Control premiums: some theory

Let's speak in broad theoretical terms for a day. In a classic "hostile takeover," some outside entrepreneur decides that the target corporation has valuable assets which are being incompetently managed. This suggests an arbitrage play -- acquire the corporation, and with it both (a) the assets and (b) the ability to fire the incompetent managers.

By hypothesis, the acquired company will be of greater value with the new bosses, and the market price of the stock will soon reflect that higher value. So in the imagery of the old west, our entrepreneur, having ridden into town on a capital-markets horse and installed the new sheriff, sells his interest in the town for a profit, and rides back out.

The problem is that its difficult to sneak up on a town/company like that. The increase in the company stock price might come too soon. Suppose a particular turn-around artist has gained a reputation for previous gun-slinging escapades of this sort. When he starts buying stock in a new company, other market participants, checking with EDGAR, learn of this and the stock becomes more valuable immediately on the expectation that he'll continuing buying and then work his magic.

Or it becomes more valuable simply because even market participants not especially impressed by this gunslinger's reputation decide to hold out for a higher price to see if he'll pay it.

For either or both reasons, he'll end up paying a hefty "control premium" before he can install a new sheriff/management.

This, of course, raises the bar for the new management. In order for the entrepreneur to profit, it isn't enough for the new bosses to be better than the old boss. They have to be SUFFICIENTLY better to justify the control premium he's already paid. And then some.

Not surprisingly, then, there's a lot of interest in developing ways to take over the control of a company without paying a control premium.

From one point of view, waging a proxy battle for control of the board of directors is exactly that.

As Milton Friedman said, though: there ain't no such thing as a free lunch. Proxy fights have their own expenses and risks.

All of this has been by way of illuminating my comment yesterday that (a) CNET had created a new poison pill for itself to ward off a takeover attempt and (b) that the real battle will be on the proxy front and related litigation.

CNET's present governance structure involved staggered board terms. This year, only two of the incumbents will stand for re-election. That's not enough to change control othe company. Still, on January 7, New York based hedge fund JANA Partners announced that it will nominate Paul Gardi and Santo Politi for those two seats.

Also, JANA announced it will seek an expansion of the size of the board of directors from eight to 13. This is the "loophole" I mentioned yesterday. If it can get that increase, then the company will have to hold an election for the five newly created seats as well as for the two common up for a vote anyway. Seven seats on the hypothetical board of 13 will of course be a majority.

Will CNET have to hold an election for seven seats, or only for two? We'll go a bit further into this question tomorrow.