A boardroom romance that began so sweetly on Valentine's Day may end sourly on Friday. On Feb. 14, Verizon, the former Baby Bell, and MCI, the long-distance company recently revived from bankruptcy, struck a deal in which Verizon would buy MCI for $6.7 billion. Soon after, Qwest jumped into the fray and kicked off a bidding war. Last Friday, MCI's board, which had plainly favored walking down the aisle with Verizon, concluded that Qwest's $9.75 billion offer was too good to pass up. Verizon has until Friday to respond.
If MCI ultimately runs off with Qwest, Verizon will be left at the altar with a sizable consolation prize. In March, MCI disclosed that if Verizon were spurned, it would receive a $240 million breakup fee plus reimbursement for up to $10 million in expenses. Who knew parting was such sweet sorrow?
This breakup fee may strike MCI shareholders as both bizarre and unwarranted—the company that submitted the inferior bid still walks away with a few hundred million bucks in pure profit. But breakup fees are a common feature in deals big and small. In the U.S., breakup fees generally run about 3 percent of the proposed purchase price. (In the U.K., breakup fees are capped at 1 percent of the offer.)
Breakup fees hint at unsavory inside dealing among big-time financial players. And they also seem dubious because they cost a huge amount yet have nothing to do with the operation of the company. But breakup fees make a lot of sense. In fact, the paying of a breakup fee is almost always very good news for shareholders. It means there was a competitive auction in which the price at which the board originally agreed to sell the company was deemed to be too low.
At root, breakup fees compensate bidders for putting other companies into play. Say the tax man appraises your house at $800,000. But a buyer shows up on your doorstep and offers $1 million for your manse. By doing so, this prospective buyer calls attention to the attractiveness of your home. Other deep-pocketed home-buyers appear and bid up the price. You wind up getting $1.3 million for the house. In that instance, you'd think it totally rational and fair to pay $25,000 to the guy who started the ball rolling. Breakup fees are especially useful when potential buyers may not be attuned to the potential value of the asset.
In other ways, however, breakup fees seem designed to inhibit a free auction. This spring, cable giants Time Warner and Comcast teamed up to offer $17.6 billion for bankrupt cable company Adelphia Communications. But in early April, Cablevision tried to get in on the action, stimulating further bids. Last week, the bankruptcy judge in the Adelphia case signed off on a $440 million breakup fee for Time Warner and Comcast if they end up losing. This would impose a draconian hit on Cablevision if it managed to win the bidding, forcing it to both top the bid on the table and pay its bitter rivals $440 million.
But for shareholders of the target company, breakup fees are generally money well-spent. The most recent bid by Qwest is $3.05 billion more than Verizon's original offer. The $250 million MCI may thus pay Verizon if it accepts Qwest's offer is only 8 percent of the increase; MCI shareholders would pocket the other $2.8 billion.
Breakup fees can also be incentives for CEOs to restrain themselves at times when ego and innate competitiveness can overwhelm common sense. They provide an economic incentive for CEOs who initiate bidding wars to walk away when the price gets too high. In 1999, when Comcast tried to buy MediaOne Group, it first offered $48.2 billion. AT&T ultimately won with a $56.4 billion bid, one Comcast CEO Brian Roberts wasn't willing to match. He walked away with a $1.5 billion breakup fee and with his company's share price intact. Eventually it turned out that AT&T had overpaid and overextended itself. A few years later, Comcast wound up acquiring many of the MediaOne assets from AT&T—at a lower price.
Verizon CEO Ivan Seidenberg has a few days left to decide if he wants to continue bidding. If he gets MCI at a good price, he'll be a hero to shareholders. If he doesn't, he'll bring home a few hundred million dollars in cash. What's more, this may not be his last bite at the apple. It's worth remembering that Qwest, whose stock is mired in the low single digits, paid $20 billion to acquire another big telecommunications brand name back in 2000: U.S. West. If the current management team proves as inept as the previous management team at integrating and managing expensive new acquisitions, MCI could be on the block again in a few years.