What Is a Fair Price Provision and How Does It Work?
Understand the corporate governance mechanism that safeguards minority shareholder interests by standardizing buyout terms in a multi-stage acquisition.
A fair price provision is a clause in a company’s corporate charter or bylaws that shields minority shareholders from coercive tactics during a takeover attempt. It is designed to counteract a two-tiered tender offer, a strategy that can pressure shareholders into selling their shares at a disadvantageous price. By establishing a predetermined method for valuing shares, the provision ensures that all shareholders receive equitable treatment and discourages hostile acquisitions based on low-value offers.
The Mechanics of a Fair Price Provision
A fair price provision is triggered by a takeover strategy known as a two-tiered tender offer. In this approach, an acquiring company makes a public tender offer to purchase a controlling interest, often more than 50% of the shares, at a premium price. This “front-end” of the deal is designed to be attractive enough to secure a majority of shares quickly. Once the acquirer gains control, it initiates a “back-end” merger to acquire the remaining shares held by minority stockholders.
The coercive nature of this strategy arises from the pricing of the second step, as the price offered for the remaining shares is lower than the price paid in the initial tender offer. This creates significant pressure on shareholders, who face a dilemma: either sell at the higher front-end price or risk being forced to sell later at the lower back-end price after the acquirer has control.
This is where the fair price provision intervenes. The provision is activated when an acquirer purchases a specified percentage of a company’s shares, an action defined in the corporate charter. Once triggered, the provision legally obligates the acquirer to pay a “fair price” to all remaining minority shareholders in any subsequent business combination. This fair price is determined by a specific formula detailed within the company’s charter.
The existence of this provision removes the financial incentive to offer a lower price in the second stage, as the company is bound by the charter to pay the calculated fair price. This ensures that shareholders who do not participate in the initial tender offer are not penalized. The provision effectively neutralizes the pressure tactic, forcing the acquirer to negotiate equitable terms for all shareholders.
Determining the Fair Price
The core of a fair price provision is the specific formula used to calculate the “fair price,” which is explicitly defined within the company’s corporate charter. This removes ambiguity and prevents the acquiring firm from dictating a low price to remaining shareholders. The formula ensures the price is based on objective criteria, and companies can adopt several methodologies.
One of the most common methods is the highest price method. Under this approach, the fair price is defined as being no less than the highest price the bidder paid for any shares of the target company during a specified period. For instance, if an acquirer purchased a block of shares at $50 per share and then launched a tender offer at $55 per share, the fair price for the back-end merger would have to be at least $55 per share.
Another widely used approach is the price-to-earnings (P/E) ratio method. This calculation links the offer price to the company’s recent financial performance. The provision might stipulate that the price paid to minority shareholders must be such that the P/E ratio of the offer is at least equal to the company’s average P/E ratio over a preceding period, for example, the last three to five years. If a company’s average P/E ratio was 15 and its earnings per share were $4, the fair price would have to be a minimum of $60 per share.
A third common formula involves a premium over the market price. This method requires the fair price to be a certain percentage above the stock’s market price at a specific point in time, usually just before the announcement of the takeover attempt. For example, the charter might require the price to be at least a 25% premium over the average closing price of the stock for the 30 days prior to the announcement.
Adoption and Waiver of the Provision
Implementing a fair price provision requires amending a company’s foundational documents and cannot be enacted by the board of directors alone. The process begins with the board approving a resolution to add the provision to the corporate charter or bylaws. Following board approval, the proposed amendment must be presented to the company’s shareholders for a vote, where a majority is required for official adoption.
Just as there is a formal process for adoption, there are also structured mechanisms for waiving the provision in specific circumstances. These waivers provide flexibility, allowing a friendly or negotiated merger to proceed without being hindered by the pricing formula. One common method for a waiver is approval by a supermajority of the shareholders, which might require a threshold of 80% or more of the outstanding shares to approve the business combination.
An alternative waiver method involves the company’s board of directors. The provision can be waived if the merger is approved by the “disinterested directors.” These are board members who have no personal financial interest in the acquiring company and are not employees or affiliates of the bidder. Their role is to provide an independent assessment of the transaction, and if they approve the merger terms, the fair price calculation can be set aside.