Spring 05 set II

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Published on March 16, 2008

Author: Marcell

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Ohio State University Advanced topic in Corporate Finance (Spring 2005) Dr. Walkling Slide Set 2:  Ohio State University Advanced topic in Corporate Finance (Spring 2005) Dr. Walkling Slide Set 2 Options:  Options Problems with NPV:  Problems with NPV May ignore valuable options imbedded in projects Fundamentals of Option Pricing:  Fundamentals of Option Pricing Black Scholes - 1973 Replicating portfolio idea Types of options:  Types of options Call option Put option European option American option Inputs needed for Black-Scholes Analysis:  Inputs needed for Black-Scholes Analysis ? _________________________ _________________________ _________________________ _________________________ _________________________ Call option:  Call option the right to ________________________________ Example: see WSJ Put option:  Put option the right ________________________________ Example: see WSJ Put option:  Put option the right to sell an asset at a specified price for a specified period of time Example: see WSJ European option:  European option __________________________ __________________________ American option:  American option _____________________ _____________________ Inputs needed for Black-Scholes Analysis:  Inputs needed for Black-Scholes Analysis ________________________________ ________________________________ ________________________________ ________________________________ ________________________________ Intuition behind each of the inputs:  Intuition behind each of the inputs Value of the underlying asset:  Value of the underlying asset As value of the underlying asset increases, call values _________________ Intuition As what you are obtaining becomes more valuable, the option to obtain it __________________________ Variance of the underlying asset:  Variance of the underlying asset As variance increases, call values __________ Intuition: ? An increase in the variance of the underlying asset, ___________ the chance your option is in the money Remember - downside risk is _________________________________ Puzzle:  Puzzle Don’t we measure risk by volatility? Isn’t it true that investor’s dislike risk and that we traditionally penalize a project with increased risk by raising its discount rate? How can an increase in volatility increase the value of an asset?:  How can an increase in volatility increase the value of an asset? Because we are measuring risk _______________________, not risk of the option An increase in the volatility of the underlying asset, __________________ the chance that it will be in the money. The downside risk from a call option is ____________ Exercise price of the option:  Exercise price of the option As the exercise price of the option increases, call values ____________ Intuition: The more it costs to exercise the option, the _________ valuable it is Time to expiration of the option:  Time to expiration of the option As the time to expiration of the option increases, call values ______________ Intuition: ? The longer the option is valid, _______________________ it could be in the money Risk free rate:  Risk free rate As the risk free increases, call values _____________ Intuition: The exercise price is not paid until _________. As the rate increases, the present value of the exercise price _____________. This in turn ______________ option value. SOME Intuition reversed for put options:  SOME Intuition reversed for put options The Black Scholes Model:  The Black Scholes Model See Brealey Myers or Comparable text SP 10:3:  SP 10:3 Briefly explain why a call option price rises as stock price increases, exercise price decreases, time to maturity increases, volatility increases, and risk-free rate increases. *SP 10:8:  *SP 10:8 Why can the equity of a firm be viewed as an option on its assets? How would you calculate the value of this option? *SP 10:9:  *SP 10:9 Briefly explain how the option analogy can be used to value loan guarantees and debts. Real Options:  Real Options Problems with NPV:  Problems with NPV May ignore valuable options imbedded in projects Real Options:  Real Options Options embedded in investment decisions Examples of Real Options:  Examples of Real Options Option to delay Option to expand Option to abandon The cost of delay:  The cost of delay Equal to the foregone dividends or cash flows Quantifying the inputs:  Quantifying the inputs Exercise price _____________________________ Risk free rate Usually measured ___________________ Value of the underlying asset Usually measured in traditional ways (NPV, etc.) MeasuringTime to expiration:  MeasuringTime to expiration Generally, the time till the option would expire Estimating variance:  Estimating variance Previous experience Comparables Estimated probabilites Simulation Option to delay:  Option to delay As a project’s inputs change, so does its value Option to expand:  Option to expand Some implications of real options:  Some implications of real options More valuable in volatile industries Barriers to entry can increase the exercise period e.g. patents Multi-stage investments:  Multi-stage investments Often have added value because of the option to expand Downside - loss in economies from piecemeal expansion Option to abandon:  Option to abandon Examples ::  Examples : Valuing Natural Resource Options Valuing a gold mine Valuing an oil reserve Valuing a patent Dangers of Real Options:  Dangers of Real Options Can be used to justify bad investments Try to quantify benefits Understand ranges of possibilities Be objective Valuing Film Studios:  Valuing Film Studios Refer to class notes and discussion Hostile Acquisitions: Takeover Defenses:  Hostile Acquisitions: Takeover Defenses Why does target management resist?:  Why does target management resist? Shareholder welfare Manager welfare Takeover defenses:  Takeover defenses Maximize your share price Concentrated ownership Legal challenges Pro-active State anti-takeover laws Reactive Miscellaneous defenses :  Miscellaneous defenses _______________________ _______________________ _______________________ _______________________ _______________________ Financial characteristics:  Financial characteristics Bid characteristics:  Bid characteristics Significant determinants of the probability of success:  Significant determinants of the probability of success __________________________ Payment of a solicitation fee % of shares held by bidder prior to the offer % bid premium “Selling Shareholders face a Prisioners Dilemma:  “Selling Shareholders face a Prisioners Dilemma Corporate Governance:  Corporate Governance Historical developments in corporate governance activity, 1960-Present:  Historical developments in corporate governance activity, 1960-Present 1960's: Acquisitions popular 1968: U.S. William's Act 1969-1977: First generation state takeover laws, few hostile acquisitions 1982: Edgar v. MITE strikes down Illinois law Start of 1980's takeover wave First poison pills (Bell & Howell, Enstar) First second generation state takeover law (Ohio) Moran v. Household Int'l poison pill decision - 1985 1987: CTS v. Dynamics Corp. of America upholds Indiana law 1987-91: Corporate governance proxy proposals gain momentum 1990: Aggressive state antitakeover laws (Pennsylvania), Ohio; widespread use of stakeholder statutes 1992: Large outside shareholders/independent directors flex muscles: --General Motors --Sears & Roebuck 1993: "Relational investing” 2002 Sarbanes Oxley Increase in size and influence of institutional investors:  Increase in size and influence of institutional investors 1981 Institutions own 38% of U.S. equities 1991 Institutions own 53% of U.S. equities Source: Brancato and Gaughan (1991) Change in institutional voting activity:  Change in institutional voting activity Before 1987 institutional investors are generally passive During 1990’s Over 80% support shareholder initiated antigreenmail resolutions Source: Bergin (1988) and Biersach (1990) Corporate Governance & Performance:  Corporate Governance & Performance A Comparison of Germany, Japan, & the U.S. Steve Kaplan, The University of Chicago Outline:  Outline Corporate Governance Systems Germany Japan U.S. Anecdotal Theories Research & Empirical Evidence Conclusions Corporate Governance Systems:  Corporate Governance Systems Corporate Governance Systems:  Corporate Governance Systems Anecdotal Theories:  Anecdotal Theories Relationship-oriented systems (Germany/Japan) Pros decrease agency costs banks & S/H have power to make changes monitoring more effective avoid costly hostile takeovers & proxy fights more long-term focus no short-term earnings pressure financing more available banks & S/H have better access to information Anecdotal Theories:  Anecdotal Theories Relationship-oriented systems (Germany/Japan) Cons managers become entrenched banks may charge abnormally high fees & rates compensation for bailing out poor-performing companies Research & Empirical Evidence:  Research & Empirical Evidence Selected large companies is each country Focused on the top managers (e.g. CEOs) What incentives do different systems offer? Why are managers fired? Why are managers paid more? Research & Empirical Evidence:  Research & Empirical Evidence Performance Measures company stock returns sales growth change in pre-tax income/total assets dummy variable of 1 if pre-tax loss Regression Analysis - dependent variables probability of losing job percentage change in compensation Why are managers fired?:  Why are managers fired? Company stock returns In all 3 countries, poor performance increases likelihood of firing Sales growth Except for Germany, slow sales growth increases likelihood of firing Change in pre-tax income/total assets In all 3 countries, earnings losses increase the likelihood of firing When are managers paid more?:  When are managers paid more? Japan & U.S. only % changes since U.S. managers get more $ Mgt compensation is strongly related to: Company stock returns Sales growth Change in pre-tax income/total assets Conclusions:  Conclusions 3 different systems generate similar outcomes Anecdotal theories do not hold no long-term focus for Germany & Japan not more sensitive to sales growth Successful governance responds to current performance measures (earnings & stock price) Bank & inter-corporate relationships partially substitute for U.S. market control mechanisms Conclusions - Explanations:  Conclusions - Explanations Successful market economies in all 3 countries Governance differences are less important when: product market is competitive including growing & changing markets firms require more capital will not allow for wasteful spending Sarbanes-Oxley Act – Key Provisions:  Sarbanes-Oxley Act – Key Provisions Creates a new oversight board to supervise the accounting profession on standards, discipline, etc. Fundamentally changes the relationship between auditors, audit committees and management teams Enhances the role and independence of audit committees Requires that CEOs and CFOs of public companies certify their financial statements and attest to their internal controls over financial reporting. Sarbanes-Oxley Act – More Key Provisions:  Sarbanes-Oxley Act – More Key Provisions Creates new auditor independence restrictions Bans a public company’s auditor from also providing financial systems information technology consulting, internal audit services (“outsourcing” the audit function), and from representing the company in Tax Court Sarbanes-Oxley Act of 2002:  Sarbanes-Oxley Act of 2002 The Act’s major provisions include: Requirement of CEO/CFO certification of financial statements and internal controls. Requirement of auditor examination of company internal controls Creation of the Public Company Accounting Oversight Board (PCAOB) to serve as an auditing profession “watchdog.” Prohibition of certain client services by firms conducting a client’s audit. Sarbanes-Oxley: Management’s Responsibility For Financial Reporting :  Sarbanes-Oxley: Management’s Responsibility For Financial Reporting One of its most important provisions (Section 302) states that the key company officials must certify the financial statements. Certification means that the company CEO and CFO must sign a statement indicating: They have read the financial statements. They are not aware of any false or misleading statements (or any key omitted disclosures). They believe that the financial statements present an accurate picture of the company’s financial condition. Source: U.S. Congress, Sarbanes-Oxley Act of 2002, Pub. L. 107-204, 116 Stat/ 745 (2002). Reasons Behind Sarbanes-Oxley :  Reasons Behind Sarbanes-Oxley SOX was enacted soon after the significant corporate scandals most popular ones are Enron and WorldCom, Factors cited as contributing to scandals Equity compensation linked executives interest to the share price. Motivations to meet market expectations among concerns. Long term bull market effect (1994-2000), The failure of gatekeepers e.g. auditors, lawyers, analyst… in the scandals. (deterrence, bubble) Enron:  Enron Enron stock price was $90 in August 2000 - America’s 7th largest company, Chapter 11 (bankruptcy) on December 2, 2001, promptly after restating their financial reports, The largest bankruptcy reorganization in American history, Stock price at that time - 60 cents. The most highlighted event at the collapse of the Enron is its relations with limited partnerships (Special Purpose Entity- SPEs), - Executives got personal gains being on both sides (Fastow -CFO-more than $ 30 million) - Enron failed to disclose the extent of these relations (off-balance sheet and related party transaction) Enron (Cont’d):  Enron (Cont’d) Failures all levels of monitoring within the company including the board. Gatekeepers such as lawyers (Vinson & Elkins) & rating agencies severely criticized. Some investment banks charged with aiding and abetting the securities fraud. Enron’s both internal and outside auditor Arthur Andersen, indicted to obstruction of justice, shredding of Enron-related documents, The whistle-blower, (Sharon Watkins) vice president of Enron resigned,, letter to the top of Enron highly emphasized by media. ROGUES GALLERY:  ROGUES GALLERY Common Accounting Tricks :  Common Accounting Tricks Revenue Recognition (Qwest, Global Crossing, Dynegy, Merck-Medco) Understating Loss Reserves Off-Balance Sheet Activity (Enron, Dynegy) Expenses being capitalized (WorldCom) Cookie-jar Accounting – setting reserves for rainy day Big Bath – Realizing excessive losses when the going is bad to set a lower benchmark Deal Design:  Deal Design Deal design Form of Reorganization Form of payment Factors in deal design:  Factors in deal design The form of reorganization is important because it affects:  The form of reorganization is important because it affects ______________ ______________ ______________ ______________ ______________ Deal Design:  Deal Design You name the price. I’ll name the terms. (And I’ll so better than you every time.) Old saying “Deal Structures are Solutions to Economic Problems”:  “Deal Structures are Solutions to Economic Problems” Bargaining on many fronts “First, seek to understand” Factors in deal design Form of payment:  Form of payment Why does it matter? Types of payment Form of payment:  Form of payment Choices: Stock Cash Other Effects More exotic strategies Historic Evidence on the Market Reaction to Security Offer Announcements:  Historic Evidence on the Market Reaction to Security Offer Announcements Smith 86 Table 1 The Stock Market Response to Announcements of Security Offerings (Source: Smith JFE 86) :  Table 1 The Stock Market Response to Announcements of Security Offerings (Source: Smith JFE 86) Types of Issuer Type of Security Offering Industrial Utility Common Stock -3.14% -0.75% (155) (403) Preferred Stock -0.19% +0.08% (28) (249) Convertible Preferred Stock -1.44% -1.38% (53) (8) Straight Bonds 0.26% -0.13% (248) (140) Convertible Bonds -2.07% n.a. (73) Empirical Evidence on Form of Payment in Acquisitions:  Empirical Evidence on Form of Payment in Acquisitions Heron - 2002 Characteristics of Stock Deals Additional evidence:  Characteristics of Stock Deals Additional evidence As these variables increase/exist 6. Hostile deal 5. Ownership structure % managers own 4. Buyer’s stock price 3. Deal size 2. Buyer Liquidity 1. Bidder avoids dilution of control The probability of a stock deal: 6. _____________________ 5. 4. 3. 2. 1. Other factors affecting form of payment:  Other factors affecting form of payment Perspective – investment vs. financing Competition Control Accounting earnings Financial Flexibility of parties Transaction costs Size – relative and absolute Information asymmetries Tips for the deal designer:  Tips for the deal designer Listen Learn Be creative Be flexible, but understand the value of your tradeoffs Bargain on multiple dimensions Strive towards a ZOPA Ch 19: Choosing the Form of Acquisitive Reorganization:  Ch 19: Choosing the Form of Acquisitive Reorganization Types of Reorganization See text for varieties including Purchase of assets for cash or debt Purchase of stock, substantially with cash or debt Triangular Cash Mergers Statutory Merger etc Why important? Contingent Payouts Risk management in M&A:  Contingent Payouts Risk management in M&A Contingent payouts in M&A:  Contingent payouts in M&A Contingent payments are options Extremely useful in negotiations Extremely useful in motivating and retaining talent Characteristics of Earnouts:  Characteristics of Earnouts As these variables increase/exist 1. Divestitures 2. Acq. of private targets 3. Size of acquiror 4. Non-horizontal combinations * The probability of an earnout: 1. increases 2. increases 3. decreases 4. increases Structuring earnouts:  Structuring earnouts Avoid excessive complexity Be realistic Warning: lack of autonomy creates frustration in striving for earnouts Exhibit 22.2:  Exhibit 22.2 Compares earnout to call option Interesting comparison of similarities and differences Example – On Assignment Speculation Spreads and the Market Pricing of Proposed Acquisitions:  Speculation Spreads and the Market Pricing of Proposed Acquisitions Jan Jindra And Ralph A. Walkling Journal of Corporate Finance Summer 2004 Example:  Example $40 - Bid price $20 - Pre-offer stock price Slide100:   Subsequent market price at t+1 Objectives:  Objectives Develop & test a simple model of speculation spreads What determines the magnitude of the spread? cross sectional variation? What factors are priced when the spread is set? Motivation:  Motivation The spread is the foundation of “arbitrage returns” Better understand acquisition pricing, acquisition trading, and the arbitrage process. arbitrage returns No existing evidence on the spread Interpreting speculation spreads:  Interpreting speculation spreads SSi = (BP – P1)/P1 Smaller spreads  greater market adjustment Components of Speculative Returns:  Components of Speculative Returns TRi = (PFi – P1 i) / P1i – Hi where TRi total % return PFi is the final price received Hi is the % holding costs Components of speculative returns:  Components of speculative returns Let BPi = first announced bid price PFi – P1i = (PFi – BPi) + (BPi - P1i) TRi = SSi + RRi – Hi where SSi = (BPi – P1i)/P1i and RRi = (PFi – BPi)/P1i Expected total return:  Expected total return E(TRi) = F ProbFi (PFi – P1i)/P1i – Hi Or equivalently, E(TRi) = SSi +Fi ProbFi (PFi – BPi ) / P1i - Hi where ProbFi is the probability of being able to sell the shares for PFi dollars. Hypotheses:  Hypotheses H1: SS  RR a negative relation H2: SS  deal duration a positive relation H3: high abn. volume (arb activity) stronger effects Sample Selection:  Sample Selection Securities Data Corp. (SDC) Target firms 1/1/81 to 12/31/95 Cash tender offers > $10 million Bidder seeks 100% Target on NYSE, AMEX, or NASDAQ Covered by Lexis-Nexus. Financial and public utilities excluded. Data:  Data First formally announced bid. Ownership - proxy statements, S&P Stock Guide Managerial attitude - outcome of the offer - SDC, Lexis-Nexus. Price, return and volume data - CRSP Probability factors:  Probability factors Target Attitude Distribution of power shareholdings of officers and directors, institutions, blockholders, bidder toeholds. volume activity runups Rumors size of the bid premium, target and industry characteristics experience of the bidder. Distribution of speculation spread:  Distribution of speculation spread Emory Handout on Article:  Emory Handout on Article Summary and Conclusions :  Summary and Conclusions 362 offers 1981 - 1995, speculation spreads on average, positive, considerable cross-sectional variation Over 23% are negative Summary and conclusions, cont.:  Summary and conclusions, cont. Spreads are significantly associated with outcome of the offer (revision) magnitude of revision duration of the offer Effects more dramatic in high abn. Vol. offers A Brief Analysis of M&A Arbitrage :  A Brief Analysis of M&A Arbitrage Risk Arbitrage:  Risk Arbitrage “Ivan Boesky They Ain’t” Arbitrage vs. Risk Arbitrage How much risk? Rumor or announcement? Simple M&A Arb Strategy:  Simple M&A Arb Strategy Buy the target (long) Short the bidder More exotic strategies options Arbitrage examples:  Arbitrage examples Objective: Understand :  Objective: Understand Alternate methods of pricing takeover transactions Techniques of hedging and allocating market risk among participants Unprotected transactions:  Unprotected transactions Fixed exchange ratio Examples US West Media& Continental Cablevision Walt Disney & CapitalCities/ABC Time Warner & Turner Broadcasting Reasoning? - companies operate similar or complementary business are will to share market risk Fixed Exchange Rate Pricing:  Fixed Exchange Rate Pricing Fixed exchange rate Bell Atlantic’s $21.34 billion stock swap acquisition of NYNEX Corp NYNEX shareholders receive 0.768 share of Bell for each share held Boeing & McDonnell Douglas $13.34 billion 0.65 share of Boeing for each McD share Advantages of Fixed Exchange Rate Pricing:  Advantages of Fixed Exchange Rate Pricing Certainty? Acquirer can determine dilution of ownership in advance Depending on market movements one party gains -- Disadvantages of Fixed Exchange Rate Pricing:  Disadvantages of Fixed Exchange Rate Pricing and the other loses! Both parties may face significant market risk If Bidder price drops, target may want to cancel Modest decline in price of LDDS Communications (now WorldCom) caused termination of the agreement to acquire ACC Corp in 1996 Rise in bidder’s price before closing may prompt bidder to terminate Fixed Value Pricing (floating exchange rate pricing) :  Fixed Value Pricing (floating exchange rate pricing) Nominal per share value fixed at inception Exchange rate altered at closing to deliver fixed value (regardless of the number of shares needed) Calculations typically involve average market prices Pricing period - length and timing - may be difficult to negotiate Pros and Cons of Fixed Rate Pricing:  Pros and Cons of Fixed Rate Pricing Target gets known value Bidder faces uncertainty over share dilution Hedging and Protection:  Hedging and Protection Increasingly used Deals IVAX Corp/ Johnson products Bank of Boston/Multibank Financial Examples of protective tools Floors, Caps, Ceilings, Collars, Temination Fees, Contingent Value Rights, Floors, Caps, Ceilings & Collars:  Floors, Caps, Ceilings & Collars May be used separately or in conjunction with fixed exchange or fixed value pricing Floor - if bidder’s price drops too low the exchange rate is amended Cap - places a limit on the number of shares the bidder would have to issue Floor + Cap = Collar IVAX acquisition of Johnson Products :  IVAX acquisition of Johnson Products Fixed exchange rate with a collar One to One exchange - could be amended if IVAX stock fell below $24.50 or above $29 during the post agreement period Cancellation Options and Walk Away Rights:  Cancellation Options and Walk Away Rights Target can terminate if bidder’s price drops dramatically BANC One’s acquisition of First Community Bancorp:  BANC One’s acquisition of First Community Bancorp Target will receive $31.96 of BanC One Stock but also had stipulations for a maximum (and minimum) exchange ratio if Banc One drops below $47 If Banc One drops below $43, First Community could cancel Bidder can also get walk away rights “As-You-Like-It-Options” and “Top-Up” Rights:  “As-You-Like-It-Options” and “Top-Up” Rights As-You-Like-It-Options Used to create exotic takeover derivatives Top-Up” Rights aka revival rights - induce a target to complete a deal Contingent Value Rights and Variable Common Rights:  Contingent Value Rights and Variable Common Rights CVRs require the bidder to pay additional cash depending on subsequent performance VCRs give extra compensation to the target if the bidder’s stock drops in a subsequent period Empirical evidence on types of collars:  Empirical evidence on types of collars M&A Valuation :  M&A Valuation Valuation:  Valuation How much should a bidder pay? Types of value Methods of valuation How much should a bidder pay for an acquisition?:  How much should a bidder pay for an acquisition? Maximum = ? Minimum = ? Some thoughts on maximizing the acquisition price:  Some thoughts on maximizing the acquisition price Maximize value Recognize the bidder’s motivation Know your bargaining strengths Enter the negotiations as informed as possible Merger Valuation:  Merger Valuation A capital budgeting perspective Similar to any other valuation NPV Multiples Comparables Important Issues in M&A Valuation:  Important Issues in M&A Valuation What cash flows do you discount? Existing? Under new management? What discount rate do you use? Targets? Bidders? Important Issues, continued:  Important Issues, continued What are the alternatives? Build vs. buy Don’t double count cash flows Allow for needed investment Bid premium size Reasons for importance::  Bid premium size Reasons for importance: 1. ____________________________ 2. ____________________________ 3. Provides opportunities for insights into managerial motivations Significant determinants of bid premiums:  Significant determinants of bid premiums As these variables increase (or exist) 1. Debt position of target 2. Market/book ratio 3. % of shares bidder controls prior to bid 4. Offers where control is sought 5. Offers where another bid exists 6. Liquidity of target 7. Offers where management resists 8. Conglomerate vs. nonconglomerate The % bid premium 1.______________ 2. ______________ 3. ______________ 4. ______________ 5. ______________ 6. ______________ 7. ______________ 8. ______________ Experiment: The controller has the power to choose the outcome number without consulting the other participant, but both parties may negotiate to split the total payoff as desired. :  Experiment: The controller has the power to choose the outcome number without consulting the other participant, but both parties may negotiate to split the total payoff as desired. Coase - "The Problem of Social Cost" :  Coase - "The Problem of Social Cost" Journal of Law and Economics, 1960 Background - What is the optimal amount of pollution? Coase's critique of government intervention The farmer and the rancher Coase Theorem: :  Coase Theorem: The outcome (with regard to externalities) is invariant to the prior assignment of rights Cooperative games Trading pollution permits Problems with the Coase Theorem. :  Problems with the Coase Theorem. It works well when: There are _____ parties to a bargain Property rights are ___________ Bargainers have ______________ of one anothers' profit or utility functions Continued:  Continued Bargainers behave competitively There is ___________ bargaining Courts will __________ enforce any bargain Agents strike advantageous bargains and avoid bargaining breakdowns There are no income effects Does the Coase Theorem work?:  Does the Coase Theorem work? Acid rain Oil Exploration Experimental results Reasons for bargaining breakdowns:  Reasons for bargaining breakdowns Transaction costs Property rights are not well defined Disagreement over information Oracle/Peoplesoft timeline through 11/19/2004:  Oracle/Peoplesoft timeline through 11/19/2004 June 2, 2003 PeopleSoft announces its intention to acquire J.D. Edwards for $1.7 billion in stock. June 6, 2003 Oracle stuns the world with a hostile offer to buy PeopleSoft for $16 per share in cash, or $5.1 billion. June 12, 2003 PeopleSoft rejects Oracle's offer; J.D. Edwards and PeopleSoft sue Oracle, claiming interference with their merger. Slide152:  June 16, 2003 PeopleSoft, seeking to accelerate the J.D. Edwards deal, amends the agreement to pay about half in cash. June 18, 2003 Oracle raises its PeopleSoft offer to $19.50 per share, or $6.3 billion. PeopleSoft rejects the offer two days later. June 30, 2003 U.S. Department of Justice begins investigating Oracle's offer. July 18, 2003 PeopleSoft completes J.D. Edwards acquisition. Jan. 12, 2004 Larry Ellison splits chairman and CEO roles at Oracle, relinquishes chairman spot to Chief Financial Officer Jeffrey Henley. Safra Catz and Charles Phillips are promoted to co-presidents. Slide153:  Feb. 4, 2004 Oracle raises bid to $26 per share. PeopleSoft rejects the offer five days later. Feb. 26, 2004 U.S. Department of Justice sues Oracle to block proposed PeopleSoft takeover. April 22, 2004 PeopleSoft issues second-quarter guidance well below Wall Street estimates. May 14, 2004 Oracle lowers bid to $21. PeopleSoft rejects offer 12 days later. July 7, 2004 PeopleSoft says it will not meet second-quarter guidance and blames shortfall on publicity surrounding Oracle bid. Slide154:  Sept. 9, 2004 Oracle prevails against Justice Department as big regulatory hurdle is cleared. Oct. 2, 2004 PeopleSoft CEO Craig Conway is fired, having lost confidence of the board. Founder David Duffield, who stepped down from the job five years earlier, is installed. Nov. 1, 2004 Oracle raises bid to $24, sets Nov. 19 deadline for tender of a majority of PeopleSoft shares or it will drop bid. PeopleSoft rejects offer nine days later. Nov. 10, 2004 PeopleSoft provides 2005 guidance that many on Wall Street see as unrealistic and unattainable. Nov. 19, 2004 A majority of PeopleSoft shares are tendered in favor of the takeover. PeopleSoft invokes its poison pill defense, which Oracle seeks to have voided in court or otherwise. Due Diligence:  Due Diligence The Due Diligence Process:  The Due Diligence Process The Deal Process Stages of the deal Important factors in due diligence The Buyer Always Pays!:  The Buyer Always Pays! Caveat Emptor Surprises now or surprises later?! Be fact based but knowledge oriented Case Studies – CUC-HFS:  Case Studies – CUC-HFS December 1997 Cendant Corp. is created By merger of HFS, Inc. Ramada, Days Inn, Howard Johnson, Avis, Coldwell Banker, Century 21 And CUC International, Inc. Sold memberships in clubs that offered travel shopping and dining discounts Advantages – combining databases and cross selling March 1998:  March 1998 Discovered that CUC had been engaging in accounting fraud since 1995 Up to 61% of 1997’s revenues were ficticious Quote Due diligence based on public information Problems discovered after the fact Due Diligence Different but complimentary perspectives from various sources:  Due Diligence Different but complimentary perspectives from various sources Due Diligence:  Due Diligence Last Steps Before Finalizing the Venture or the Business Acquisition Due Diligence Process:  Due Diligence Process “Due diligence” - an examination of the business and legal issues concerning a proposed business partner, venture opportunity or acquisition target. Process of obtaining reliable information about the proposed venture to uncover facts that would influence the offer or decision to acquire the business or enter the venture. Due Diligence Process:  Due Diligence Process Conduct at an early stage of the transaction. Address questions and issues that will reveal the true nature, conditions and position of the business. Factors considered: price of the deal perceived risks urgency of consummating the deal gaining a level of comfort that makes the opportunity attractive Internally-Generated Information:  Internally-Generated Information To verify seller representations To assist in determination of value Assets and liabilities To uncover problems, issues and concerns To gain a better understanding of the business and industry key customers, trends, regulatory requirements To evaluate management and key employees Externally-Generated Information:  Externally-Generated Information Public information regarding the company, its principals and key employees Key customers Market research to gain a better understanding of the dynamics of the marketplace Case Studies – Quaker Oats/Snapple:  Case Studies – Quaker Oats/Snapple 11/94 Quaker announces acquisition of snapple for $1.7 billion 4/96 Quaker agrees to sell Snapple for $300 million The Plan:  The Plan Grow Snapple as it had done with Gatorade Integrate Snapple with Gatorade and achieve synergies Streamline distribution of Snapple Swap distribution rights Snapple’s 300 independent distributors would get to deliver Gatorade to convenience stores and Mom & Pop outlets But give up distributing Snapple to Supermarkets The Problem:  The Problem Apparently, No one asked the distributors Supermarket business Established Twice as profitable as convenience stores Other problems Growth of Snapple had been from cramming distributor pipeline full of inventory Bottling production scheme caused blockages and stockouts Late in the deal:  Late in the deal Snapple discloses plummeting sales and profits and continued expected weaknesses Snapple’s owners reject stock and cash plan in favor of ‘all cash’ deal Quaker buys Snapple for $1.7 billion cash Tips for Conducting a Due Diligence Investigation:  Tips for Conducting a Due Diligence Investigation Professional judgement and experience is critical if you are lacking in certain areas get help Develop a questionnaire to guide you through the process questionnaires are available in books and from major accounting and law firms Tips for Conducting a Due Diligence Investigation:  Tips for Conducting a Due Diligence Investigation Document the findings of your investigation Be aware of how the nature of the information impacts its reliability internal vs. external how and from whom it is obtained Is it independently verifiable? Tips for Conducting a Due Diligence Investigation:  Tips for Conducting a Due Diligence Investigation Look for inconsistencies in verbal representations or information Practices, values and reputation of business Consistent with your approach to doing business? Ask open ended questions Rather than asking for the confirmation of a fact, ask a question that leads you to the same answer Tips for Conducting a Due Diligence Investigation:  Tips for Conducting a Due Diligence Investigation Remember that past behavior can be a good predictor of future performance Crucial in evaluating management's and employee's values, practices and performance May or may not uncover fraud Tips for Conducting a Due Diligence Investigation:  Tips for Conducting a Due Diligence Investigation Have the seller sign a letter of representation before closing the deal Confirm the representations the seller has made That there are no known facts or circumstances that would affect your decision to buy under the terms and conditions agreed upon Tips for Conducting a Due Diligence Investigation:  Tips for Conducting a Due Diligence Investigation Balance cost of investigation against total risk exposure Undiscovered pending liability could wipe out total investment Legal remedy is costly and time-consuming Tech Coast Angel’s Six-Step Process:  Tech Coast Angel’s Six-Step Process Submit Application – Register and complete Business Plan Summary form on TCA website Pre-Screening Assessment – Meet with small team of TCA members; present business plan. TCA members provide same-day assessment: accepted for formal screening, or not Formal Screening – Present to 20-30 TCA members at meetings in LA, OC, SD Entrepreneur’s objective – Generate enough interest to advance to due-diligence… at least one person willing to “lead” and at least 20 other “interested” angels Investors’ objective – Identify promising opportunities: strong management team with a clear, compelling and credible business plan Due-Diligence – Starts after successful formal screening; ends with funding Dinner Presentations – Present “tuned” business plan to TCA membership. Firm up funding interest Funding – Close on equity placement Submit Application Pre-Screening Assessment Formal Screening Dinner Presentations Funding Due-Diligence Process Focus of this talk What Is Due Diligence? (courtesy of Akin Gump):  What Is Due Diligence? (courtesy of Akin Gump) The process by which we discover, review and analyze material information in the context of a transaction The nature and extent of investigation is dependent on, among other things: the type of transaction Time constraints Money constraints Object: to get the maximum useful information in the minimum time Why Do It?:  Why Do It? Allows investors to: Value the business Assess risk exposure Negotiate agreements to address existing or contingent liabilities through appropriate representations, warranties and indemnifications Position for negotiation Allows the company to: Make full and complete disclosure Make accurate representations and warranties Position for negotiation Top 10 Diligence Subjects:  Top 10 Diligence Subjects People Creation, Development, Ownership and Licensing of Intellectual Property Rights Ownership of Company Assets and Property Barriers to Competitive Entry and Third Party Barriers Market – Pain and Painkiller Financial – Revenue Model and Projections Differentiated Story Equity Ownership Material Contracts Litigation and Claims The People - Often the Most Important Factor:  The People - Often the Most Important Factor Consider founders, management and other investors Probe into backgrounds Credentials Prior business background Reference checks Background checks Case Studies – Daimler Chrysler:  Case Studies – Daimler Chrysler What's culture got to do with it? DaimlerChrysler's bumpy post-merger road Despite significant pre-merger due diligence related to finance and product line offerings, this marriage has failed to deliver promised dividends to shareholders with stock prices still below pre-merger levels. Despite management changes (Germans now head all divisions) and personnel layoffs of over 30,000, the Chrysler division continues to under perform and drain resources. The widely acclaimed PT Cruiser was unable to put the company back in the fast lane of automobile traffic. What's culture got to do with it? :  What's culture got to do with it? Both the Germans and Americans anticipated issues related to their respective cultures such as language and lifestyle differences. However, they failed to consider fundamental differences in the operation of their organizations. While the Germans viewed themselves as the superior partner in what they really believed to be an acquisition, they were surprised to find American management practices that segregated personnel, eg. reserved parking, separate cafeterias for staff and administration, and management compensation packages that were not tied to performance. Creation, Development, Ownership and Licensing of Intellectual Property Rights:  Creation, Development, Ownership and Licensing of Intellectual Property Rights Does the Company own/have proper rights to its intellectual property (patents, copyrights, trademarks, trade secrets)? Examine source of IP or way in which it is protected (employees, 3rd parties, transfer) These are "Bet The Company" issues Solutions might include licensing, transfer for equity, new development Market:  Market What is the relevant market? Why haven't others attacked it, who might, and how big are the players? What is the real market size -- not what Jupiter or Forrester project it to be, but what it is now? How you look for it: Talk to strategic investors. e.g., if the market is broadband wireless, talk to Hughes and TRW. What are their buying and investment plans? Cost of failure to look: Pets.com -- is the market really $30 billion (i.e. market size over estimated); etoys (big market, overspent); Webvan (does the market care, customer acquisition cost?); EMC (keep eye on market, focused, driven sales team, helped create and drive the market through innovation) Financial - Revenue Model, Projections and Recognition :  Financial - Revenue Model, Projections and Recognition How you look for it: Analyze all of the numbers--take nothing for granted and ask for back up and third party validation (e.g. talk to customers, sales persons; review contract terms and bank records) Accounting and operational analysts with domain experience Review accounting procedures and policies Research SEC and FAS positions on that industry Consider who built the models (talk to him or her in addition to management) Cost of failure to look Due Diligence:  Due Diligence Establishing “Truth”:  Establishing “Truth” VC Due Diligence Basics October 15, 2002 Craig Gomulka Draper Triangle Ventures :  VC Due Diligence Basics October 15, 2002 Craig Gomulka Draper Triangle Ventures Who is Draper Triangle?:  Who is Draper Triangle? Located in Pittsburgh, Pennsylvania PA-based fund of Draper Fisher Jurvetson First-round, early stage, lead investor High-tech fund - Education, MEMS, Data, Semiconductor, Advanced Software, Medical Devices, Optical, Automation The DFJ Network:  The DFJ Network Timberline Venture Partners Vancouver, WA Draper Fisher Jurvetson Redwood City, CA Zone Ventures Los Angeles, CA Wasatch Venture Fund Salt Lake City, UT Access Venture Partners Westminister, CO Austin, TX DFJ Portage Chicago, IL Draper Atlantic Reston, VA Draper Triangle Ventures Pittsburgh, PA DFJ New England Cambridge, MA Draper Fisher Jurvetson Gotham New York, NY Draper Triangle Portfolio:  Draper Triangle Portfolio The Funding Timeline:  The Funding Timeline Review business plan Bring in management team to present Evaluation of opportunity Internal partners meeting Term sheet In-depth due diligence Legal documentation Funding 1 to 4 Months Initial level of due diligence:  Initial level of due diligence Level I (after the plan and initial go/no-go) Meet the team Prior entrepreneurial experience Experience in the market place Would we enjoy working with the team? High level understanding of Product, Market size and Exit Potential Competition and Differentiation Marketing, Sales, Competitive strategy Go or no-go decision Secondary level of due diligence:  Secondary level of due diligence Level II (gets more interesting now) Market research, competitive analysis Marketing and sales plan validation Financial validation (numbers make sense?) Potential/existing customer/partner calls Independent industry insider/expert calls IP review, existing patent scan Better validation of likely exit scenarios Have we enjoyed working with the team? Go or no-go decision for term sheet Final level of due diligence:  Final level of due diligence Level III (after term sheet, the boring stuff) Management team background checks Corporate and organizational (books in order?) Capitalization structure, benefit plan Intellectual property (legal review) Financials (historical audit/review, tax returns) Existing contracts and obligations Properties, leases and insurance Reps and warranties in the term sheet The Oracle of Bacon:  The Oracle of Bacon Best Practices in M&A:  Best Practices in M&A Today’s Corporate Environment in Historical Perspective (Jensen - Presidential Address):  Today’s Corporate Environment in Historical Perspective (Jensen - Presidential Address) 1st, 2nd and Modern Industrial Revolutions Change Forces at work on the Modern Corporation The first industrial revolution :  The first industrial revolution Originated in Britain Late 18th century Application of new energy sources to methods of production The second industrial revolution:  The second industrial revolution Middle to end of the 19th century: birth of modern transportation & communication railroad, telegraph, steamship, cable systems High speed consumer packaging technology Mass production & distribution systems Innovation and Invention:  Innovation and Invention McCormick Reaper - 1830s Sewing maching - 1844 High volume canning and packaging- 1880s Interchangable parts for hand-tooled components Coal replaces wood, water and animals as energy source Paper industry: wood pulp replaces rags Innovation and Invention:  Innovation and Invention Wire industry: rod rolling - new technology Wire nails replace cut nails Woolen textile industry - advances in combing technology - worsted textiles Tobacco - Bonsack machine reduces labor cost by 98% Bessemer process reduces cost of steel rails by 88% Electrolytic refining reduces the price of aluminum by 96% Chemicals - mass production of synthetic dyes The Modern Industrial Revolution:  The Modern Industrial Revolution Technology The internet PCs Revolution in Political Economy Socialist and communist becomes capitalist Globalization of Trade The greatest bull market in history Change = :  Change = Crisis? Sharp decline in production costs and prices Widespread excess capacity The necessity of exit Change = :  Change = _____________ _____________ _____________ _____________ Rock and Finance:  Rock and Finance Course Wrapup:  Course Wrapup Valuation Options Capital Structure Arbitrage Financial Analysis Statistical Modeling Cumulative Abnormal Returns Altman’s Z-score Agency problems Informational assymetry Mergers and Acquisitions Guest speakers Tim Portland – Scotts’ Moe Modecki – Marathon Cyndi Richson – Opers Case Analyses Conoco-Dupont Scott’s Hershey Yeat’s/TSE

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