#04-18
Holdups, Renegotiation and Termination
Fees in Mergers
Edith Hotchkiss, Jun Qian and Weihong Song
Abstract: We examine contracts used in mergers from the announcement of initial definitive agreement to the
completion or termination of the deal, and the renegotiation process in between. We build a model that allows
for renegotiation following the arrival of new information, and demonstrate that a properly designed contract
solves the holdup problem and induces higher deal-specific efforts that increase the synergy of the merger. The
contract grants an option to the target to terminate the merger, while the strike price can be regarded as the “termination fee” paid by the target. The optimal target termination fee compensates the acquirer’s dealspecific
effort without imposing excessive costs on the target for pursuing non-merger alternatives. With a
sample of stock mergers from 1994 to 1999 we find: 1) termination fees are used more frequently on the target
side than on the acquirer side because the target’s holdup problem is more severe; 2) an acquirer’s lockup option
or a toehold are also devices to solve target’s holdup problem; 3) target termination fee increases when measures
of acquirer’s deal-specific effort increase, but it decreases when measures of the target’s non-merger alternatives
increase; and 4) renegotiation of the initial agreement ensures that the merger decision is efficient at the time of
merger completion or termination.
Keywords: Holdup, renegotiation, merger, termination fee, lockup, toehold.
JEL classifications : G34, C71, D8.
