Holdups, Renegotiation, and Termination Fees in Stock Mergers

We examine contract forms used in stock mergers from the announcement of initial definitive agreement to the final completion or termination of the deal, as well as the renegotiation process in between. Within the incomplete contract framework, we first build a model that allows for renegotiation of the initial contract following the arrival of new information. We demonstrate that the signing of a simple initial contract can induce higher deal-specific efforts that increase the synergy of the merger. This contract also grants a call option to the target to withdraw from the merger, while the strike price on this option can be regarded as the “termination fee” paid by the target. The optimal termination fee compensates the acquirer’s deal-specific effort without imposing excessive costs on the target for pursuing non-merger alternatives when it is optimal to do so. Employing a sample of stock mergers from 1994 to 1999, we find empirical evidence supporting our predictions at different stages of the merger process. First, target termination fee increases when measures of merger synergy increase, but it decreases when measures of the target firm’s non-merger alternatives increase. Second, renegotiation following the signing of initial merger agreement ensures that the merger decision is efficient at the time of merger completion or termination.