The Toehold Puzzle

The substantial control premium in corporate takeovers makes a compelling case for acquiring target shares (a toehold) prior to launching a bid. Nevertheless, with a sample exceeding ten thousand initial control bids for public targets, we show that toehold bidding has declined steadily since the early 1980s and is now surprisingly rare. At the same time, the average toehold is large (twenty percent), and toeholds are the norm in hostile bids. To explain this puzzle, we develop and test a two-stage takeover model in which optimal toeholds centre on either zero or a positive threshold. Toehold bidding gives rise to target-borne toehold costs, causing some targets to reject negotiations. In our sample, an average toehold threshold of nine percent is required to compensate the bidder for the expected cost of rejection. With liquidity costs, thresholds of this size may well induce a broad range of bidders to select zero toehold. As predicted, the probability of toehold bidding decreases and the toehold size increases with the threshold estimate. The model also predicts toehold bidding in hostile bids, as we observe.