BIWS: M&A Deals and Merger Models

Why might one company want to buy another company?

There are a number of reasons as to why a company would want to acquire another.

• Revenue and expense synergies

• Market share protection

• Valuable IP or assets

• Expansion opportunities

• Industry diversification

In all of these cases, the acquirer believe that the return they get from the acquisition will exceed the price they’ll have to pay to acquire the company and they’ll be better off as a result

How can you analyze an M&A deal and determine whether or not it makes sense?

There are a few ways to analyze an M&A deal. You could look at whether the company will benefit from product optionality, IP, geographies, talent, or customers.

You could also determine if the seller is undervalued and by purchasing them you could eventually realize their fair value.

Also, you can look at whether the deal will be accretive or dilutive to EPS.

Walk me through a merger model (accretion/dilution analysis).

In a merger model, you start by projecting the financial statements of the Buyer and Seller. Then, you estimate the Purchase Price and the mix of Cash, Debt, and Stock used to fund the deal. You create a Sources & Uses schedule and Purchase Price Allocation schedule to estimate the true cost of the acquisition and its after-effects.

Using these assumptions, you combine the two companies’ financial statements to get pro forma financials. You factor in the additional interest expense from the debt, the lost interest income from the cash, and potentially synergies along your way to getting pro-forma NI.

Then, you’ll factor in any newly issued shares that have caused dilution to determine pro-forma EPS. You’ll compare it to the buyer’s standalone EPS to determine if the acquistion will be accretive or dilutive.

Why might an M&A deal be accretive or dilutive?

Whether an M&A deal is accretive or dilutive depends on how it was financed and what incremental benefits a buyer can realize from a seller.

If an M&A deal increases the buyer’s pre-tax income and that outweighs any new interest and foregone interest, then the deal will be accretive as long as they didn’t meaningfully dilute shareholders.

Meanwhile, if an M&A deal decreases the pre-tax income of the buyer, and the share count remains the same or increases, it is going to be dilutive to EPS.

How can you tell whether an M&A deal will be accretive or dilutive?

You compare the Weighted Cost of Acquisition to the Seller’s Yield at its Purchase Price.

• Cost of Cash = Foregone Interest Rate on Cash (1 – Buyer’s Tax Rate) • Cost of Debt = Interest Rate on New Debt (1 – Buyer’s Tax Rate)

• Cost of Stock = Reciprocal of the Buyer’s P / E multiple, i.e., Net Income / Equity Value.

• Seller’s Yield = Reciprocal of the Seller’s P / E multiple, calculated using the Purchase Equity Value.

Weighted Cost of Acquisition = % Cash Used Cost of Cash + % Debt Used Cost of Debt + % Stock Used * Cost of Stock.

If the Weighted Cost is less than the Seller’s Yield, the deal will be accretive; if the Weighted Cost is greater than the Seller’s Yield, the deal will be dilutive.

Why do you focus so much on EPS in M&A deals?

You focus on EPS because it is both more visible and tangible to the board or common shareholders, and it is fully reflective of the impacts of an acquisition. Even though what really matters is long-term free cash flow, that number won’t reflect the increase in interest expense, or foregone interest income.

How do you determine the Purchase Price in an M&A deal?

It depends if you are looking at a public or private company.

If you are looking at a public company, the acquisition price needs to reflect a control premium of roughly 10-30% over the current equity value.

If you are looking at a private company, you instead determine an appropriate multiple on one of their financial metrics, like EBITDA or revenue.

The actual price the buyer is willing to pay is determinant on the magnitude of the incremental benefits or synergies they can realize from buying the seller.

What are the advantages and disadvantages of each purchase method (Cash, Debt, and Stock) in M&A deals?

Cash - cheapest form, and the fastest and simplest for getting a deal done. Interest income decreases which reduces pre-tax income a little, and now the company doesn’t have the flexibility of cash for opportunities or dangers that may come up.

Debt - more expensive than cash but still cheaper than equity, however it can increase the risk of leverage on the combined entity, which makes future issuance more costly, and it takes longer because you need to secure financing.

Equity - most expensive and dilutes current shareholders, but the “cost” is not as tangible since no cash has to leave the door. Also, there isn’t an immediate tax on the seller like there is in the other methods. Finally, equity can be quicker to raise than debt if a deal needs to get over the line.

How does an Acquirer determine the mix of Cash, Debt, and Stock to use in a deal?

To give a deal the best chance of being accretive, the buyer will typically seek to reduce the weighted average cost of acquisition.

So, they start by maximizing the amount of cash they can put into the deal, though leaving them enough to still run the operations of the business.

Then, they’ll use the most amount of debt they can before leverage ratios become too high or the cost of debt elevates too high.

Finally, for whatever gap still remains to complete the acquisition, they’ll issue equity, diluting current shareholders.

Which purchase method does a Seller prefer in an M&A deal?

There is no single preferred method because the trade-offs of each method are good or bad depending on the perspective of the seller.

Cash and debt provide certainty and immediate payout, but they also incur immediate taxes upon the seller. And, if the acquisition proves extremely accretive to the buyer, then the seller participates in none of the upside.

Contrast that with a stock deal, where there is not certainty of how many shares or how much ownership will be received, but taxes aren’t immediate and they seller can benefit from increases in the new stock price. However, they can also get hurt if the buyer’s stock performs poorly.

So, the preferred method depends on the Seller’s confidence in the Buyer: Cash and Debt are better with higher uncertainty, while Stock may be better with large, stable Buyers.

What’s the impact of each purchase method in an M&A deal, and how do you estimate the Cost of each method?

The cost of cash is just the interest you could have earned on it, called the Foregone Interest on Cash. On the other side, the interest expense paid on any debt used to fund the deal is the cost of debt. The after-tax costs of these methods are found by multiplying the impact by (1-TaxRate)

The cost of stock is the dilution to EPS that the newly issued stock creates for the combined entity, which can be found with the reciprocal of the acquirer’s P/E multiple.

Isn’t the Foregone Interest on Cash just an “opportunity cost”? Why do you include it?

It is not just an opportunity cost because it represents real money the company was earning that, after the acquisition, it now is not, making it a real cost associated with making the acquisition.

Isn’t it a contradiction to calculate the Cost of Stock by using the reciprocal of the Acquirer’s P / E multiple? What about the Risk-Free Rate, Beta, and the Equity Risk Premium?

No, because they are different methods for different use-cases. The reciprocal of the acquirer’s P/E multiple measures the impact of new shares on the company’s EPS.

The CAPM method used in WACC measures the expected annualized return to shareholders based on risk and opportunity cost.

Why might an Acquirer choose to use Stock or Debt even if it could pay for the Target with Cash?

Paying with cash means that the cash leaves the door right now, which reduces flexibility for the company. Say a short-window opportunity for an acquisition comes about for which they could only use cash, or one of their key suppliers had issues and they need cash to stabilize the supply chain, without cash they wouldn’t be able to deal with those situations and it may negatively impact the company. Also, if maturities on past debt are coming due.

Also, some cash can be hard to access or may be restricted. Finally, if the acquirer is trading at a very high P/E multiple, issuing new stock can be cheaper than cash.

Are there cases where EPS accretion/dilution is NOT important? What else could you look at?

There are definitely cases when EPS won’t be the determinant of a good acquisition, at least not in the short-term.

For example, a large healthcare company could acquire a small biotech startup making a key drug even though it has negative earnings. Or a software company could acquire a small tech firm to poach to talent. Or a large incumbent could acquire a high growth disruptor to prevent their market share from being taken.

***For example, if the Buyer is private, or it already has negative EPS as a standalone entity, it won't care about whether the deal is accretive or dilutive. It also makes little difference if the Buyer is far bigger than the Seller (e.g., 10x – 100x its size). Besides EPS accretion/dilution, you can also analyze the deal's qualitative merits, compare the IRR to the Discount Rate, and value the Seller + Synergies and compare that to the Equity Purchase Price. Finally, you can create a Contribution Analysis to look at how much the Buyer and Seller "contribute" to each financial metric and then compare the contribution percentages to their respective ownership percentages. Value Creation Analysis, to determine how the Buyer’s share price will change after the deal closes, may also be useful in certain contexts, such as if the Buyer +

How does a merger differ from an acquisition?

Typically, a merger is just an acquisition where the two companies are a similar size. Because of this, all or majority stock deals are much more common. Also, the contribution analysis or value creation analysis will be a lot more relevant.

What are the main PROBLEMS with merger models?

There are a few key problems.

First of all, at the end of the day cash flows are what truly matters, and if those are way different than EPS then EPS will be a misleading metric to pay attention to.

Also, merger models are very one-dimensional. Just because an all-cash deal looks accretive on paper doesn’t mean that the process will be smooth, the companies will fit together, or than shareholders will be in favor. And, because of this fact that merger models also can’t predict how the stockholders will respond, then the cost of issuing stock could look very different between the time of announcement and closing.

Lastly, merger models are completely quantitative, and don’t reflect strategically buying disruptive startups or cultural fit between companies.

Company A, with a P / E of 25x, acquires Company B for a purchase P / E multiple of 15x. Will the deal be accretive?

It depends. If Company A uses a mix of financing methods, we would need more details.

However, if the acquisition is an all-stock deal, then it will be accretive because Company B’s shares are yielding more than Company A’s would cost. We get this be inverting their P/E multiples, and seeing that Company A has a 4% cost of issuing stock, while Company B’s shares are yielding roughly 6.7%.

Company A, with a P / E of 25x, acquires Company B for a purchase P / E multiple of 15x.

Assume that Company A has 10 shares outstanding at a share price of $25.00, and its Net Income is $10. It acquires Company B for a Purchase Equity Value of $150. Company B has a Net Income of $10 as well.

Assume the same tax rates for both companies. How accretive is this deal?

Company A has an EPS of $1 with 10 shares outstanding and $10 of NI.

If the deal is all-stock, then company A would need to issued 6 shares at $25/share to get the $150 necessary to purchase Company B. So, the combined company has an equity value of $400 and there are 16 shares outstanding. By combining the financial statements, we see than it also has $20 in NI. $20/16 is $1.25 EPS, meaning this deal is 25% accretive.

Company A, with a P / E of 25x, acquires Company B for a purchase P / E multiple of 15x.

Assume that Company A has 10 shares outstanding at a share price of $25.00, and its Net Income is $10. It acquires Company B for a Purchase Equity Value of $150. Company B has a Net Income of $10 as well.

Assume the same tax rates for both companies.

Company A now uses Debt with an Interest Rate of 8% to acquire Company B. Is the deal still accretive? At what interest rate does it change from accretive to dilutive?

If company A is just using this debt for the financing, then its weighted average cost of acquisition is 8% (1 - tax rate), or 6%. This is lower than the 6.7% yield on Company B’s shares, so the deal would be accretive.

For the deal to be dilutive, the interest rate before factoring in the tax shield would need to be higher than 8.9% (6.7%/(1-25%))

Company A, with a P / E of 25x, acquires Company B for a purchase P / E multiple of 15x.

Assume that Company A has 10 shares outstanding at a share price of $25.00, and its Net Income is $10. It acquires Company B for a Purchase Equity Value of $150. Company B has a Net Income of $10 as well.

Assume the same tax rates for both companies.

What are the Combined Equity Value and Enterprise Value in this deal? Assume that Equity Value = Enterprise Value for both the Buyer and Seller and use 100% Stock funding.

Because company A would need to issue 6 shares at $25 dollars each to get the capital needed to acquire company B at $150, equity value increases to $400 since the combined equity value is the buyer’s equity vale + market value of stock issued in the deal.

The enterprise value, though, will remain also increase to $400, since you need to add the Buyer’s EV and the Purchase EV of the seller.

How do the Combined TEV / EBITDA and P / E multiples change if the deal financing method changes?

If deal financing methods change, then metrics like TEV/EBITDA don’t actually change since both the numerator and denominator are capital structure neutral.

P/E though, will be affected. If stock is issuance, the equity value will increase. If cash or debt are used, the interest income or expense will change, the earnings will change.

Company A, with a P / E of 25x, acquires Company B for a purchase P / E multiple of 15x.

Without doing any math, what range would you expect for the Combined P / E multiple?

I would expect that the P/E multiple will be somewhere in between 15x and 25x. Since company A is larger, it will likely skew closer to 25x.

In this situation, Company A, with a P / E of 25x, acquires Company B for a purchase P / E multiple of 15x.

Now, assume the financial size of Company A doubles. Is a 100% stock deal more or less accretive?

The deal is going to be less accretive. Even though the P/E multiple is the same, so the cost of stock issuance is the same, the relative size difference between company A and B means that company B’s earnings will have a proportionally smaller impact.

Also, the combined P/E multiple will be even closer to 25x.

Company A, with a P / E of 25x, acquires Company B for a purchase P / E multiple of 15x.

Assume that Company A is twice as big financially, so its Equity Value is $500, and its Net Income is $20. It has 10 shares outstanding.

What is the accretion/dilution in a 100% Stock deal with a $150 Purchase Equity Value for Company B?

With NI of $20 and 10 shares outstanding, company A has an EPS of $2.

To finance the deal, if their shares are worth $50 each, they need to issue 3 shares. So, the combined entity has 13 shares. Also, since company B has $10 in NI, the combined NI is $30. So, with $30 of NI and 13 shares, EPS is ~2.31, or 15% accretive.

Company A has a P / E of 10x, a Debt Interest Rate of 8%, a Cash Interest Rate of 4%, and a Tax Rate of 25%.

It wants to acquire Company B at a purchase P / E multiple of 16x using 1/3 Stock, 1/3 Debt, and 1/3 Cash. Will the deal be accretive?

The weighted average cost of acquisition for company A is ((1/3×8%)+(1/3×4%))*(1-25%) + (10% *1/3). Or, 6.33%.

The yield on Company B’s shares is 1/16, or 6.25%.

So, the deal would be dilutive.

Company A acquires Company B using 100% Debt. Company B has a purchase P / E multiple of 12x, and Company A has a P / E multiple of 15x. ]

What interest rate on Debt is required to make the deal dilutive?

For the interest rate on the debt to make the deal dilutive, it’s post-tax impact would have to exceed the yield on Company B’s shares, which is about 8.33%.

So, we can set 8.33% equal to x times (0.75), with x being the interest rate on the debt that would precisely equal the yield. Dividing 8.33% by 0.75, we get x equals about 11.11%. So, the interest rate on the debt would have to roughly exceed 11.11% for the deal to be dilutive.

Company A has an Equity Value of $1,000 and a Net Income of $100. Company B has a Purchase Equity Value of $2,000 and a Net Income of $50.

For a 100% Stock deal to be accretive, how much in Synergies must be realized?

Before acquisition, company A’s P/E is 10x.

After purchasing company B and combining the financial statements, the combined company will have an equity value of $3000 and NI of $150 since the deal is all stock, assuming no synergies have been realized. This gives a P/E of 20x.

For the deal to be accretive, the P/E of the combined company needs to be less than 10x, so they would need to realize synergies of at least $150 to net income. Which, assuming a 25% tax rate, means $200 of pre-tax synergies.

An Acquirer has an Equity Value of $1 billion, Cash of $50 million, EBITDA of $100 million, Net Income of $50 million, and a Debt / EBITDA of 2x. Peer companies have a median Debt / EBITDA of 4x.

It wants to acquire another company for a Purchase Equity Value of $500 million. The Seller has a Net Income of $30 million, EBITDA of $50 million, and no Debt.

What’s the best way to fund this deal? Use the Combined EBITDA figures in the calculations.

We will assume that they can use all of their cash.

So, they would start by putting all $50M of cash towards the acquisition since, at a 5% cost debt financing is likely still cheaper. This leaves $450M left. With combined EBITDA of $150M and capacity to take on 4x leverage, we can have $600M of debt total. But, since the acquirer already has $200M of debt, we can only take $400M additional.

This leaves $50M towards the price, which the acquirer will have to fund using stock issuances.

An Acquirer has an Equity Value of $500 million, Cash of $100 million, EBITDA of $50 million, Net Income of $25 million, and Debt / EBITDA of 3x.

Similar companies in the market have Debt / EBITDA ratios of 5x.

What’s the BIGGEST acquisition this company might be able to complete?

First, we’re going to assume that they can use all $100M of their cash, though it may be more accurate to leave $50M left over. Then, if they have 2 turns more wiggle room for their leverage ratio, they can add $100M of debt. Then, if they really stretched themselves, they could issue an amount of stock around $500M and still retain their majority ownership, though around $250M of stock would likely be the realistic high end. So, the largest acquisition within their reach would be around $700M

An Acquirer with an Equity Value of $500 million and Enterprise Value of $600 million buys another company for a Purchase Equity Value of $100 million and a Purchase Enterprise Value of $150 million.

What are the Combined Equity Value and Enterprise Value?

The combined equity value will depend on the way the deal is financed. If it is all-stock, then the combined equity value would be $600 million. But, if there was less equity issued to make the deal, we would have to only add that amount to the acquirer’s equity value to get combined equity value.

The combined enterprise value is unaffected by financing, and can be found by simply adding the acquirer’s EV to the EV of the seller, which in this case gets us a combined EV of $750M.

How do the Combined Equity Value and Enterprise Value change based on the deal financing?

The combined equity value will only increase from the buyer’s equity value by the amount of stock issued to make the deal. So, if it is 100% stock financed, then the combined equity value will just add the buyer and seller’s values. But, if there is a mix, then the combined equity value decreases.

The combined enterprise value is neutral to any changes in financing, so you always just add the buyer’s and seller’s EV to get it.

Wait, you’re saying that in a 100% Cash or Debt deal, the Seller’s Equity Value just “disappears.” How is that possible?

The seller’s equity value doesn’t disappear, it just isn’t in the form of equity any longer. Whether the buyer uses debt or equity, the seller receives cash, and that cash paid to the seller is in the interest of their equity stake. You can see this in the fact that both companies’ EV is the same after the deal, meaning no value is “destroyed”`

Wait a minute, you’re also saying that the purchase premium the Acquirer pays for the Target lasts after the deal closes? How is that possible?

The purchase premium does not necessarily “last” because the acquirer’s equity value can change from the time the deal is announced to the time it actually closes, so it depends on the market’s reaction to the deal. If the market believes the Target's premium was justified, then the rules about Combined Equity Value and Combined Enterprise Value will hold up. However, if the market believes the Acquirer overpaid for the Target, the Acquirer’s share price will fall to reflect the amount by which it overpaid – whether that means the entire purchase premium, part of the premium, or more than the premium.

Let’s say an Acquirer has an Equity Value of $500 million and an Enterprise Value of $600 million. The Acquirer has 100 million shares outstanding at $5.00 per share.

The Target has an Equity Value of $100 million and an Enterprise Value of $150 million, and the Acquirer pays a 30% premium to acquire the Target in a 100% Stock deal.

A few months after the deal is announced, the market loses faith in the deal and believes the 30% premium is no longer justified.

What happens to the Combined Equity Value and Enterprise Value immediately after the deal is announced and several months after, when the market loses faith in the 30% premium?

Immediately after, Combined Equity Value = $500 million + $130 million = $630 million since it’s a 100% Stock deal. Combined Enterprise Value = $600 million + $180 million = $780 million. When the market loses faith in this 30% premium, the Acquirer’s share price will fall, such that its Eq Val and TEV both fall by $30 million. So, its share price will fall to $4.70, and the Combined Equity Value will decrease to $600 million because the Acquirer’s Equity Value is now only $470 million. Combined Enterprise Value = $570 million + $180 million = $750 million, so it is also down by this $30 million premium.

Let’s say an Acquirer has an Equity Value of $500 million and an Enterprise Value of $600 million. The Acquirer has 100 million shares outstanding at $5.00 per share.

The Target has an Equity Value of $100 million and an Enterprise Value of $150 million, and the Acquirer pays a 30% premium to acquire the Target in a 100% Stock deal.

A few months after the deal is announced, the market loses faith in the deal and believes the 30% premium is no longer justified.

What happens to the Combined Equity Value and Enterprise Value immediately after the deal is announced and several months after, when the market loses faith in the 30% premium?

How does that last answer change if the Acquirer uses 100% Debt or Cash instead?

The Combined Enterprise Value changes the same way in both steps: initially, it’s $780 million, but then it falls to $750 million as the Acquirer’s share price falls. The Combined Equity Value is initially only $500 million in a 100% Debt or 100% Cash deal because no Stock is issued. When the Acquirer’s share price falls, the Combined Equity Value drops to $470 million.

An Acquirer with an Equity Value of $500 million and an Enterprise Value of $600 million has Net Income of $50 million and EBITDA of $100 million.

The Target, with a Purchase Equity Value of $100 million and a Purchase Enterprise Value of $150 million, has Net Income of $10 million and EBITDA of $15 million.

What are the Combined P / E and TEV / EBITDA multiples in a 100% Stock deal? Assume the same tax rates for the Acquirer and Target.

The combined EV is going the be $750M, and because this is an all-stock deal, the combined equity value is going to be $600M. After we create pro-forma financials, the combined entity is going to have an EBITDA of $115M and net income of $60M.

So, the combined P/E is going to be 10x, and the combined EV/EBITDA is going to be around 6.5x

The Target, with a Purchase Equity Value of $100 million and a Purchase Enterprise Value of $150 million, has Net Income of $10 million and EBITDA of $15 million. What are the Combined P / E and TEV / EBITDA multiples in a 100% Stock deal? Assume the same tax rates for the Acquirer and Target.

How would those Combined Multiples change in a 100% Cash or Debt deal?

Enterprise value and EBITDA do not change in this situation, since they are capital structure neutral and EBITDA doesn’t include the effects of interest. So, the EV/EBITDA multiple is the same

Equity value and net income, though, would change. Equity value would be equivalent to the acquirer’s equity value since no additional stock was issued. NI would be lower because of the impact of foregone interest on the cash or a higher interest expense from the debt. Because equity value is likely changing by a larger proportion than the interest considerations, then P/E would likely decrease.

How do the Combined Multiples change based on the deal financing?

Enterprise value and its corresponding metrics like EBIT, EBITDA, and revenue are unaffected by changes in deal financing. As a result, EV-based multiples are also unaffected.

Equity value does change, though, by the amount of equity issued to make the acquisition, and the metrics paired like net income and free cash flow are impacted by interest on any new debt, and foregone interest on the cash that was spent.

What are the possible ranges for the Combined Multiples after a deal takes place?

Typically, the combined EV and equity value multiples are going to be somewhere in-between the buyer’s and seller’s multiples and skewed to the larger company, usually the buyer, since their finances will make up a disproportionate amount of the combined company.

Equity value mulitples can, though, be outside of this range.

Consider this M&A scenario:

• Company A: Enterprise Value of $100, Equity Value of $80, EBITDA of $10, Net Income of $4, and Tax Rate of 50%.

• Company B: Enterprise Value of $40, Equity Value of $40, EBITDA of $8, Net Income of $2, and Tax Rate of 50%.

Calculate the TEV / EBITDA and P / E multiples for each company.

Company A: TEV/EBITDA = $100/$10 = 10x; P/E = $80/$4 = 20x

Company B: TEV/EBITDA = $40/$8 = 5x; P/E = $40/$2 = 20x

Consider this M&A scenario:

• Company A: Enterprise Value of $100, Equity Value of $80, EBITDA of $10, Net Income of $4, and Tax Rate of 50%.

• Company B: Enterprise Value of $40, Equity Value of $40, EBITDA of $8, Net Income of $2, and Tax Rate of 50%.

Calculate the TEV / EBITDA and P / E multiples for each company?

Company A acquires Company B using 100% Cash and pays no premium to do so. Assume a 5% Foregone Interest Rate on Cash. What are the Combined TEV / EBITDA and P / E multiples?

Combined enterprise value is $140, combined equity value is $80. Combined EBITDA is $18. Pre-tax income decreases by $2 from the foregone interest on cash, so at a 50% tax rate combined net income is $5.

So, combined TEV/EBITDA is around 7.9x, and combined P/E is 16x

Consider this M&A scenario:

• Company A: Enterprise Value of $100, Equity Value of $80, EBITDA of $10, Net Income of $4, and Tax Rate of 50%.

• Company B: Enterprise Value of $40, Equity Value of $40, EBITDA of $8, Net Income of $2, and Tax Rate of 50%.

Now, let’s say that Company A instead uses 100% Debt with a 10% interest rate to acquire Company B.

Again, Company A pays no premium for Company B. What are the combined multiples?

Combined enterprise value is $140, combined equity value is $80. Combined EBITDA is $18. Pre-tax income decreases by $4 because of the interest on new debt, so at a 50% tax rate combined net income is $4.

So, combined TEV/EBITDA is around 7.9x, and combined P/E is 20xWhy is the “real purchase price” in an M&A deal NOT equal to the Seller’s Purchase Equity Value or Purchase Enterprise Value?

Why is the “real purchase price” in an M&A deal NOT equal to the Seller’s Purchase Equity Value or Purchase Enterprise Value?

There are a few reasons. First of all, there are various fees and expenses incurred in an acquisition from paying people like bankers or lawyers, these expenses will make the total purchase cost greater than just the seller’s purchase equity value.

The reason the real purchase price won’t typically equal the purchase EV is mainly due to the varying treatments of debt and equity. For example, if the acquirer comes in and finances all of the seller’s debt, then the cost of “acquiring” that debt is not incurred. But, if they come in and immediately pay down all of the debt, then the acquisition cost would closer reflect the purchase enterprise value.

Similarly, the seller’s cash could be used to cover some of the expenses or debt repayments revolving around the acquisition.

Typically, the buyer’s real cost falls somewhere in-between.

What information do you need from the Buyer and Seller to create a full merger model?

You would ideally have their income statements AND cash flow statements to make it easier to see how cash and debt are impacted on a pro-forma basis, but you could get away with just an income statement. You don’t need a balance sheet in order to make these cash flow or find the accretive or dilutive impacts on EPS since you just need net income.

Why is a Sources & Uses schedule important in a full merger model?

A sources and uses schedule tells you how you are going to get the financing needed to make the deal happen and when/what you are going to use it on. This reveals the true cost you are actually paying to buy the seller by looking at how many shares you’re purchasing, how much debt is refinanced, and what transaction fees are being paid on the uses side. Then the sources side show what mix of debt, equity, and cash is being used to get the capital to make each of those things happen.

How does a Cash-Free, Debt-Free deal for a private Seller differ from a standard M&A deal for a public Seller?

In this type of private transaction, the seller is left with no debt and no cash after the acquisition.

This means that the seller will use their cash to pay off as much of their debt as possible. If it covers the entire amount, then they’ll use the excess to buyback shares or issue a special dividend to shareholders, or something else that reduces equity value. If debt exceeds cash, then the buyer will have to use their cash to pay it down to zero.

Additionally, private deals are based on a multiple on some underlying metric for the company and the sources and uses schedule is based on purchase enterprise value, not equity value, since private companies don’t have a market cap.

What’s the purpose of a Purchase Price Allocation schedule in a merger model?

When an acquisition is made, the buyer is usually paying a premium over what the seller’s balance sheet says it should be worth: CSE. Since there’s this premium, goodwill must be created since the financing used exceeds to CSE that was written down.

To make the balance sheet of the combined company balance, you need to account for asset and liability write-ups, intangibles, goodwill, and changes to Deferred taxes/creation of DTLs

Why do Deferred Tax Liabilities get created in many M&A deals?

They get created because, in a stock purchase, aka “full”, acquisition, the acquirer has to re-write all of the seller’s assets and liabilities up or down to fair value. Then, the combined company depreciates the PP&E based on this new value. For book taxes, this allows them to get a better tax shield. But for cash taxes, they don’t allow the company to use the depreciation on the wrote-up incremental value of the asset to offset higher taxes. The expectation that this is going to happen creates a DTL that decreases as the company pays higher cash taxes than book taxes in the future.

An Acquirer purchases a Target for a $1 billion Equity Purchase Price. This Target has $600 million in Common Shareholders’ Equity and no existing Goodwill. The Acquirer plans to write up the Target’s PP&E and Other Intangible Assets by $100 million. Walk me through the Purchase Price Allocation, assuming a 25% tax rate.

The “Allocable Purchase Premium” equals the Equity Purchase Price minus the Common Shareholders’ Equity plus the Target’s existing Goodwill, so $1 billion – $600 million + $0 = $400 million.

The PP&E and Other Intangible Assets increase by $100 million, so you subtract this figure because it means you’ll need less Goodwill to make the Balance Sheet balance.

So, the Purchase Premium is down to $300 million. Then, you create a Deferred Tax Liability that corresponds to these write-ups. It’s equal to $100 million * 25%, or $25 million, and you add it because an increase on the L&E side means that more Goodwill will be needed on the Assets side.

So, $325 million of Goodwill gets created, along with Asset Write-Ups of $100 million and a new Deferred Tax Liability of $25 million.

What happens if an Acquirer purchases another company for a $1 billion Equity Purchase Price, but the Target’s Common Shareholders’ Equity is $1.5 billion?

Assume there are no write-ups or other adjustments.

There is no such thing as negative goodwill.

So, in this situation, you record this $500 million difference as an Extraordinary Gain on the Income Statement, which increases Pre-Tax Income and Net Income.

On the Cash Flow Statement, Net Income is higher, and you reverse this Extraordinary Gain because it’s non-cash. You also reverse the additional Book Taxes paid on it via a positive adjustment in the Deferred Taxes line item on the CFS.

The initial Balance Sheet combination still works the same way, but you don’t record any Goodwill; you just add all the Target’s Assets and Liabilities to the Acquirer’s and reflect the Cash, Stock, and Debt used to fund the deal.

The increased Net Income (due to the Extraordinary Gain) flows into Common Shareholders’ Equity, and the DTL changes based on the adjustment in the Deferred Tax line item.

Cash does not change because the Extraordinary Gain is non-cash and the company’s Cash Taxes stay the same.`

What are the main adjustments you make when combining the Balance Sheets in an M&A deal?

You need to factor in the source of financing whether that is stock, debt, or cash, then goodwill, A&L write-ups or downs, other intangibles, and any assumed or refinanced debt from the seller. Also, any deferred taxes created are reflected while existing DTLs and DTAs are written off.

Seller’s CSE goes to zero, reflect transaction and financing fees (transaction fees are deducted from CSE, and financing fees are deducted from the Book Value of the New Debt).

***These are the most common adjustments, but there are others; for example, you might reduce the combined Accounts Receivable or Accounts Payable to reflect intercompany receivables or payables, and you might write down Deferred Revenue after the transaction closes because companies can recognize only the profit portion of the Seller’s Deferred Revenue following a deal. 10. Give me an example of how you might estimate Revenue and Expense Synergies in an M&A deal.

Give me an example of how you might estimate Revenue and Expense Synergies in an M&A deal.

You could estimate revenue and expense synergies by looking at lease costs on offices, employees that could be shed, supply chains that could be consolidated, products that could be cross or up-sold.

So for example, if the buyer has 10 customers, and the seller has a product that 1 of them would want for $5, then the combined company made an extra $5 of top line. Of course, then COGS might go up by $1, and so will operating expenses, so operating income is only up by $3. But, then maybe you can lay off one of the HR departments and close a few offices, so then opex goes down by a $1, and you pre-tax income after synergies is $4 higher than the buyer alone.Why do many merger models tend to overstate the impact of Synergies?

Why do many merger models tend to overstate the impact of Synergies?

Merger models are only looking at potential synergies from a quantitative perspective, not a qualitative one. Differences in culture, management, and priorities can impact how readily, if at all, synergies are realized. Plus, synergies take time and money to realize, and many merger models fail to consider these integration costs or severance costs for laid-off employees.

How do you calculate the Combined Company’s Debt repayment capacity in a merger model?

You want to project CFO, which factors in interest expense, and then subtract necessary cash outflows like CapEx or maybe dividends, which then gives you the cash flow you have to be able to repay debt with. Ultimately, you are trying to see how much the company will have to be able to put towards principal payments.

How should you treat Stock-Based Compensation (SBC) in a merger model?

You should treat it as a cash operating expense on the income statement in order to reflect the economic cost to the company without having to increase the share count to show future dilution after/during the merger. Meaning, you don’t add SBC back as a non-cash expense on the balance sheet. Estimating the level and value of that dilution would be essentially impossible since you don’t know the company’s compensation plans or future stock price, and it really just clouds the results of the merger model you are trying to build.

Why might you calculate metrics such as Debt / EBITDA and EBITDA / Interest for the Combined Company in an M&A deal?

You may estimate these to get an idea of the combined companies debt capacity and ability to repay debt. This helps determine how much debt financing may be appropriate for the deal without putting the combined company under. You typically will want to look at this metrics a bit into the future since initial debt loads can distort metrics that would otherwise be in a more reasonable range if the company plans to de-lever quickly.

How do Pro-Forma EPS and Pro-Forma accretion/dilution from the standard, or IFRS/GAAP-compliant, figures?

Though the definition of pro-forma EPS is not universal, most companies try to reflect the earnings by adding back non-cash expenses from the deal like amortization of intangibles or depreciation of write-ups and also non-recurring expenses like integration costs. This gives them their pro-forma pre-tax income and accretion/dilution figures that they report. Suppose that you set up an IRR vs. Discount Rate analysis to judge the merits of an M&A deal. Why might you not be able to take the results of this analysis literally?

Suppose that you set up an IRR vs. Discount Rate analysis to judge the merits of an M&A deal. Why might you not be able to take the results of this analysis literally?

The first issue is that the discount rate is difficult to determine, you might use the buyer’s, or the seller’s or a weighted average. Either way, the results could differ materially. As far as the IRR goes, it is also difficult to determine the actual impact of synergies, who they should be attributed to, and how the synergies will persist into their terminal value.

Walk me through a Contribution Analysis for a 100% Stock M&A deal.

Because it is an all-stock deal, we do not have to worry about foregone interest on cash or additional interest expenses.

First, what you’re going to do is look at each company’s financials, and specifically key metrics, in isolation. Look at things like revenue, EBITDA, customers, etc. Then, combine these financials and key metrics to reflect the combined company. Compare the proportional impact of each company’s line items and metrics on the combined company.

Say the buyer has $100 in revenue which contributes 75% to the combined company, so the seller contributes 25%. Meaning, on a revenue basis, the pro-forma combined enterprise value would be $1,333.

You then subtract the Buyer’s Enterprise Value from this number to get the Seller’s Implied Enterprise Value, and you subtract the items in the TEV bridge to get its Implied Equity Value. Then, you divide by its share count to get the Implied Offer Price. You can then compare this Implied Offer Price to the actual Offer Price in the deal to determine whether the Buyer is paying an appropriate price based on the importance of their business operations to the combined business’ operations. In a real contribution analysis, you would look across many metrics and line items to make this determination.

How does the Value Creation Analysis in M&A deals work, and when is it appropriate?

In a Value Creation Analysis, you assume that the Buyer + Seller as a combined entity will trade at higher valuation multiples, in-line with the multiples of larger public companies in the sector. You calculate the Combined Enterprise Value based on those higher multiples, subtract all the TEV bridge items (and reflect the Cash and Debt used in the deal) to get the Combined Equity Value, and divide by the Combined Share Count to get the Implied Share Price for this entity. If this share price is higher than the Acquirer’s standalone share price, the deal “created value.” This analysis is highly speculative because there’s no guarantee that the Buyer + Seller combined will magically trade at higher multiples; it’s most relevant if the deal represents a clear case of Companies #2 and #3 in the market combining to compete with Company #1. It’s less relevant when the market is highly fragmented, and the Buyer + Seller together still does not resemble larger companies.

Why do Buyers tend to prefer Asset Purchases, and Sellers tend to prefer Stock Purchases?

Asset purchases are advantageous to buyers because they get to hand-pick the assets and the liabilities that will be assumed without having to take on speculative risk on assets and liabilities they didn’t want. Also, D&A on Asset write-ups is allowed for cash taxes in an asset sale.

A seller prefers a stock purchase because it cleans their hands of everything and they aren’t left with assets and liabilities to find another buyer for or manage the risk of themselves. Also, in an asset sale the seller has to pay taxes not just on the proceeds from the sale, but also the write-ups on their assets.

What's the advantage of a 338(h)(10) election for a U.S.-based Buyer?

It allows them to get the tax benefits of an Asset Purchase while still making a stock purchase. The buyer must acquire all of the Assets, Liabilities, and off-balance items, but it is also able to deduct D&A on Asset Write-Ups for cash-taxes. Also like a normal asset purchase, the seller’s entire NOL balance is written down.

If a Seller has a massive NOL balance, should the Buyer use a Stock Purchase, Asset Purchase, or 338(h)(10) election to acquire it?

The Buyer should use a Stock Purchase because NOLs are written down 100% in Asset Purchase and 338(h)(10) deals, so the Buyer cannot use any of the Seller’s NOLs in those deal structures.

Walk me through what happens in a Stock Purchase deal where the Buyer pays an Equity Purchase Price of $2 billion for the Seller, and the Seller has an off-Balance Sheet NOL balance of $400 million. The NOLs expire in 5 years.

Assume that the Long-Term Adjusted Rates for the past three months were 0.5%, 0.7%, and 1.0% and that the Buyer’s Tax Rate is 25%.

If the off-BS NOL balance is $400 million, the portion within the DTA should be approximately $100 million at a 25% tax rate.

The Buyer is allowed to use MAX(0.5%, 0.7%, 1.0%) $2 billion, or $20 million, per year.

The NOLs expire in 5 years, which means the Buyer can use 5 $20 million = $100 million total.

Therefore, the Buyer will write down $300 million of the off-BS NOLs and $75 million of the NOLs within the DTA when the transaction closes.

The remaining off-BS NOL balance will be $100 million, and the NOL portion within the DTA will be $25 million.

After that, the Buyer will use $20 million of the NOLs each year to reduce its cash-taxable income, so the off-BS balance will decline by $20 million per year.

The DTA portion will decline by $5 million per year until both the on-BS and off-BS NOL balances reach $0 at the end of Year 5.

Walk me through the difference in doing an asset purchase instead of a stock purchase for a deal where the Buyer pays an Equity Purchase Price of $2 billion for the Seller, and the Seller has an off-Balance Sheet NOL balance of $400 million. The NOLs expire in 5 years.

Assume that the Long-Term Adjusted Rates for the past three months were 0.5%, 0.7%, and 1.0% and that the Buyer’s Tax Rate is 25%.

The difference is that all of the NOLs on and off the BS must be written down immediately.Why would a Buyer and Seller agree to an Earn-Out in an M&A deal?

Why would a Buyer and Seller agree to an Earn-Out in an M&A deal?

An earn-out is more common in private company deals when the Buyer and seller don’t agree on the value of the business. If the seller thinks they are worth more than the buyer will pay, then one of them could propose an earn out, where if the seller contributes to the buyer reaching certain key metrics or results, then they will receive additional compensation or interest of some sort.

***earn outs also can incentivize executives and key employees at the Seller to stay at the new company after the deal closes.

A Buyer acquires a Seller for an Equity Purchase Price of $1 billion. It also promises an additional $200 million in 2 years if the Seller reaches $100 million in EBITDA by then.

The Seller’s Common Shareholders’ Equity is $600 million, it has no existing Goodwill, and the Buyer plans to write up Assets for a total of $100 million. Assume a 25% tax rate and a Stock Purchase deal structure and walk me through the Purchase Price Allocation.

First, you subtract the Seller’s CSE from the Equity Purchase Price, which results in an Allocable Purchase Premium of $400 million.

The Buyer writes up Assets for $100 million, which reduces that Premium because less Goodwill is needed. So, it’s down to $300 million.

A Deferred Tax Liability will be created because of these write-ups, which we can estimate at $100 million * 25% = $25 million. This DTL will increase the Premium because more Goodwill must balance this DTL on the other side. So, we’re up to $325 million.

Next, we have to record the $200 million Earn-Out as “Contingent Consideration” on the L&E side, increasing the amount of Goodwill required.

So, we end up with a total of $525 million in Goodwill from this deal.

A Buyer acquires a Seller for an Equity Purchase Price of $1 billion. It also promises an additional $200 million in 2 years if the Seller reaches $100 million in EBITDA by then.

The Seller’s Common Shareholders’ Equity is $600 million, it has no existing Goodwill, and the Buyer plans to write up Assets for a total of $100 million. Assume a 25% tax rate and a Stock Purchase deal structure

In Year 1, the Buyer believes the Seller is far less likely to reach $100 million in EBITDA in 2 years, so it reduces the value of the Contingent Consideration Liability by 30%. Walk me through the three statements.

You record a gain on re-measurement for $60M on the income statement, increasing your pre-tax income by $60M. Assuming a 25% tax rate, net income is up by around $45M going into the CFS. On the CFS, we need to subtract the gain because it is non-cash, but we need to add back the $15 in deferred taxes since the company’s cash taxes aren’t impact. So, on the CFS, there is net no change in cash. On the balance sheet, contingent considerations are down by $60M, but the DTA decreases by $15M. Equity is up by $45M from the increase in Net income increasing CSE. So, net both sides are down by $15M and they balance.

A Buyer acquires a Seller for an Equity Purchase Price of $1 billion. It also promises an additional $200 million in 2 years if the Seller reaches $100 million in EBITDA by then.

The Seller’s Common Shareholders’ Equity is $600 million, it has no existing Goodwill, and the Buyer plans to write up Assets for a total of $100 million. Assume a 25% tax rate and a Stock Purchase deal structure

In Year 1, the Buyer believes the Seller is far less likely to reach $100 million in EBITDA in 2 years, so it reduces the value of the Contingent Consideration Liability by 30%.

In Year 2, the Buyer realizes it was wrong and reverses this change. Then, at the end of Year 2, the Seller achieves its goals and reaches $100 million in EBITDA.

Walk me through the financial statements when the Earn-Out is paid out to the Seller. Ignore the Reversal of the Earn-Out Write-Down and walk through ONLY the payout.

The payout is recorded under CFF as an outflow of $200M, so cash is down by $200M.

On the BS, cash is down by $200M, so assets are down by $200M. On the L&E side, contingent considerations are down by $200M, so the L&E side is down by $200M. So both sides of the balance sheet balance down by $200M.

What's the difference between Fixed and Floating Exchange Ratios, and which one do Buyers prefer?

A fixed exchange ratio means that the buyer has agreed to pay the seller through stock issuance by allocation them a specific ratio of their shares to the seller’s shares. If this ratio is fixed, it means that the same proportion of shares will be issued regardless of the price the shares are issued at, so ownership will remain the same but purchase price may differ.

If the ratio is floating, it means that the buyer will have to issue however many shares necessary to provide the seller with a certain purchase price, and the actual ownership for the seller in the combined company may differ.

Buyers would like to avoid dilution, so they prefer the fixed exchange ratio if it believes that its share price could fall and, under floating, it would have to give up more ownership to reach the purchase price. The opposite is the case if they think their share price could increase.

Why might a Buyer and Seller agree to a collar in a 100% Stock deal?

They may agree to a collar if the stock price is volatile and the buyer wants to avoid dilution past a certain point and the seller wants to lock in a certain threshold of purchase price. A collar compromises this risk between the two parties by either making sure the seller gets a fixed purchase price or number of shares, and the buyer can make sure they limit dilution or the purchase price they have to pay.

What are example terms for a Fixed Exchange Ratio with a collar in an M&A deal?

This structure means that the Seller gets a fixed number of shares within a certain share price range for the Buyer.

So, the purchase price will vary within that range, and above or below that range, the purchase price is fixed, but the shares received by the Seller will vary.

For example:

• Buyer’s Share Price Between $50.00 and $60.00: The Seller always gets 10 million of the Buyer’s shares.

• Buyer’s Share Price Above $60.00: The Seller gets a maximum price of $600 million, and the shares issued vary based on the Buyer’s share price.

• Buyer’s Share Price Below $50.00: The Seller gets a minimum price of $500 million, and the shares issued vary based on the Buyer’s share price.

What would change in a merger model if the deal closed on an irregular date, such as August 15th?

You would “roll forward” the Balance Sheets for both companies to August 15th and combine them on that date, ensuring that the Purchase Price Allocation and Sources & Uses schedules are also based on that date.

You would also create a “stub period” for the Combined Income Statement and Cash Flow Statement to show what happens between August 15th and the end of the companies’ first quarter (or first year) as a combined company.

Even with an irregular closing date and a stub period, you tend to focus on the first full year of combined results in a merger model because EPS accretion/dilution means more over an entire year than it does over a stub period or a single quarter.