Optimal and efficient takeover contests with toeholds

Target firms often face a takeover threat from raiders with prior stakes in its ownership (toeholds). Previous literature has shown that, when takeovers are modeled as standard auctions, toeholds induce more aggressive bids from raiders, which has two important consequences for the selling process: (i) the board of directors is no longer indifferent about the sale procedure used to get the highest price, and (ii) the target may not be assigned to the highest-value raider. This paper characterizes how the price-maximizing procedure should be in the presence of asymmetric toeholds. Our central result is that the optimal rule needs to be implemented by a discriminatory mechanism quite different from conventional auction formats. By imposing an extra-charge against high-toehold bidders, the optimal mechanism is able to extract more surplus from raiders who bid more aggressively. As a result, nonbidding shareholders benefit unambiguously from the toehold asymmetry. Furthermore, as this bias restores the symmetry in bidders' expected payoffs, the proposed mechanism also allows to allocate efficiently the target among them.