The Saga of Musk vs Twitter: Valuing the Social Network Premium

If nothing else, the saga of Elon Musk vs Twitter was fascinating to watch and an excellent learning experience on the basic mechanics and legal points of mergers and acquisitions (M&A). Until almost the end, it looked like a Delaware Chancery Court would determine the outcome. On Oct. 17, a trial was set to commence to decide whether Musk had to fulfill the merger agreement that he signed with Twitter earlier this year. Musk had tried to back out of the original merger agreement using the claim that Twitter had experienced a material adverse effect (MAE). Twitter responded and subsequently filed suit in Delaware (where it is registered) to force Musk to make good on the merger agreement and pay $54.20 per share for Twitter’s shares outstanding ($44 billion in total). Then, Musk backtracked on his attempt to void the merger agreement as it became clear that he had a very weak case. Finally, he and Twitter negotiated to amend the terms of the original merger agreement and close the merger as originally planned.

In a normal acquisition process, if someone wants to acquire a company, she¹ would first approach the Board of Directors of that company. If the Board agreed, the company and the individual would sign a letter of intent (LOI)². This would start the detailed and final negotiations process and due diligence. If these were completed successfully, then a final merger agreement would be signed by both parties, and the company would be acquired by the individual.

However, if the Board does not agree to the acquisition, then the individual has two choices: walk away from the deal entirely or bypass the Board and go directly to shareholders of the company in what is known as a hostile acquisition attempt. In general, while negotiating with a Board that is reluctant about signing a letter of intent or even negotiating with a potential acquirer, threatening a hostile acquisition is sometimes enough to change the Board’s mind.

In the case of Musk’s discussions with Twitter’s board, the leverage in the initial negotiations seems to have been on the Board’s side. The Board indicated to Musk that Twitter was not available for purchase (as Boards typically do initially for negotiating purposes). Following some more negotiation, the Board appeared to reluctantly agree to sell the company to Musk for $44 billion.³ Furthermore, and very importantly, Musk agreed to skip the letter of intent and directly signed a merger agreement. What makes this action crucial is that in doing so Musk waived his ability to do due diligence on the company and thereby renegotiate the terms of the acquisition if any problems were discovered in Twitter’s operations or financial statements.⁴ From a legal standpoint, a merger agreement is a binding contract (unlike an LOI).

A few weeks later, however, Musk changed his mind and sent the Board a letter terminating the merger agreement on the grounds that the business had experienced a material adverse effect, or MAE.⁵ The Board responded that no such MAE had occurred and filed a lawsuit in Delaware (where it is incorporated) asking the court to force Musk to abide by the merger agreement and complete the acquisition of Twitter.

The MAE that Musk claimed is that the number of “bots” on Twitter’s platform is higher than the 5% number that the firm claimed in a filing with the SEC. Bots are fake user accounts on a platform, which can be used for several purposes including spamming accounts with ads to trolling the users of that platform. Because Twitter generates revenue by selling ads to companies, who are trying to target actual users, the more bots there are on Twitter as a percentage of the total mDAU,⁶ the lower the prices that Twitter would be able to charge for ads. This is because a potential advertiser is interested in targeting people, not bots. Bots do not represent people; therefore, given a fixed number of accounts, the more bots there are on Twitter, the fewer actual people, or users, there are to target for ads. And the fewer users available for ad targeting, the less interesting Twitter becomes for advertisers.

Musk claimed that Twitter’s estimate of bots was substantially lower than the actual number of bots on Twitter. He therefore claimed an MAE, and cited the MAE clause in the merger agreement to terminate the merger.

The fact that there are bots on Twitter is undisputed by both sides. The question is only what percentage of user accounts are bots vs actual people.

However, the legal point that was been cited by Twitter is that bots have been present on Twitter virtually the whole time that Twitter has been in existence. Bots are an (unfortunate) part not only of Twitter, but in fact of any social media platform. So, when anyone (whether it’s a potential acquirer or a potential advertiser or a user) looks at Twitter’s historical revenues, those include the effects of bots. It isn’t the case that bots suddenly came onto Twitter’s platform after the merger agreement was signed, or even that bots suddenly ramped up as a percentage of Twitter’s user accounts after the merger agreement. The presence of bots, while unfortunate for all parties, is a well-known characteristic of a social media platform, and all of Twitter’s historical and current financial statements include whatever negative effects bots have had on Twitter’s operations.

Therefore, when Musk investigated Twitter’s financial statements/condition, he was viewing financial statements that included any negative effects of bots. So, unless Musk claimed that the percentage of bots suddenly changed substantially from historical patterns (which he did not), Musk’s legal case was weak.

The analogy here would be warranty claims on a product that is made and sold to customers by a business. Most products sold comes with warranties, and companies have to make good on a small percentage of those warranties as there are always defects that arise from manufacturing, shipping, etc. Making good on warranties is an expense to a business, but it is just a normal part of doing business (though it is unfortunate because it means a customer received a deceptive product). So, if someone were acquiring a business, as long as the business had accurately recorded historical warranty claims by customers, the acquirer would not be able to legally claim an MAE just because of the presence of warranties — warranties are just a normal part of doing business. Similarly, Musk cannot claim that the mere presence of bots as an MAE — bots are a normal, though unfortunate, part of doing business for a social media platform.

To the contrary, if the number of warranties suddenly increased substantially for products between the time a merger agreement was signed and the transaction closed, that would be grounds for declaring an MAE and terminating a merger. Similarly, if the number of bots on Twitter had suddenly increased substantially shortly after Musk and Twitter signed their merger agreement, that would be grounds for declaring an MAE. However, Musk isn’t claiming this.

What Musk claimed is that the company falsely reported the number of bots on Twitter. This would be like a company falsely recording the number of customer warranty claims, and therefore incorrectly recording warranty expenses on its income statement filed with the SEC. This indeed would be an MAE — in fact, this would be accounting fraud, and the company as well as its CEO and CFO would be in serious legal trouble.⁷ In the case of Twitter, however, their 10-K filings with the SEC included the following important clause:

“However, this estimate [of false or spam accounts] is based on an internal review of a sample of accounts and we apply significant judgement in making this determination. As such, our estimation of false or spam accounts may not accurately represent the actual number of such accounts, and the actual number of false or spam accounts could be higher than we have currently estimated.”

Musk had access to these SEC filings, and therefore knew (just like all other investors) that Twitter was just estimating the percentage of bots and that the actual percentage could be higher or lower. So, from a legal standpoint, it would have been difficult for Musk to win on the grounds that he was misled by false claims on the SEC filings by Twitter. This is why it was always unlikely that Musk would win his legal challenge on the grounds of an MAE.⁸

The weakness of his case probably dawned on Musk as he started losing pretrial rulings in the Delaware court.⁹ These likely made him realize that he would lose in court and would be forced to purchase Twitter on the original terms of the merger agreement. So, he decided to get back into the negotiating room with Twitter and see if he could alter the original merger terms to his benefit, even if only slightly.

In the end, Musk followed through on the merger agreement and ended up paying $54.20 per share for Twitter, or roughly $44 billion, a massive premium to Twitter’s true market value. If he had never agreed to purchase Twitter, Twitter’s shares probably would have performed in line with other social media companies from the beginning of April onwards (when the markets first heard about Musk’s interest in Twitter). In that case, its shares would have dropped about 55% by the time of this writing, making Twitter’s shares worth about $17 per share, or a $14 billion market cap. With such a huge overpayment, it seems unlikely that Musk will earn a positive return on his investment — even if he is able to triple Twitter’s market value through operational improvements, he would just about break even.

It’s no wonder Musk desperately tried to get out of the merger agreement. Similarly, Twitter’s management, board, and shareholders were equally desperate to close the transaction. Management realized that completing the merger was far and away more valuable for shareholders than any value that management could add by running the business. In fact, it represents the most value creating action by Twitter’s management since the founding of Twitter.

Footnotes

[1] In reality, a person would never try to buy the company as an individual. Even if he/she had the resources, for liability, tax, and legal reasons it would always be better to set up a corporate entity such as a C-corp or an LLC (limited liability company) to undertake the actual transaction. The individual could choose to be the 100% owner of this entity, or the majority owner, as Musk initially structured the Twitter acquisition.

[2] A letter of intent is simply a term sheet, or memo of understanding, between the two parties indicating they are negotiating a final merger agreement. This memo would lay out the negotiating process including things like non-disclosure agreements, non-solicitation agreements, etc.

[3] Reluctantly is in quotes to indicate a bit of sarcasm because the Board was likely very happy with this purchase price. The $44 billion was a substantial premium to the market price of Twitter. In fact, the main reason many feel Musk was trying to walk away from this deal is that the value of tech companies collapsed soon after Musk agreed to buy Twitter. This led Musk to realize that he is substantially overpaying for Twitter, with little chance of getting a positive return on his investment.

[4] Due diligence is the process by which an acquirer investigates the financials and operations of the company to make sure everything is in order. If a problem in the target firm’s operations or financials is discovered during the due diligence process, it gives the acquirer the grounds to walk away from the transaction, or at least renegotiate the acquisition price.

[5] The merger agreement had a clause stating that if the business had a substantial change in its operations for the worse (an MAE), Musk could terminate the agreement. This is standard language in merger agreements.

[6] mDAU stands for monetizable daily active users. It represents the number of users who logged in on any given day to whom Twitter could show ads and generate revenue off the ads.

[7] Interestingly, in the case of Twitter, falsely reporting the number of bots would likely not result in the income statement being any different because neither revenue nor expenses would be affected by a false bot percentage. The effect of bots would be to lower advertising rates, but advertisers would already be paying these lower rates because they would be aware of the reduced effectiveness of their ads, due to the pattern of customer responses, or “clicks,” they are seeing from these ads.

[8] Musk also threw in other claims for an MAE such as a termination payment by Twitter to an executive after the merger agreement was signed, as well as a whistleblower lawsuit by Twitter’s former head of security, Peiter Zatko. But these claims were really just sideshows and ended up obfuscating the main claim Musk made for an MAE — the supposed intentional underestimation of bots by Twitter in its SEC filings.

[9] In fact, Musk likely knew when he sent the letter to Twitter’s board terminating the merger agreement that his legal case was weak. He was probably hoping that Twitter’s board would “blink” and allow Musk to walk away from the transaction with just having to pay a breakup fee of $1 billion (which was part of the merger agreement).