Using M&A Collar Provisions to Solve the Underpaid Star Problem (Part 1 of 2)

In this two-part series, I will propose a unique contract structure that can potentially help teams and star players agree to terms by addressing some of the risks faced by each. In Part 1, I will identify the unique concerns of star players and describe a method by which corporate attorneys address similar concerns in an analogous context. In Part 2, I will use the concepts described in Part 1 to design similar provisions applicable to the NFL context.

Every contract signed in the NFL carries risk for both the player and the team, but contracts involving star players carry somewhat unique risks. Most NFL players sign long-term deals with the knowledge that it is unlikely they will remain under contract for the duration of the deal, and thus their primary risk is that they will not receive all of the money they are purportedly scheduled to earn. These players simply attempt to maximize the amount of money they actually earn. The team, on the other hand, attempts to limit its risk related to injury or performance decline.

However, star players are much more likely to remain under contract for the duration of the deal, as they are less easily replaced by cheaper free agents or draft picks and more likely to continue delivering surplus value to the team.[1] Furthermore, the market price for star players tends to continually increase by a material amount. Therefore, the primary risk for a star player is the opportunity cost associated with being under contract and therefore being unable to receive a new, larger deal. Teams, however, understandably desire to capitalize on this surplus value, given the larger initial risks associated with star player contracts.

As a result, contract terms for star players are often difficult to agree upon, as the star player desires to avoid becoming helplessly underpaid, while the team desires to take advantage of eventual risk-free surplus value. While both parties must undoubtedly accept some risk, it is more difficult for the player to determine how much future-underpayment risk is appropriate, given the unpredictability of the star player contract market. Precedent-setting contracts often abruptly accelerate the market price for top players in a non-linear upward fashion. Consequently, the star player faces more uncertainty than the team with respect to each of their respective primary forms of risk, and the longer the potential contract, the more uncertainty the star player faces.

In the context of corporate Mergers & Acquisitions (M&A), some transactions utilize consideration that places both parties to the agreement in a similar situation as the star player and NFL team with respect to risk associated with uncertainty. When one company acquires all of the stock of another company, the parties may agree to have the acquirer pay some or all of the consideration in the form of its own stock (rather than all cash). This creates a potential problem because most deals do not take effect (“close”) until months after they are signed. During the post-signing, pre-closing period, the price of the publicly traded stock of both the target and the acquirer will change as the shares are traded on exchanges. As a result, the value of the consideration actually paid by the acquirer to the previous owners of the target at the time of the closing will be different than what the value of the consideration would have been at the time of the signing.

Just as the star player faces the risk that the market contract for players at his position will unexpectedly increase during the course of his contract, the owners of the target in an M&A transaction face the risk that the target stock price will increase between signing and closing.[2] The longer the star player’s contract, the more such uncertainty he faces; the longer the period between signing and closing, the more such uncertainty the owners of the target face. Furthermore, each of the parties in both scenarios may disagree on the potential volatility of the applicable market, and they likely come to the table with different levels of risk tolerance.

In order to address this problem, M&A practitioners have developed “collar” provisions that significantly reduce the risk associated with uncertainty by providing for built-in consequences in the event of various degrees of market change. A collar provides each party with a limit on both the downside and the upside associated with potential movements in stock price. What begins as a “fixed-value” deal (acquirer pays the target X dollars worth of acquirer stock in exchange for each share of target stock) may switch to a “fixed-exchange” deal (acquirer pays X number of shares of acquirer stock in exchange for each share of target stock) if the share price of target stock rises above, or falls below, certain thresholds.[3] In the case of extreme changes in pre-closing stock prices, one or both of the parties may even be given the option to terminate the deal.

The following chart illustrates one example of how a collar provision could be structured:

Collar Chart

In this hypothetical transaction, the parties have agreed to a fixed-price deal in which the acquirer provides the existing target shareholders with $50 worth of acquirer stock in exchange for each share of target stock. At the time of signing, each share of target stock is worth $40. The X Axis represents the price of a share of target stock during the pre-closing period, and the Y Axis represents the amount of consideration provided by the acquirer at any given target share price.

Each party to this agreement has accepted symmetrical risk. The acquirer will provide $50 worth of consideration at any target share price between $37 and $43. If the target share price falls below $40, then the acquirer will have overpaid relative to the original deal (it still pays $50 worth of stock for shares it thought were worth $40). Conversely, if the target share price rises above $40, then the existing target shareholders will have been underpaid relative to the original deal (they still only receive $50 worth of stock for shares that are now worth more than originally thought).

At $43 and $37, the collar provision is triggered, and the deal switches from a fixed-value deal to a fixed-exchange deal. Rather than pay a fixed $50 per share, the acquirer will now provide acquirer shares worth a multiple of the value of the target shares, such multiple being the same ratio as that of acquirer share price to target share price at the point of the threshold (i.e. $50:$43 and $50:$37). Within the range of target share price between $43 and $50,the acquirer will be required to provide more shares of acquirer stock for each share of target stock than under the original deal (assuming acquirer share price remains constant). For example, instead of a 1:1 exchange when the acquirer shares were worth $50 and the target shares were worth $40, the exchange would be 1.12:1 when the acquirer shares are worth $50 and the target shares are worth $48 ($48 per target share x (50/43) fixed exchange ratio = $56 required per target share; $56 / $50 per share = 1.12 acquirer shares per target share). Conversely, within the range of target share price between $37 and $30, the acquirer will be required to provide fewer shares of acquirer stock for each share of target stock as compared to the original deal.

Under this arrangement, both parties assume some risk of underpayment/overpayment, but they place a cap on the risk by establishing a threshold beyond which the risk will be shifted to the other party. When the target share price is anywhere between $40.01 and $43.00, the target shareholder will be underpaid relative to the original deal. However, between $43.01 and $50.00, the degree of underpayment will not be any worse than it is at $43, and the acquirer will assume any further risk. Conversely, when the target share price is anywhere between $39.99 and $37.00, the acquirer will be overpaying relative to the original deal. However, between $36.99 and $30.00, the degree of overpayment will not be any worse than it is at $37, and the target will assume any further risk. Each party has therefore eliminated most of the uncertainty associated with market fluctuation between signing and closing.

Once the target share price reaches $50, the fixed-exchange feature concludes, and the existing target shareholders assume the risk of further underpayment in the form of a fixed-value consideration of $58. However, at and above this threshold the existing target shareholders will have the option to terminate the deal rather than proceed to closing at $58. If the underpayment is extreme, then they will likely terminate the deal, but there may be other factors that could cause them to proceed despite the severe underpayment. Likewise, the acquirer will have the option to terminate the deal if the target share price drops all the way to $30. Alternatively, it can proceed with a fixed-value deal in which it provides acquirer stock worth $42 for each share of target stock.

The collar provision causes each party to assume some degree of initial risk related to the uncertainty of market fluctuation. Beyond the first threshold on each side of the starting point ($43 and $37), the risk then shifts to the other party. Beyond the second threshold on each side of the starting point ($50 and $30), the risk shifts back to the original party, but the original party has the option to terminate the deal in its entirety rather than reassume the risk.

M&A collar provisions can become much more complicated than this example, but this illustrates the concept to a sufficient degree to apply it to the scenario of an NFL contract negotiation. In Part 2, I will explain how I propose to utilize M&A collar provisions to help teams and star players agree to contract terms by reducing risk related to the uncertainty associated with fluctuating market changes.

[1] I do not have quantitative support for this statement. I am making this assertion based on anecdotal observations. I am also using the term “star” loosely.

[2] The target also faces the risk that the acquirer stock price will decrease between signing and closing, but this is less analogous to the NFL context.

[3] Collars can also work the other way; a fixed-exchange deal can be triggered to transform into a fixed-value deal. The trigger can also be keyed on acquirer stock price instead of target stock price.

  • McGeorge

    Can you give us a hypothetical example, say using Russel Wilson.
    How would the contract be worded within the framework of the CBA?

  • Andrew Stevens

    Why not just use escalators and deescalators or performance incentives? Also, isn’t there an inherent advantage in having a player signed for less than the market would pay him, which is the reason to extend players before their contract is up?