What is Toehold Purchase?

Toehold purchases, where an investor acquires a small stake (less than 5%) in a public company as part of a longer-term strategy, can be controversial. On one hand, they allow large shareholders to pressure boards for changes that may benefit all investors. 

However, they also open the door for covert hostile takeovers and raise questions about transparency. In this article, we will analyse the toehold purchase strategy so you can fully understand how it works and make informed investment decisions.

What drives an investor to make a toehold purchase?

When an investor makes a toehold purchase, it means they believe that a company is worth more than its current stock price reflects. By owning a portion of the company, they can work with the management to make changes that will hopefully increase the stock price. 

However, toehold purchases can also signify that someone is trying to take over the company for their gain rather than to help the business. We’ll look at the different reasons investors make toehold purchases so you can understand what drives these decisions.

Definition of a toehold purchase

A “toehold purchase” refers to when an investor buys a small, less-than-5% ownership position in a publicly traded company. Their ownership allows them to influence management but avoids passing the 5% SEC filing threshold that would force them to declare their intentions. This gives the investor flexibility in driving for changes while still “flying under the radar.”

Examples of toehold purchases

To better understand toehold purchases, let’s walk through some real-world examples across the spectrum of motivations:

• Value-Driven: Back in 2016, a company called Elliott Management bought a small percentage of another company called Cognizant Technology Solutions. Elliott thought that Cognizant could do better than it was doing, so it suggested some changes. These changes included giving some of the company’s money to its shareholders and changing the people in charge of the company. But instead of being mean about it, Elliott was nice and helpful. Everyone thought this was a good idea.

• Opportunistic: In 2014, hedge fund Starboard Value bought a small stake in Olive Garden. They criticised the management and proposed cost-cutting measures. When Olive Garden needed to make more changes, Starboard tried to take over the company. This made it seem like they cared more about making money than helping Olive Garden succeed.

The motivation behind a toehold and how an investor leverages it plays a major role in whether the strategy is seen as ethical or abusive by a company and its shareholders.

Objectives of toehold purchases

While the specifics may differ, most toehold purchasers are driven by one of two core objectives:

1. Catalyse Value-Creating Changes: As seen in the Elliott Management example, toehold buyers often believe a company can improve its financial performance or business practices. So, they use their ownership stake as leverage to pressure management for publicly viewed as constructive changes.

2. Pave the Way Toward Acquisition: Less ethical toehold purchasers are speculation-driven and hoping to acquire the entire company cheaply. They try to use their public criticism to drive down stock prices before launching a tender offer or hostile takeover attempt.  

Toehold positions allow big shareholders to have more influence on a company. Understanding why someone buys a small amount of a company’s stock is important for all shareholders.

Does a toehold purchase amount to insider trading?

There’s an ongoing debate about whether toehold purchases are a type of insider trading enabled by weak reporting requirements. Toehold buyers who want to take over a company usually have important non-public information regarding their intent. When they don’t disclose this information, other investors may trade at a disadvantage. 

However, the current regulations state that toehold purchases under 5% ownership don’t need to be reported. This is done to balance transparency with the ability of big shareholders to communicate privately with management. But this is a tricky situation, as toehold purchasers must be careful to avoid suspicion of improper insider trading.

Example of a Toehold Purchase

To illustrate how toehold purchases work in practice, consider the following scenario:

At Acme Hedge Fund, we are thrilled to share our belief that Beta Company’s shares are undervalued. We are passionate about helping Beta improve its financial performance and make positive changes that benefit everyone. 

Rather than making a public announcement, we have taken a more thoughtful and strategic approach. We’ve started buying shares of Beta’s stock on the open market, one at a time, to avoid disclosing our plans to the government.

After acquiring enough shares, we requested a private meeting with Beta’s management to present our innovative ideas for boosting its revenue. We collaborated closely with Beta’s management to make these changes happen. We are delighted to report that Beta’s stock price has soared, and as a result, we have profited from the increase in the stock price.

This is a prime example of how buying small shares can help a company make positive changes that benefit everyone. However, we know that only some people who buy a small number of shares have the best intentions. We remain committed to our sincere and confident approach to working with companies like Beta to create a win-win situation for all.

How does a toehold purchase work? 

Now, let’s go through the basics of how a toehold purchase works. It’s important to understand these steps if you’re considering making a toehold purchase:

1. Identify Target Company: The investor performs research and analysis on public companies to identify a target firm they believe has the potential for substantial value improvement.  

2. Develop Strategy: The investor determines the details around how they can catalyse changes at the target company to help achieve that value potential. This may involve improvements to operations, financial structuring, management shakeups, or even an outright takeover.

3. Make Initial Purchases: The investor begins discreetly acquiring shares of the target company through open market purchases, keeping each buy under 5% of total shares to avoid required SEC disclosures on their ownership stake.

4. Build Toehold Position: Over weeks or months, the investor continues accumulating target company shares in smaller increments until reaching an aggregate ownership level sufficient to qualify as a major shareholder but below the 5% reporting threshold.

5. Engage Management: With the voting power from their toehold, the investor approaches management with proposals and pressure to make operational, financial or governance changes consistent with the investor’s strategy around improving performance and shareholder value.

6. Exercise Influence:  Over an extended campaign, the toehold owner utilises their leverage as a large shareholder to drive management toward implementing the desired value-creating changes.

When you want to buy a significant stake in a company, it’s important to do a lot of research and keep talking to the company’s leaders about how to make the most of your investment. Sometimes, the company’s leaders must be more open to your ideas or how you’re trying to make changes.

Conclusion

Toehold purchases are a way for shareholders to have a say in how a business is run. However, these purchases can sometimes be used by other companies to try and take over the business for their benefit. It’s important to understand why someone might want to make a toehold purchase so you can decide whether it’s a good thing for the business. By carefully looking at all the information, we can ensure that toehold purchases are used in a way that helps everyone involved.

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