What Is A Toehold Purchase (Explained: All You Need To Know)

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What Is A Toehold Purchase

In mergers and acquisitions, a toehold purchase refers to a situation when a company acquires less than 5% of the shares in another company with the intention of exercising some pressure on the company or initiating an acquisition strategy.

In other words, when an acquiring company buys less than 5% of a target company’s shares, we refer to the equity position as a “toehold” position.

The main reason why a company may initiate an investment or M&A strategy with a toehold purchase is to avoid having to disclose its position to the Securities and Exchange Commission (SEC).

In fact, in the United States, a company buying more than 5% of another company must file the necessary disclosures and paperwork with the SEC.

However, since a toehold purchase does not need to be disclosed to the SEC, a potential acquirer can take a long position in a company without raising any flags.

Keep reading as I will further break down the meaning of a toehold purchase and tell you how it works.

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Why Make A Toehold Purchase

There are many reasons why a company may decide to initiate a toehold position in another company.

The main reason a toehold purchase is considered is for a potential acquirer to start purchasing shares in a target company without raising any flags.

Since the SEC does not require companies to disclose their equity position that is less than 5%, an acquiring company can quietly start purchasing shares of another, initiating a slow but progressive acquisition strategy.

However, when the equity position of the acquiring firm exceeds 5%, then the SEC requires proper disclosures and notices to be filed where the acquiring company provides details on how many shares the company intends to purchase and for what reason.

Another reason why a company may decide to engage in a toehold position in another firm is to exert pressure on the company to make changes so the value of the stock can rise over time.

The purchaser’s idea is to use its toehold position to have the company make changes that will result in more profit for the shareholders.

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Toehold Purchase Example

Let’s look at an example of a toehold purchase to better understand how it works.

Let’s imagine that Company ABC is interested in acquiring Company XYZ.

However, Company ABC is still not ready to disclose its intention to acquire Company XYZ.

To start its acquisition strategy, Company ABC starts purchasing outstanding shares of Company XYZ in the open market by ensuring that its position does not exceed 5%.

Company ABC can accumulate shares of Company XYZ below a 5% threshold without having to file anything with the SEC.

When Company ABC’s “foot is in the door” and it is ready to proceed with the acquisition, it will typically purchase additional shares and file the necessary disclosures with the SEC.

To get the majority control of Company XYZ, the acquiring company can present an offer to its board for approval or directly submit a tender offer to the company’s shareholders.

If Company ABC is able to acquire the majority of Company XYZ’s shares, then its acquisition strategy is successful.

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Toehold Purchase FAQ

What are the advantages of taking a toehold position?

There are many benefits for investors, acquiring firms, private equity funds, and other organizations to purchase less than 5% of the outstanding shares of another company.

The main benefits are that the investor can purchase the shares at a price that is not impacted by any SEC filings, it provides the acquirer a headstart to a successful takeover strategy, the company will get access to internal and strategic information, and the acquiring firm can carefully plan its acquisition strategy.

What are the disadvantages of taking a toehold position?

Although there are many benefits to taking a toehold position in a company, you should also be mindful of its drawbacks.

The main disadvantage is that the investor purchases the shares based on an inflated market price, a slow acquisition strategy may lead to more risk if the market conditions change for the acquirer or the target, and there may be a risk of purchasing more than 5% without doing the proper disclosures.

What is an example of a toehold position in real life?

A real example is when Paul Singer, an activist investor, bought 4% of the outstanding shares of Cognizant Technologies.

Following his acquisition, he exerted pressure on the company to change its board members, make changes to increase profitability, and increase shareholder return.

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Takeaways 

So there you have it folks!

What does a toehold purchase mean?

In a nutshell, a toehold purchase refers to the purchase of less than 5% of a company’s outstanding shares with the intention to either acquire the company in the future, put pressure on the company, or to achieve another objective.

Very often, a toehold purchase is taken by companies looking to acquire or take over another company.

When a toehold position is taken by an individual investor, quite often the objective is to force the company to make certain changes or satisfy certain demands.

When the toehold position is taken by another company, this is the precursor to a takeover or acquisition.

Now that you know what a toehold position is all about and how it works, good luck with your research!

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