, and researching whether the therapy is protected by a
patent.
How would you incorporate the technological risk of a new pharmaceutical product into the valuation of an acquisition? How would the potential existence of synergies affect
your opening and final bids?
● You should model the technological risk by building various scenarios when developing your valuation.
● You can create a weighted average of those scenarios to generate your final expected value for the acquisition.
● You also want to think about the stand- alone value and the value you will be providing to that company.
With a contingent value right (CVR) instrument, the payoff to the seller is the function of a future event, such as drug performance or the performance of an acquisition. How
does a CVR reallocate risks in the Biogen-Convergence deal and why would Clancy want to use one?
● By using a CVR, Biogen has shifted some risk to the seller, relative to an outright acquisition

● When faced with taking a CVR, only con- dent sellers would be willing to accept it, so it selects against those with weaker prospects.
● The CVR gives the seller an incentive to work hard to ensure the success of the drug.
● The CVR addresses the deep asymmetric information problem in this setting—Convergence knows the value of the molecule that it’s selling better than Biogen ever could.
Should Convergence remain in England or be brought to the United States? → If it turned out to be a marketable project, Biogen would reconsider. By keeping the Convergence team
in England, Biogen thought that it could preserve the team’s entrepreneurial spirit.
What would some of the challenges be if Biogen decided to fully integrate Convergence?
● The scientists who developed the treatment may not want to move to Boston, which could result in losing knowledge of how to continue development.
● Cultural clashes may impede integration if the team from Convergence is no longer fully stand- alone.
5.2 HEINEKEN IN ETHIOPIA-RISK OF EXPANDING IN ANOTHER COUNTRY
Heineken purchased 2 companies in Ethiopia. Potential risks of acquiring a company in another country: foreign currency, trade agreements or taxation, revenue projections, political risk,
logistics, costs, cultural differences.
5.3 BIOGEN`S SHARE REPURCHASES
Shares repurchase program. Taking share buybacks over a short time gives a strong signal that it believes that its stock price is undervalued.
5.4 A SHAREHOLDER REVOLT AGAINST APPLE
Activist investor pressure manager to justify their capital allocation decisions. investors called upon Apple to distribute cash; they had an amount of cash that exceeded plausible values.
Apple was resistant to dividends and buybacks.
 L2 - EJ:AMAZON

Mergers and acquisitions (M&A) have long been a major component of corporate strategy. Google’s growth strategy, for example, has been driven by acquisition. M&A deal values
peaked in 1999 and 2007. In addition, over the past twenty years, investment bank revenues from M&A brokering, structuring, and advising rose by 23%.

Anheuser-Busch InBev: In November 2015, Belgium-based beer brewer Anheuser-Busch InBev announced an agreement to acquire its largest competitor, SABMiller, for more than $100
billion.

Reasons for acquiring a company, its assets, or its stock include capturing market share, consolidating a supply chain, increasing bargaining power, deploying capital in a tax-effective
way, opportunistically responding to a target company’s distress, and quickly obtaining competitively sensitive knowledge or technology. The perceived benefits of M&A are commonly called
deal synergies. Evaluating those synergies is an important part of valuing a merger or acquisition.

M&A transactions also involve allocating the combined value of two or more businesses among their varied constituents: boards, officers, shareholders, lenders, employees, or even
communities. Whether a transaction is described as a merger or as an acquisition depends on a variety of deal characteristics. A deal is considered an acquisition when one company,
typically the larger one, buys the stock or assets of a target company, typically the smaller one, and then either integrates the target company into its operations or preserves it as a new
stand-alone subsidiary.
In contrast, a deal is considered a merger of equals when two companies of roughly the same size decide to form a new company. A smaller company may technically acquire a larger
company, as in a typical inversion. Mergers tend to be interpreted as friendly or cooperative, whereas acquisitions make it clear that one party is in charge and can even carry the
connotations of a hostile takeover. There are two types of buyers that pursue M&A transactions: strategic acquirers and financial acquirers.

● Strategic acquirers: are bidders with existing businesses that buy another company or a subset of another company’s assets to achieve operational improvements. Their purpose for
acquiring a company may include vertical integration with a customer or supplier, or horizontal integration with a target that offers products or services that are similar or complementary to
those of the buyer. These M&A deals are often referred to as strategic deals; they are the most common type of M&A. Strategic acquirers primarily buy a target company for operational
improvements. These typically fall into two categories: cost savings and revenue enhancements.

● Financial acquirers: are typically backed by private equity firms or other financial sponsors who create a new company to make each new acquisition. The target of a financial acquirer is
often preserved as a stand-alone business after the acquisition. Usually, a different management team is installed, although some financial acquirers seek to retain the target’s managers in a
management buyout. In any event, the acquirer gives the post-buyout management team new, higher-powered incentives in the form of equity, options, performance-based pay; it also
sometimes gives the target a new strategic or operational direction. Financial acquirers often aim to sell the target within three to five years after their acquisition.

Typical Financial Acquires:

Contrasts Between Strategic and Financial Acquirers

● Strategic buyers focus on how well the target fits into their overall organization, while financial acquirers typically evaluate the target as a stand-alone investment.
● Strategic buyers are often willing to pay more for a company than financial buyers are, due to the expected value of operational synergies.
● They also tend to be larger, publicly listed companies, able to use their own liquid stock to finance the deal.
● Although both types of buyers usually expect to adjust the target’s capital structure, financial acquirers are more likely to increase the target’s debt to finance the acquisition and take
advantage of an income tax shield.
● Some financial acquirers engage in “roll-up” strategies consisting of a series of acquisitions that lead them to behave more like strategic acquirers in some respects.
2.3 DEAL VALUATION
A key issue in M&A is quantifying the deal`s potential total value. Deal valuation is complex and encompasses (engloba) the key components of deal design, tax analysis and general
business and operation planning and implementation. There are 2 broad valuation methods: direct and indirect. The distinctiveness of M&A valuation is that it must not only be applied when
estimating the target`s value, but it must also reflect the expected costs and benefits of the deal itself.
2.3.1 DIRECTLY VALUING THE TARGET: DISCOUNTED CASH FLOWS
First is to value the target on a stand-alone basis using the discounted cash flow (DCF method), estimate value by discounting relevant cash flows at an estimate of their net present value
(NPV). The DCF method can be used to value deal synergies and deal costs.The NPV derived from a DCF is an estimate of the current value of the future free cash flows that the target
expects to generate over a specified period, potentially into the indefinite future. Free cash flows (FCF) are defined as operating profit + depreciation and amortization - capital expenditures,
taxes, and changes in working capital. The FCFs are discounted to their present value using WACC. This WACC should match the estimated risk of the cash flows, matching risk, and return.
All this assuming an optimized capital structure which may or may not match the proposed financing for the deal. The target`s stand-alone valuation must then be adjusted to reflect both the
costs and benefits of the deal.
2.3.2 INDIRECTLY VALUING THE TARGET AND THE DEAL:
Based on public data about other similar companies or transactions. Bidders can observe stock prices and market multiples of comparable companies and from that develop an estimated
value for the target. Comparable M&A transactions, that is control acquisitions of other companies. Advantages: the data is straightforward; the valuation does not involve projections or
estimates, and the methods are relatively transparent. Limit: the company and control acquisition must be truly like the deal. This method involves judgment.
When using stand-alone comparable company valuations, synergies, and deal costs. must be valued separately from the target because they will not be reflected in other companies’ stock
prices. Marginal share stock prices may not provide a reliable benchmark for a control acquisition because they seldom convey (comunica) control and can be affected by liquidity or market
forces that are not directly relevant to a bidder.
2.4 COMPONENTS OF DEAL PRICE
Analysis of the sources of an M&A valuation to justify a deal price. The deal price is commonly compared with the target`s current stand-alone market value; as a result, all deals include a
deal price that exceeds that stand-alone market value, that difference is called deal premium. In return for paying that premium, the acquirer expects to achieve synergies or improve the
value of the target.
2.4.1 JUSTIFICATIONS FOR DEAL PREMIUMS
In an efficient capital market, the public market capitalization is a point for estimating the value. For private or illiquid companies, the value must be based on DCF or comparable analysis.
For strategic buyers of publicly listed targets, if the pre-bid market capitalization is a fair estimate, then an acquisition would have a +NPV if only the premium is - or = to the operational
synergies resulting from the deal.
For financial bidders, the maximum + NPC price will depend on whether the cost of financing the deal (leverage, tax shield, cost savings) will justify the premium. Also, they consider a
projected future sale price after 5-10 years holding period. The takeout price is projected as a multiple of the target's current EBITDA.
2.4.2 SIZE OF DEAL PREMIUMS
Bidders must be able to justify the size of the premium with synergies or other sources of value. Premium for strategic buyers will vary for various reasons, but primarily reflect differences in
estimates of deal synergies. Financial bidders paid lower premiums than strategic bidders who pay more for operational synergies.
2.4.3 THE COSTS AND BENEFITS OF THE DEAL: VALUATIONS WITH SYNERGIES
Cost: achieving deals generates costs (banker fees, legal fees, etc.), severance costs, plant costs and others. For strategic acquirers, deals generate operational costs. All of these costs are
estimated based on information from past transactions or from advisors. In DCF, the estimates are to the period in which the transaction is expected to be completed and 1-2 periods after
the deal is completed, depending how long the post-deal M&A integration is expected to take. Additional deal costs may include negative effects because of customer churn or reactions to
the deal. Benefit: the buyer must estimate synergies. Synergies can be valued on their own, in the DCF model and then combined with a valuation of target based on an indirect comparable
method. The period-by-period cash flow effects of expected synergies are projected separately and are treated as a marginal addition. Synergies are best estimated identifying sources of
value and projecting them separately. Limits on available data may require synergies to be estimated in a cruder way. Bidders must also decide whether to assume that synergies grow into
 perpetuity and the %.
Operational synergies usually include cost savings and revenue enhancements.
Cost Synergies: reduction in COGS, technology cost, procurement cost, marketing cost. Revenue Synergies: increase in revenues, in customer willingness to pay, in innovation.
Financial synergies: likely to be realized only when some friction or other form of market information is at work. Example: tax shield, debt overhang, agency costs, tax asymmetries.
Once costs and benefits of the synergies have been estimated, both must be discounted. Buyer must determine an appropriate discount rate that reflects the risk of the relevant cash flows.
Deal costs can be estimated and discounted at a risk-free rate. Cost synergies are less certain and are assumed to reflect the risk. Revenue synergies are even less certain and are
discounted at a rate reflecting the risk of the buyer`s business model. Because of the difficulty to predict responses, investors are skeptical of revenue synergies. But cost savings are easier
to estimate and more reliable because the bidder can control them after the deal. Deal premiums generally do not exceed the expected value of the deal synergies. But some bidder
managers end up bidding more than the synergies at their own shareholders` expense.
2.5 THE OFFER
The price a bidder will offer depends on what might happen next. A take it or leave it offer or will be negotiations. Other bidders will compete for the target. Bid`s tax effect-something that
can affect how the target's shareholders perceive the bid`s value compared to the alternatives? How to translate a valuation into an actual bid?
2.5.1 SALES PROCESS FOR DEALS AND DEAL CONTRACTS
In the US a bidder might choose to make an unsolicited offer-a private proposal. Or the target may initiate a sales process, which tends to an exclusive negotiation with 1 buyer or a
sequence of potential buyers or a closed auction involving multiple rounds from multiple bidders. Also, targets may also put themselves up for sale to any and all bidders in an open
auction.
2.5.2 THE EFFECTS OF M&A REGULATION ON THE SALE PROCESS
M&A sales procedures are shaped by law and vary across countries (national securities regulator). Laws impose obligations on public companies comprising participants in M&A, these
obligations include M&A contracts, completions, and proposals to M&A deals. Securities laws also dictate the sale process for targets that are public companies. For most countries, deals for
publicly held targets must legally remain open for weeks or months. Also, the target`s shareholders must give all information of the deal before voting. Bidders can make a topping bid, that
is a bid at a higher price than the initial deal price. Public targets often contract to pay a break fee (2-5% of the deal, 2.5% cash bids and 3.5% stock bids) or other compensation to an initial
bidder in case a topping bid merges and is accepted. Break fees compensate for costs and are subject to limits imposed by target boards. Bidders can also pay reverse break fees if they
fail to complete a deal for specific reasons like failure to obtain financing or antitrust regulatory approval. These fees are not limited and rage in value more.
If a bidder wants to make an offer, it can make a hostile bid directly to shareholders by threatening to initiate a proxy fight to remove the target`s director unless they negotiate. Hostile bids
are costly and have low success. Private targets cannot be acquired in hostile bids, also do not give the option to accept a topping bid. Also experience delays between signing the contract
and closing, which occur if the target is large enough to require antitrust approval, if the bidder needs time to complete financing arrangement, if special regulatory approvals are needed
(industries like banking, airlines, telecommunications).
NEGOTIATIONS
● A typical negotiated deal begins with a planning phase, in which the buyer and the target consider an M&A as one of several ways to implement business strategies.
Steps in the Typical M&A Negotiation Process: Planning, Courtship, Negotiation, Processing, Integration
● In a closed auction, the seller and its advisors typically prepare a confidential information or sales memorandum with details about the target and the types of terms it is seeking. Bidders
submit bid packages consisting of proposed terms and even proposed contracts
● Starting in the courtship phase and continuing through the closing, the bidder will conduct due diligence (an investigation) of the target. If the bidder is offering stock as part of the deal
consideration, the target will conduct its own due diligence to confirm the bidder’s value.
● The processing phase-M&A transactions are governed by contracts that set forth the parties’ obligations and commitments between signing the contract and closing the deal. The contract
specifies any necessary shareholder, regulatory, or third-party approvals, and whether the deal financing must be completed by negotiating loan agreements and/or privately placing or
publicly registering and selling securities.
● Negotiations can take days or months, depending on the complexity of the deal and the urgency with which it is pursued. M&A contracts typically contain the following sequence of
provisions:
➔ core terms on price, deal structure, and deal currency, representations and warranties and related disclosure schedules in which the parties provide information and allocate risk, covenants,
which are promises about what actions the buyer will take to complete the deal, and how they will be restricted until the deal is completed conditions, which are events that must occur
before the two companies are obliged or permitted to complete the deal, termination and any walkaway provisions
DEAL STRUCTURES
In addition to determining the deal price and process, the parties must also consider the following:
● a deal structure—an asset purchase, a stock purchase, a merger, or some combination
● a consideration or currency—cash, stock, debt, hybrid securities, or a mix
- whether the pricing will be fixed or adjusted in some way There are six major types of M&A deal structures
1. Asset purchase. In an asset purchase, the buyer purchases some or all the target’s assets. The buyer pays the deal currency to the target company, and it then takes ownership of the
assets
2. Stock purchases and tender offers (also known as bids). In a stock purchase, the buyer pays the deal currency directly to the target company’s shareholder(s) and then takes ownership
of the target company
3. Two-step merger: (1) tender offer plus (2) merger. In the United States, tender offers are typically coupled with a merger in a two-step merger, making it possible for a bidder to acquire
100% of the target’s stock. Not all shareholders will accept the tender offer, so if it is not coupled with a merger, the bidder would only acquire shares from those shareholders who
affirmatively tendered them
4. Direct merger. The buyer distributes the deal currency directly to the target’s shareholders, and the target company merges into the buyer company and disappears as a separate company.
5. Forward triangular merger. The buyer generally creates a new company, often called a merger sub, which merges with the target. The buyer pays the deal currency directly to the target’s
shareholders and takes ownership of the target company via the merger sub
6. Reverse triangular merger. A reverse triangular merger is the same as a forward triangular merger, except that the merger sub merges into the target, and the target continues as a wholly
owned subsidiary of the buyer.
2.8 DEAL CURRENCIES AND DEAL PRICING
● Deal currency and price terms also vary, and which is better is independent of the deal structure.
● In an all-cash deal, the bidder simply pays for the target, including any premium, in cash.
● The price can be fixed or contingent—that is, adjusted or determined by a variety of financial or operational metrics
● In private target deals, for example, it is common to adjust the price based on changes in working capital or cash between signing and closing.
● An earn-out is another example of contingent pricing, where the target’s shareholders receive a variable price based on the target’s post-closing performance.
EXCHANGE RATIOS
● The price in such deals is typically specified as an exchange ratio—the number of bidder shares to be issued to each target shareholder in exchange for each target share.
● An exchange ratio is commonly fixed at signing, equal to the premium plus the target price divided by the bidder stock price at or shortly before signing
● The ratio can be set by naming a dollar deal price in the contract, equal to the premium plus the target’s per-share stock price at signing and dividing that deal price by the buyer’s stock price
at closing, so the value is fixed and the exchange ratio floats.
● Both fixed and floating exchange ratios can be subject to caps, floors, or combinations. Combinations have economic payoffs like collars used in risk management programs

● Values can be variable within a set range but are fixed above a cap or below a floor, or alternatively, can be fixed within a set range, but variable above a cap or below a floor.
● Stock deals can also include price adjustments or earn-outs that change the ratio based on specified metrics prior to or after closing.
● In a mixed-consideration deal, the target’s shareholders can be given a fixed share of each type of deal currency.
2.9 Stock as Deal Currency and Some Basic Merger Math: The use of stock as deal currency slightly complicates the basic valuation point made earlier—that a deal is good for a
buyer if the synergies exceed the deal premium. abidder’s pro forma, post-deal share price should exceed itspre-deal share price ifthe deal is a positive-NPV investment.
Assume that the market capitalizations of the two companies are the best estimates of their stand-alone value. Also assume that neither the deal nor the use of stock as deal currency will
have signaling effects that affect market value. o the pre-deal shares prices for the bidder, Ps, and the target, Pr, are equal to the market value of their equity divided by number of shares
outstanding:
he shareholders of the pre-deal bidder will own Ng/Nc of the combined company, and the shareholders of the pre-deal target will own Np/Nc of the combined company.
After the deal: The deal premium is the deal price less the target’s pre-deal share price, A zero-premium deal is one with an exchange ratio of Pr/Ps. This is sometimes seen in mergers of
equals where there is no clear buyer or target.
Now let us assume the deal is for all cash. If the bidder pays cash, the target’s shareholders have no ownership in the post-deal firm. The deal value depends only on the price per share that
is paid to the target’s shareholders. When the deal currency is al stock. Now the shareholders in the bidder firm share ownership of the combined firm with the target’s shareholders after the
deal. The post-deal percentage of ownership depends on how many shares are issued by the bidder firm.
The ratio of the pre-deal earnings per share (EPS) of the target firm (Er/Nr) to the pre-deal EPS of the buyer (Es/Ns), is the zero (earnings) dilution exchange ratio. This is the exchange ratio
that will have no effect on the buyer’s EPS.
2.9.1 Value-Preserving Break-Even Point
Another, more theoretically sound way to benchmark a deal price is to calculate a value-preserving break- even point (ie., the maximum the bidder could pay without the deal having a
negative NPV). The stock price of the combined company will be the equity value of the combined company divided by its number of shares, NPV will be greater than zero if the combined
company’s share price is greater than the bidder’s pre-deal share price, The break-even point in terms of the optimal number of shares to be issued, N’p, must be =(N*D < NB (TE +S
))/BE. The break-even (or zero-NPV) exchange ratio is calculated by dividing the maximum value-preserving number of bidder shares by the target’s pre-deal shares outstanding:
2.9.2 Losses Avoided and Other Wrinkles
Possibility that the failure to complete a deal may impose a loss on the bidder, occur if a competitor were to buy the target instead, gaining market share in the product market. In that case,
losses avoided might be added to the synergies when you are calculating a true break-even deal price and exchange ratio. Estimating the size or even the existence of avoided losses is
even more difficult than estimating synergies, Other issues to consider when calculating a break-even exchange ratio are whether the target’s stock price may be overvalued or undervalued.
Stock deals also often experience longer deal delays due to securities regulations, and are therefore perceived as riskier transactions, potentially making a given bid less attractive than it
otherwise might be.
2.10 Deal Completion Risk, Risk Arbitrage, and Price Pressure
Topping bids may force the bidder to raise its price. Alternatively, the offer may fail to obtain regulatory clearance. Financing arrangements may fall through, or the target (or the bidder) may
suffer a material adverse change or breach its representations or contract commitments, allowing the other party to either walk away from the deal or threaten to do so to force a
renegotiation.
In a hostile bid, the target firm’s board often declines to accept a bid and instead recommends that existing shareholders not tender their shares, even when the acquirer offers a significant
premium over the pre- offer share price deals face completion risk. deal announcement greatly alters the expected return distribution for the target’s stock. f the deal is completed, the target
stock will be converted into the specified deal currency at the specified price or exchange ratio. If the deal fails, the target’s stock will revert to trading on the target’s stand-alone business
fundamentals, less any harm caused by the deal failure.Because the deal price typically includes a premium, deal failure results in a large drop in the target’s stock price, typically returning
the target’s stock price to its pre-bid level, or even lower, if the deal’s failure reflects some harm or previously unrevealed problem at the target firm. If, for example, one bidder cannot obtain
regulatory clearance, but other potential acquirers could, the failure of one deal might trigger a bid by one of the other potential acquirers. Specialized investors, known as risk arbitrageurs or
merger arbitrageurs, now routinely bear the deal completion risk.
In cash deals, the arbitrage strategy is simple: Buy target shares and hold them until closing. In stock or part-stock deals, the arbitrage strategy is more complex, as target shares are
converted into new securities at closing. risk arbitrageurs focus on deal completion risk, not on the risk of the buyer’s ongoing business, they hedge the risk associated with any buyer’s
securities that they would receive when the deal is completed. To do so, they typically short the buyer’s stock. These short positions can exert short-term price pressure and cause a buyer’s
stock price to decline in response to a deal announcement.
In stock deals, the method and timing of arbitrage hedging depends on how and when the exchange ratio is determined. In floating exchange ratio deals, the ratio is not fixed until a pricing
period that occurs later in the deal process, often after shareholder approval and closer to the closing date
arbitrageur’s perspective, floating exchange ratio deals are like cash deals before the pricing period because the deal price is specified in dollars. after the pricing period, floating exchange
ratio deals are identical to fixed exchange ratio deals because the promised deal currency is then specified as a fixed ratio of buyer shares.

3 SUPPLEMENTAL READING

3.1 Tax Issues → Both bidders and targets take tax implications into account when considering, planning, and evaluating deals. Deal structure and deal currency can affect the target’s
shareholders and the combined firms’ taxes. Taxation of corporations and M&A deals is complex and constantly changing in response to regulatory changes. US law imposes: (a) corporate
income taxed at a high nominal rate (35% federal tax plus 5% state tax); (b) tax when shareholders receive dividends; and (c) capital gains tax when shareholders sell or liquidate
investments in corporate businesses. In other countries, corporate tax rates are lower. OECD countries average 25% and corporate taxes paid reduce the tax that shareholders owe on
dividend income. Unlike other countries, the US imposes taxes on the worldwide income of US corporations, including that generated by foreign subsidiaries, only when it is repatriated, also
the US imposes a high withholding tax on dividends paid to foreign investors (30%). Under US law, any cash that the target’s shareholders receive for shares in a deal triggers a tax on the
difference between the deal price and the price they paid when they first bought the shares. To avoid this tax, may limit deal currency to stock, and then structure the deal to qualify as a
reorganization. Reorganizations do not allow the acquirer to step up the basis of the target’s assets. If a buyer pays for the target entirely with stock, the target shareholders’ capital gains
taxes can generally be deferred until the bidder stock is sold. If a deal involves a mix of deal currency, the target’s shareholders may be able to defer tax on the stock portion, depending on
the deal structure. If a buyer purchases the target’s assets directly, it can step up the book value of those assets to the purchase price. The higher basis can reduce future taxes through
larger tax depreciation charges. Any goodwill created by the deal can be amortized for tax purposes over 15 years. The same treatment applies to an all-cash, forward triangular merger.
Another goal of deals involving both US and non-US companies is to structure the transaction to minimize the ongoing income tax that the combined company pays. In inversions, a foreign
company acquires or merges with a US company, sometimes in deals where the nominal foreign buyer is smaller than the nominal US target. The company is then no longer a US company
for tax purposes, which permits it to reduce taxes if the subsidiary borrows from a foreign affiliate, generating interest deductions. Because many countries only tax domestic corporate
income, inversions can also reduce tax on future earnings of foreign subsidiaries. By law, to reduce US tax, the inversion must result in shareholders of the US corporation in the deal ending
up with less than 80%. If the taxes for shareholders triggered by the transaction exceed the tax benefits of the inversion, the transaction would destroy, and not create tax-based value for
investors. However, because many US investors (e.g., pension funds, non-profits) are tax-exempt and many others (e.g., hedge funds) can pass tax through to their own investors, many of
whom are tax- exempt, any shareholder-level tax triggered by an inversion may not be as significant as the tax benefits to the companies.
Pfizer and Allergan’s $160 Billion Failed Inversion → Late in November 2015, Pfizer, announced its plan to merge with Botox maker, Allergan, in a deal of $160 billion. The combined
company was to be renamed Pfizer Plc, but the transaction was structured so that Dublin-based Allergan would be buying Pfizer. The combined company would use Allergan’s tax address in
Ireland, where it expected to have an effective tax rate of 17 to 18%, compared to 25% in the US. Pfizer shareholders would have owned 56% of the combined company. Despite the
expected benefits, Pfizer’s stock price dropped 2.6% at the deal’s announcement; Allergan’s stock fell 3.4%, despite having risen more than 20% based on deal rumors in the weeks prior to
announcement. The decline was attributed to the fact that the synergies that the company's forecasted disappointed investors and analysts. The possibility that the deal might not close due
to regulatory and political reaction to the inversion also contributed to the fall. On April 5, the companies called the deal off, blaming new US Treasury regulations. Those rules would
determine taxation of a company doing business in the US in part based on whether it was part of a serial inverter, or whether the company had engaged in more than one inversion in the
prior three years. Indeed, Allergan resulted from a 2014 inversion. In addition, the new regulations added new limitations on the ability of companies to engage in earnings stripping using
intercompany debt. Together, these new restrictions led the companies to walk away from the deal. Allergan’s stock fell 15%. However, Pfizer’s stock rose 5% over the week prior to the
announcement.
3.2 Accounting for M&A and Earnings Dilution →Although the method of payment affects the value of the target’s assets for tax purposes, it has no effect on the combined firm’s
financial statements for financial reporting. If the acquirer buys > 20%, the stock will be held like any other asset, and results of the target’s operations will not affect the buyer’s income
statement. If the buyer purchases between 20% and 50%, it will reflect the target’s net income or loss in its own statements on a pro rata basis as equity accounting. Finally, if the buyer
purchases < 50%, it will fully consolidate the target’s financials with its own. In a control acquisition, the buyer must mark up the value of the target’s assets on the financial statements by
allocating their purchase price according to their fair market value. If the purchase price exceeds, then the remainder is recorded as goodwill. The firm’s accountants examine goodwill
annually to determine whether its value has been impaired and should be written off. Pooling is no longer permitted, and all-stock deals have become less common. Even when a deal has
a positive NPV, bidder managers are concerned with the deal’s effect on earnings. Merging two companies can either increase or decrease earnings without affecting their economic value.
Earnings and earnings dilution can be misleading guides to valuation generally, as well as in the M&A context. Nevertheless, earnings do tend to correlate with value, and a deal’s true
economic effects on value are difficult to observe with any precision. markets tend to react negatively to deals that result in earnings dilution for the bidder and positively to deals that
increase earnings per share.
3.3 M&A and Financing → Pricing, deal currency, and deal structure can all affect the combined post-deal capital structure. Companies that bid in M&A deals must take future
acquisition plans and the related risks of financial distress into account as part of their basic capital planning. In an asset deal, the buyer will establish a new company to hold the target
business and arrange new financing, and the bidder will adjust its own financing. In a stock deal or triangular merger, the target’s financing sometimes remains in place, or the seller may
prepackage new financing. In a direct merger, the surviving company inherits the target’s debt, contracts, and other liabilities. When debt is used directly as deal currency the deal will affect
the buyer’s capital structure. If the target is larger than the bidder, he may require new debt financing to raise the cash for the deal. In a stock deal, the bidder’s pre-deal shareholders will see
their ownership diluted. The deal’s effects on financing can be offset by preplanned, simultaneous, or subsequent financing transactions.
3.4 Board Approval, Board Fiduciary Duties, and Shareholder Approval → The specific actions required for an M&A deal depend on the deal structure and deal currency. for a
simple direct merger, the boards and common shareholders of each merging company must vote for the deal. If one or both are public, a proxy statement, cleared by the SEC, must be
distributed before the required vote. For other deal structures, the buyer’s shareholders do not need to vote, except when the buyer issues more than 20% of its stock. A buyer’s board may
not need to approve a triangular merger deal if the board has delegated authority to managers to act on behalf of its subsidiaries. For deals structured as stock purchases, the target’s
shareholders sign the deal agreement or are asked to tender their shares to the buyer. In a hostile takeover the target’s board of directors fights the takeover attempt. To succeed, the
acquirer must garner enough shares to take control of the target and then use the related voting rights to replace the board of directors. Standard poison pills prevent such accumulations,
forcing bidders to wage a proxy fight before being allowed to buy more than the fixed amount of stock that the pills permit. When a takeover is hostile, the acquirer is called a raider. The
board might legitimately believe that the offer price is too low. The target might find another suitor that is willing to pay more If the offer includes stock currency, the target’s management may
oppose it because they feel the acquirer’s shares are overvalued. Or because of their own self- interests, if the buyer’s primary motivation for the takeover is efficiency gains in the form of
cost savings. In friendly and hostile deals alike, most buyers generally change the target’s leadership after the deal. If substantial efficiency gains are possible, it may mean that current
management is not doing an effective job. In law, the duty of the target’s board of directors is to choose the course of action that is in the best interests of the company and its shareholders.
But courts are not good at making business judgments, so they give targets’ directors latitude in determining the best course for their companies. The rule also permits them to reject a
premium offer if they have a reasonable basis for believing the offer is a threat to corporate interests and they act reasonably in response. In merger transactions, courts can bring
heightened scrutiny of various sorts. These doctrines include Revlon duties and the Unocal doctrine and the entire fairness doctrine. Revlon duties state that if a change of control is going
to occur, the directors must seek the highest value for shareholders; they cannot favor one bidder over another based on anything other than value to shareholders. According to the Unocal
doctrine, when a board takes actions deemed as defensive to a hostile takeover, its actions are subject to extra scrutiny to ensure that they are not coercive or designed to prevent a deal.
The entire fairness doctrine applies to conflict-of-interest transactions. The impact of Revlon and Unocal is unclear. Entire fairness review, by contrast, does tend to Result in significant
changes in the deal process. Still, these doctrines shape the deal process because they are part of the context in which target boards of public companies review bids.

L3: THE GROWING IMPORTANCE OF CORPORATE GOVERNANCE

● Governance is challenging for any large organization, but it is particularly problematic when an organization’s owners are dispersed. Such owners have provided the company with capital but
are not involved in its operations.
● One of the first known corporate governance disputes occurred at the Dutch East India Company.
 ● The company was funded through bonds and shares of stock sold to the public.
2.1 What is Corporate Governance?
● Corporate governance encompasses the many components of the systems by which companies are directed and controlled.
● These components vary by country, over time, and by company type, size, and ownership.
● Different researchers and commentators have different points of view on what topics and issues are central to the discipline.
● Economists have tended to take a finance view of the topic, that is, focusing on how investors obtain returns for financing companies, or on the constraints that shape bargaining over
corporate profits.
● Accounting scholars focus on mechanisms that provide information that allow investors to choose among investment opportunities and to monitor managerial performance.

2.2 Our Focus: For-Profit Companies Owned Privately by Dispersed Owners Conflicts of Interest Between Company Stakeholders

2.3 What Problems Does Corporate Governance Try to Solve?

2.3.1 Two Types of Conflicts: Owner-Manager Conflicts
● The most influential perspective on corporate governance, at least in the United States, addresses how equity investors can retain control over the companies in which they invest or
otherwise induce managers to make decisions in the interests of equity investors.
● The single shareholder retains both legal authority and practical ability to determine strategy, staffing, and financial policy for the company.
● Basic principles of efficient diversification also motivate single founder-shareholders to exchange equity in one company for other assets.
● Finally, for several reasons (such as to improve the liquidity of its shares and to have a liquid and reliable “acquisition currency” for merger-and acquisition transactions), it can be useful for a
company to list its stock on a stock exchange, which entails increasing the number of owners.
● The world’s largest companies that are listed on stock exchanges can have many thousands of shareholders and millions of shares outstanding.
● This basic conflict of interest between managers and owners, then, is a primary reason for the existence of the interesting and complex reality of corporate governance.

● Economists commonly refer to shareholders as principals and to managers as their agents, and they call the associated conflicts part of principal-agent theory or the principal-agent
problem.In a classic taxonomy sketched by Michael Jensen for corporations, agency costs are defined as:
→ (1) the reduced value that shareholders earn as a result of the agents taking actions (or failing to take actions) that will maximize shareholder returns
→ (2) costs incurred by shareholders as they attempt to monitor managers
→ (3) costs incurred by managers as they attempt to demonstrate that they are acting in shareholders’ interests.
2.3.2 Two Types of Conflicts: Intra-Shareholder Conflicts
● Ownership dispersion can also give rise to a second type of conflict: a conflict among shareholders.
● While a controlling shareholder can help mitigate the manager-owner conflict described in the previous section, the controlling shareholder can and generally does have interests that diverge
from other shareholders.
● Control shareholders may seek to engage in transactions with other businesses they control, to the detriment of non-controlling shareholders.
● A second major objective of corporate governance is to resolve or mitigate conflicts of interest among owners: intra-shareholder conflicts of interest.
2.3.3 Mechanisms to Mitigate Agency Conflicts
Owner-Manager Agency Conflicts
● The core mechanisms for mitigating owner-manager conflicts of interest are law, boards, compensation contracts, various intermediaries, and institutional owners.
● These mechanisms are reinforced by market pressures, including those arising in the capital markets, the product and labor markets, and the market for corporate control.
● An important component of the capital markets for many companies includes loans, bonds, and other debt contracts.
● An important component of the labor markets consists of executive compensation arrangements.
Intra-Shareholder Agency Conflicts
● To mitigate intra-shareholder conflicts of interest, core mechanisms include direct legal restraints, taxation, disclosure laws, specially designed minority rights and process protections,
business groups, debt-based governance, and public law enforcement.
● As a result, our presentation is general, attempts to capture stable regularities across countries, and notes only in passing some of the more unusual country-specific mechanisms.
● As with owner-manager mechanisms, many intra-shareholder mechanisms can be and are tailored at the individual company level, and we focus on standard choices and note only a few
unusual choices in passing.
2.3.4 Importance and Prevalence of Two Types of Conflicts Vary Common Law Versus Civil Law Countries
● Specifically, in the United States, the United Kingdom, and other British-heritage countries, more so than in other countries, more of the largest companies have ownership structures that are
fully dispersed
● In the sense that there is no single shareholder that owns enough stock to control the company in the ordinary course.
● In Europe, Asia, and Latin America, more companies have one or a small number of controlling shareholders, even if they have sold substantial amounts of stock to the public, meaning
dispersed private investors.
● As a result, owner-manager conflicts are more common in the United States and other British- heritage countries, and intra-shareholder conflicts are more common elsewhere.
● There are many public companies in the United States with controlling shareholders—Ford, Google, Facebook, and Walmart are prominent examples—and there are prominent public
companies in Germany, France, Japan, and elsewhere that have no single controlling shareholder, such as Deutsche Bank, Vivendi, and Toyota.
2.3.5 Recent Trends in Ownership
A more recent but growing regularity in corporate governance involves the type and role of owners themselves. Once owners were predominantly individuals, but now ownership is
increasingly institutionalized. Banks were important institutional owners in Japan and Germany from the early twentieth century, although not in the United States and the United Kingdom.
Pension funds, mutual funds, and insurance companies rose in prominence over the middle part of the twentieth century in the United States and the United Kingdom.
2.4 Mechanisms for Mitigating Owner-Manager Agency Conflicts
2.4.1 Corporate Law -> The law of nearly every country permits individuals to establish private corporations and sets out basic rules for the governance of corporations. The law treats
corporations as “legal persons” with their own assets and liabilities, distinct from the owners of their stock and distinct from the individuals that participate in their governance and operation.
● Corporate law allows for variations in many aspects of governance, including voting rights and rules for director elections.
● Some countries permit companies to provide for multiple classes of directors, with overlapping multi-year terms, known as staggered boards or classified boards.
● Several other elements of basic corporate law are important to corporate governance. US law, for example, permits shareholders to demand information, specifies default rules for the
transferability of shares, and commonly gives shareholders the ability to sue in court for specific reasons.
● A final way in which US corporate law influences corporate governance (and, by virtue of the economic importance of US corporations and governance practices generally, influences global
practices) is through the enforcement of fiduciary duties.
2.4.2 Securities Law and Stock Exchange Standards
Securities regulations also restrict insider trading. (Company insiders are individuals who are employed by the company.) Regulations mandate disclosures for insiders regarding
compensation and trades in company securities and impose a duty not to trade while in possession of material nonpublic information, with limited exceptions, and this duty may extend to
those given tips by insiders.
Stock exchange listing standards are even more prescriptive, with additional requirements for board composition and practices. After the Enron-era scandals, the New York Stock Exchange
(NYSE) mandated that most a company’s board members be independent (not an officer or employee of the company) and that the compensation and nomination committees of the board
be fully independent.
2.4.3 Boards -> Are the ultimate legal authorities over corporations, their identity, selection, and methods of operation are central to corporate governance. Conventionally, board directors
have nominated their successors through a process controlled by the board itself.
● Director selection is increasingly shaped by activist shareholders (discussed below). These activists threaten or begin election competitions by soliciting votes directly from other
shareholders—a process called a proxy fight or proxy contest in the United States.
● In Germany and Scandinavian countries, corporations have two boards: a supervisory board composed of independent directors and a management board that is the equivalent of the C-
suite of officers at US companies.
● In Germany and other European countries, co-determination requires or permits boards to include representatives from national labor unions.
Committees:
 ● Audit committees oversee the independent audit process (discussed more below) and sometimes have other roles, such as overseeing legal compliance programs and risk management.
In the United States, audit committees must include a minimum number of financial experts who meet specific legal criteria for experience in preparing or overseeing the preparation of
financial statements.
● Compensation committees oversee executive compensation, especially for the top officers, and increasingly have direct relationships with compensation consultants.
● Nominating committees and governance committees oversee the ongoing need to refresh boards with new directors and set policies on a variety of other governance issues, such as
board leadership (for example, whether the chair should be separate from the chief executive officer), self-evaluation, retirement, tenure, insider trading, executive sessions, and takeover
defenses.
2.3.4 IMPORTANCE AND PREVALENCE OF TWO TYPES OF CONFLICTS VARY
There are 2 regularities that affect the importance of owner-manager versus controller-noncontroller conflicts and their mechanisms. (1) Corporate governance and ownership structures vary
by country: common law and civil law countries. (2) Passive ownership (invest in a relatively passive way on behalf of dispersed individuals such as indexed mutual funds) have grown. Both
have influenced the development of corporate governance mechanisms.

● Common law versus Civil law countries:

In some US-UK, companies have ownership structures that are fully dispersed, there is no single shareholder that owns enough stock to control the company. Owner-manager conflicts are
common in the US or UK. In Europe-LA, companies have one or a small number of controlling shareholders.
Common law and civil law have influenced the patterns of ownership and corporate governance. Common law (Anglo-American) countries have more public offerings, dispersed ownership,
and deeper capital markets.
2.3.5 RECENT TRENDS IN OWNERSHIP
Type and role of owners, ownership is institutionalized such as banks, pension funds, mutual funds, and insurance companies. The growth of institutional owners can mitigate some causes
of the owner-manager conflict because institutional owners can reduce the number of individuals, but do not forget that institutional investors are managed by managers and are restricted by
many laws.
2.4 MECHANISMS FOR MITIGATING OWNER-MANAGER AGENCY CONFLICTS
The basic elements of corporate governance arise from law, which structures the relationship between the board of directors and shareholders. Intermediaries (auditors, advisers, and
sponsors) also help to mitigate owner-manager conflicts.
2.4.1 CORPORATE LAW
The law of every country permits individuals to establish corporations and sets out basic rules for the governance of corporations. The law treats corporations as legal personas, distinct from
the owners of stock who participate in their governance and operation. Authority over a corporation is given to a board, which is elected by shareholders, boards are the core of legal
authority over companies.
Corporate law allows for variations in many aspects of governance, like voting rights and rules. Depending on the country and type of company, other participants have voting rights or
different classes of stock with voting rights. Director elections depending on the law vary; some countries provide multiple classes of directors with overlapping multi-year terms, known as
staggered boards or classified boards. Staggered boards make it harder to remove or replace most of the board.
The ease and usefulness of shareholder litigation varies by country (information, default rules of transfer, etc.).
US outlier og high incidence of shareholder litigation. Also, US corporate law is through the enforcement of fiduciary duties, law which imposes duties on directors to act with care and loyalty.
This plays an ongoing quasi-regulatory role supervising and evaluating corporate governance.
2.4.2 SECURITIES LAW AND STOCK EXCHANGE STANDARDS
Companies with dispersed ownership must comply with securities law and companies with stock exchange listings must comply with securities law and listing standards. These rules require
disclosures (revelaciones), like audited financial statements. Securities laws mandate governance specific disclosures and prescribes rules for specific governance choices. In US, the law
mandates audit committees and review of company's control systems.
Securities regulations also restrict insider trading (company insiders are individuals employed by the company). Regulations mandate disclosures for insiders regarding trades in company
securities and impose not to trade while in possession of material nonpublic information.
Stock exchange listing standards are more established with additional requirements for board composition and practices. The NYSE mandated that most a company's board members be
independent and the nomination committees. Also mandated executive sessions (portions of meetings with only independent directors and no officers present), reports, ethics codes.
Companies can choose not to list on the stock exchange, but do list has advantages (increase liquidity of equity).
2.4.3 BOARDS
Corporate law locates final authority over corporations in a board of directors. The law encourages companies to have multi-member boards, boards act collectively, typically by majority
boards (10-12). Because boards are the legal authority over corporations, their identity, selection and methods of operation are central to corporate governance and are the focus for public
pressures. The standard norm for boards is for only 1-2 directors not to be independent.
Director selection is shaped by activist shareholders, activists who begin election competitions by soliciting votes directly from other shareholders, a process called a proxy fight or proxy
contest in the US and reach settlements in which incumbent (titular) boards agree to nominate and support 1-3 directors chosen by a minority or activist shareholder.
In the US and UK there is only 1 board, in Germany and Scandinavian countries companies have 2 boards: supervisory board composed of independent directors and a management
board. In European countries, codetermination requires or permits boards to include representatives from national labor unions.
● Committees:
Boards divide tasks by function and organize themselves in committees. By law there are at least 3 important and independent committees:
Audit committees oversee the independent audit process and sometimes oversee legal compliance programs and risk management. In US is required in this committee financial experts.
Compensation committees oversee executive compensation and have relationships with compensation consultants.
Nominating committees and governance committees oversee the ongoing need to refresh boards with new directors and set policies on governance issues like board leadership, insider
trading, retirement, self- evaluation.
Board committees have a high degree of autonomy within their subject areas, and play a role in mediating between the board`s inclinations and shareholders` inclinations.
● Officers:
Independent directors have other jobs and need to delegate day to day management to corporate officers. A typical C-suite includes the chief executive officer (CEO), chief operating officer
(COO), chief financial officer (CFO), chief audit officer (CAO), chief legal officer (CLO). Some of them by law or choice have direct reporting lines to the board.
2.4.4 COMPENSATION CONTRACTS
A complementary corporate governance arrangement is the compensation arrangements for executives. A compensation contract can be efficient to minimize agency costs between
shareholders and manager. The compensation schemes reflect the demands of a competitive market for executive talent. Controversy: boards of directors provide excessive levels of pay to
executives. Executive pay: base salary + short term incentive compensation (bonus) + long term incentive plan (stock options). Components designed to reward past and future
performance. Incentive schemes, especially when they are tied to stock price performance, reduce agency costs because a manager`s income is tied to wealth generation for
shareholders.
Engagements → large shareholders frequently engage with boards to influence corporate governance. In the US, pension funds and other institutional investors have engaged with the
management of companies to improve shareholder value. Through these meetings and calls, large institutions exert influence, obtain information, and form opinions about whether directors
and officers are competent and loyal.
Public Shaming and Vote No Campaigns → Shareholders also engage in public shaming of directors and officers. An effective form of shaming is a vote no campaign, activists lobby other
shareholders to withhold votes in director elections as an expression of investor displeasure with the company’s performance or strategy, executive pay, or some governance practice such
as inadequate director qualification. Such votes can be viewed as symbolic. But over time, many companies have adopted majority vote bylaws or charter provisions. Even then, a board can
often use its power to legally reappoint the unelected director.
14a-8 Resolutions → Shareholders can submit proposals for presentation at a meeting of the company’s shareholders and can even include such proposals in the company’s own proxy
statement under SEC rule 14a-8, with up to 500 words of advocacy, with the cost borne by the company. Under current rules, the shareholder must have held either $2,000 or 1% of a
company’s shares for at least one year before he or she can submit a proposal to be voted on by other shareholders. The proposals can range from the frivolous to the serious. Many of the
most successful proposals focus on other aspects of corporate governance, such as staggered boards and executive compensation. Most proposals are framed to be nonbinding, which
avoids conflicting with law. The nonbinding nature of most proposals means that companies do not have to implement a proposal even if it wins majority shareholder support. In recent years,
activist campaigns by hedge fund investors have become a powerful influence in forcing operational, financial, and governance changes in companies.
Hedge fund activism → differs from other forms of institutional activism. Hedge fund managers have stronger financial incentives to improve the value of their investment than the average
mutual fund money manager and are not bound by mutual fund economics, and investment restrictions. Hedge funds receive significant performance fees (20% of returns over some
benchmark) as well as a high fixed fee (2%) on the assets under management. Investors in hedge funds typically comprise institutions and high net worth individuals; that allows hedge funds
greater regulatory freedom to intervene and take actions in companies that are normally not allowed for mutual funds. Hedge funds tend to make large, concentrated investments. They also
tend to have shorter holding periods than many other investors. hedge funds target companies that appear to have valuations lower than their fundamentals would suggest they should. That
is, targets have good operating cash flows but low sales growth, leverage, and dividend payouts. Targets are also generally smaller. Activists also target firms with greater stock liquidity and
greater institutional ownership. Target companies are seen to have weaker shareholder rights than comparable firms, lending some credence to the notion that activists target firms where
poor performance was likely driven by weak governance.
Proxy Fights → typical proxy fights between activist investors seeking board seats and the incumbent board that resists it. Proxy fights often reflect a failed attempt at behind-the-scenes
negotiation. Vote no campaigns can lead boards to eliminate takeover defenses, making hostile takeovers easier, and can attract attention from activist hedge funds.
2.5 Mechanisms for Mitigating Intra-Shareholder Conflicts of Interest → there are conflicts of interest among different owners of a corporation. The conflicts arise from the difference
 between ownership (cash flow rights) and control of management (voting rights); controlling shareholders can influence firm policies to benefit themselves rather than benefit all investors. In
many companies, a small group of shareholders has limited direct ownership but controls the company’s operations through various mechanisms. The agency problem involves a conflict
between minority and controlling owners. In companies with a high level of ownership concentration, it is commonly assumed that the large owners can monitor managers closely. Agency
problems caused by information asymmetry are thought to be mitigated because the controlling owner can obtain the information needed for monitoring.
2.5.1 How the Potential for Intra-Shareholder Conflict Is Manifest → less in the US and UK, companies are controlled by a small group of shareholders, often by families. In some
countries, control rests with financial institutions. Even in the US, many large companies are controlled by family owners or by founders. The nature of the majority shareholder differs greatly:
companies controlled by a single family made up a plurality of these controlled firms, with approximately 34.5% of controlled firms falling under family control. Other major groups included
private firms without an identifiable controlling shareholder, governments, widely held public companies, and widely held private firms. the prevalence of controlling shareholders can differ
greatly from one country to the next.
Control Shareholders with Majority Ownership → majority ownership is often held directly by a controlling family. These families also typically sit on boards and are involved in
management. In cases of direct shareholding, there is no divergence between cash flow rights and control rights. Yet conflicts can exist, as when a majority shareholder appoints an
unqualified manager who has other relationships with the shareholder.

Control Shareholders with Less Than Majority Ownership → Alibaba maintained a governance structure under which 28 current or former Alibaba managers, who comprised the so-
called Alibaba partnership, collectively owned around 12% of the equity of the company but retained nominating control of most the company’s board of directors. Several NYSE listed
companies had a dual share class structure whereby a superior class of shareholders owned shares that conferred a greater proportion of the voting rights. However, the Alibaba structure
attracted widespread concern, “Investors rushing to participate in the Alibaba IPO must recognize the substantial governance risk that they would be taking. Alibaba’s structure does not
provide adequate protection to public investors.”
Multiple Classes of Shareholders → More commonly, control is exercised through multiple classes of stock that effectively restrict or dilute the voting rights of minority shareholders. An
important characteristic of multiple-class shareholder arrangements is that they aim only to preserve the voting rights of a select few controlling shareholders while maintaining standard,
proportional rights to cash flow, creating a wedge between shareholder groups based on unevenly distributed cash flow rights and voting rights.
Pyramidal Ownership → Pyramidal ownership structures allow a minority shareholder to maintain voting control of a company through holding companies, often with byzantine
arrangements. A group, usually a family, could use a series of holding companies in which the stake in each successive holding company is increased to control the final company through a
smaller initial stake. Pyramidal ownership was most common in Asia companies and in some European companies.
Cross Holdings → A common control mechanism involves cross holdings. Cross holdings between companies, however, allow a party to maintain control over multiple companies without
necessarily owning most of the shares in these companies. A different form of cross shareholdings exists in Japan, where companies in close supplier-customer relationships hold ownership
stakes in each other. While such investments can promote long-term partnerships, worry that such structures also protect managers by creating large blocks of supportive shareholders.
What is the value of voting cash?
the economic value of voting rights is hard to assess, given the contextual nature of that determination. The value of a vote fluctuates significantly over time, with the probability that the vote
will matter and be important to a corporate decision requiring shareholder approval.
2.5.2 Mitigating Intra-Shareholder Agency Conflicts
major concerns with conflicts between controlling and minority shareholders arise from the possibility that the controlling shareholders or corporate insiders can engage in self-dealing
transactions to the detriment of the minority shareholders. the negative impact of controlling shareholders is seen in the form of related party transactions (RPTs), which are transactions or
resource transfers between the company and the controlling shareholders that harm the minority shareholders.
intra- shareholder agency problems: a ban on the separation of ownership and control rights, prohibition of related party transactions, and transparency and approval requirements.
Ban on the Separation of Ownership and Control Rights
The first approach is the outright ban on the separation of ownership and control rights. In the Alibaba case referred to above, the Hong Kong stock exchange refused the listing of a dual-
share class company (though many Hong Kong listed companies create controlled ownership through pyramidal ownership, and Hong Kong changed its rules in 2018 to permit listings by
dual-share companies).
Prohibition of Related Party Transactions
try to limit self-dealing by prohibiting related party transactions. EXAMPLE: the Sarbanes-Oxley Act in the United States prohibited loans by the company to corporate executives and
directors because of abuses in two scandal-ridden companies,
Increasing Transparency and Approval Requirements
A third approach is to regulate RPT's by increasing transparency and by requiring special approvals before they occur.
As a potential remedy to lax board oversight, some countries (e.g., Israel and India} provide a formal role for shareholders in approving substantial transactions. In India, market regulations
require a “majority of minority” shareholders to vote in favor of a proposed merger before it can proceed.
Taxation’s Incidental but Important Effect in Discouraging Pyramids in the United States
pyramidal ownership is common in many countries, Such ownership was common in the United States until the 1930s, however. Morck identifies the introduction of intercorporate dividend
taxes. pyramid ownerships that passed on dividends from one company to another up the pyramid paid taxes at every stage, thus reducing the desirability of such ownership structures. The
United States is unique in taxing intercorporate dividends.
Appraisals and Cash-out Rights to Obtain or Force Liquidation
appraisal statutes allow objecting shareholders to sell their shares back to the corporation at “fair value.” This protects minority shareholders from freeze- out mergers where majority
shareholders approve a merger that does not provide minority shareholders with fair value for their shares.
Enhancement of Independent Director Roles
regulators often look to independent directors for protection of minority shareholder rights. recommendations in some cases and mandates in others on (1) the fraction of independent
directors on the board, (2) the presence of independent directors on board committees, notably the audit committee, and (3) the greater role of independent directors in monitoring and
approving self-dealing by managers or controlling shareholders. the role of independent directors has also been increasing in the monitoring of RPT’.
Debt Governance—Banks
creditors (especially large banks) can have numerous interests in the long-term prospects of a company. Creditors had substantial rights to cash flow and thus significant ability to affect
corporate strategy and behavior. In addition, debt is often easier to value than stock given that there is collateral.
2.5.3 Some Examples of Ownership Structures
ownership pattern for LVMH, the French luxury goods company. The ultimate ownership can be traced to the private company Groupe Arnault SAS, which is the investment vehicle of
French businessman Bernard Arnault and his family. ownership structure of Mechel OAO, a major Russian mining and metals company. Control appears to be dispersed among the
largest shareholders for Mechel; however, these companies are 100% controlled by a Russian businessman, Igor Vladimirovich Zyuzin.”
3. supplementary reading
3.1 Shareholder Versus Stakeholder Models
the issue of employee representation on company boards illustrates the ongoing debate on shareholder versus stakeholder models of corporate governance. The stakeholder model, as
opposed.to the shareholder model, considers corporate governance broadly “as the design of institutions that induce or force management to internalize the welfare of stakeholders.”
3.2 Co-Determination and-Employee Directors
The German co-determination model provides for a two-tier board structure for all listed companies. the management board consists of managers and deals primarily with strategic and
operational issues. The supervisory board, like the board of directors of a US corporation, includes only nonexecutive directors and is elected by shareholders. Members of the management
board are appointed by the supervisory board. For companies with more than 2,000 employees, German corporate law requires that one half of the supervisory board must comprise
employees. These representatives are chosen and elected by the employees, giving them full control of the process.
3.3 Corporate Governance in Japan
Japan’s corporate governance practices are viewed as protecting managers from shareholder pressure. Managers are seen as having an obligation to all stakeholders in a company,
including employees, customers, banks, and suppliers. Ownership of corporations was long characterized by the keiretsu system—a web of cross holdings across group companies, often
suppliers and customers of one another, with the main bank in the middle as a significant owner of the group companies. The cross-holding structure prevented hostile takeovers.
3.4 Constituency statutes
allow directors to recognize the effects of business decisions on stakeholders who are not shareholders. The nonshareholder stakeholders that can be considered include employees,
customers, suppliers, creditors, and local communities. Some constituency statutes also allow directors to consider both the long- and short-term effects of their decisions. In practice, the
application of these statutes varies widely across jurisdictions, and there appears to be limited consensus among legal scholars on their implications for the fiduciary responsibility of directors
or on whether the statutes affect behavior in practice.
3.5 Golden Shares
Golden shares are a popular tool used predominantly by governments when they privatize certain companies. Golden shares give the controlling party—in this case, the government—the
power to veto any decisions by the privatized corporation.
were popular in post- Soviet Union Russia and have appeared in privatization transactions in other countries around Europe.
Golden shares violate the free movement of capital. As such, the European Court of Justice has often moved to block the exercise of golden share privileges.
3.6 consistency with shareholder model if all Externalities Can Be Internalized
Business decisions are not just transactions between management and shareholders; they have numerous externalities that can affect employees, other business partners, creditors, and
general citizens. “Divergence of objectives create externalities.”
stakeholder society=“broad mission of management“, a society in which management aims to maximize all stakeholder utility, thus internalizing the externalities inherent in various business
decisions. This internalization process can improve corporate value consistent with the shareholder model.