A Primer on the Mechanics of Mergers

With just a few weeks left in 1998, this year is on track to be by far the biggest ever for corporate mergers. And analysts don’t expect much slowing of the deal pace in 1999, given that most companies continue to be driven to cut costs and boost growth prospects--goals often easily satisfied by mergers.

If a stock you own becomes a takeover target--or one of your companies becomes an acquirer--would you know your rights, and options, as a shareholder?

Here’s a primer on the mechanics of different types of takeovers, and what shareholders can expect if a stock they own is involved in a deal:

Question: What’s the first thing I should examine if a stock I own gets a takeover offer?

Answer: The terms of the deal. Generally, a company buys another in one of three ways: by swapping stock (the acquirer’s for the target’s); by paying cash for the target’s shares; or by offering a combination of stock and cash.

With many companies’ shares selling at or near historic highs, stock-swap deals have become the most common type of takeover, because stock in effect becomes a rich “currency” to use as payment.

Generally, an acquiring company will offer a set number of its shares for the target’s shares. For example, Exxon Corp. is offering 1.32 of its shares for each Mobil Corp. share outstanding.

With Exxon stock currently worth $74.44 a share, the offer is worth the equivalent of $98.26 for each Mobil share (1.32 times $74.44). But as Exxon’s stock price fluctuates in the market, so too will the value of the deal.

In cases of cash takeover offers, an acquiring firm extends a “tender offer” to buy the target’s shares at a specific price. Deutsche Bank, for example, has offered to pay $93 cash for each share of Bankers Trust Corp. Unless Deutsche Bank changes the terms, the offer’s value will remain the same.

Q: If the buyout offer is a stock swap, how does the process work?

A: In the case of “friendly” mergers--the vast majority of deals--the boards of directors of both companies (acquirer and target) usually will have already voted in favor by the time the merger is announced.

To finalize the agreement, the target’s shareholders--and often, but not always, shareholders of the acquirer--must approve the deal. (After all, you’re the owners of the companies.) That means you’ll get a chance to vote by mail.

Of course, you can vote against the deal, and some mergers are shot down because shareholders object. But in most cases stockholders give their assent. Most mergers require a simple majority of shareholders to approve.

Mergers also must pass muster with antitrust regulators, but relatively few deals are denied on antitrust grounds.

Q: How does the voting process work in a stock-swap deal?

A: Several months after a merger is proposed, shareholders of the target company receive a “proxy statement” in the mail. These packages contain details on the structure of the merger, the financial condition of the acquiring company, and other information.

The proxy package contains forms that shareholders mail in to indicate their support for, or disapproval of, the deal.

In this process, companies hire proxy solicitation firms to handle any questions from investors. Their telephone numbers are included in the proxy materials.

Q: Assuming a stock-swap deal is approved, what happens then?

A: For shareholders of the target firm, that depends on whether you have actual stock certificates representing your shares, or whether your investment is registered in “street” name through a broker.

Years ago, most investors held stock certificates attesting to their ownership of shares. Today, most stock transactions are handled electronically. Rather than companies keeping records of each individual holder, brokerages hold large blocks of stock in “street” name, and keep tabs on the specific holdings of their clients without issuing actual certificates to them.

After a merger deal is approved, investors with stock certificates of the target firm receive forms to fill out and return, along with their certificates, to a “stock transfer agent.” This outside firm then mails back new certificates representing shares of the acquiring company, in the ratio agreed upon as part of the deal.

For example, if the Exxon-Mobil deal is approved, an owner of 100 Mobil shares will become the owner of 132 Exxon shares.

If your Mobil shares are held in street name, your account at your brokerage would simply be updated to reflect that you now own 132 Exxon shares.

Q: What if I own shares of an acquirer?

A: Generally, your shares remain as they are. In a relative few cases, shareholders of acquiring companies are asked to turn in their shares for new stock in the merged entity, usually on a one-for-one basis. That was the case with German owners of Daimler-Benz stock, for instance: They swapped their shares for shares of the merged DaimlerChrysler.

Q: How do the mechanics of all-cash offers differ from stock swaps?

A: If an all-cash offer is friendly, the acquiring company, with the target’s blessing, asks shareholders to hand over their shares for a set cash payment per share.

But if the offer is hostile--in other words, if the board of the target opposes the offer--the situation can become complicated, with the target appealing to shareholders not to agree to the deal.

Whether the offer is friendly or not, the outcome of cash deals can be quicker than stock-swap deals. Because they’re being offered cash, rather than an equity stake in another company, the target’s shareholders usually don’t receive proxy statements. Instead, they get shorter packages simply outlining the payment terms, with a deadline for agreeing to the offer.

Q: What are the tax implications of takeover deals for a target’s shareholders?

A: For all-cash offers, you will owe taxes on the difference between your purchase price of the stock and the cash payment when received, assuming the latter is higher. If you’ve held the stock more than one year, the tax rate will be the capital gains rate (maximum: 20%).

In the case of stock swaps, such deals often are structured to be tax free, if you take the acquirer’s shares. However, tax experts say investors should carefully read the proxy material to ensure they aren’t being hit by taxes. Especially in mergers of smaller companies, deals sometimes aren’t structured to protect against taxes.

Assuming your stock swap is tax free, your “cost basis” for the new stock then would be whatever you originally paid for the target’s stock, adjusted for the deal terms.

Example: You own 100 shares of XYZ Corp., purchased for $10 each, or $1,000 total. ABC Corp. agrees to buy XYZ, swapping 1.3 ABC shares for each XYZ share in a tax-free exchange. You end up with 130 ABC shares. Your cost basis per ABC share becomes $7.69 (because 130 times $7.69 equals your original $1,000 investment in XYZ).

Q: After a merger is announced, why do shares of the target usually remain below the price offered by the acquirer?

A: Generally, in a friendly deal, the boards of the two companies agree on the price the acquirer will pay, which is typically some “premium” above the target’s current share price. The target’s board is supposed to make sure that shareholders are being fairly compensated for their stock.

The target’s stock price then usually rises after the deal is announced. But at that point, a specific type of investor becomes the most interested buyer of the target’s stock: professional traders known as arbitragers.

“Arbs,” as they’re called, specialize in risk-taking with regard to deals. They judge the likelihood of a deal’s approval and the time expected to pass before consummation. Based on those factors, they are willing to buy the stock from investors who prefer to cash out early rather than wait to be paid in stock or cash by the acquirer.

Say ABC Corp. agrees to buy XYZ Corp. for $50 a share in stock. XYZ’s stock, which had been trading for $40 a share, suddenly surges to, say, $48 a share, as some current owners sell and arbs buy.

It doesn’t reach $50 because there is a chance the deal might unravel because of opposition from shareholders or regulators. Arbs also might “discount” the price they’re willing to pay because there is a chance that ABC’s shares will decline in value in coming months, thus pulling the deal value down before it’s consummated.

Basically, if the gap between the buyout offer and the target’s stock price stays fairly small after a deal is announced, that indicates investors believe the deal will go through. A very wide gap indicates investor doubt.

Q: Why do shares of an acquiring company sometimes decline after a deal is announced?

A: Such action in an acquiring company’s stock is sometimes a signal of what the market thinks of the deal overall.

It’s not uncommon for an acquirer’s stock to fall a modest amount because investors may be worried about the cost the company will incur to do the deal. If that expense is big enough, the acquirer’s earnings may be depressed near term.

In the case of stock swaps, whether you’re the owner of the target’s shares or the acquirer’s shares, your decision whether to hold or sell your stock will depend largely on your assessment of the deal: Will the merged entity be a better, or worse, investment in the future than either company alone?

That assessment will be different in every deal, of course. You’ll also have to weigh the potential tax bite in selling out versus taking a chance on the merged entity.

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The Deal ‘Discount’

Once a takeover deal is announced, the target company’s stock price often rises to near--but still below--what the acquiring company intends to pay. The “discount” in the stock price from the stated deal value can be narrow or wide. The size of the discount depends on traders’ expectations for the length of time before the deal closes, the certainty of the deal, and (in the case of stock swaps) the expected value of the acquirer’s stock when the deal closes. Some current discounts on pending deals:

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Bid Target’s current Buyer/target Terms value* price and discount American Oncology/ Stock $11.46 $11.00 -4% Physician Reliance AOL/Netscape Stock 40.16 38.13 -5 Deutsche Bank/Bankers Trust Cash 93.00 82.00 -12 Exxon/Mobil Stock 98.26 89.38 -9 Mattel/Learning Co. Stock 26.40** 25.00 -5 Scottish Power/PacifiCorp Stock 24.15 20.56 -15 Vulcan/CalMat Cash 31.00 30.75 -1

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* For stock swaps, bid value is current value of the stock the acquirer plans to swap for the target’s shares.

** Low end of stepped price range

Source: Times research