Lockups(2) are an increasingly important element of M&A deals in the United States. In friendly U.S. mergers greater than $50 million in value, lockups appeared in 80% of deals in 1998, compared to 40% of deals a decade ago.(3) Despite growing importance in practice, lockups have been largely misunderstood in the academic literature. Prior theories have failed to fully incorporate the tools of agency theory or behavioral economics. They have not fully considered real-world factors such as tax effects, informational effects, switching costs, and reputational effects. Moreover, prior theories have not been tested against the available empirical evidence to assess their predictive (or even descriptive) power. This article attempts to address these gaps in our understanding of lockups. In doing so it arrives at substantially different conclusions regarding the role of lockups in the market for corporate control.
M&A transactions involving public company targets face a (law-derived) risk of non-consummation that is unique (or at least rare) in three respects: (1) the law requires that shareholders of the target be given some opportunity to decide for themselves whether to accept or approve the transaction; (2) compliance with disclosure and other rules regulating the process of obtaining target shareholder acceptance or approval entails delay, ranging from a minimum of thirty days up to six months in some situations; and (3) shareholders may decide not to accept or approve the transaction for any reason, including a third-party bid that emerges after agreements for the initial transaction are signed.(4) In effect, an M&A agreement gives shareholders of a public company target the option to accept the deal, and does not effectively bind the target (or its shareholders) to the deal.(5) Lockups have emerged as a second-best way for bidders to protect their expectancy interests in the transaction. Even if bidders cannot be sure to consummate a deal for a given target, they can at least get the consolation prize of a lockup payout.
Prior lockup scholarship has been premised on several problematic assumptions relating to the "buy-side" of M&A transactions. First, it has made the implicit assumption that bidders are monolithic, and bidder managers, by extension, are perfect agents for their shareholders. Buy-side agency costs have been ignored. Second, prior scholarship has ignored tax effects and the additional information that bidders gain from the decisions of other bidders. Third, prior scholarship has implicitly assumed that bidders can costlessly abandon an acquisition strategy whenever the expected value of a lockup payout exceeds the ex ante expected value of completing the deal. Fourth, prior scholarship has treated lockup decisions in a static, single-period model, without considering the effect of accepting a lockup payout on bidder reputation. Finally, prior scholarship has treated bidder managers as perfectly rational actors, and has neglected even the most basic and robust findings of cognitive psychology in predicting how lockups might affect bid outcomes.
In addition, prior scholarship has been almost entirely uninformed by statistical evidence.(6) At best, it has been built on armchair empiricism. None of the many conflicting positive predictions implicit in prior scholarship has been tested in a rigorous way. Despite the theoretical gaps in prior scholarship, and despite the lack of empirical scholarship, prior scholarship has also been uniformly normative in nature. Scholars have offered prescriptions ranging from a near-complete ban on lockups(7) to near-complete judicial deference to manager decisions on lockups.(8) Yet because of the lack of empirical testing, scholars have had no valid basis even for the implicit assumption that legal rules on lockups affect bidder strategy, target behavior, or bid outcomes.
This article attempts to address both the theoretical and empirical gaps in prior scholarship. After presenting evidence that Delaware case law strongly shapes lockup decisions, we present and test the theoretical models put forward by Ayres,(9) Fraidin and Hanson,(10) and Kahan and Klausner(11) against the available empirical evidence. We find that these models are inadequate in explaining the impact of lockups on bidder behavior and, more generally, on the market for corporate control.
We then extend the standard model by introducing buy-side agency costs, tax effects, information effects, switching costs, reputational effects, and endowment effects. Including these elements allows us to explain two features of lookups that are unexplained (and unidentified) by prior work:
(1) lockups substantially increase the likelihood that an initial bid will be consummated, and thus are likely to affect allocational efficiency; and
(2) stock lookups, often thought to raise more troublesome issues than breakup fees, are less likely to affect bid outcomes than fees of the same expected value.
Throughout, we are able to rely on two types of evidence on lockups. First, we draw upon interviews with leading M&A practitioners to develop a better picture than exists at present of the way that Delaware law has shaped and continues to shape the choice, use, and effects of lockups.(12) Second, we construct a large sample of friendly merger bids that allows us to test--and in large measure confirm--our specific predictions on lockup design, incidence, and effect.
The remainder of the article proceeds as follows. Part I summarizes trends and statistics on lockup incidence and design, and presents evidence that lookup choice is responsive--indeed, "overresponsive" in a sense--to Delaware case law.(13) Part II reviews prior models of lockups and tests these models against the available empirical data. Part III sets out our theoretical extension and presents evidence that this new model better explains available data. Part IV concludes with implications for both court scrutiny of lockups and decisions about lockups by directors of bidders and targets.
DESCRIPTIVE STATISTICS ON LOCKUP INCIDENCE AND DESIGN
Three types of lockups can be distinguished.(14) Stock lockups give the acquirer a call option on a specified number of shares of the target at a specified strike price. Asset lockups give the acquirer a call option on certain assets of the target at a specified price. Breakup fees give the acquirer a cash payment from the target if a specified event occurs.(15) An acquirer's rights under each type of lockup are "triggered" by specified events that vary but usually make completion of the original deal unlikely or impossible.(16) More than one type of lockup may be included in a deal, and in mergers both parties may obtain one or more lockups ("cross" lockups).
We begin with data from Securities Data Corporation (SDC) on all mergers and acquisitions of U.S. public targets, announced between January 1, 1988 and August 31, 1999, greater than $50 million in value (in 1999 dollars). Because we want to focus on deals in which lockups may affect outcome, we exclude hostile deals,(17) deals involving targets with a controlling shareholder,(18) and minority purchases (including "white squire" purchases).(19) This leaves us with all friendly deals for public targets with no controlling shareholder, in which an acquirer gained a controlling share of the target's stock (n = 3163). Throughout, we also focus on a subsample of deals (n = 179, or 6% of the full sample) where a competing bid subsequently appears (or is present upon announcement of the original deal).
Overall Incidence, By Type and Over Time
Figure 1 shows that over the past twelve years significant changes have occurred in both type and overall level of lookup incidence.
[Figure 1 ILLUSTRATION OMITTED]
Lockup incidence has generally increased over the period, growing from 40% of all deals in 1988 to 80% of all deals by 1998. Asset lockups, never popular in the period studied, fell from the picture by the mid-1990s. Stock lockups have enjoyed varying levels of use, from a high of 40% in 1991 to a low of 10% in 1996. Breakup fees have proven most popular over time, and were deployed in almost 70% of deals in 1998, although they too have gone through cycles of greater and lesser use.
Table 1A shows overall incidence of stock lockups and breakup fees and The interaction between the two types of deal protection devices:
Table IA. Overall Incidence by Lockup Type
Stock Lockup? Breakup Fee? No Yes No 39.2% 37.7% Yes 12.9% 10.1% n = 3163: Incidence of stock option agreements and breakup fees in all friendly deals >$50 million from January 1988 to August 1999 involving majority acquisition or merger of public company targets that lack a controlling shareholder
Table 1A shows that over the full period, lockups are common, but far From universal: almost as many deals are "naked" as are those protected by some form of lookup (39% vs. 61%).(20) Breakup tees are more common man stock lockups (48% vs. 23%), and deals with both a stock lockup and a breakup fee are almost as common as deals with a stock lockup alone (10% vs. 13%).
In the subset of deals involving bust-up bids, lockups are somewhat less common (but the differences are not statistically significant):
Table 1B. Incidence by Lockup Type Given Another Bidder
Breakup Fee? Stock Lockup? No Yes No 46.4% 37.4% Yes 6.7% 9.5% n = 179: Incidence of stock option agreements and breakup fees in all friendly deals >$50 million where another bidder appears, from January 1988 to August 1999 involving majority acquisition or merger of public company targets that lack a controlling shareholder.
In this subsample, lockups appear in 54% of deals, compared to 61% of deals in the full sample. Simple incidence tables may under-represent the influence of lockups in the M&A marketplace, because the data show that larger deals turn out to be far more likely to have lockups than smaller deals.(21) We stratify the...