How Instagram Could Have Cut a Better Deal
In hindsight, perhaps Instagram should have cut a different deal with Facebook.
Mike Krieger, left, a co-founder of Instagram, and Shayne Sweeney, an engineer. / Peter DaSilva
In April, Facebook agreed to acquire Instagram, the hot social media photo-sharing site, in a deal valued at the time at about $1 billion.
The problem is that Facebook did not agree to pay $1 billion in cash. The deal terms said Instagram would receive $300 million in cash and about 23 million shares of Facebook stock once the deal closed. Facebook stock at the time of the deal was valued by the parties at about $30 a share.
But since that time, Facebook’s initial public offering has taken place — and we all know what happened. Facebook shares have fallen substantially, and the Instagram acquisition is now valued at about $735 million. The Instagram founders are out almost $300 million, at least on paper.
Instagram’s founders could have avoided this situation by bargaining differently.
What is notable is that Instagram and Facebook did not agree to a floating share exchange ratio or a stock collar, two fairly common merger tools.
A floating share exchange ratio ensures that a seller will receive a fixed value in the acquisition regardless of what happens to the purchaser’s shares. As a result, the number of shares issued by the buyer will increase or decrease to match that fixed dollar amount.
This means that the seller does not take the risk of the buyer’s share price going down before the acquisition is completed. In exchange, the seller forgoes any upside increase.
In contrast, Instagram agreed to a fixed number of shares rather than a fixed dollar value. That meant Instagram’s owners took the risk of a decline in Facebook shares in exchange for all the benefits of an increase.
Either type of deal structure can be accompanied by a stock collar.
If the parties agree to a fixed number of shares, as with the Instagram deal, a collar could work like this: the number of shares to be issued is fixed within a range – or a collar. If the share price rises above or below the range, the number of shares adjusts to pay a minimum or maximum dollar amount to a seller. The range, or the collar, is typically set at about 5 to 10 percent around the share price value at the time.
As a result, if the seller’s stock price falls below this 5 to 10 percent range, more stock is issued to compensate the seller — and less if the stock goes up. Again, the goal is to protect the seller on the downside in exchange for giving up some of the benefits of the upside.
The type of exchange ratio and collar can take different forms than the above, generally with the net goal of giving the sellers downside protection.
There are also other protections that Instagram could have asked for to brace itself against a Facebook stock decline, like the right to terminate the deal if Facebook’s stock price declined substantially. But no combination of these mechanisms was used in the Instagram deal.
We do not know why this is the case, but about 80 to 90 percent of stock deals use fixed exchange ratios, according to Factset Mergermetrics, and stock collars were only employed in about 11 percent of recent deals.
It may have been that the Instagram founders did not want to exchange a share of the upside for downside protection, preferring instead to make what is so far a losing bet on Facebook stock. It may also be that since the parties were both in the same industry, a fixed exchange ratio was thought more appropriate because the market would assign them equally in value, a common assumption underlying this choice.
But at the time of the deal, Facebook was pretty bullish on its stock prospects. Facebook probably would have acceded to some type of collar protection, possibly even without a collar on the upside.
This also appears to be a very hastily negotiated deal by some young executives, inexperienced in the world of mergers and acquisitions. The deal may already have been set by the time the lawyers and investment bankers came in, so that probably meant that a collar or floating share exchange ratio was already out of the question.
Instagram’s negotiations are looking particularly important in hindsight because of the delays to the completion of this transaction, delays it probably should have expected.
Facebook still needs antitrust clearance to complete the deal. It received antitrust clearance from British authorities last week, but is still awaiting approval from American regulators.
It appears the parties thought there might be some level of antitrust review and delay because Facebook agreed to pay Instagram $200 million if the deal was terminated as a result of a failure to receive such clearance. If so, this would be another indicator for Instagram to have bargained harder on how it was paid.
Recent reports have implied that Facebook is trying to speed up the close of the acquisition by using a California fairness hearing process.
A California fairness hearing is one of those quirky procedures under the securities laws. For a stock to be able to be traded freely in the public market, it must be registered with the Securities and Exchange Commission or qualify under an exemption. Facebook, for example, just went through the whole registration process to sell its stock in its I.P.O. The registration process can be arduous and take three to four months.
An alternative is to use the exemption under Section 3(a)(10) of the Securities Act, which allows shares to be freely sold without registration if they are qualified through a state fairness hearing. Six states have these procedures. California is the most prominent state providing for this by statute.
A fairness hearing is really an alternative to S.E.C. registration at the state level. The exemption is available under the presumption that the state determination of fairness is sufficient to replace S.E.C. review in a registration.
Supporting documentation is filed with the California Department of Corporations, and a fairness hearing is held at which the presiding officer makes a determination of fairness. The exemption is commonly used in Silicon Valley to sidestep registration. It is cheaper and faster, costing up to $2,500 plus a hearing fee and taking only one to two months.
When the Instagram deal was struck, the parties probably expected an antitrust delay, so using the fairness proceeding was more about saving money and having a less complex proceeding.
In any event, the hearing is scheduled for Aug. 29. It is open to the public, but as Brian Quinn at the M.&A. Law Prof blog has written, nothing much is likely to happen.
Fairness is determined by reference to whether arms’ length bargaining occurred, something that appeared to happen here. Even then you need objectors to state a case against fairness, something not likely to happen as Instagram at this point is probably happy with what they are receiving, given the rerating of social media going on after the soured Facebook I.P.O. And even if the fairness hearing did not result in approval, the acquisition agreement would probably just allow Facebook to register the shares with the S.E.C. as an alternative.
Ultimately, though, the antitrust delay is what has really hurt Instagram, and the timing of the fairness hearing is a nonevent that will not speed up this deal.
The end result is that delay has cost Instagram’s owners hundreds of millions, losses they could have avoided or reduced by negotiating differently. It is a lesson for those who strike deals in the heat of the moment — and perhaps too hastily.
Steven M. Davidoff, a professor at the Michael E. Moritz College of Law at The Ohio State University, is the author of “Gods at War: Shotgun Takeovers, Government by Deal and the Private Equity Implosion.”
This article originally appeared at: http://dealbook.nytimes.com/2012/08/20/how-instagram-could-have-cut-a-better-deal/. 1,344 words.
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