WSP Red Book: Accretion/Dilution Modeling

Walk me through a simple M&A model.

• Determine price to pay

• Determine sources, costs, and uses of funding

• Combine balance sheets

  • The major adjustment to the combined balance sheet involves calculating the incremental goodwill created in the transaction, which involves making assumptions regarding asset write-ups and deferred taxes created (or eliminated).

  • Factor in the consequences of the borrowing and paydown

• Project pro-forma IS to get pro-forma EPS

What are two ways to determine the accretive/dilutive impact to EPS?

Bottom-up: When the post-transaction EPS calculation is done as a bottom -up analysis, this involves starting from the buyer ’s and seller’s standalone EPS and adjusting to reflect the incremental interest expense, additional acquirer shares that must be issued, synergies, and incremental depreciation and amortization due to asset write-ups.

Top-down: Alternatively, the accretion/dilution analysis can be done top-down, whereby the two income statements are combined, starting with revenue and then moving down to expenses while making the deal-related adjustments.

What does accretion/dilution analysis tell you about the attractiveness of a transaction?

It truthfully doesn’t tell you very much. Many of the benefits of a transaction will only be truly realized after synergies and integration costs have been factored in, and earnings per share is not what a company’s value is based off, it’s cash flows.

That said, the short-term market reaction around an acquisition does look at EPS, so the stock price in the short-term will very likely be impacted. The fear is that the buyer’s apply the same P/E multiple to the lower EPS.

What does it mean when a transaction is done on a “cash-free, debt-free” basis?

This is a very common structure that assumes the seller distributes all excess cash and pays off all debt outstanding before the transaction is completed, excess cash being what is left over after debt is paid down and minimum requirements are met.

Since there is no debt or cash to factor in, the buyer is just paying the seller’s EV because their funds that they pay the seller go towards that debt paydown.

Is it better to finance a deal via debt or stock?

Buyer: When the buyer’s P/E ratio is significantly higher than the target’s, a stock transaction will be accretive, which is an important consideration for buyers and may tilt the decision towards stock. When considering debt, the buyer ’s access to debt financing and the cost of debt will influence the buyer’s willingness to finance a transaction with debt. The buyer will also analyze the deal’s impact on its capital structure, credit rating implications, and credit statistics.

Seller: Most sellers will prefer cash (i.e., debt financing) over a stock sale unless tax deferment is a priority for the seller. A stock sale is usually most palatable to the seller in a transaction that more closely resembles a merger of equals and when the buyer is a public company, where its stock is viewed as a relatively stable form of consideration.

What does purchase consideration refer to in M&A?

The purchase consideration in an M&A deal represents the acquirer's proposed payment method to the target’s shareholders. The purchase consideration can be categorized as cash, stock, or a combination.

• An acquisition paid all-cash has an immediate tax consequence, as a taxable event has been triggered.

• In contrast, if the purchase method made was all-equity (i.e., exchange of shares in the newly merged company), this would not trigger any taxes.

Shareholders’ perception of the post-M&A company and its future can also impact their decision:

• If they have negative views of the company’s future, they would not want to own shares in that company – even if it means they must pay taxes for that year associated with the deal.

• But if they believe the new company will perform well and the share price will appreciate, the shareholders will be inclined to accept stock as compensation to take part in the potential upside.

What is an exchange ratio and what are the two main types?

An exchange ratio is a fixed ratio of a buyer’s shares to a seller’s shares made in a stock deal.

Two types:

• Fixed: the seller’s shareholder’s are guaranteed a fixed amount of shares for each share. This means their ownership percentage is constant once the agreement is signed and executed, but based on how the share price moves post-closing, they have no protections

• Floating: the seller’s shareholders receive a specific dollar value’s worth of shares. This means that their downside is protected if the stock price moves, but the post-close ownership percentage could change.

shares are exchanged at closing.

When might an acquirer prefer to pay for a target company using stock over cash?

If their shares yield more than their cash (super high P/E over the amount they could make in a money market), or they may want cash on hand for opportunities and risks that could arise in the near future.

Paying with stock also means you don’t have to use debt as the alternative if you are low on cash.

For the seller, a stock deal makes it possible to share in the future growth of the business and enables the seller to defer the payment of tax on gain associated with the sale.

Why might some shareholders prefer cash compensation rather than stock?

If the shareholder doesn’t believe in the merger or the potential of the combined company, then they won’t want the chance in participating in downside of the shares.

Also, the seller might need cash to pay down debt balances.

Would you expect an all-cash or all-stock deal to result in a higher valuation?

In all likelihood an all-stock deal would result in a lower valuation because the new owners get to participate in potential upside. The guarantee of the cash payment would feed into any premium, while providing the upside optionality allows them to buy for less.

In all-stock deals, how can you determine whether an acquisition will be accretive or dilutive?

You can use the P/E trick.

If the buyer’s P/E is greater than the target, it is accretive because you are getting higher yield shares for less

If the buyer’s P/E is less than the target, it is dilutive because you are getting lower yield shares for a higher cost.

Assume that a company is trading at a forward P/E of 20x and acquires a company trading at a forward P/E of 13x. If the deal is 100% stock-for-stock and a 20% premium was paid, will the deal be accretive in year 1?

Yes, because the company is using its stock with a 5% yield to acquire shares at a ~6% yield.

How do you calculate the offer value in an M&A deal?

The offer price per share refers to the purchase price to acquire the seller's equity on a per-share basis.

Thus, the calculation of offer value involves multiplying the fully diluted shares outstanding (including options and convertible securities) times the offer price per share.

Offer Value = Fully Diluted Shares Outstanding × Offer Price Per Share

Why is a “normalized” share price used when calculating the offer value?

Shares can fluctuate a good deal on any given day, so you don’t want one day of volatility to create a large difference in the purchase price. So, especially when that day may include news of the merger or acquisition and the share price could already reflect investor sentiment about the future of the deal.

How do you calculate the control premium in an M&A model?

Control premium % = ((Offer price per share/normalize current price per share) - 1) X 100

How do you calculate the transaction value?

Transaction value in the M&A context refers to the target’s implied enterprise value given the offer value

Transaction Value = Target Offer Value + Net Debt

What are the most common balance sheet adjustments in an M&A model?

• Write down seller’s CSE to 0

• Re-value assets and liabilities with write-ups and write-downs

  • create any corresponding DTLs

• Write down any deferred taxes

• Goodwill

• Create new acquirer debt, cash, or equity

What are the most common income statement adjustments in an M&A model?

• You combine revenue and expense line items

• Interest expense, foregone interest on cash

• Pro-forma EPS

• Incremental D&A

• Transaction, financing and integration related costs

• Tax adjustments to acquirer’s tax rate

What does a goodwill impairment tell you about a deal?

It tells you that the acquirer paid more for the deal than the company is worth now and is not getting the value they believed that they would.

Which balance sheet items are often adjusted to fair market value in a transaction?

PP&E and Intangibles because they are typically held far below fair value on the books of a company

Who determines the value of fair market write-ups in a transaction?

Independent appraisers, accountants, and other valuation firms can help determine the write-up amounts.

What is the purpose of a fairness opinion in the M&A context?

A fairness opinion is a document provided by a seller’s investment banker to the seller’s board of directors attesting to fairness of the transaction from a 3rd party perspective and give an unbiased evaluation

Would an acquirer prefer $100 in revenue synergies or $100 in cost synergies?

They would prefer $100 in cost synergies because it is closer to cash flow and net income. $1 of revenue gets eaten away by costs, while $1 of costs can flow straight through

Are acquirers more likely to achieve revenue synergy or cost synergy expectations?

Acquirers are more likely to achieve cost synergies because they are simpler and internal. You can create specific cost cutting plans like combining headquarters or cutting headcount.

With revenue, though, it is more high-level and speculative. There is far less certainty when it comes to assuming which items can be cross-sold, what new products can be successfully launched, etc.

For investment bankers, why is a sell-side process typically shorter than a buy-side assignment?

As a practical matter, once the owner of a company proceeds with a potential sale, it'll usually be easy to find a group of buyers. So when working on behalf of the seller, the likelihood of completing a transaction is higher.

On the other hand, many companies regularly engage in market research and “dipping their toe in the water” type explorations of potential acquisition candidates. Thus, when working on behalf of a buyer, these engagements can drag on for months and often end in no transaction.

What is the accounting for transaction fees in M&A?

Transaction fees are incorporated as a use of funding added on to the acquisition cost of a deal. They are expensed as incurred and reduce pro-forma net income and EPS.

What is the accounting treatment for financing fees?

When an acquirer borrows debt to finance an acquisition, the fees related to this borrowing are not treated like transaction fees. Instead, there are treated differently by being capitalized and amortized over the life of the debt issuance, which creates an incremental amortization expense. Therefore, the pro forma net income and pro forma EPS will be reduced over the term of the borrowing.

Regarding the balance sheet, financing fees are deducted from the debt liability directly as a contra-liability. In terms of modeling the financing fees, the financing fees are amortized over the borrowing term, classified as “Debt Issuance Costs," and embedded as a non-cash expense within interest expense.

What are some standard income statement adjustments related to a transaction?

Expected Synergies

Capitalized Financing Fees

Incremental Depreciation & Amortization

Additional Interest Expense

Loss of Interest Income

What causes incremental D&A to be recorded in M&A deals?

Incremental D&A is caused by the write-up of assets to their fair value. In a stock purchase deal, these are not cash tax deductible, though.

What is the impact of target NOLs in M&A?

Depending on the deal structure, target NOLs are assumed by the acquirer, although their use by the acquirer is capped at an annual limit that's a function of the purchase price x the long-term tax-exempt rate. Alternatively, target NOLs can be used to offset the seller’s gain on sale, which since the 2017 tax reform act, has been capped at 80% of the target’s taxable income.

Why are deferred tax liabilities (DTLs) created in transactions?

DTLs are created in stock purchases because the incremental D&A is not cash-tax deductible. So, as of the time the acquisition happens, the company must acknowledge that its cash taxes will be higher than its book taxes in the future.

What happens to a target’s existing NOLs in transactions?

Depends:

• Asset Sales: NOLs can be used up by the target to offset any gain on sale on the corporate level. The acquirer doesn't get any remaining unused NOLs as they're permanently lost.

• Stock Sales: NOLs can be used by the acquirer in the future but are subject to an annual “IRC 382 limitation,” which limits the annual carryforward to a regularly published “long term tax-exempt rate” times the equity purchase price.

An M&A deal has an adjustment for a deferred revenue write-down. Why would this occur?

A deferred revenue write-down adjustment is often seen in software M&A deals (e.g., Adobe's acquisition of Marketo-Magento), as revenue is typically under long-term subscription contracts. The value of the deferred revenue might get revalued (and reduced) to its fair value before the transaction closes, leading to a write down if it's determined the amount recognized is less than what was originally on the books.

There could various causes, such as collectability not being reasonably assured, terminated/breached contracts, or changes in customer contract terms (e.g., upgrades, maintenance, support) that all require re estimating the remaining performance obligation, the costs required to fulfill the performance obligations, and the appropriate profit margin associated with fulfilling the performance obligation.

**this write down is offset with goodwill on the balance sheet, and the extra cash on the CFS must be recorded in non-GAAP measures only

What is an earnout in the context of M&A?

An earnout is common when the buyer and seller can’t quite agree on a price for the deal, because the seller thinks it is worth more.

So, the buyer will offer the management team of the seller an earnout as essentially incentive pay for hitting certain metrics and KPIs.

More formal term is contingent consideration.

Which side do you believe an earn-out helps more: the buyer or seller?

The buyout seems like it would help the buyer more.

It’s like getting a great salesperson for a lower base salary, but paying commission to them based on performance. Either they do good, and you benefit and they benefit, or they do bad, and you are insulated and they do bad.

It also incentivizes the seller to align itself with the buyer as best as possible to meet those goals.

How are earn-outs typically structured?

They are always negotiated on a case-by-case basis. Some commonalities, though, include:

• 1-5yr period

• Paid out in installments based on yearly percentage tiers and hurdle rates

• Two types

  • Percentage of Future Performance: The seller is compensated for each tier met plus the pro rata amount earned over (usually based on how close to meeting a target it was on a percentage-basis).

  • Binary Payments: Often called "all-or-nothing" payments, there will be no payout for a specific tier unless a target is met 100%, which places more risk and pressure on the seller.

For earn-outs, why is EBITDA the most common metric to use as the target?

Because EBITDA is a proxy for cash flow that excludes non-recurring expenses and seeks to isolate the performance of the core business.

EBITDA is a commonly used, simple metric to use that meets a balance between growth and profitability. It also isn’t as impacted by short-term management decisions.

Net income is less ideal because it is also easy to manipulate by cutting costs or CapEx, similar to how revenue can be manipulated with lighter credit terms or channel stuffing, or make riskier decisions overall

How would an earn-out be modeled on the three statements?

The earn-out is modeled as a contingency on the financial statements

• IS: gains (probability of payout down) or losses (probability of payment goes up) are reflected on the IS

• BS: Recorded as a contingent liability measured at fair value on the date of the sale, which is determined as the present value of the probability-weighted expected future payout amounts.

  • this liability is continually re-evaluated and adjusted until the earn-out ends

• CFS: Cash amounts of payouts will be shown here, and the gains and losses will be reversed.

Which industries would you expect earnouts to be the more prevalent?

Healthcare

• high regulatory risks around drugs and innovation

• Asset value is based on impossible to predict decisions from the FDA, patent office, etc

• Many earnouts are then based on the outcomes of these events, like FDA approval, classification, patent production approval

In M&A, what is the purpose of seller notes?

A seller will take part of their payment as interest in the buyer as a creditor.

• Incentivizes them to stick around and make sure they protect their downside (meaning the combined entity does well)

• This could mean acting in less risky ways, or helping a smooth management transition play out

How are seller notes in M&A modeled?

Seller notes (or seller financing) are modeled the same way as any other debt instrument. Therefore, it'll show up in the Sources & Uses schedule as a source of funds since these notes helped finance the deal. In most cases, seller notes will come in the form of subordinated debt with a high, fixed interest rate given its position in the capital structure. But often, the option for PIK interest or conversion feature will be attached.

What is the purpose of the working capital peg negotiation in M&A?

The working capital peg is the negotiated sufficient level of net working capital required post-closing of a transaction and should represent the normalized NWC requirements to operate the business on an ongoing basis. From the perspective of the buyer, the purpose of setting this target is to prevent the seller from taking cash beyond NWC requirements. Therefore, a working capital peg ensures the business can continue operating with no more capital required upon closing.

Can you name a scenario when the post-deal EPS accretion/dilution would not be a significant consideration?

• Acquiring for the purpose of getting IP

• Defending moat or business position

• Acquiring for talent

These are especially low considerations when the acquirer is buying a startup or otherwise small company relative to its position