Hostile Takeovers

Understanding Hostile Takeovers

A hostile takeover bid occurs when an entity attempts to take control of a firm without the
consent or cooperation of the target company's board of directors. In lieu of the target
company's board approval, the would-be acquirer may then issue a tender offer, employ a
proxy fight or attempt to buy the necessary company stock in the open market. To deter the
unwanted takeover, the target company's management may have preemptive defenses in
place, or it may employ reactive defenses to fight back.

Factors playing into a hostile takeover from the acquisition side often coincide with those
of any other takeover, such as believing that a company may be significantly undervalued
or wanting access to a company's brand, operations, technology or industry foothold.
Hostile takeovers may also be strategic moves by activist investors looking to effect change
on a company's operations.

Hostile Takeovers Through Tender Offers and Proxy Fights

When a company, an investor or a group of investors makes a tender offer to purchase the
shares of another company at a premium above the current market value, the board of
directors might reject the offer. The acquiring company can take that offer directly to the
shareholders, who may choose to accept it if it is at a sufficient premium to market value or
if they are unhappy with current management. The sale of the stock only takes place if a
sufficient number of stockholders, usually a majority, agree to accept the
offer. The Williams Act of 1968 regulates tender offers and requires the disclosure of all-
cash tender offers.1

In a proxy fight, opposing groups of stockholders persuade other stockholders to allow

them to use their shares' proxy votes. If a company that makes a hostile takeover
bid acquires enough proxies, it can use them to vote to accept the offer.

Preemptive Offenses
To protect against hostile takeovers, a company can establish stocks with
differential voting rights (DVR), where a stock with less voting rights pays a higher
dividend. This makes shares with a lower voting power an attractive investment while
making it more difficult to generate the votes needed for a hostile takeover if management
owns a large enough portion of shares with more voting power. Another defense is to
establish an employee stock ownership program (ESOP), which is a tax-qualified plan in
which employees own a substantial interest in the company. Employees may be more likely
to vote with management, which is why this can be a successful defense. In a crown jewel
defense, a provision of the company's bylaws requires the sale of the most valuable assets if
there is a hostile takeover, thereby making it less attractive as a takeover opportunity.

Reactive Defenses
Officially known as a shareholder rights plan, a poison pill defense allows existing
shareholders to buy newly-issued stock at a discount if one shareholder has bought more
than a stipulated percentage of the stock; the buyer who triggered the defense is excluded
from the discount. The term is often used broadly to include a range of defenses, including
issuing both additional debt to make the target less attractive and stock options to
employees that vest upon a merger.

A people pill provides for the resignation of key personnel in the case of a hostile takeover,
while the Pac-Man defense has the target company aggressively buy stock in the company
attempting the takeover.

Real-World Examples
A hostile takeover can be a difficult and lengthy process and attempts often end up
unsuccessful. In 2011, for example, billionaire activist investor Carl Icahn attempted three
separate bids to acquire household goods giant Clorox, which rejected each one and
introduced a new shareholder rights plan in its defense.2 The Clorox board even sidelined
Icahn's proxy fight efforts, and the attempt ultimately ended in a few months with no
takeover. Another classic example that became a disaster was the Getty Oil takeover fiasco.
 Corporate Takeover Defense: A Shareholder's Perspective
Much has been written, often in dramatic and ominous language, about hostile
takeovers and the various steps companies take to prevent them. While most articles and
books view such events from the perspective of investment bankers and corporate officers,
little has been written about the impact of hostile takeovers on shareholders of target
companies. Yet these shareholders can experience significant financial consequences when
the target company's board activates a defense or signals its intention to do so by adding
defensive strategies to the corporate charter after the news of an impending takeover
breaks.

To assess the ramifications of a takeover, shareholders need to identify and understand the
various defensive strategies companies employ to avoid one. These shark repellent tactics
can be both effective in thwarting a takeover and detrimental to shareholder value. This
article will discuss the effects of some typical shark repellent and poison pill strategies.

KEY TAKEAWAYS

 The defensive strategies a company employs to thwart a hostile takeover can have a
significant impact on its shareholders, including sometimes a decline in shareholder
value.
 Shark repellent refers to clauses a company can add to its charter that are triggered
by a hostile takeover attempt and make the company unappealing to the would-be
acquirer.
 A poison pill is a common defensive tactic used by target companies to discourage
an acquirer from their hostile takeover attempts.
 Poison pills will frequently increase the cost of the takeover beyond what the
acquirer is willing or able to pay.
 A shareholders' rights plan is an example of a poison pill that gives existing
shareholders the opportunity to buy additional company stock at a discounted price.

Shareholders' Rights Plans

Martin Lipton is the American lawyer credited in 1982 for creating a warrant dividend
plan, also commonly known as a shareholders' rights plan. At the time, companies facing a
hostile takeover had few strategies to defend themselves against corporate raiders, men
like Carl Icahn and T. Boone Pickens, who would purchase large stakes in companies in an
attempt to gain control.

A shareholders' rights plan triggers immediately after the potential acquirer reveals their
takeover scheme. These plans give existing shareholders the opportunity to buy additional
company stock at a discounted price. Shareholders are tempted by the low price to buy
more stock, thereby diluting the acquirer's ownership percentage. This makes the takeover
more expensive for the acquirer and could potentially thwart the takeover entirely. At the
very least, it gives the company's board of directors time to weigh other offers.
Example of a Shareholders' Rights Plan
A shareholders' rights plan is a type of "poison pill" strategy because it makes the target
company hard to swallow for the acquirer. For shareholders, however, a poison pill can
have harsh side effects.

This was the case in July 2018 when the board of directors for Papa John’s International
Inc.’s (PZZA) voted to add a shareholders' rights plan to its charter to prevent ousted
founder John Schnatter from gaining control of the company. The move caused the price of
the company's common stock to soar, making it too expensive for Schnatter's hostile
takeover plan.

While the poison pill warded off the hostile takeover of Papa John's, its beneficial effects for
shareholders was temporary at best. The elevated stock price quickly tumbled after the
takeover threat subsided, dropping over 25% within a few weeks.

In addition to causing a temporary spike in stock prices, a shareholders' rights plan can
have the negative side effect of preventing shareholders from reaping any profits that
might occur should the takeover be successful.

Voting Rights Plans

A voting rights plan is a clause a company's board of directors adds to its charter in an
attempt to regulate the voting rights of shareholders who own a predetermined percentage
of the company's stock. For example, shareholders may be restricted from voting on certain
issues once their ownership exceeds 20% of outstanding shares. Management might use
voting rights plans as a preemptive tactic to prevent potential acquirers from voting on the
acceptance or rejection of a takeover bid.

Management might also use a voting rights plan to require super-majority voting to
approve a merger. Rather than a simple 51% of shareholder approval, the voting rights
plan could stipulate that 80% of shareholders would need to approve a merger. With such a
stringent clause in effect, many corporate raiders would find it impossible to gain control of
a company.

Often companies find it difficult to persuade shareholders that such clauses are beneficial
to them, particularly since they could prevent shareholders from achieving gains that a
successful merger could bring. In fact, the adoption of voting rights clauses is often
followed by a fall in the company's share price.

Staggered Board of Directors

This defensive tactic hinges on making it time-consuming to vote out an entire board of
directors, thus making a proxy fight a challenge for the prospective raider. Instead of
having the entire board come up for election at the same time, a staggered board of
directors means that directors are elected at different times for multiyear terms.
Since the raider is eager to fill the company's board with directors that are friendly to the
takeover plans, having a staggered board means that it will take time for the raider to
control the company via a proxy fight. The target company is hoping the raider will lose
interest rather than engage in a protracted fight. While employing a staggered board of
directors could benefit company management, there is no direct benefit to shareholders.

Greenmail Option
Greenmail is when a targeted company agrees to buy back its shares from the prospective
raider at a higher price in order to prevent a takeover. The term is derived from combining
"blackmail" with "greenbacks" (dollars). In exchange for receiving the premium, the raider
will agree to halt attempts at a hostile takeover.

Example of Greenmail
Activist investor Carl Icahn is well-known for his use of greenmail to pressure companies to
repurchase their shares from him or risk being the target of a takeover. In the 1980s, Icahn
used the greenmail strategy when he threatened to take control of Marshall Field, Phillips
Petroleum, and Saxon Industries. In the case of Saxon Industries, a New York distributor of
specialty papers, Icahn purchased 9.5% of the company's outstanding common stock. In
exchange for Icahn agreeing to not undertake a proxy battle, Saxon paid $10.50 per share
to buy back its stock from Icahn. This represented a 45.6% profit to Icahn, who originally
paid an average price of $7.21 per share.

After the announcement that management had succumbed to this payout strategy, Saxon's
stock price plummeted to $6.50 per share, providing a clear example of how shareholders
can lose out even while avoiding a hostile takeover.

In order to discourage greenmail, the U.S. Internal Revenue Service (IRS) enacted an
amendment in 1987 that places a 50% excise tax on greenmail profits.
 White Knight, Strategic Partner
A white knight strategy enables a company's management to thwart a hostile bidder by
selling the company to a bidder they find more friendly. The company sees the friendly
bidder as a strategic partner, one who will likely keep the current management in place and
who will provide shareholders with a better price for their shares.

In general, a white knight defense is seen as beneficial to shareholders, particularly when

management has exhausted all other options to avoid a takeover. However, exceptions to
this are when the merger price is low or when the combined value and performance of the
two companies fails to achieve the anticipated financial benefit.

Example of a White Knight

In 2008, global investment bank Bear Stearns sought a white knight after facing
catastrophic losses during the global credit crisis. The company's market capitalization had
declined by 92%, making it a potential target for a takeover and vulnerable to bankruptcy.
White knight JPMorgan Chase & Co. (JPM) agreed to purchase Bear Stearns for $10 a share.
While this was a far cry from the $170 a share the company traded for just a year earlier,
the offer was up from the $2 a share JPMorgan Chase initially offered shareholders.

Increasing Debt
A company's management can deliberately increase its debt as a defensive strategy to deter
corporate raiders. The goal is to create concern regarding the company's ability to make
repayment after the acquisition is completed. The risk, of course, is that any large debt
obligation could negatively impact the company's financial statements. If this happens, then
shareholders could be left bearing the brunt of this strategy as stock prices drop. For this
reason, increasing debt is generally seen as a strategy that in the short term helps the
company avert a takeover, but over time could hurt shareholders.

Making an Acquisition
Compared to increasing debt, making a strategic acquisition can be beneficial for
shareholders and can represent a more effective option for averting a takeover. A
company's management can acquire another company through some combination of stock,
debt, or stock swaps. This will make the corporate raiders' takeover efforts more expensive
by diluting their ownership percentage. Another advantage to shareholders is that if the
company's management has done its due diligence in selecting a suitable company to
acquire, then shareholders will benefit from long-term operational synergies and increased
revenues.

Acquiring the Acquirer

This defense is often referred to as the Pac-Man defense, after the popular video game. The
target company staves off the unwanted advances of the acquiring company by making its
own bid to take control of the acquiring company. The approach is rarely successful and
runs the risk of saddling the company with a large acquisition debt. Shareholders may end
up paying for this expensive strategy through a drop in share price or
decreased dividend payments.
Triggered Option Vesting
A triggered stock option vesting is a clause the board of directors adds to the company's
charter that activates when a specific event occurs, such as the acquisition of the company.
The clause states that should there be a change of control in the company, all unvested
stock options vest automatically and must be paid out to the employees by the acquiring
company.

This tactic wards off hostile investors because of the large expense involved and because it
could lead to talented employees selling their stock and leaving the company. Shareholders
generally do not benefit when this clause is added because it often leads to a drop in share
price.

The Bottom Line

The use of poison pills and shark repellent is on the decline, and the percentage of Standard
& Poor's 1500 Index companies with a poison pill clause in place fell to 4% at the end of
2017, according to 2018 information from the ISS Governance U.S. Board Study. By
contrast, 54% of companies had one in 2005. The S&P 1500 index combines the Standard &
Poor’s 500 (S&P 500), the Standard & Poor’s MidCap 400 (S&P 400), and the Standard &
Poor’s SmallCap 600 (S&P 600).

The decline in popularity is attributable to a number of factors, including increased

activism by hedge funds and other investors, shareholder desire for acquisition, moves to
block boards from adding defensive plans, and the lapse of such clauses over time.

The effect that anti-takeover tactics have on shareholders often depends on the
motivations of management. If management feels the takeover will lead to a decline in the
company's ability to grow and generate a profit, the correct action may be to use all
strategies available to fend off the takeover. If management performs its due diligence and
recognizes the acquisition could benefit the company and by extension its shareholders,
then management can cautiously use certain tactics as a way to increase the purchase
price without jeopardizing the deal. However, if management is purely motivated to protect
its own interests, then it may be tempted to use whatever defensive strategies it deems
necessary, regardless of the impact on shareholders.
 Leveraged Buyout
What Is a Leveraged Buyout?
A leveraged buyout (LBO) is the acquisition of another company using a significant amount
of borrowed money to meet the cost of acquisition. The assets of the company being
acquired are often used as collateral for the loans, along with the assets of the acquiring
company.

KEY TAKEAWAYS

 A leveraged buyout is the acquisition of another company using a significant amount

of borrowed money (bonds or loans) to meet the cost of acquisition.
 One of the largest LBOs on record was the acquisition of Hospital Corporation of
America (HCA) by Kohlberg Kravis Roberts & Co. (KKR), Bain & Co., and Merrill
Lynch in 2006.
 In a leveraged buyout (LBO), there is usually a ratio of 90% debt to 10% equity.

Understanding Leveraged Buyout (LBO)

In a leveraged buyout (LBO), there is usually a ratio of 90% debt to 10% equity. Because of
this high debt/equity ratio, the bonds issued in the buyout are usually are not investment
grade and are referred to as junk bonds. Further, many people regard LBOs as an especially
ruthless, predatory tactic. This is because it isn't usually sanctioned by the target company.
It is also seen as ironic in that a company's success, in terms of assets on the balance sheet,
can be used against it as collateral by a hostile company.

LBOs are conducted for three main reasons. The first is to take a public company private;
the second is to spin-off a portion of an existing business by selling it; and the third is to
transfer private property, as is the case with a change in small business ownership.
However, it is usually a requirement that the acquired company or entity, in each scenario,
is profitable and growing.

An Example of Leveraged Buyouts (LBO)

Leveraged buyouts have had a notorious history, especially in the 1980s, when several
prominent buyouts led to the eventual bankruptcy of the acquired companies. This was
mainly due to the fact that the leverage ratio was nearly 100% and the interest payments
were so large that the company's operating cash flows were unable to meet the obligation.

One of the largest LBOs on record was the acquisition of Hospital Corporation of America
(HCA) by Kohlberg Kravis Roberts & Co. (KKR), Bain & Co., and Merrill Lynch in 2006. The
three companies paid around $33 billion for the acquisition of HCA.

LBOs are often complicated and take a while to complete. For example, JAB Holding
Company, a private firm that invests in luxury goods, coffee and healthcare companies,
initiated an LBO of Krispy Kreme Doughnuts, Inc. in May 2016. JAB was slated to purchase
the company for $1.5 billion, which included a $350 million leveraged loan and a $150
million revolving credit facility provided by the Barclays investment bank.

However, Krispy Kreme had debt on its balance sheet that needed to be sold, and Barclays
was required to add an additional 0.5% interest rate in order to make it more attractive.
This made the LBO more complicated and it almost didn't close. However, as of July 12,
2016, the deal went through.
 Angel Investor
What Is an Angel Investor?
An angel investor (also known as a private investor, seed investor or angel funder) is a high
net worth individual who provides financial backing for small startups or entrepreneurs,
typically in exchange for ownership equity in the company. Often, angel investors are found
among an entrepreneur's family and friends. The funds that angel investors provide may be
a one-time investment to help the business get off the ground or an ongoing injection to
support and carry the company through its difficult early stages.

Angel Investor
KEY TAKEAWAYS

 An angel investor is usually a high net worth individual who funds startups at the
early stages, often with their own money.
 Angel investing is often the primary source of funding for many startups who find it
more appealing than other, more predatory, forms of funding.
 The support that angel investors provide startups fosters innovation which
translates into economic growth.
 These types of investments are risky and usually do not represent more than 10% of
the angel investor's portfolio.

Understanding Angel Investors

Angel investors are individuals who seek to invest at the early stages of startups. These
types of investments are risky and usually do not represent more than 10% of the angel
investor's portfolio. Most angel investors have excess funds available and are looking for a
higher rate of return than those provided by traditional investment opportunities.

Angel investors provide more favorable terms compared to other lenders, since they
usually invest in the entrepreneur starting the business rather than the viability of the
business.1 Angel investors are focused on helping startups take their first steps, rather than
the possible profit they may get from the business. Essentially, angel investors are the
opposite of venture capitalists.

Angel investors are also called informal investors, angel funders, private investors, seed
investors or business angels. These are individuals, normally affluent, who inject capital for
startups in exchange for ownership equity or convertible debt. Some angel investors invest
through crowdfunding platforms online or build angel investor networks to pool capital
together.

Origins of Angel Investors

The term "angel" came from the Broadway theater, when wealthy individuals gave money
to propel theatrical productions. The term "angel investor" was first used by the University
of New Hampshire's William Wetzel, founder of the Center for Venture Research. Wetzel
completed a study on how entrepreneurs gathered capital.
Who Can Be an Angel Investor?
Angel investors are normally individuals who have gained "accredited investor" status but
this isn’t a prerequisite. The Securities and Exchange Commission (SEC) defines an
"accredited investor" as one with a net worth of $1M in assets or more (excluding personal
residences), or having earned $200k in income for the previous two years, or having a
combined income of $300k for married couples.2 Conversely, being an accredited investor
is not synonymous with being an angel investor.

Essentially these individuals both have the finances and desire to provide funding for
startups. This is welcomed by cash-hungry startups who find angel investors to be far more
appealing than other, more predatory, forms of funding.

Sources of Funding
Angel investors typically use their own money, unlike venture capitalists who take care of
pooled money from many other investors and place them in a strategically managed fund.

Though angel investors usually represent individuals, the entity that actually provides the
funds may be a limited liability company (LLC), a business, a trust or an investment fund,
among many other kinds of vehicles.

Investment Profile
Angel investors who seed startups that fail during their early stages lose their investments
completely. This is why professional angel investors look for opportunities for a
defined exit strategy, acquisitions or initial public offerings (IPOs).

The effective internal rate of return for a successful portfolio for angel investors is
approximately 22%.3 Though this may look good for investors and seem too expensive for
entrepreneurs with early-stage businesses, cheaper sources of financing such as banks are
not usually available for such business ventures. This makes angel investments perfect for
entrepreneurs who are still financially struggling during the startup phase of their
business.

Angel investing has grown over the past few decades as the lure of profitability has allowed
it to become a primary source of funding for many startups. This, in turn, has fostered
innovation which translates into economic growth.
 Venture Capital

What is Venture Capital?

Venture capital is a form of private equity and a type of financing that investors provide
to startup companies and small businesses that are believed to have long-term
growth potential. Venture capital generally comes from well-off investors, investment
banks and any other financial institutions. However, it does not always take a monetary
form; it can also be provided in the form of technical or managerial expertise. Venture
capital is typically allocated to small companies with exceptional growth potential, or to
companies that have grown quickly and appear poised to continue to expand.

Though it can be risky for investors who put up funds, the potential for above-average
returns is an attractive payoff. For new companies or ventures that have a limited
operating history (under two years), venture capital funding is increasingly becoming a
popular – even essential – source for raising capital, especially if they lack access to capital
markets, bank loans or other debt instruments. The main downside is that the investors
usually get equity in the company, and, thus, a say in company decisions.

Venture Capital
Basics of Venture Capital
In a venture capital deal, large ownership chunks of a company are created and sold to a
few investors through independent limited partnerships that are established by venture
capital firms. Sometimes these partnerships consist of a pool of several similar enterprises.
One important difference between venture capital and other private equity deals, however,
is that venture capital tends to focus on emerging companies seeking substantial funds for
the first time, while private equity tends to fund larger, more established companies that
are seeking an equity infusion or a chance for company founders to transfer some of their
ownership stakes.

KEY TAKEAWAYS

 Venture capital financing is funding provided to companies and entrepreneurs. It

can be provided at different stages of their evolution.
 It has evolved from a niche activity at the end of the Second World War into a
sophisticated industry with multiple players that play an important role in spurring
innovation.

History of Venture Capital

Venture capital is a subset of private equity (PE). While the roots of PE can be traced back
to the 19th century, venture capital only developed as an industry after the Second World
War. Harvard Business School professor Georges Doriot is generally considered the "Father
of Venture Capital". He started the American Research and Development Corporation
(ARDC) in 1946 and raised a $3.5 million fund to invest in companies that commercialized
technologies developed during WWII. ARDC's first investment was in a company that had
ambitions to use x-ray technology for cancer treatment. The $200,000 that Doriot invested
turned into $1.8 million when the company went public in 1955.

Location of the VC
Although it was mainly funded by banks located in the Northeast, venture capital became
concentrated on the West Coast after the growth of the tech ecosystem. Fairchild
Semiconductor, which was started by the traitorous eight from William Shockley's lab, is
generally considered the first technology company to receive VC funding. It was funded by
east coast industrialist Sherman Fairchild of Fairchild Camera & Instrument Corp.

Arthur Rock, an investment banker at Hayden, Stone & Co. in New York City, helped
facilitate that deal and subsequently started one of the first VC firms in Silicon Valley. Davis
& Rock funded some of the most influential technology companies, including Intel and
Apple. By 1992, 48% of all investment dollars were on the West Coast and the Northeast
coast accounted for just 20%. According to the latest data from Pitchbook and National
Venture Capital Association (NVCA), the situation has not changed much. During the third
quarter of 2018, west coast companies accounted for 38.3% of all deals (and a massive
54.7% of deal value) while the Mid-Atlantic region had 20.4% of all deals (or approximately
20.1% of all deal value).

Help From Innovations

A series of regulatory innovations further helped popularize venture capital as a funding
avenue. The first one was a change in the Small Business Investment Act (SBIC) in 1958. It
boosted the venture capital industry by providing tax breaks to investors. In 1978, the
Revenue Act was amended to reduce the capital gains tax from 49.5% to 28%. Then, in
1979, a change in the Employee Retirement Income Security Act (ERISA) allowed pension
funds to invest up to 10% of their total funds in the industry.

Called the Prudent Man Rule, it is hailed as the single most important development in
venture capital because it led to a flood of capital from rich pension funds. Then the capital
gains tax was further reduced to 20% in 1981. Those three developments catalyzed growth
in venture capital and the 1980s turned into a boom period for venture capital, with
funding levels reaching $4.9 billion in 1987. The dot com boom also brought the industry
into sharp focus as venture capitalists chased quick returns from highly-valued Internet
companies. According to some estimates, funding levels during that period peaked at
$119.6 billion. But the promised returns did not materialize as several publicly-listed
Internet companies with high valuations crashed and burned their way to bankruptcy.

Angel Investors
For small businesses, or for up-and-coming businesses in emerging industries, venture
capital is generally provided by high net worth individuals (HNWIs) – also often known as
‘angel investors’ – and venture capital firms. The National Venture Capital Association
(NVCA) is an organization composed of hundreds of venture capital firms that offer to fund
innovative enterprises.
Angel investors are typically a diverse group of individuals who have amassed their wealth
through a variety of sources. However, they tend to be entrepreneurs themselves, or
executives recently retired from the business empires they've built.

Self-made investors providing venture capital typically share several key characteristics.
The majority look to invest in companies that are well-managed, have a fully-
developed business plan and are poised for substantial growth. These investors are also
likely to offer to fund ventures that are involved in the same or similar industries or
business sectors with which they are familiar. If they haven't actually worked in that field,
they might have had academic training in it. Another common occurrence among angel
investors is co-investing, where one angel investor funds a venture alongside a trusted
friend or associate, often another angel investor.

The Venture Capital Process

The first step for any business looking for venture capital is to submit a business plan,
either to a venture capital firm or to an angel investor. If interested in the proposal, the firm
or the investor must then perform due diligence, which includes a thorough investigation
of the company's business model, products, management, and operating history, among
other things.

Since venture capital tends to invest larger dollar amounts in fewer companies, this
background research is very important. Many venture capital professionals have had prior
investment experience, often as equity research analysts; others have a Master in Business
Administration (MBA) degrees. Venture capital professionals also tend to concentrate in a
particular industry. A venture capitalist that specializes in healthcare, for example, may
have had prior experience as a healthcare industry analyst.

Once due diligence has been completed, the firm or the investor will pledge an investment
of capital in exchange for equity in the company. These funds may be provided all at once,
but more typically the capital is provided in rounds. The firm or investor then takes an
active role in the funded company, advising and monitoring its progress before releasing
additional funds.

The investor exits the company after a period of time, typically four to six years after the
initial investment, by initiating a merger, acquisition or initial public offering (IPO).

A Day In The Life

Like most professionals in the financial industry, the venture capitalist tends to start his or
her day with a copy of The Wall Street Journal, the Financial Times and other respected
business publications. Venture capitalists that specialize in an industry tend to also
subscribe to the trade journals and papers that are specific to that industry. All of this
information is often digested each day along with breakfast.

For the venture capital professional, most of the rest of the day is filled with meetings.
These meetings have a wide variety of participants, including other partners and/or
members of his or her venture capital firm, executives in an existing portfolio company,
contacts within the field of specialty and budding entrepreneurs seeking venture capital.

At an early morning meeting, for example, there may be a firm-wide discussion of

potential portfolio investments. The due diligence team will present the pros and cons of
investing in the company. An "around the table" vote may be scheduled for the next day as
to whether or not to add the company to the portfolio.

An afternoon meeting may be held with a current portfolio company. These visits are
maintained on a regular basis in order to determine how smoothly the company is running
and whether the investment made by the venture capital firm is being utilized wisely. The
venture capitalist is responsible for taking evaluative notes during and after the meeting
and circulating the conclusions among the rest of the firm.

After spending much of the afternoon writing up that report and reviewing other market
news, there may be an early dinner meeting with a group of budding entrepreneurs who
are seeking funding for their venture. The venture capital professional gets a sense of what
type of potential the emerging company has, and determines whether further meetings
with the venture capital firm are warranted.

After that dinner meeting, when the venture capitalist finally heads home for the night,
they may take along the due diligence report on the company that will be voted on the next
day, taking one more chance to review all the essential facts and figures before the morning
meeting.

Trends in Venture Capital

The first venture capital funding was an attempt to kickstart an industry. To that end,
Doriot adhered to a philosophy of actively participating in the startup's progress. He
provided funding, counsel, and connections to entrepreneurs.

An amendment to the SBIC Act in 1958 led to the entry of novice investors, who provided
little more than money to investors. The increase in funding levels for the industry was
accompanied by a corresponding increase in the numbers for failed small businesses. Over
time, VC industry participants have coalesced around Doriot's original philosophy of
providing counsel and support to entrepreneurs building businesses.

Growth of Silicon Valley

Due to the industry's proximity to Silicon Valley, the overwhelming majority of deals
financed by venture capitalists are in the technology industry. But other industries have
also benefited from VC funding. Notable examples are Staples and Starbucks, which both
received venture money. Venture Capital is also no longer the preserve of elite firms.
Institutional investors and established companies have also entered the fray. For example,
tech behemoths Google and Intel have separate venture funds to invest in emerging
technology. Starbucks also recently announced a $100 million venture fund to invest in
food startups.
With an increase in average deal sizes and the presence of more institutional players in the
mix, venture capital has matured over time. The industry now comprises an assortment of
players and investor types who invest in different stages of a startup's evolution,
depending on their appetite for risk.

Hit From the 2008 Financial Crisis

The 2008 financial crisis was a hit to the venture capital industry because institutional
investors, who had become an important source of funds, tightened their purse strings. The
emergence of unicorns, or startups that are valued at more than a billion dollars, has
attracted a diverse set of players to the industry. Sovereign funds and notable private
equity firms have joined the hordes of investors seeking return multiples in a low-interest
rate environment and participated in large ticket deals. Their entry has resulted in changes
to the venture capital ecosystem.

Growth in Dollars
Data from the NVCA and PitchBook indicated that VC firms funded US$131 billion across
8949 deals in 2018. That figure represented a jump of more than 57% from the previous
year. But the increase in funding did not translate into a bigger ecosystem as deal count, or
the number of deals financed by VC money fell by 5%. Late-stage financing has become
more popular because institutional investors prefer to invest in less-risky ventures (as
opposed to early-stage companies where the risk of failure is high). Meanwhile, the share of
angel investors has remained constant or declined over the years.
 Private Equity
What is Private Equity?
Private equity is an alternative investment class and consists of capital that is not listed on
a public exchange. Private equity is composed of funds and investors that directly invest
in private companies, or that engage in buyouts of public companies, resulting in
the delisting of public equity. Institutional and retail investors provide the capital for
private equity, and the capital can be utilized to fund new technology, make acquisitions,
expand working capital, and to bolster and solidify a balance sheet.

A private equity fund has Limited Partners (LP), who typically own 99 percent of shares in
a fund and have limited liability, and General Partners (GP), who own 1 percent of shares
and have full liability. The latter are also responsible for executing and operating the
investment.

Understanding Private Equity

Private equity investment comes primarily from institutional investors and accredited
investors, who can dedicate substantial sums of money for extended time periods. In most
cases, considerably long holding periods are often required for private equity investments
in order to ensure a turnaround for distressed companies or to enable liquidity events such
as an initial public offering (IPO) or a sale to a public company.

Advantages of Private Equity

Private equity offers several advantages to companies and startups. It is favored by
companies because it allows them access to liquidity as an alternative to conventional
financial mechanisms, such as high interest bank loans or listing on public markets. Certain
forms of private equity, such as venture capital, also finance ideas and early stage
companies. In the case of companies that are de-listed, private equity financing can help
such companies attempt unorthodox growth strategies away from the glare of public
markets. Otherwise, the pressure of quarterly earnings dramatically reduces the time
frame available to senior management to turn a company around or experiment with new
ways to cut losses or make money.

Disadvantages of Private Equity

Private equity has unique challenges. First, it can be difficult to liquidate holdings in private
equity because, unlike public markets, a ready-made order book that matches buyers with
sellers is not available. A firm has to undertake a search for a buyer in order to make a sale
of its investment or company. Second, pricing of shares for a company in private equity is
determined through negotiations between buyers and sellers and not by market forces, as
is generally the case for publicly-listed companies. Third, the rights of private equity
shareholders are generally decided on a case-by-case basis through negotiations instead of
a broad governance framework that typically dictates rights for their counterparts in public
markets.

History of Private Equity

While private equity has garnered mainstream spotlight only in the last three decades,
tactics used in the industry have been honed since the beginning of last century. Banking
magnate JP Morgan is said to have conducted the first leveraged buyout of Carnegie Steel
Corporation, then among the largest producers of steel in the country, for $480 million in
1901. He merged it with other large steel companies of that time, such as Federal Steel
Company and National Tube, to create United States Steel – the world’s biggest company. It
had a market capitalization of $1.4 billion. However, the Glass Steagall Act of 1933 put an
end to such mega-consolidations engineered by banks.

Private equity firms mostly remained on the sidelines of the financial ecosystem after
World War II until the 1970s when venture capital began bankrolling America’s
technological revolution. Today’s technology behemoths, including Apple and Intel, got the
necessary funds to scale their business from Silicon Valley’s emerging venture capital
ecosystem at the time of their founding. During the 1970s and 1980s, private equity firms
became a popular avenue for struggling companies to raise funds away from public
markets. Their deals generated headlines and scandals. With greater awareness of the
industry, the amount of capital available for funds also multiplied and the size of an average
transaction in private equity increased.

When it took place in 1988, conglomerate RJR Nabisco’s purchase by Kohlberg, Kravis &
Roberts (KKR) for $25.1 billion was the biggest transaction in private equity history. It was
eclipsed 19 years later by the $45 billion buyout of coal plant operator TXU Energy.
Goldman Sachs and TPG Capital joined KKR in raising the required debt to purchase the
company during private equity’s boom years between 2005 and 2007. Even Warren Buffett
bought $2 billion worth of bonds from the new company. The purchase turned into a
bankruptcy seven years later and Buffett called his investment “a big mistake.”

The boom years for private equity occurred just before the financial crisis and coincided
with an increase in their debt levels. According to a Harvard study, global private equity
groups raised $2 trillion in the years between 2006 and 2008 and each dollar was
leveraged by more than two dollars in debt. But the study found that companies backed by
private equity performed better than their counterparts in the public markets. This was
primarily evident in companies with limited capital at their disposal and companies whose
investors had access to networks and capital that helped grow their market share.

In the years since the financial crisis, private credit funds have accounted for an increasing
share of business at private equity firms. Such funds raise money from institutional
investors, like pension funds, to provide a line of credit for companies that are unable to tap
the corporate bond markets. The funds have shorter time periods and terms as compared
to typical PE funds and are among the less regulated parts of the financial services industry.
The funds, which charge high interest rates, are also less affected by geopolitical concerns,
unlike the bond market.
How Does Private Equity Work?
Private equity firms raise money from institutional investors and accredited investors for
funds that invest in different types of assets. The most popular types of private equity
funding are listed below.

 Distressed funding: Also known as vulture financing, money in this type of funding
is invested in troubled companies with underperforming business units or assets.
The intention is to turn them around by making necessary changes to their
management or operations or make a sale of their assets for a profit. Assets in the
latter case can range from physical machinery and real estate to intellectual
property, such as patents. Companies that have filed under Chapter 11
bankruptcy in the United States are often candidates for this type of financing. There
was an increase in distressed funding by private equity firms after the 2008
financial crisis.
 Leveraged Buyouts: This is the most popular form of private equity funding and
involves buying out a company completely with the intention of improving its
business and financial health and reselling it for a profit to an interested party or
conducting an IPO. Up until 2004, sale of non-core business units of publicly listed
companies comprised the largest category of leveraged buyouts for private
equity. The leveraged buyout process works as follows. A private equity firm
identifies a potential target and creates a special purpose vehicle (SPV) for funding
the takeover. Typically, firms use a combination of debt and equity to finance the
transaction. Debt financing may account for as much as 90 percent of the overall
funds and is transferred to the acquired company’s balance sheet for tax benefits.
Private equity firms employ a variety of strategies, from slashing employee count to
replacing entire management teams, to turn around a company.
 Real Estate Private Equity: There was a surge in this type of funding after the 2008
financial crisis crashed real estate prices. Typical areas where funds are deployed
are commercial real estate and real estate investment trusts (REIT). Real estate
funds require higher minimum capital for investment as compared to other funding
categories in private equity. Investor funds are also locked away for several years at
a time in this type of funding. According to research firm Preqin, real estate funds in
private equity are expected to clock in a 50 percent growth by 2023 to reach a
market size of $1.2 trillion.
 Fund of funds: As the name denotes, this type of funding primarily focuses on
investing in other funds, primarily mutual funds and hedge funds. They offer a
backdoor entry to an investor who cannot afford minimum capital requirements in
such funds. But critics of such funds point to their higher management fees (because
they are rolled up from multiple funds) and the fact that unfettered diversification
may not always result in an optimal strategy to multiply returns.
 Venture Capital: Venture capital funding is a form of private equity, in which
investors (also known as angels) provide capital to entrepreneurs. Depending on
the stage at which it is provided, venture capital can take several forms. Seed
financing refers to the capital provided by an investor to scale an idea from a
prototype to a product or service. On the other hand, early stage financing can help
 an entrepreneur grow a company further while a Series A financing enables them to
actively compete in a market or create one.

How Do Private Equity Firms Make Money?

The primary source of revenue for private equity firms is management fees. The fee
structure for private equity firms typically varies but usually includes a management fee
and a performance fee. Certain firms charge a 2-percent management fee annually on
managed assets and require 20 percent of the profits gained from the sale of a company.

Positions in a private equity firm are highly sought after and for good reason. For example,
consider a firm has $1 billion in assets under management (AUM). This firm, like the
majority of private equity firms, is likely to have no more than two dozen investment
professionals. The 20 percent of gross profits generates millions in firm fees; as a result,
some of the leading players in the investment industry are attracted to positions in such
firms. At a mid-market level of $50 to $500 million in deal values, associate positions are
likely to bring salaries in the low six figures. A vice president at such a firm could
potentially earn close to $500,000, whereas a principal could earn more than $1 million.

KEY TAKEAWAYS

 Private equity is an alternative form of private financing, away from public markets,
in which funds and investors directly invest in companies or engage in buyouts of
such companies.
 Private equity firms make money by charging management and performance fees
from investors in a fund.
 Among the advantages of private equity are easy access to alternate forms of capital
for entrepreneurs and company founders and less stress of quarterly performance.
Those advantages are offset by the fact that private equity valuations are not set by
market forces.
 Private equity can take on various forms, from complex leveraged buyouts to
venture capital.

Concerns Around Private Equity

Beginning in 2015, a call was issued for more transparency in the private equity industry
due largely to the amount of income, earnings, and sky-high salaries earned by employees
at nearly all private equity firms. As of 2016, a limited number of states have pushed for
bills and regulations allowing for a bigger window into the inner workings of private equity
firms. However, lawmakers on Capitol Hill are pushing back, asking for limitations on the
Securities and Exchange Commission’s (SEC) access to information.
 White Knight
What Is a White Knight?
A white knight is a hostile takeover defense whereby a 'friendly' individual or company
that acquires a corporation at fair consideration that is on the verge of being taken over by
an 'unfriendly' bidder or acquirer, who is known as the black knight. Although the target
company does not remain independent, acquisition by a white knight is still preferred to
the hostile takeover.

Unlike a hostile takeover, current management typically remains in place in a white knight
scenario, and investors receive better compensation for their shares.

KEY TAKEAWAYS

 A white knight is a hostile takeover defense whereby a friendly company purchases

the target company instead of the unfriendly bidder.
 While the target company still loses its independence, the white knight investor is
nonetheless more favorable to shareholders and management.
 A white knight is just one of several strategies that a company can employ to try to
avert a hostile takeover.

How a White Knight Defense Works

The white knight is the savior of a company subject to a hostile takeover. Often, company
officials seek out a white knight to preserve the company's core business or to negotiate
better takeover terms. An example of the former can be seen in the movie "Pretty Woman"
when corporate raider/black knight Edward Lewis, played by Richard Gere, had a change
of heart and decided to work with the head of a company he'd originally planned to
ransack.

Some notable examples of white knight rescues are United Paramount Theaters 1953
acquisition of the nearly bankrupt ABC, Bayer's 2006 white knight rescue of Schering from
Merck KGaA, and JPMorgan Chase's 2008 acquisition of Bear Stearns that prevented their
complete insolvency.

The terms white knight and black knight can find their origin the adversarial game of chess.
A white squire is similarly an investor or friendly company which buys a stake in a target
company to prevent a hostile takeover. This is akin to a white knight defense, except here
the target firm does not have to give up its independence as it does with the white knight,
because the white squire only buys a partial share in the company.

Hostile Takeovers
A few of the most hostile takeover situations include AOL's $162 billion purchase of Time
Warner in 2000, Sanofi-Aventis' $20.1 billion purchase of biotech company Genzyme in
2010, Deutsche Boerse AG's blocked $17 billion merger with NYSE Euronext in 2011, and
Clorox's rejection of Carl Icahn's $10.2 billion takeover bid in 2011.
Successful hostile takeovers, however, are rare; no takeover of an unwilling target has
amounted to more than $10 billion in value since 2000. Mostly, an acquiring company
raises its price per share until shareholders and board members of the targeted company
are satisfied. It is especially hard to purchase a large company that does not want to be
sold. Mylan, a global leader in generic drugs, experienced this when it unsuccessfully
attempted to purchase Perrigo, the world's largest producer of drugstore-brand products,
for $26 billion in 2015.

Variations on the White Knight

In addition to white knights and black knights, there is a third potential takeover candidate
called a gray knight. A gray/grey knight is not as desirable as a white knight, but it is more
desirable than a black knight. The gray knight is the third potential bidder in a hostile
takeover who outbids the white knight. Although friendlier than a black knight, the gray
knight still seeks to serve its own interests. Similar to the white knight, a white squire is an
individual or company that only exercises a minority stake to aide a struggling
company. This aide provides the company with enough capital to improve its situation
while allowing the current owners to maintain control. A yellow knight is a company that
was planning a hostile takeover attempt, but backs out of it and instead proposes
a merger of equals with the target company.
 De Facto Merger
What is de facto merger?

Transaction that is not declared as a merger but effects acquisition of one firm's assets
and/or voting stock by another firm. Courts may consider it as a statutory merger for the
purposes of the combined firm's appraisal, shareholder voting rights, and other such
matters.

The de facto merger doctrine states that courts will look to substance over form when
determining whether statutory merger law applies to a company's shareholders. Thus,
where an asset acquisition leads to the same result as a statutory merger,
these jurisdictions demand that shareholders are given the same rights as in the statutory
merger. The doctrine was primarily established in Farris v. Glen Alden Corp., 143 A.2d 25
(Pa. 1958)
Since the establishment of the doctrine in Pennsylvania, many courts have adopted their
own versions of the doctrine or rejected it. The de facto merger in application allows courts
to declare the nature of a transaction stated as a sale-of-assets into a merger; therefore, all
rights and liabilities attached to a statutory merger would be applied.

Considerations
The three primary considerations to the doctrine are in reference to the corporation,
shareholders and third parties involved.
Corporate law scholars argue against the ability of legislature to change transactions that
add greater and unforeseen debts and obligations. This ability doesn’t allow for proper
planning, certainty and predictability, of agreements to assure effective transactions.
Other scholars still argue in favor of the doctrine to protect shareholders. Statutory
mergers give shareholders exit rights, such as appraisal rights. Frequently in a sale-of-
assets, shareholders in a privately traded company may have no option but to sell shares to
a new corporation that they do not support the merger with.
Liability of the successor corporation, in reference to third parties, is another
consideration. In a sale-of-assets debt, present and possible, stay with the old corporation
instead of transferring, even if the purchasing corporation continues similar business.
“Third parties with a claim against the dissolving corporation lose the opportunity to bring
suit if successor liability does not attach.”

Factors of differing application by courts

Most courts, particularly in Delaware, have rejected the de facto merger doctrine and refuse
to imply merger-type protection in these cases. See Hariton v. Arco Electronics, Inc., 182
A.2d 22 (Del. Ch. 1962), aff'd, 188 A.2d 123 (Del. 1963) (relying on the independent legal
significance doctrine).
Delaware will acknowledge a de facto merger “when a corporation misinterprets or
misapplies the sale of assets statutes” See Orzeck v. Englehart, 195 A.2d 375, 378 (Del.
1963)
The states that do apply the doctrine typically, but not exclusively, have four primary tests
to judge its usage. Some courts require only one factor, others require all, and others still
have entirely different factors when deciding if a transaction is a de facto merger.
Factors:
(1) continuity of ownership [or continuity of shareholders]; (2) cessation of the ordinary
business and dissolution of the predecessor as soon as practically and legally possible; (3)
assumption by the successor of liabilities ordinarily necessary for uninterrupted
continuation of the business of the predecessor; and (4) a continuity of [enterprise,
including] management, personnel, physical location, aspects, and the general business
operation.
 Why do a reverse merger instead of an IPO?
A reverse merger (also sometimes called a reverse takeover or a reverse IPO) is often the
most expedient and cost-efficient way for a private company that holds shares that are not
available to the public to begin trading on a public stock exchange. Prior to the rise in the
popularity of reverse mergers, the vast majority of public companies were created through
the initial public offering (IPO) process.

In a reverse merger, an active private company takes control and merges with a
dormant public company. These dormant public companies are called "shell corporations"
because they rarely have assets or net worth aside from the fact that they previously had
gone through an IPO or alternative filing process.

It can take a company from just a few weeks to up to four months to complete a reverse
merger. By comparison, the IPO process can take anywhere from six to 12 months. A
conventional IPO is a more complicated process and tends to be considerably more
expensive, as many private companies hire an investment bank to underwrite and
market shares of the soon-to-be public company.

Reverse mergers allow owners of private companies to retain greater ownership and
control over the new company, which could be seen as a huge benefit to owners looking to
raise capital without diluting their ownership.

Benefits of a Reverse Merger

In most cases, a reverse merger is solely a mechanism to convert a private company into a
public entity without the need to appoint an investment bank or to raise capital. Instead,
the company aims to realize any inherent benefits of becoming a publicly listed company,
including enjoying greater liquidity.

There may also be an opportunity to take advantage of greater flexibility with alternative
financing options when operating as a public company.

The reverse merger process is also usually less dependent on market conditions. If a
company has spent months preparing a proposed offering through traditional IPO channels
and the market conditions become unfavorable, it can prevent the process from being
completed. The result is a lot of wasted time and effort. By comparison, a reverse merger
minimizes the risk, as the company is not as reliant on raising capital.

The expediency and lower cost of the reverse merger process can be beneficial to smaller
companies in need of quick capital. Additionally, reverse mergers allow owners of private
companies to retain greater ownership and control over the new company, which could be
seen as a huge benefit to owners looking to raise capital without diluting their
ownership. For managers or investors of private companies, the option of a reverse merger
could be seen as an attractive strategic option.
Special Considerations
One of the risks associated with a reverse merger stems from the potential unknowns
the shell corporation brings to the merger. There are many legitimate reasons for a shell
corporation to exist, such as to facilitate different forms of financing and to enable large
corporations to offshore work in foreign countries.

However, some companies and individuals have used shell corporations for various
illegitimate purposes. This includes everything from tax evasion, money laundering, and
attempts to avoid law enforcement. Prior to finalizing the reverse merger, the managers of
the private company must conduct a thorough investigation of the shell corporation to
determine if the merger brings with it the possibility of future liabilities or legal
entanglements.
 Reverse Mergers: Advantages and Disadvantages
A reverse merger is a way for private companies to go public and while they can be an
excellent opportunity for investors, there are cons in addition to the pros.

KEY TAKEAWAYS

 A reverse merger is an attractive strategic option for managers of private companies

to gain public company status.
 It is a less time-consuming and less costly alternative to the conventional IPO.
 As a public company, management can enjoy greater flexibility in terms of financing
alternatives, and the company's investors can also enjoy greater liquidity.
 Managers should be cognizant of the additional compliance burdens faced by public
companies, and ensure that sufficient time and energy continues to be devoted to
running and growing the business.
 It requires being a strong company with robust prospects to attract sufficient
analyst coverage, as well as prospective investor interest. Pulling in these elements
can increase the value of the stock and its liquidity for shareholders.

Reverse Mergers: An Overview

Reverse mergers are typically through a simpler, shorter, and less expensive process than
that of a conventional initial public offering (IPO), in which private companies hire
an investment bank to underwrite and issue shares of the new soon-to-be public entity.
They are also commonly referred to as reverse takeovers or reverse IPOs.

Aside from filing the regulatory paperwork and helping authorities review the deal, the
bank also helps to establish interest in the stock and provide advice on appropriate initial
pricing. The traditional IPO necessarily combines the go-public process with the capital-
raising function. A reverse merger separates these two functions, making it an attractive
strategic option for corporate managers and investors alike.

In a reverse merger, investors of the private company acquire a majority of the shares of a
public shell company, which is then combined with the purchasing entity. Investment
banks and financial institutions typically use shell companies as vehicles to complete these
deals. These simple shell companies can be registered with the Securities and Exchange
Commission (SEC) on the front end (prior to the deal), making the registration process
relatively straightforward and less expensive. To consummate the deal, the private
company trades shares with the public shell in exchange for the shell's stock, transforming
the acquirer into a public company.

Advantages of Reverse Mergers

A Simplified Process
Reverse mergers allow a private company to become public without raising capital, which
considerably simplifies the process. While conventional IPOs can take months (even over a
calendar year) to materialize, reverse mergers can take only a few weeks to complete (in
some cases, in as little as 30 days). This saves management a lot of time and energy,
ensuring that there is sufficient time devoted to running the company.

Minimizes Risk
Undergoing the conventional IPO process does not guarantee that the company will
ultimately go public. Managers can spend hundreds of hours planning for a traditional IPO.
But if stock market conditions become unfavorable to the proposed offering, the deal may
be canceled, and all of those hours will have become a wasted effort. Pursuing a reverse
merger minimizes this risk.

Less Dependent on Market Conditions

As mentioned earlier, the traditional IPO combines both the go-public and capital-raising
functions. As the reverse merger is solely a mechanism to convert a private company into a
public entity, the process is less dependent on market conditions (because the company is
not proposing to raise capital). Since a reverse merger functions solely as a conversion
mechanism, market conditions have little bearing on the offering. Rather, the process is
undertaken in order to attempt to realize the benefits of being a public entity.

Benefits of a Public Company

Private companies—generally those with $100 million to several hundred million in
revenue—are usually attracted to the prospect of going public. Once this happens, the
company's securities are traded on an exchange and thus enjoy greater liquidity. The
original investors gain the ability to liquidate their holdings, providing a convenient exit
alternative to having the company buy back their shares. The company has greater access
to capital markets, as management now has the option of issuing additional stock
through secondary offerings. If stockholders possess warrants—giving them the right to
purchase additional stock at a pre-determined price—the exercise of these options
provides additional capital infusion into the company.

Public companies often trade at higher multiples than private companies. Significantly
increased liquidity means that both the general public and institutional investors (and
large operational companies) have access to the company's stock, which can drive its price.
Management also has more strategic options to pursue growth, including mergers and
acquisitions.

As stewards of the acquiring company, they can use company stock as the currency with
which to acquire target companies. Finally, because public shares are more liquid,
management can use stock incentive plans in order to attract and retain employees.

As in all merger deals, the risk goes both ways. Both managers of the company and
investors need to conduct due diligence.
Disadvantages of a Reverse Merger
Due Diligence Required
Managers must thoroughly vet the investors of the public shell company. What are their
motivations for the merger? Have they done their homework to make sure the shell is clean
and not tainted? Are there pending liabilities (such as those stemming from litigation) or
other "deal warts" hounding the public shell? If so, shareholders of the public shell may
merely be looking for a new owner to take possession of these problems. Thus,
appropriate due diligence should be conducted, and transparent disclosure should be
expected (from both parties).

Investors of the public shell should also conduct reasonable diligence on the private
company, including its management, investors, operations, financials, and possible pending
liabilities (i.e., litigation, environmental problems, safety hazards, and labor issues).

Risk Stock Will Be Dumped

If the public shell's investors sell significant portions of their shares right after the merger,
this can materially and negatively affect the stock price. To reduce or eliminate the risk that
the stock will be dumped, clauses can be incorporated into a merger agreement,
designating required holding periods.

No Demand for Shares Post Merger

After a private company executes a reverse merger, will its investors really obtain
sufficient liquidity? Smaller companies may not be ready to be a public company. There
may be a lack of operational and financial scale. Thus, they may not attract analyst coverage
from Wall Street. After the reverse merger is consummated, the original investors may find
out that there is no demand for their shares. Reverse mergers do not replace
sound fundamentals. For a company's shares to be attractive to prospective investors, the
company itself should be attractive operationally and financially.

Regulatory and Compliance Burden

A potentially significant setback when a private company goes public is that managers are
often inexperienced in the additional regulatory and compliance requirements of being a
publicly-traded company. These burdens (and costs in terms of time and money) can prove
significant, and the initial effort to comply with additional regulations can result in a
stagnant and underperforming company if managers devote much more time to
administrative concerns than to running the business.

To alleviate this risk, managers of the private company can partner with investors of the
public shell who have experience in being officers and directors of a public company. The
CEO can additionally hire employees (and outside consultants) with relevant compliance
experience. Managers should ensure that the company has the administrative
infrastructure, resources, road map, and cultural discipline to meet these new
requirements after a reverse merger.
 Back Door Listing
What Is a Back Door Listing?
A back door listing is one way for a private company to go public if it doesn't meet the
requirements to list on a stock exchange. Essentially, the company gets on the exchange by
going through a back door. This process is sometimes referred to as a reverse
takeover, reverse merger, or reverse IPO.

How Does a Back Door Listing Work?

By going through a back door listing, the private company avoids the public offering
process and gains automatic inclusion on a stock exchange. Following the acquisition, the
buyer may merge both companies' operations or, alternatively, create a shell
corporation that allows the two companies to continue operations independent of each
other.

Although not as prevalent, a private company will sometimes engage in a back door listing
simply to avoid the time and expense of engaging in an IPO.

Benefits of a Back Door Listing

One of the major upsides of going through a back door listing is that it is considered a cost-
effective measure for a private firm to go public. Because it can strike up a deal with an
already public company, it doesn't have to go through the expenses of regulatory filings or
funding to go public.

Private firms may also inject life into a troubled company without the need to raise more
money from the market. Not only does this bring a new set of people to the table, but it may
also bring new technology, products, and marketing ideas.

There is also some upside for existing stock owners. Shareholders in the target company
may also get some cash for the deal. If the merger is successful and the two companies'
synergy is compatible, it may mean added value for the new entity's shareholders as well.

Downsides of Back Door Listings

As with any other process, there are also disadvantages to undergoing a back door listing.
Since it doesn't happen very often, it may be cumbersome to explain to shareholders,
leaving them confused and upset.

This process can also lead to new shares being issued for the incoming private company.
This leads to share dilution, which can decrease existing shareholders' ownership and
value in the company.

While a back door listing may help boost a failing public company's bottom line, it can have
the reverse effect as well. If the two companies don't have a natural fit, it may hurt profits
in the end.
Finally, depending on which country the listing is in, trading of the listed company can be
halted or suspended until the merger is fully executed.

Example of a Back Door Listing

Say a small private firm wants to go public but it just doesn't have the resources to do so. It
may decide to buy out an already publicly-traded company to meet the requirements. The
company would need a lot of cash on hand in order to make this possible.

Let's take a hypothetical example of two companies—Company A and Company B. Through

its shareholders, Company A (the private company) buys control of Company B. Company
A's shareholders will then control B's Board of Directors.

Once the transaction is complete, the merger is negotiated and executed. Company B will
then issue a majority of its shares to Company A. Company A will then start to do business
under Company B's name and merge the operations of both. In some cases, as noted above,
Company A may open up a shell corporation and keep the two operations separate.

One of the biggest examples of a back door listing was when the New York Stock
Exchange (NYSE) acquired Archipelago Holdings. In 2006, the two agreed to a $10 billion
deal and created the NYSE Group. Archipelago was one of the exchange's main competitors,
despite the fact that it offered trading services electronically, compared to the open outcry
system of the NYSE.
 Shell Corporation
What Is a Shell Corporation?
A shell corporation is a corporation without active business operations or significant
assets. These types of corporations are not all necessarily illegal, but they are sometimes
used illegitimately, such as to disguise business ownership from law enforcement or the
public. Legitimate reasons for a shell corporation include such things as a startup using the
business entity as a vehicle to raise, funds, conduct a hostile takeover or to go public.

Understanding Shell Corporation

Shell corporations are used by large well-known public companies, shady business dealers
and private individuals alike. For example, in addition to the legal reasons above, shell
corporations act as tax avoidance vehicles for legitimate businesses, as is the case with
Apple's corporate entities based in the United Kingdom. They are also used to obtain
different forms of financing.

However, tax avoidance is sometimes seen as a loophole to tax evasion, as these

corporations have been known to be used in black or gray market activities. It's natural to
be suspicious of a shell corporation and it's important to understand the various scenarios
in which they arise.

Reasons to Legitimately Set Up a Shell Corporation

The number one reason for a domestic company to set up a shell company is to realize a tax
haven abroad. Large corporations, like in the Apple example, have decided to move jobs
and profits offshore, taking advantage of looser tax codes. This is the process of
"offshoring" or "outsourcing" work that was once conducted domestically.

To remain within legal bounds internationally, American corporations will set up shell
companies in the foreign countries in which they are offshoring work. This is legally
allowed by the United States and some say that it's the U.S. tax code itself that's forcing
domestic companies to create shell corporations abroad.

Another way that shell companies help with taxes surrounds the need for financial
institutions to conduct financial activity in foreign markets. This allows them to invest
in capital markets outside of domestic borders and realize potential tax savings.

Ways That People Abuse Shell Companies

Even though there are legitimate reasons to set up a shell company, many wealthy
individuals abuse shell companies for personal gain. Progressive taxation within the United
States, that is, tax brackets, slowly caused people to seek personal tax havens. Significantly
high earners set themselves up as shell companies in one or many locations, like the
Cayman Islands. This is a gray area of tax evasion where people funnel earnings through
shell companies in such a way that it isn't counted toward personal income.
 Shelf registration
Shelf registration is a procedure, included in the regulation that a corporation can evoke to
comply with U.S. Securities and Exchange Commission (SEC) registration requirements for
a new stock offering up to two years before doing the actual public offering. However, the
corporation must still file the required annual and quarterly reports with the SEC. Shelf
registration is formally known as SEC Rule 415.

Breaking Down Shelf Registration

Shelf registration is a method for publicly traded companies to register new stock offerings
without having to issue them immediately. Instead, the securities can be issued at any time
within a two-year period, allowing a company to adjust the timing of the sales to take
advantage of more favorable market conditions should they arise.

Sometimes current market conditions are not favorable for a specific firm to issue a public
offering. For example, suppose the housing market is heading toward a dramatic decline. In
this case, it may not be a good time for a home builder to come out with its second offering,
as many investors will be pessimistic about companies in that sector. By using shelf
registration, the firm can fulfill all registration-related procedures beforehand and go
public quickly when conditions become more favorable.

Issuer Advantages
Once shelf registration is complete, the only other SEC requirements revolve around
standard reporting. The issuing company can adjust the release of the securities depending
on variances in comparable market areas. If the market is expected to be unfavorable for a
period of time, the issuer is not obligated to release the securities as long as time still exists
within the two-year window.

The company maintains any unissued shares; the shares fall into the category of treasury
shares. Since they are not seen as outstanding, they are not included in calculations used to
determine statistics like earnings per share. Even though they are not issued, investor
awareness of the existence of the pending shares can affect current market sentiment and
activity.

Administrative Advantages
If a company has a long term new security issuing plan, the process of shelf registration
allows it to address multiple issues of a particular security within a single registration
statement. This can be simpler to create and manage, since multiple filings are not
required, lowering administrative costs for the business as a whole. Further, no
maintenance requirements exist beyond standard reporting, because shelf registrations do
not create an additional burden while they are waiting for issue.

Company Use of Shelf Registrations

SafeStitch Medical Inc. (formerly TransEnterix), a manufacturer of robotic surgical
technology, used shelf registration to prepare new offerings to correspond with launch
plans of a new product. When shelf registrations were expanded pursuant to the release of
a new product line, the market responded with a 10% increase in share value. Even though
the risk of share dilution was present, the market responded to the favorable news
regarding the pending technological advancement.
 Going Private
What Is Going Private?
The term going private refers to a transaction or series of transactions that convert
a publicly traded company into a private entity. Once a company goes private,
its shareholders are no longer able to trade their shares in the open market.

There are several types of going private transactions, including private equity buyouts,
management buyouts, and tender offers.

KEY TAKEAWAYS

 A going private transaction is one in which a public company is converted into

private ownership.
 Common examples include private equity buyouts, management buyouts, and
tender offers.
 Many going private transactions involve significant amounts of debt.
 The assets and cashflows of the acquired company are used to pay for those debts.

How Going Private Works

A company typically goes private when its shareholders decide that there are no longer
significant benefits to being a public company.

One way for this transition to occur is for the company to be acquired through a private
equity buyout. In this transaction, a private equity firm will buy a controlling share in the
company, often leveraging significant amounts of debt. In doing so, the private equity firm
secures these debts against the assets of the company being acquired. The interest and
principal payments on the debt are then paid for using the cashflows from the business.

Another common method is the management buyout transaction, in which the company is
taken private by its own management team. The structure of a management buyout is
similar to that of a private equity buyout, in that both rely on large amounts of debt.
However, unlike a private equity buyout, a management buyout is undertaken by “insiders”
who are already intimately familiar with the business.

In some cases, going private transactions will also involve seller financing, in which the
owners of the company (in this case, the shareholders of the publicly traded corporation)
help the new buyers finance the purchase. In practice, this generally consists of allowing
the buyer to delay payment of a portion of the purchase price for some period of time, such
as five years.

Many going private transactions involve significant amounts of debt. In these situations, the
assets of the acquired company are used as collateral for the loans, and its cashflows are
used to pay for debt servicing.
Another common example of going private transactions is a tender offer. This occurs when
a company or individual makes a public offer to buy most or all of a company’s shares. At
times, tender offers are made (and accepted) even when the current management team of
the target company does not want the company to be sold. In this situation, the tender offer
is referred to as a hostile takeover.

Because the entity putting forward the tender offer can be a public corporation, tender
offers are often financed using a mixture of cash and shares. For example, Company A
might make a tender offer to Company B in which the shareholders of Company B would
receive 80% of the offer in cash and 20% in shares of Company A.

Real World Example of a Going Private Transaction

In December 2015, the private-equity group JAB Holding Company announced its plans to
acquire Keurig Green Mountain. Unlike many private-equity buyouts, this was an all-cash
offer.

The offer priced the shares at $92, a nearly 80% premium over their market value prior to
the announcement. Unsurprisingly, share prices rose dramatically following the
announcement and the company accepted the offer shortly thereafter.

The transaction was completed in March of the following year. Accordingly, the company’s
shares ceased trading on the stock market and Keurig Green Mountain became a private
company.
 Underwriter
What Is an Underwriter?
An underwriter is any party that evaluates and assumes another party's risk for a fee. The
fee is often a commission, premium, spread, or interest. Underwriters are critical to the
financial world including the mortgage industry, insurance industry, equity markets,
and common types of debt security trading. A lead underwriter is called a book runner.

According to the U.S. Bureau of Labor Statistics, employment of insurance underwriters is

projected to decline 5% from 2016 to 2026.

Underwriter
The Different Types of Underwriters
The term "underwriter" first emerged in the early days of marine insurance. Shipowners
sought insurance for a ship and its cargo in case the ship and its contents were lost.
Businessmen would meet in coffeehouses and examine a paper describing the ship, its
contents, crew, and destination.

Each person who wished to assume some of the obligation or risk would sign their name at
the bottom and indicate how much exposure they were willing to assume. An agreed-upon
rate and terms were set out in the paper. These signees became known as underwriters.

Underwriters play a variety of specific roles depending on the context. Underwriters are
considered the risk experts of the financial world. Investors rely on them because they
determine if a business risk is worth taking. Underwriters also contribute to sales-type
activities; for example, in the case of an initial public offering (IPO), the underwriter might
purchase the entire IPO issue and sell it to investors.

Underwriters don't always purchase IPO-issued stock or guarantee a certain price for it.
They only promise to use best efforts to sell the issue to the public at the best possible
price.

Mortgage Underwriters
The most common type of underwriter is a mortgage loan underwriter. Mortgage loans are
approved based on a combination of an applicant's income, credit history, debt ratios, and
overall savings.

Mortgage loan underwriters ensure that a loan applicant meets all of these requirements,
and they subsequently approve or deny a loan. Underwriters also review a property's
appraisal to ensure that it is accurate and the home is approximately worth the purchase
price and loan amount.

Mortgage loan underwriters have final approval for all mortgage loans. Loans that are not
approved can go through an appeal process, but the decision requires overwhelming
evidence to be overturned.
Agents and brokers represent both consumers and insurance companies, while underwriters
work for insurance companies.

Insurance Underwriters
Insurance underwriters, much like mortgage underwriters, review applications for
coverage and accept or reject an applicant based on risk analysis. Insurance brokers and
other entities submit insurance applications on behalf of clients, and insurance
underwriters review the application and decide whether or not to offer insurance coverage.

Additionally, insurance underwriters advise on risk management issues, determine

available coverage for specific individuals, and review existing clients for continued
coverage analysis.

Equity Underwriters
In equity markets, underwriters administer the public issuance and distribution of
securities—in the form of common or preferred stock—from a corporation or other issuing
body. Perhaps the most prominent role of an equity underwriter is in the IPO process. An
IPO is the process of selling shares of a previously private company on a public stock
exchange for the first time.

IPO underwriters are financial specialists who work closely with the issuing body to
determine the initial offering price of the securities, buy the securities from the issuer, and
sell the securities to investors via the underwriter's distribution network.

IPO underwriters are typically investment banks that have IPO specialists on staff. These
investment banks work with a company to ensure that all regulatory requirements are
satisfied. The IPO specialists contact a large network of investment organizations, such as
mutual funds and insurance companies, to gauge investment interest. The amount of
interest received by these large institutional investors helps an underwriter set the IPO
price of the company's stock. The underwriter also guarantees that a specific number of
shares will be sold at that initial price and will purchase any surplus.

Debt Security Underwriters

Underwriters purchase debt securities, such as government bonds, corporate bonds,
municipal bonds, or preferred stock, from the issuing body (usually a company or
government agency) to resell them for a profit. This profit is known as the "underwriting
spread."

An underwriter may resell debt securities either directly to the marketplace or to dealers,
who will sell them to other buyers. When the issuance of a debt security requires more
than one underwriter, the resulting group of underwriters is known as an underwriter
syndicate.

Automated underwriting has reduced the need for underwriters.

KEY TAKEAWAYS

 Underwriters are the risk experts of the financial world.

 The term underwriter first emerged in the early days of marine insurance when
businessmen agreed to assume some of the risk of shipments during transport.
 Underwriters are critical to the mortgage industry, insurance industry, equity
markets, and common types of debt security trading.