The Lifecycle of Firm Takeover Defenses

Jonathan M. Karpoff is Professor of Finance at University of Washington Foster School of Business. This post is based on a recent paper authored by Professor Karpoff; William C. Johnson, Assistant Professor of Finance at Suffolk University Sawyer Business School; and Sangho Yi, Sogang University. Related research from the Program on Corporate Governance includes What Matters in Corporate Governance? by Lucian Bebchuk, Alma Cohen and Allen Ferrell (discussed on the Forum here); The Costs of Entrenched Boards by Lucian Bebchuk and Alma Cohen; and How Do Staggered Boards Affect Shareholder Value? Evidence from a Natural Experiment by Alma Cohen and Charles C. Y. Wang.

Are takeover defenses good or bad for shareholders? The answer depends on whom you ask. Many researchers find support for the view that takeover defenses entrench managers and decrease firm value (e.g., Gompers, Ishii and Metrick (2003), Masulis, Wang, and Xie (2007), Bebchuk, Cohen and Ferrell (2009)). But others find that takeover defenses are associated with improved value and performance (e.g., Linn and McConnell, 1983; Caton and Goh, 2008; Chemmanur and Tian, 2013; Smith 2013). In this paper, we propose that takeover defenses confer costs and benefits to a firm’s shareholders that change in systematic ways as the firm ages. Previous findings are mixed because they do not account for this lifecycle effect in takeover defenses.

Takeover defenses offer benefits by encouraging long-term investment (Stein, 1988; Cremers and Ferrell, 2014) and by bonding relationships with important counterparties (Johnson, Karpoff, and Yi, 2015; Cen, Dasgupta, and Sen, 2015). As firms mature and rely less heavily on a small number of key customers or strategic partners, the marginal benefits of takeover defenses decline. Takeover defenses also convey costs by insulating managers from the threat of outside takeovers (e.g., DeAngelo and Rice, 1983). As firms mature, the marginal costs of takeover defenses increase because managers tend to own smaller ownership stakes and the agency cost of equity increases.

Our lifecycle argument implies that the value-maximizing level of takeover protection decreases as the firm ages. In the absence of frictions, firms would adjust by removing takeover defenses as they mature. We document, however, that firms’ use of takeover defenses is sticky, as the likelihood of a firm keeping its current takeover defenses in any given year is 98%, and 90% of firms never remove any takeover defenses during the 15 years after their IPOs. Previous research suggests that takeover defenses are sticky for at least four reasons: power conflicts between managers and shareholders that lead to a stalemate (Coates, 2001); shareholder heterogeneity and free-riding problems in attempts to force the removal of takeover defenses (Shleifer and Vishny, 1986; Bagwell, 1991); regulation that exacerbates the collective action problem (Hannes, 2005); and bounded rationality and anchoring that increase the cost of changing the status quo (Samuelson and Zeckhauser, 1988; Kahan and Klausner, 1996).

Sticky takeover defenses have consequences for firm value. The very same takeover defenses that create value when the firm is young impose increasing costs as the firm ages. In this paper we conduct several experiments to test this value reversal implication of the lifecycle hypothesis with sticky takeover defenses. First, we find that the relation between Tobin’s q and a firm’s use of defenses decreases as the firm ages. The relation between firm value and the use of takeover defenses is positive for firms at their IPOs, and declines steadily as the firm matures, becoming negative approximately five years after the IPO. This overall pattern is robust to various empirical specifications in univariate comparisons and multivariate tests.

Next, we construct a measure of a firm’s cost of adjusting its takeover defenses based on the empirical frequency with which each of the six provisions in the E-index is removed by our sample firms. Consistent with the lifecycle hypothesis, the value reversal occurs primarily among the subset of firms for which the adjustment cost is relatively high.

We then examine four particular channels that change the benefits and costs of takeover defenses and through which the lifecycle hypothesis works. We find that the value reversal—that is, the decrease in q as a firm matures—is most pronounced among firms that subsequently lose large customers, end strategic partnerships, or part ways with their founder-CEOs. The value reversal also is stronger among firms whose managers’ ownership stakes decrease significantly, consistent with the prediction that a decrease in managerial share ownership increases the agency cost of equity and increases the cost of takeover defenses. These results indicate that the value reversal does not occur automatically as a firm ages. Rather, it is driven by the particular contracting problems that affect takeover defenses’ benefits and costs, which tend to change in systematic ways as a firm ages.

A potential concern with our empirical analysis is that firm value and the use of takeover defenses are endogenous to the firm’s competitive environment. Unlike standard analyses of the determinants of firm value, however, our tests are identified by the assumption that takeover defenses are sticky and do not adjust optimally over time. To examine any remaining influence of the endogenous selection of a firm’s value and takeover defenses, we conduct three additional tests that introduce plausibly exogenous variation in firms’ uses of takeover defenses. First, we use each firm’s E-index value at the time of its IPO as a proxy for its E-index in future years. Second, we estimate 2SLS models in which we develop instruments for a firm’s E-index based on geography and the characteristics of the firm’s law firm at the time of its IPO. Third, we use our law firm and geography based instruments as proxy variables for the E-index in reduced form models that examine the relation between firm value and the firm’s takeover defenses. The results of all of these tests are consistent with our main findings. Throughout, there is strong evidence of a value reversal as a firm matures.

Finally, we conduct a series of additional tests to probe the robustness of these results. The results are similar using an alternate measure of firm value created by Dybvig and Warachka (2015), alternate measures of the firm’s takeover defenses, and alternate measures of takeover defense stickiness. The results also are robust to alternate measures of the firm’s lifecycle.

This paper makes five contributions to our understanding of firm’s use of takeover defenses. First, we document that firm’s takeover defenses are largely determined by the defenses they have at the time of their IPOs and are sticky over time. Firms do increase their defenses slightly, by an average of 0.2 new (E-index) defenses per year, but rarely remove existing defenses. Second, we document that the relation between a firm’s value and its use of takeover defenses declines as the firm ages. The relation is positive, on average, at the time of the IPO and turns negative around five years later. Third, we show that this reversal in the value of takeover defenses is attributable to takeover defense stickiness. As firms age, their takeover defenses become less beneficial and more costly, on average. If defenses were not sticky, firms would adjust by shedding defenses as they age. Because firms do not typically shed defenses, however, the defenses that contributed to firm value when the firms were young serve as a drag on firm value as these firms age. This result holds particularly for firms with the most sticky defenses. Fourth, we show that the value reversal occurs not because of age per se, but rather, because of specific changes that correlate with firm age. In particular, takeover defenses lose value and become costly as firms lose large customers, key strategic partners, or founding CEOs—thus attenuating the bonding benefits of defenses—and as top managers’ shareholdings decrease and the agency cost of takeover defenses increase. Fifth, our results provide an explanation for the mixed empirical results regarding the impact of takeover defenses on firm value. Our lifecycle hypothesis implies that takeover defenses serve to increase value for some, typically younger, firms, and to decrease value for other, typically older, firms.

The full paper is available here.

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