Toehold Position/Purchase

A strategy that investors or firms use to acquire a publicly traded or target firm buying less than 5% of its outstanding stock

Author: Sid Arora
Sid Arora
Sid Arora
Investment Banking | Hedge Fund | Private Equity

Currently an investment analyst focused on the TMT sector at 1818 Partners (a New York Based Hedge Fund), Sid previously worked in private equity at BV Investment Partners and BBH Capital Partners and prior to that in investment banking at UBS.

Sid holds a BS from The Tepper School of Business at Carnegie Mellon.

Reviewed By: Kevin Henderson
Kevin Henderson
Kevin Henderson
Private Equity | Corporate Finance

Kevin is currently the Head of Execution and a Vice President at Ion Pacific, a merchant bank and asset manager based Hong Kong that invests in the technology sector globally. Prior to joining Ion Pacific, Kevin was a Vice President at Accordion Partners, a consulting firm that works with management teams at portfolio companies of leading private equity firms.

Previously, he was an Associate in the Power, Energy, and Infrastructure Investment Banking group at Lazard in New York where he completed numerous M&A transactions and advised corporate clients on a range of financial and strategic issues. Kevin began his career in corporate finance roles at Enbridge Inc. in Canada. During his time at Enbridge Kevin worked across the finance function gaining experience in treasury, corporate planning, and investor relations.

Kevin holds an MBA from Harvard Business School, a Bachelor of Commerce Degree from Queen's University and is a CFA Charterholder.

Last Updated:January 23, 2024

What Is A Toehold Purchase?

A Toehold Purchase, also called a Toehold Position, is a strategy that investors or firms use to acquire a publicly traded or target firm buying less than 5% of its outstanding stock. This 5% is purchased in any market even if the company is not publicly listed on common stock exchanges.

Anything over 5% requires compliance with the Securities and Exchange Commission (SEC). This is because the SEC wishes to be knowledgeable about possible mergers and acquisitions with the many companies it oversees and wants to ensure all business practices are legal.

The toehold position essentially gives the investor a foot (or toe) in the door of the business. This purchase is for investors to get to know a company from its functions and all the processes it takes for the company to succeed in its field.

It is frequently the initial action taken by an investor who wants to buy the business.

Key Takeaways

  • A corporation or individual investor makes a toehold purchase when they acquire less than 5% of the outstanding stock of the target company.
  • Without informing the target company or submitting a Schedule 13D to the Securities and Exchange Commission, a company or investor might covertly amass a toehold purchase of a target company's stock (SEC).
  •  A company's attempt to buy the target company may start with a toehold acquisition.
  • Activist investors use Toehold purchases to pressure businesses to comply with requests, such as making changes to improve shareholder value.

Why do firms or investors participate in Toehold Purchases?

As mentioned, these purchases are a strategy for investors to get introduced to the firm's stock success.

A simple analogy to toehold purchase is similar to the purchasing of cars. When people buy cars, they likely test drive the car. Likewise, potential buyers might drive around the dealership for some time to see its features and performance in real streets and traffic conditions.

Similarly, investors and firms participate and facilitate toehold purchases to understand how the company performs in the stock market and its industry. The position allows investors and executives to understand how valuable a potential merger or acquisition might be.

If another corporation buys the toehold, it can be a prelude to an acquisition plan, such as a takeover bid or tender offer. In addition, when an individual investor buys a toehold position, they often demand that the target company take action to raise the firm's shareholder value.

This strategy can be used for aggressive results in taking over a company or more of a threat to call attention to executives and board members to make changes as soon as possible to improve the company's financial value.

SEC Compliance for Toehold Purchases

Because the toehold purchase is anywhere up to 5%, the SEC does not get involved. However, suppose this purchase is indeed a precursor to a more extensive acquisition. In this case, the SEC must be notified within ten days after the purchase above 5%.

If the purchase is above 10%, the SEC must be notified within two days as it is treated as more aggressive. Moves of this capacity require more oversight to prevent any actions deemed illegal in the securities markets by the SEC.

The Securities and Exchange Commission requires investors or firms to file a Schedule 13D form to keep track of any potential breach of antitrust laws and avoid monopolies from forming.

This form requires the investors to disclose information such as:

1. Security and Issuer  

The sort of securities acquired, along with the name and address of the corporation that issued them, are all inquired about in this part.

2. Identity and Background 

The purchasers provide personal information in this area, including their business type, citizenship, and any criminal convictions or participation in civil lawsuits during the last five years.

3. Source and Amount of Funds or Other Considerations 

This section details the sources of the funds, including if some of them were borrowed.

4. Purpose of Transaction 

The investors are informed of any potential change of control in this part of Schedule 13D

Note

Beneficial owners must disclose various information, including any plans they may have for the merger, restructuring, or liquidation of the issuer or any of its subsidiaries.

5. Interest in Securities of the Issuer 

Here, the beneficial owner specifies the number of shares being bought and the proportion of the total number of shares in the firm that these shares represent.

6. Contracts and Agreements

Any arrangement or connection the beneficial owner may have about the securities of the target firm should be disclosed. That may include things like voting privileges, finder's fees, partnerships, loans, understandings, or relationships concerning securities of the issuer.

7. Material to be Filed as Exhibits 

These documents consist of copies of the beneficial owner's written contracts about the securities.

Toehold Position Effect on the Target Firm

When firms announce the purchase or are made public after an SEC filing, the target company's stock value usually rises. This is because current shareholders believe that the toehold purchase symbolizes a transaction that may be underway to raise their positions.

An investor who buys a toehold typically intends to change the target company in specific ways to increase the firm's market value.

The toehold is a crucial element that raises the likelihood of a successful takeover attempt. In the event of a takeover, an acquirer has a good probability of succeeding and outpacing the competition if he has a larger percentage of the target company's shares.

Another result is that the toehold is crucial in sectors like manufacturing, food, and agriculture, where the likelihood of a successful takeover transaction is much higher.

In a public letter to the company's board of directors, this activist investor would inform them that they had amassed a sizable interest, explain the rationale for the investment, and recommend (or demand) specific steps to boost shareholder value.

Note

The public announcement can, and frequently does, happen before the 5% threshold is attained.

Toehold Position Strategy

One strategy a corporation can use to acquire a publicly traded company is establishing a toehold position.

Establishing a toehold position enables the acquiring company to start buying shares of the target without being discovered by management if it is preparing a hostile acquisition of the target company.

The tactic permits the prospective acquiring corporation to hide out for as long as possible while positioning itself to try to take over the target business.

When the purchasing business is prepared to announce its takeover plans, it frequently does so via a tender offer. The acquiring business will offer the target firm's shareholders shares, typically at a price over the going market rate.

The purchasing business can avoid the target company's board of directors' approval needs by making its tender offer directly to the shareholders and tempting them with a higher price in exchange for accepting it.

The biggest drawback is that the investor buys the shares at an inflated market price, a gradual acquisition approach may increase risk if market conditions change for the target or the acquirer, and there may be a danger of buying more than 5% of the stock without making the necessary disclosures.

Toehold position Purchase Examples

As discussed above, there are two main strategic reasons for these purchases. Both add leverage to the buyer and can shift the target company into a transformation position either to be acquired and run by different management or to be demanded to make executive changes.

Let us look into some examples of these purchase strategies:

Example 1

The first example considers a purchase from the mindset of Company ABC as a company looking to acquire Company XYZ to gain market share, customer bases, technology, and all other proprietary information.

  • Consider that Company ABC is considering buying Company XYZ, and it has not yet made public any plans to buy Company XYZ.
  • Company ABC begins acquiring outstanding shares of Company XYZ on the open market as part of its acquisition plan, ensuring its stake does not exceed 5%.
  • Company ABC is not required to register with the SEC if it accumulates less than 5% of the outstanding shares of Company XYZ.
  • Company ABC will normally buy more shares and submit the required disclosures to the SEC after it has a "foot in the door" and is prepared to move forward with the acquisition.
  • The purchasing business has two options for obtaining majority control of Company XYZ: it can either submit a tender offer to the company's shareholders directly or propose an offer to the board of directors for approval.
  • The success of Company ABC's acquisition strategy will depend on its ability to purchase the majority of Company XYZ's shares.

Example 2

Now let us look into an example that considers the position where an approaching shareholder demands changes in the target company operations to raise the share value.

The well-known activist investor Paul Singer of Elliott Management Corporation has had great success in making toehold purchases, agitating for changes at his target investment, and then eventually cashing out at significant profits if his recommendations or demands are successfully carried out.

In November 2016, Singer revealed his plans to increase profitability, distribute cash to shareholders, and a 4% stake in Cognizant Technology Solutions. Additionally, he pushed for the board of directors to change.

The outcomes came quickly. Cognizant committed to increasing profit margins, returning cash to shareholders, and replacing the current independent directors in February 2017.

Researched and authored by Akshaj Nair | LinkedIn

Reviewed and edited by Parul GuptaLinkedIn

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