What is Toehold Purchase?

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  • 13 Dec 2023
What is Toehold Purchase?

Key Highlights

  • Institutional or retail investors make a toehold purchase when they buy less than 5% of the target company's outstanding shares.
  • A firm or investor may secretly take a toehold position on a target company's stock without notifying the target company or the market regulator.
  • A toehold purchase might be the first step to purchasing the target company.
  • Using toehold purchases, some investors pressure companies to fulfil demands. These include making specific changes to increase shareholder value.

A toehold purchase is an investment where investors target a particular firm but purchase less than 5% of the company's shares. They may put enough pressure on the firm with this "toehold" position. Their goal is to purchase it or only to increase performance and returns. Filing the transaction with the market regulators is optional. This is because of the small ownership percentage.

Let's take a look at an example to understand better how toehold purchases work.

Suppose Company XYZ wants to purchase Company Alpha. However, Company XYZ is still not prepared to announce that it plans to buy Company Alpha. To begin implementing its purchase plan, Company XYZ begins buying outstanding shares of Company Alpha on the open market. It makes sure that its stake stays within 5%.

Company XYZ does not need to submit any paperwork with the market regulator for buying shares in Company XYZ below a 5% threshold. Usually, Company XYZ will buy more shares. It will finally submit the required filings after it is well-prepared to move forward with the acquisition.

The acquiring company has two options for gaining majority control of Company Alpha. Either it can immediately make a tender offer to the company's shareholders or propose an offer to the board for approval. Company XYZ's acquisition plan is effective if it can purchase the majority of shares in Company Alpha.

The following are the objectives of toehold purchases.

1. Acquiring the target firm: Usually, toehold purchases are done to acquire the target companies. The investor may begin buying outstanding shares after a toehold purchase. The number of shares acquired later is typically fewer. So, it isn’t noticed. Sometimes it may be noticed. Yet, it is generally regarded as harmless.

2. Specific Objectives: Toehold purchases may also be done for particular goals. These include increasing the company's market value, energising operations, and maximising return on investment. The main purpose of a toehold purchase is to influence the management's actions by putting pressure on them. The aim is to control the company's management to make choices that benefit the shareholders.

Now that you know what a toehold purchase let's look at a real-life instance. In 2016, renowned activist investor Paul Singer revealed his 4% ownership in Cognizant Technology Solutions. He also offered his suggestions for enhancing returns and profitability. He also demanded a change in the board of directors. The firm and its investors both benefited from the quick and favourable outcomes.

A toehold purchase/position is essentially a minor but noteworthy stock stake in a business. To avoid the need to notify the market regulator, the stake taken is at most 5% of the company's outstanding shares. The buyer should submit a notice to the regulator outlining the plans for purchases that exceed the 5% level. Buyers must mention if they want to buy more shares and the reason for it. It helps in understanding any possible attempt at a takeover.

After acquiring the toehold position, the investor or investment firm will likely proceed to purchase more of the outstanding shares of the target business. Typically, the investor proceeds quietly, buying shares in a small percentage. The target company is likely to overlook these small transactions. It may also consider them harmless if it notices them.

An alternative strategy to purchase would be to utilise a toehold position to put pressure on the business. The goal is to influence the company's board of directors to take particular steps. The buyer hopes this will raise the company’s market value and return on investment.

Conclusion

Toehold purchase means acquiring less than 5% of a publicly listed company's stock. It is only necessary to inform the purchase to the market regulator once one reaches the 5% level. This makes it possible to start the process of a potential hostile takeover quietly. Yet, one would have to finally reveal the plans going forward. Investors usually gain as they are buying the shares at a premium. However, a takeover does not necessarily benefit the business or its investors. Therefore, investors need to be cautious when making decisions.

FAQs on Toehold Purchase

A toehold purchase is a smaller investment. It may or may not result in a complete acquisition of a company. Conversely, a complete acquisition involves acquiring the majority or all the shares.

Toehold purchases are generally funded using the acquiring firm's capital. It may also purchase some shares in cash and the remaining through debt.

Yes, toehold purchases are common in the share market. They often take place in industries where there is intense competition.

Yes, a toehold purchase can be a part of merger and acquisition (M&A) strategies. Toehold purchases allow investors to analyse the target company before making further plans.

Yes, the acquiring firm can reverse its toehold position if it doesn’t want to make more investments in the target firm. This decision is generally influenced by market conditions or a change in investment plans.

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