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By now you've probably read endless takes on the news that Elliott Associates, one of the oldest hedge funds, with over US $16 billion under management, has made an unsolicited offer for Novell.  Almost all of these articles have focused on whether Elliott means business, what they'll do to Novell if they are successful, and whether another (and perhaps ultimately successful) bidder will enter the scene. 

I haven't seen any article yet, though,  that describes in detail how the high stakes game of tender offers is played, and how the usual process maps (and doesn't) to a high tech company like Novell.  So I thought I'd provide an overview for those that haven't had occasion to follow a tender offer in the past, and also my thoughts on what may happen over the next several months in this particular game of cat and mouse.

So here goes.

The tender offer game:  First up, let's talk about how the standard drama plays out.  It starts with the acquiror trying to pick up as much stock as possible on the sly before it comes out of the closet.  That's because once word gets out that the company (referred to as the “target”) is "in play," the stock will go up.  So the acquiror wants to build as big as stake as possible at the cheapest price it can.

But the securities regulators have long realized that this presents two problems: first, the sellers will feel cheated if they later find out they sold at a steep discount to what others get a short while later, and second, the acquiror will vote all the shares it picks up in favor of the acquisition.  So the Securities and Exchange Commission (SEC) requires any company that acquires more than 5% of the stock in a public company to make a public filing disclosing that ownership and its intentions.

That filing is made on form 14D, and it must be regularly updated as the acquiror's ownership percentage changes, and as its intentions change.  When an acquiror files a 14D, it could affirmatively state that it has no intentions of making a tender offer.  Depending on the acquiror, that statement might be credible, or it might be viewed with suspicion.  But if it affirmatively states that it intends to make a tender offer, or is keeping its options open, then the word spreads - fast.

As you might imagine, stock speculators follow 14D filings like a hawk, because if they buy immediately when one is filed, they can benefit from the fast run up in the stock price of the target that is likely to follow if the potential acquiror has credibility (e.g., the ability to follow through on an acquisition).  So the early movers can either enjoy a quick flip profit, or hold on and see whether the sale goes through.

In this case, Elliott Associates resolved any doubt by informing the Novell board of directors on March 2 that it wishes to buy all of Novell's stock.  You can read that letter here.  And, since the offer had credibility, the stock shot up.  In fact, it shot up to a price higher than the Elliott offer, indicating that the market assumes that Elliott will either up its offer, or that another bidder will jump in.

That brings us up to where we are now.  So what happens next?

Next moves:  There are two things to watch for at this point: the first is whether Novell's board decides to enter into negotiations with Elliott, or to rebuff the offer (you saw Microsoft and Yahoo go through this dance not so long ago).  And the second is whether other bidders enter the scene.  Such a bidder could be solicited by Novell's management and board (a "White Knight"), because they don't like the looks of the Elliott bid and what may come afterwards, or there could be further unsolicited bids.

Why would the Board want to find a White Knight? Because, Elliott, since it is a purely "financial" purchaser, only really cares about the ultimate profit it can make.  So unlike an offer from another technology company, Elliott actually has two ways to win: by successfully acquiring Novell at a price it thinks makes sense, or by driving the price up, through bidding, with one or more other potential acquirors that enter the scene.  In a sense, Elliott's biggest risk is therefore winning, and paying too much, rather than "losing," and making a nice profit for its time.

In this sense, Elliott is in a far better position than Novell's board and management, or of a technology company that may make a bid, so long as Elliott retains self-discipline and walks when the bidding exceeds the internal calculation that it has already certainly made that reflects a prudent purchase.

But these other chess players do have their own advantages.  First up, no one at Novell is going to want to be acquired by Elliott.  Why?  Because Elliott will almost certainly want to break Novell up and sell the pieces.  Indeed, while it has offered $2 billion for Novell, it has already acquired over 8% of Novell at a significant discount off that per-share bid number.  And Novell has almost $1 billion in cash.  So the rewards of a quick hit, followed by a quick breakup, make far more sense than trying to turn around the business of a company that has been struggling to reinvent itself for over 15 years.

What that means is that one would imagine that Novell's talent will be heading for the exits in droves if the Elliott bid looks like it might succeed.  Even if Elliott convinces the target that it plans to run the Company in the long term, the prospect of being managed by a fund with a reputation as a "Vulture Capitalist" better known for buying distressed third world debt is hardly likely to inspire loyalty.

This, of course, will lower the sale value of the business units that Elliott would be hoping to sell, and damage any remaining units that it might choose to continue to run for any period of time.  Indeed, for this reason unsolicited tender offers for technology companies, even by other technology companies, were almost unknown until IBM made a hostile tender for Lotus in 1995. IBM made a major effort to make that combination work, and largely succeeded.  But hostile offers remain rare in technology for this reason.

What this means is that a technology company that Novell's management liked, and that Novell's employees would see as a shelter in a storm, could afford to pay more than Elliott, because another technology company would be likely to be able to count on preserving greater value that could Elliott, assuming that the acquisition otherwise makes sense, and if the successful acquiror does a good job with integration.  The fact that the IT job market remains soft means that raiding by other companies, while still a threat, will be less so than would be the case in better times.

Elliott's strategy:  So how does Elliott play its hand now?  First, it will try and compel the Novell board, and particularly the independent members of that board, to play ball - and they have some powerful tools at their disposal in this regard.  The most powerful is the possibility of personal liability for the Board, and financial liability for the Company, if Novell rejects a bid and the shareholders sue.  Elliott's strategy, therefore, will include putting as much pressure on the Board as possible to accept its bid, or reject it at their peril.

In response, not only will Novell seek the advice of its traditional legal counsel, but will likely hire one or more special advisors (e.g., investment banks) to advise it in how to respond.  And the independent directors will seek their own independent legal counsel, and investment advisor, to advise them.  Ultimately, before accepting any offer,  Novell will pay an investment bank to deliver a "fairness opinion," which is a third party valuation of the Company that must come in at least as high as the bid that the Board accepts in order to protect the Board in recommending the sale.

All of this advice is intended to document that the Board has in fact acted in the best interests of the stockholders, and not, for example, to support management in saving their jobs.

All of this can get rather nasty.  Some years back, I represented a client in a hostile tender where management was trying to steal a thinly traded company private at a ridiculously low price.  Our letters to the board were intended to make abundantly clear to the independent board members that they could ignore our offer only at their peril.  That felt a bit callous, given that several of the independent board directors were out of their depth (one was a charming, elderly professor - the originator of the "dirty snowball" theory of comet composition, who rode his bike to class every day).  But it was the right thing to do, given that the final sale to management was at a price more than three times as high as the management bid that the Board had originally approved.

The Board's strategy:  Novell's board is now in the unenviable position of deciding whether to accept Elliott's offer, solicit other offers, or try to justify a position that the Company is not for sale at all.  There is little question that it will not accept Elliott's opening bid, because that would be to fail to explore the possibility of a higher offer.  Instead, it will seek the advice of the advisors noted above, and decide whether to rebuff the Elliott bid, enter into negotiations with Elliott to try for a higher offer, or solicit bids from other potentially interested parties.

The only way to justify rebuffing the Elliott offer would be to demonstrate a business plan that seems reasonably likely to result in greater value accruing to shareholders within a reasonable time frame than would an immediate sale at the offered price.  Given Novell's performance over the past ten years and the fact that its Suse Linux business seems to be starting to level off, this would become increasingly difficult as the bid price increases.

The situation can change rapidly for the Board, however, since almost all cards are in the hands of others.  Additional financial purchasers could bid in, or technology companies.  And once the Company is in play, it becomes more and more difficult for the Board not to eventually accept an offer from some bidder, assuming that the price is compelling.

What I would expect to happen, and particularly if another bidder enters the scene, would be for the Board to seek a White Knight, and seek to negotiate not only the highest price for the shareholders, but a partner that would be most likely to keep the Company intact.

Other bidders:  So who might that White Knight be?  Most obviously, the crucial asset at stake is Suse Linux, Novell's open source operating system distribution.  Suse Linux is the major commercial distribution in the marketplace in addition to Red Hat, and there are many companies (e.g., IBM, HP, Hitachi, and so on) that have placed very major strategic stakes on  the health of the commercial Linux marketplace.  Although there are many other excellent Linux distributions, none of them is supported by a company with the size, service resources, and comfortable feel of a long term corporate vendor like Novell.

Why does that matter, so long as Red Hat is there?  Because no one likes to be dependent on a single source.  If anything were to happen to Red Hat (mismanagement, another hostile takeover, a change in strategic direction), then customers might be left in the lurch if Novell no longer represented a viable alternative.  The result is that if Elliott acquires Novell, then large enterprise customers (major corporations,  government agencies, universities and  the like) may waiver in their acceptance of Linux-based systems, undercutting the business of major vendors that offer those systems, and services related to them.

For this reason, there are special incentives for a variety of companies to either acquire Novell themselves, or to throw them some sort of lifeline (perhaps in the form of a strategic relationship) that would provide a basis for the Board to rebuff the Elliott bid.

Curiously enough, one of the companies that may have the most to lose if Elliott acquires Novell is Microsoft.  Microsoft is no friend of open source in general, and of Linux, the OSS poster child, in particular, to be sure.  But Microsoft continues to be dragged by its customers down the road of tolerating, if not (yet) embracing, OSS.  Given that its customers have already opted in to heterogeneous operating system environments, Microsoft has had no choice but to work with those customers to make those environments work well - or lose those customers entirely.

The result was the announcement a few years back of a marketing partnership between Microsoft and Novell, which has worked well for both of them.  Microsoft has invested heavily in this relationship in multiple ways - externally, in its marketing budget, internally through joint training of its sales force in collaboration with Novell, and almost as significantly by fighting the internal battle needed to convince proprietary stalwarts to traffic with open source at all.

Given that a loss of a viable Novell Linux distribution would at most impede, rather than reverse, the march of Linux, Microsoft thus has much more to lose than to gain if Novell's distribution were to rapidly lose market share.  In such an event, Microsoft would need to form a new strategic relationship with another distribution, which would be..what?  Although one could speculate about Canonical as a possibility, its distribution has nowhere near the market penetration or supporting infrastructure of Novell’s.

End game:  What Elliott hopes is that the Board will ultimately accept its offer, and that Elliott and the Board will collaborate on proxy materials that will be delivered to the Novell shareholders recommending that they agree to the sale.  If another bidder secures the support of the Board, or if the Board rejects all offers, then there is the prospect of a public tender by Elliott without the cooperation of management, with full page newspaper ads presenting each sides arguments against the other, and the shareholders ultimately deciding whether to be sold or not.

There is also the possibility that Elliott is not successful in acquiring Novell, and that no other bidder makes the acquisition.  In that case, Elliott will be stuck with a mountain of Novell shares and no way to easily sell them into the market without taking a loss.  In that event, Elliott may mount a proxy contest to replace the Novell board, so that it could force a sale of assets and distribution of profits to the shareholders, or a sale of the entire Company.  But that’s a subject for another blog entry.

Wrapping up:  The net result is that what happens next will be fascinating to watch.  I expect that there will be a great deal of activity behind the scenes as well as in plain view.  Want an example of a behind the scenes possibility?  An IBM, an Oracle or an SAP wouldn't have to buy Novell outright to remove Novell's Linux distro from the risk category - they could simply approach Elliot even before the sale, and arrange to buy it simultaneous with the close of the purchase of the Novell shares by Elliott.  Between the near-$1 billion in Novell's account and the proceeds of such a sale, Elliott would be buying the rest of Novell for pennies on the dollar.

Where things will end is difficult to predict, but what happens over the next several months will provide an interesting benchmark for what Linux means to the world of commerce today, as well as telling insight into who cares about Linux the most.

Have you discovered the Alexandria Project?