IB M&A Questions Flashcards
Can you define M&A and explain the difference between a merger and an acquisition?
An umbrella term that refers to the combination of two businesses. To buyers, M&A serves as an alternative to organic growth, whereas for sellers, M&A provides an opportunity to cash out or share in the newly formed entity’s risk/reward.
Merger: Combination of two similarly sized companies (i.e., “merger of equals”)
- form of consideration is at least partially with stock, so shareholders from both entities remain.
- two companies will operate under a combined name (Citigroup)
Acquisition: An acquisition typically implies the target was of smaller-size than the purchaser.
- target’s name will usually slowly dissipate over time as the target becomes integrated with the acquirer or…
- the target will operate as a subsidiary to take advantage of its established branding. (e.g. Google’s acquisition of Fitbit)
What are some potential reasons that a company might acquire another company?
Value Creation from Revenue and Cost Synergies
Ownership of Technology Assets (IP, Patents, Proprietary Technology)
Talent Acquisitions (New Skilled Employees)
Expansion in Geographic Reach or into New Product/Service Markets
Diversification in Revenue Sources (Less Risk, Lower Cost of Capital)
Reduce Time to Market with New Product Launches
Increased Number of Channels to Sell Products/Services
Market Leadership and Decreased Competition (if Horizontal Integration)
Achieve Supply Chain Efficiencies (if Vertical Integration)
Tax Benefits (if Target has NOLs)
What are the differences among vertical, horizontal, and conglomerate mergers?
Vertical Merger: Increased control over the supply chain (ADM and vital farms)
Horizontal Merger: Are companies directly competing in the same (or very similar) market. Thus, following a horizontal merger, competition in the market
decreases (e.g., Sprint & T-Mobile merger).
In terms of vertical integration, what is the difference between forward and backward integration?
Backward Integration:When an acquirer moves upstream, it means they’re purchasing suppliers or manufacturers of the product the company sells
Forward Integration: When an acquirer moves downstream, it means they’re purchasing a company that moves them closer to the end customer such as a distributor or technical support
Describe a recent M&A deal (Perfect Corp.’s Acquisition of Wannaby)
- Acquirer and Target Company
Acquirer: Perfect Corp. (AI/AR beauty and fashion tech leader, serving brands like Estée Lauder and Lululemon).
Target: Wannaby Inc. (specializes in virtual try-on for luxury fashion, with clients like Dolce & Gabbana and Reebok). - Strategic Rationale
Expands Perfect’s capabilities into shoes, bags, and apparel.
Combines beauty and fashion tech for cross-selling opportunities.
Aligns with rising demand for virtual try-ons in luxury retail. - Transaction Details
Form of Consideration: Not disclosed.
Integration Timeline: Began January 2025. - Share Price Movement Post-Announcement
Analysts raised Perfect’s target price by 14%, citing $2M+ revenue upside from the deal. - Personal Perspective
This is a smart deal due to market expansion, strong synergies, and scalability potential, despite risks like integration challenges and legal issues
What are synergies and why are they important in a deal? (2)
Expected cost savings or incremental revenues arising from an acquisition
A higher premium would be paid if an acquirer believes synergies can be realized
Revenue Synergies: Cross-selling, upselling, product bundling, new distribution channels, geographic
expansion, access to new end markets, reduced competition leads to more pricing power
- Cost Synergies: Eliminate overlapping workforces (reduce headcount), closure or consolidation of redundant facilities, streamlined processes, purchasing power over suppliers, tax savings (NOLs)
How do you perform premiums paid analysis in M&A?
What: A type of analysis prepared by IB when advising a public target.
Average premium* paid (comparable comp)= reference point for an active deal
*Average of the historical premiums paid in those comparables deals should be a proxy (or sanity check) for the premium to be received in the current deal.
Why should companies acquired by strategic acquirers expect to fetch higher premiums than those selling to private equity buyers?
Strategic buyers can often benefit from synergies, which enables them to offer a higher price. However, the recent trend of financial buyers making add-on acquisitions has enabled them to fare better in auctions and place higher bids since the platform company can benefit from synergies similar to a strategic buyer.
Tell me about the two main types of auction structures in M&A.
Broad Auction: sell-side bank will reach out to as many prospective buyers as
possible to maximize the number of interested buyers.
Targeted Auction: sell-side bank (usually under the client’s direction) will have a shortlist of buyers contacted. These contacted buyers may already have a strong strategic fit with the client or a pre-existing relationship with the seller.
Competition directly correlates with……
The valuation…. the goal is to cast a wide net to intensify an auction’s competitiveness and increase the likelihood of finding the highest possible offer (i.e., removing the risk of “leaving money on the table”) - broad auction
What is a negotiated sale?
Involves only a handful of potential buyers and is most appropriate when there’s a specific buyer the seller has in mind. - seller intends to remain in the relationship
Deals are negotiated
“behind-closed-doors” and generally on friendlier terms based on the best interests of the client.
What are some of the most common reasons that M&A deals fail to create value?
Overpaying/Overestimating Synergies: Overestimating synergies
Inadequate Due Diligence: neglecting the risks. A competitive auction with a short timeline can lead to this type of poor judgment, in which the other buyers become a distraction.
Lack of Strategic Plan: fixated on pursuing more resources
and achieving greater scale without an actual strategy, synergies not being realized despite an abundance of resources on-hand and potential growth opportunities.
Poor Execution/Integration: acquirer’s management team may exhibit poor leadership
and an inability to integrate the new acquisition.
Studies have repeatedly shown a high percentage of deals destroy shareholder value. If that’s the case, why do companies still engage in M&A?
M&A is often a defensive response to structural sector
disruption that presents a threat to an existing business
model.
- Many studies have concluded that most M&A deals destroy shareholder value. Yet,
many companies continue to pursue growth through M&A.
Reasons companies choose to engage in M&A:
- Deals done out of necessity (defensive measures taken to protect their market share
or to maintain competitive parity)
(Once a company owns a sizeable percentage of a
market, its focus shifts towards protecting its existing market share as opposed to
growth and stealing more market share (i.e., the company is now the target
incumbent to steal market share from).
- Look out for threats, M&A is a method for companies to fend off outside threats and gain new technological capabilities.
What is the purpose of a teaser?
What: One to two-page marketing document that’s usually put together by a sell-side banker on behalf of their client. First marketing document presented to potential buyers and is used to gauge their
initial interest in formally taking part in the sale process.
Why: Intent is to generate enough interest for a buyer
to sign an NDA to receive the confidential information memorandum (“CIM”).
Details:
- Content is limited
- Name of the company is never revealed in the document
(instead “Project [Placeholder Name]”),
- Provides the basic background/financial
information of the company to hide the identity of the client and protect confidentiality.
Information, a brief description of:
- Business operations
- Investment highlights
- Summary financials (e.g.,
revenue, operating income, EBITDA over the past two or three years) – just enough details for the buyer to
understand what the business does, assess recent performance and determine whether to proceed or pass.
What does a confidential information memorandum (CIM) consist of? (What, why, details)
A more detailed version of the teaser. Provides potential buyers with an in-depth overview of the
business being offered for sale. Once a buyer has executed an NDA, the sell-side investment bank will distribute
the CIM to the private equity firm or strategic buyer for review.
Format:
- Range from being a 20 to 50-page document with the specific contents being:
- Detailed company profile
- Market overview
- Industry trends
- Investment highlights
- Business segments
- Product or service offerings
- Past summary financials,
- Performance projections (called the “Management Case”),
What are the typical components found in a letter of intent (LOI)?
What: Once a buyer has proceeded with the next steps in making a potential acquisition, the next step is to provide
the seller with a formal letter of intent (“LOI”). An LOI is a letter stating the proposed initial terms, including:
- purchase price,
- the form of consideration
- planned financing sources. Usually non-binding, an LOI
represents what a definitive agreement could look like, but there’s still room for negotiation and revisions to be made in submitted LOIs (i.e., this is not a final document).
What are “no-shop” provisions in M&A deals?
In M&A deal agreements, there’ll be a dedicated section called the “no solicitation” provision ( “no-shop” provision)
What: No-shop provisions protect the buyer and give exclusivity during negotiations. The sell-side representative is prevented from looking for higher bids and leveraging the buyer’s current bid with other buyers. Violating the no-shop would trigger a significant breakup fee by the seller, and
an investigation would be made into the sell-side bank to see if they were contacting potential buyers when legally restricted from doing so.
On the other side, a seller can protect themselves using reverse termination
fees (“RTFs”), which allow the seller to collect a fee if the buyer were to walk away from the deal.
What is a material adverse change (MAC), and could you provide some examples?
What: List out the conditions that allow the buyer the right to walk away from a deal without facing legal repercussions or significant fines.
(Highly negotiated, legal mechanism intended to
reduce the risk of buying and selling parties from the merger agreement date to the deal closure date.)
Common Examples of MACs
- Significant Changes in Economic Conditions, Financial Markets, Credit Markets, or Capital Markets
- Relevant Changes such as New Regulations, GAAP Standards, Transaction Litigation (e.g., Anti-Trust)
- Natural Disasters or Geopolitical Changes (e.g., Outbreak of Hostilities, Risk of War, Acts of Terrorism)
- Failure to Meet an Agreed-Upon Revenue, Earnings, or Other Financial Performance Target
Contrast a friendly acquisition and hostile takeover attempt.
Friendly Acquisition: The takeover bid was made with the consent of both companies’ management teams and boards of directors.
Hostile Takeover: Comes after a failed friendly negotiation. The
acquirer has continued pursuing a majority stake by going directly to the shareholders.
What are the two most common ways that hostile takeovers are pursued?
Tender Offer: The acquirer will publicly announce an offer to purchase shares from
existing shareholders for a premium. The intent is to acquire enough voting shares to have a controlling stake in the target’s equity that enables them to push the deal through.
Proxy Fights: Involves a hostile acquirer attempting to persuade existing shareholders to vote out the existing management team to take over the company. Convincing existing shareholders to turn against the existing management team and board of directors to initiate a proxy
fight is the hostile acquirer’s objective, as the acquirer needs these shareholders’ votes, which it does by trying to convince the company is being mismanaged.
How does a tender offer differ from a merger?
When a public company receives a tender offer, an acquirer has offered a takeover bid to purchase some or all of the company’s shares for a price above the current share price. (Often associated with hostile takeovers)
In contrast, a traditional merger would involve two companies jointly negotiating on an agreement to combine.
What are some preventive measures used to block a hostile takeover attempt?
Poison Pill Defense: Give existing shareholders the option to purchase additional shares
at a discounted price, which dilutes the acquirer’s ownership and makes it more difficult for the acquirer to own a majority stake (i.e., more shares necessary).
Golden Parachute Defense: key employees’ compensation packages are adjusted to provide more benefits if they were to be laid off post-takeover.
Dead Hand Defense: Additional shares are automatically issued to every existing shareholder (excluding the acquirer).
Crown Jewel Defense: Creating an agreement where the company’s crown jewels (patents, intellectual property (IP), and trade secrets) could be sold if the company is taken over. make the target less valuable and less desirable to the acquirer
What are some active defense measures to block a hostile takeover attempt?
White Knight Defense: A friendly acquirer interrupts the takeover by purchasing the target.
White Squire Defense: The target
company will not have to give up majority control over the business as the white squire investor only purchases a partial stake, sized just large enough to fend off the hostile acquirer.
Acquisition Strategy Defense: Target company can make an acquisition. End result is
the balance sheet is less attractive post-deal from the lower cash balance (and/or use of debt).
Pac-Man Defense: Target attempts to acquire the hostile acquirer. Employed as a last-resort.
Greenmail Defense: The target will be forced to resist the takeover by repurchasing its
shares at a premium (anti-greenmail regulations have made this nearly impossible nowadays)
What is a divestiture and why would one be completed?
What: A divestiture is the sale of a business segment (and the assets belonging to the unit)
Why: Divestitures are completed once the mgt has determined that a segment doesn’t add enough value to the core business (e.g., redundant, a distraction from core operations, and non-complementary to other divisions).
Additional reasons:
- Allows the parent company to cut costs and shift their focus to their core business while
(allowing the divested business’s operations to become leaner and unlock hidden value potential.)
- Restructuring (i.e., prevents falling into insolvency) or regulatory pressure to prevent the existence of a monopoly.
- From the viewpoint of investors, a divestiture can arguably be interpreted as a failed strategy in the sense that
this non-core business failed to deliver the expected benefits (e.g., economies of scale) and show that there’s a
need for cash for reinvestment or to better position themselves from a liquidity standpoint. Hence, many
divestitures are influenced by activist investors that push for the sale of a non-core business and then request a capital distribution.
What is a staggered board and how does it fend off hostile takeover attempts?
Each board member is intentionally classified into distinct classes regarding their term length.
Why: A staggered board is used to defend
against hostile takeover attempts as this type of ordering protects the existing board of directors and the management team’s interests. Since the board is staggered, gaining additional board seats becomes a more
complicated and lengthy process for hostile acquirers (and deters takeover attempts).
How does an equity carve-out differ from a divestiture?
Equity carve-out (“partial IPO”): The subsidiary will be established as a new legal entity with its separate management team and board of directors. The equity is provided also to public investors.
(parent company will sell a portion of their equity interest in a subsidiary to public investors. In nearly all cases, the parent company will still retain a substantial equity stake in the new entity (usually > 50%)
The cash proceeds of the sale to 3rd investors are then distributed to the parent, the subsidiary, or a combination.
What is a spin-off and why are they completed?
Subsidiary that would be better off as a standalone company. (E.g. Perfect Corporation)
What is the difference between a subsidiary and an affiliate company?
Subsidiary: A subsidiary is when the parent company remains the majority shareholder (50%+)
Affiliate Company: An affiliate company is when the parent company has only taken a minority stake
What is a reverse merger and what benefits does it provide?
A privately held company undergoes a merger with another company that’s already
publicly traded in the markets.
The public company can either be an operating company or be an empty corporate shell (SPAC)
Benefit: The public entity can now issue shares without incurring the costs associated with IPOs.
What is an S-4 filing and when does it have to be filed?
Filed with the SEC prior to a merger and acquisition activity taking place
Information includes:
-Deal rationale
- Negotiated terms
- Risk factors
- Pro forma financials
- Other related material.
What is the difference between the Schedule 13-D and 13-G filing?
Forms intended to disclose publicly when an investor has taken a significant stake in a company in terms of ownership and voting power (filings notify other investors of the influential investor’s stake (i.e., “beneficial owners”)
Schedule 13-D: Filed when an investor acquires a minimum of 5% of a public company’s total common equity, and over 2% was acquired in the last twelve months.
Schedule 13-G: Filed in lieu of the 13-D as long as the investor doesn’t intend to take control of the company or filed when an investor acquires 5%+ of
the total equity but less than 2% in the last twelve months.
Can you explain what the “winner’s curse” is in M&A?
The tendency for the winning bidder to have paid far beyond the target’s fair value.
(While a certain premium is expected during competitive processes, this can often be elevated to irrational levels.)
What is a holdback in M&A?
To help mitigate transaction risks, a holdback mechanism can require a portion of the purchase price of an
acquisition to be placed in escrow to protect the interests of the buyer post-closing until the terms of the
agreement have been satisfied.
What type of material is found in an M&A pitchbook?
Introduction of the Investment Bank and Dedicated Team Members
Situational Overview of the Deal and Client Company
Prevailing Market and Industry Trends
Implied Valuation Range and Combined M&A Model
Proposed Deal Strategy Outline and Key Considerations
Credentials and Tombstones of Relevant Industry Experience
Appendix (DCF Model, Trading Comps, Transaction Comps)
Walk me through a simple M&A model.
- Assumptions 1, need to be made about the purchase price and other uses of funds
such as refinancing target debt and paying transaction and financing fees. - Assumptions 2, about the sources of funds need to be made. The question being
answered here is: “Will the acquirer pay for the acquisition using cash, take on additional debt, issue equity, or a combination?” - The acquirer’s balance sheet is adjusted to reflect the
consolidation of the target. Certain line items such as working capital can be added together, while others
require further analysis. 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). - Deal-related borrowing and paydown, cash used in the transaction, and the elimination of target
equity all need to be reflected. - The income statements are combined to determine the combined, pro forma accretion/dilution in
EPS – which is ultimately the question being answered: “Will this deal be accretive or dilutive?”
What are two ways to determine the accretive/dilutive impact to EPS?
- Bottom-Up Analysis: 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
- incremental D&A due to asset write-ups. - Top-Down Analysis: 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?
What:
Accretion: Pro Forma EPS > Acquirer’s EPS
Dilution: When Pro Forma EPS < Acquirer’s EPS
Breakeven: No Impact on Acquirer’s EPS
Accretive vs. Dilutive Deals: either or don’t not guarantee value creation for the acquirer, and a dilutive deal does not necessarily imply value destruction.
Investor Perception: Buyers, especially public companies, often view significant accretion or dilution as indicators of potential investor reactions to the transaction.
Fear of Dilution: Buyers are wary of dilutive deals because they can lead to a post-announcement decline in share price. This concern arises from the assumption that investors will apply the pre-deal Price-to-Earnings (P/E) ratio to the lower pro forma Earnings Per Share (EPS).
Short-Term vs. Long-Term Value: While dilution concerns are valid in the short term due to EPS targets, they are irrelevant when assessing long-term value creation for shareholders. Long-term value depends on the intrinsic worth of the combined entity rather than immediate EPS changes.
What does it mean when a transaction is done on a “cash-free, debt-free” basis?
Assumes the seller will pay off all the debt outstanding and extract all the excess cash* before the new buyer completes the transaction
(Nearly all M&A deals are negotiated on a “cash-free, debt-free” basis.)
*Excess cash in this context is defined as the cash remaining after the debt has been paid down and above its minimum cash balance.
The acquirer is just paying the seller for the company’s
enterprise value since the acquirer doesn’t have to assume the debt on
the seller’s balance sheet or get to use its cash
Is it better to finance a deal via debt or stock?
Buyer’s Perspective: 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 (LBO). The buyer will also analyze the deal’s impact on its capital structure, credit rating implications, and credit statistics.
Seller’s Perspective: 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 acquirer’s proposed payment method to the target’s shareholders. The purchase consideration can be categorized as cash, stock, or a combination.
The tax consequences represent decisive factors that shareholders consider when assessing an offer:
An acquisition paid all-cash has an immediate tax consequence, as a taxable event has been triggered.
vs 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:
Negative views: Prefer cash but incur the tax
Positive views: Prefer stock and enjoy the possible upside
What is an exchange ratio and what are the two main types?
For partial or all-stock deals, the purchase offer can be structured as either a fixed or floating exchange ratio.
Fixed Exchange Ratio (regardless of share price movements=no insurance on price moves): Clearly defines the number of shares of the acquirer’s stock to be exchanged for one share of the target. (X Meta share = Y Perfect Corp Shares). Target’s shareholders bear the risk that the share price could decline post-closing, with no provision in place to protect them in the event this were to occur.
Floating Exchange Ratio (specific=protection): Sets a specific amount per share the acquirer has agreed to pay for each share of the target’s stock in the form of the acquirer’s shares. The target’s shareholders have downside protection if the share price falls post-closing.
When might an acquirer prefer to pay for a target company using stock over cash?
It preserves cash. For buyers short on cash, paying with stock avoids the necessity of using debt to help fund the deal.
Why might some shareholders prefer cash compensation rather than stock?
cash is tangible, and the value received post-closing is guaranteed. These types of shareholders are more risk-averse and may not view the prospects of the combined company positively.
Other shareholders may prefer compensation in stock to take part in the combined entity’s upside potential
and to delay paying taxes.
Would you expect an all-cash or all-stock deal to result in a higher valuation?
An all-stock deal will result in a lower valuation since the target’s shareholders get to participate in the potential upside of owning equity in the new entity (more mouses want cheese)
If the deal were all-cash, the proceeds from the sale would be a fixed amount (and be capped), but an all-stock
deal comes with the possibility of higher returns if the combined entity performs well and the market has a
favorable view of the acquisition, leading to share price appreciation.
In all-stock deals, how can you determine whether an acquisition will be accretive or dilutive?
Dilutive: Target P/E>Acquirer
(more shares must be issued, which increases the dilutive impact. Since the denominator (the pro forma share count of the combined entity) has increased, the EPS will decline.)
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, stock-for-stock deals where the acquirer’s P/E ratio is higher than the target’s P/E are always accretive.
Don’t get tricked. A 20% premium just brings the target’s P/E to 13 + (13 x 20%) = 15.6 P/E, which is still
below the acquirer ’s P/E.
How do you calculate the offer value in an M&A deal?
Refers to the purchase price to acquire the seller’s equity on a per-share basis.
Offer Value = Fully Diluted Shares Outstanding × Offer Price Per Share
Why is a “normalized” share price used when calculating the offer value?
News of the deal or even rumors can leak and cause the price of the companies involved in the deal
to rise (or decrease). Therefore, the latest share price may already reflect investors’ opinions on the deal and not be an accurate depiction of the real standalone valuation of the target company.
How do you calculate the control premium in an M&A model?
Control Premium % = (Offer price per share/Current Price Per Share-1)*100
- Use the normalized share price for the current price per share
How do you calculate the transaction value?
Transaction Value = Target Offer Value + Net Debt
“target’s implied enterprise value given the offer value.”
What are the most common balance sheet adjustments in an M&A model?
Accounting Side
- Goodwill: Eliminate the existing, pre-deal target goodwill and create new goodwill from the new deal.
- PP&E and Intangible Assets: Write up assets to fair market value (FMV).
- Deferred Tax Liabilities (DTLs): Create new deferred tax liabilities in a stock sale.
- Target Equity: Eliminate target equity from the consolidation.
Funding Side
- Debt: Create new acquirer debt (if the deal was partially funded with debt) and eliminate Target debt
(Target debt is often refinanced and reflected in the new acquirer debt financing, although in rare cases, it
can carry over).
- Equity: Increase the existing value of acquirer equity by the value of new acquirer equity issued.
- Cash: Reduce cash by the excess cash used to fund the deal and pay transaction and financing fees, reduce this to equity (the transaction fees) and to new debt (the financing fees).
What are the most common income statement adjustments in an M&A model?
Line items needing adjustments as part of purchase accounting before acquirer and target income statements are consolidated.
Income Statement Adjustments
- Revenue: Increase consolidated revenue by any revenue synergies.
OPEX: Reduce consolidated expenses by any expected cost synergies.
- Incremental D&A: Asset write-ups often result in more non-cash D&A. Thus,
incremental D&A expenses from write-ups need to be added to consolidated D&A.
- Other Expenses: Transaction fees are expensed on the income statement.
- Interest Expense: Acquirer interest expense is adjusted up when debt financing is used to fund the deal.
Target interest expense is eliminated when target debt is refinanced.
- Financing Fees: Financing fees related to raising debt are amortized over the term of the debt, and the
non-cash expense is recognized within interest expense.
- Interest Income: Reduce interest income by the impact of excess cash used to fund the deal.
- Taxes: All the adjustments above need to be tax-affected at the acquirer’s tax rate.
- Pro Forma EPS: Use the acquirer’s pre-deal share count and then add the number of acquirer shares
issued in the transaction.
What is the purpose of a fairness opinion in the M&A context?
A a document provided by the seller’s investment banker to the seller’s board of directors
attesting to the fairness of a transaction from a 3rd party perspective. The purpose of the fairness opinion is to
provide the selling shareholders with an unbiased evaluation of the deal.
Which balance sheet items are often adjusted to fair market value in a transaction?
Property, plant, and equipment (PP&E) and intangible assets are often carried at book values significantly below market values. As a result, these two assets are written-up the most in a transaction.
What does a goodwill impairment tell you about a deal?
occurs when the acquiring company determines the current value is lower than
the original price paid for the target company. Companies are required to estimate the value of their past acquisitions periodically.
For example, suppose an acquirer that paid $100 million for a business with $40 million in goodwill now estimates the acquired business’s value to be $70 million. Here, the acquirer must recognize a $30 million goodwill impairment via retained earnings, bringing the goodwill balance down to $10 million.
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.
Would an acquirer prefer $100 in revenue synergies or $100 in cost synergies?
An acquirer would prefer $100 in cost synergies because all those cost savings (after accounting for tax) flow
through to the bottom line, while revenue synergies have associated costs that reduce the bottom-line benefit.
For example, $100 in revenue synergies for a company with 40% pre-tax profit margins and a 25% tax rate
would see $100 x 40% x (1 - 25%) = $30 flow to the bottom line, while the same company with $100 in cost
synergies would see $100 x (1 - 25%) = $75 flow to the bottom line.
Are acquirers more likely to achieve revenue synergy or cost synergy expectations?
Revenue synergy assumptions are less accurate than cost synergy assumptions. Cost synergies can point towards specific cost-cutting initiatives such as laying off workers and shutting down facilities. In contrast, revenue synergies are driven by higher-level, more uncertain assumptions around cross-selling, new product launches, and other growth initiatives.
For investment bankers, why is a sell-side process typically shorter than a buy-side assignment?
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.
VS
For buyers, these engagements and explorations can drag on for months and often end in no transaction.
What is the accounting for transaction fees in M&A?
Transaction fees include IB advisory, accounting, and legal fees, which are expensed as incurred. In effect, the pro forma net income and pro forma EPS will be reduced.
What is the accounting treatment for financing fees?
Capitalization & Amortization: Financing fees for acquisition-related debt are capitalized (not expensed immediately) and amortized over the debt’s term, creating incremental amortization expense. This reduces pro forma net income and pro forma EPS over the borrowing period.
Balance Sheet Impact: Financing fees are recorded as a contra-liability (deducted directly from the debt liability), rather than being expensed upfront.
Modeling Considerations:
Classified as “Debt Issuance Costs” on the balance sheet.
Amortized as a non-cash expense within interest expense over the borrowing term.
Contrast with Transaction Fees: Unlike transaction fees (often expensed immediately), financing fees follow this amortization-based accounting treatment.
What causes incremental D&A to be recorded in M&A deals?
Created due to asset write-ups. The assets of the target, most often PP&E and intangible assets, are written-up to their fair value in a deal if appropriate. The increase in D&A will reduce pro forma net
income and pro forma EPS.
What are some standard income statement adjustments related to a transaction?
M&A Income Statement Adjustments:
Expected Synergies
Capitalized Financing Fees
Incremental D&A
Additional Interest Expense
Loss of Interest Income
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?
Deferred tax liabilities (DTLs) are created because of deal-related asset write-ups. Specifically, when a company is acquired, its assets’ book basis often gets written up to fair market value.
However, when deals are structured as stock sales, the tax basis doesn’t always get stepped up to align with the book basis write up.
Here, DTLs are created on the deal date because depreciation on assets written-up will be higher for book purposes than for tax purposes.
What happens to a target’s existing NOLs in transactions?
The treatment of existing target NOLs depends on the structure of the deal:
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?
Primary Context: Common in software M&A deals (e.g., Adobe’s Marketo/Magento acquisitions) due to long-term subscription contracts. Deferred revenue is revalued to fair value at deal close, often resulting in a write-down if the original booked amount exceeds this fair value.
Key Causes:
Collectability concerns: Uncertainty about receiving payments from customers.
Terminated/breached contracts: Invalid agreements reduce future obligations.
Customer contract changes: Upgrades, maintenance, or support adjustments alter performance obligations.
Revaluation Process: Requires re-estimating:
Remaining performance obligations (services/products owed to customers).
Costs to fulfill obligations (e.g., delivery, support).
Profit margin tied to fulfilling obligations.
Impact: Reduces deferred revenue on the balance sheet, lowering future revenue recognition and potentially affecting short-term financial metrics post-acquisition.
What is an earnout in the context of M&A?
An earn-out bridges the gap between the purchase price the seller is looking for
and the highest amount the buyer is willing to pay.
(A portion of the purchase price will be issued to the seller upon achievement of a certain milestone within a given time frame….To break out of this purchase price deadlock– an earn-out provision is often used as a compromise)
Which side do you believe an earn-out helps more: the buyer or seller?
Earn-outs can be viewed as a risk-allocation mechanism as the payment is deferred and the burden of meeting the target is placed on the seller.
Primary Beneficiary: Generally favors buyers by:
Transferring performance risk to the seller (seller bears burden of meeting targets).
Aligning seller incentives with buyer goals (seller motivated to achieve milestones for full payment).
Seller Perspective:
Reluctance: Sellers often resist earn-outs due to payment uncertainty.
Necessity: Earn-outs bridge valuation gaps, enabling deal closure when buyer/seller price expectations differ.
Upside: If targets are met, sellers receive full/near-full requested consideration.
Risk Allocation:
Buyer advantage: Reduced upfront payment risk; pays only if performance criteria are satisfied.
Seller risk: Potential underpayment if targets are missed (e.g., market shifts, operational challenges).
Structural Influence:
Earn-out terms (e.g., milestones, payment timing) determine balance of power.
Aggressive targets or narrow metrics may disproportionately benefit buyers.
How are earn-outs typically structured?
Earn-outs are highly negotiated and will differ by the deal, but most will last for one to five years and be paid
out in installment payments (rather than a lump sum).
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).
2. 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?
Valuation Alignment:
EBITDA is the most common valuation multiple in M&A (e.g., businesses priced as a multiple of EBITDA). Earn-outs using EBITDA directly align with this valuation framework, simplifying negotiations.
Example: A $1M EBITDA business valued at 4.0x vs. 5.0x by buyer/seller can bridge the gap via a $4M upfront payment + $1M earn-out tied to future EBITDA.
Balanced Performance Measure:
Combines growth (revenue) and profitability (cost control), incentivizing sustainable value creation.
Discourages short-term risk-taking (unlike revenue targets) and resists manipulation (unlike net income).
Drawbacks of Alternatives
Revenue: Encourages risky, short-term sales tactics (e.g., discounting, lax terms).
Net income: Easily manipulated via cost-cutting, reduced capex, or asset sales.
Long-Term Focus:
Achieving EBITDA targets often requires strategic investments and operational discipline, reflecting genuine value creation for the buyer.
How would an earn-out be modeled on the three statements?
An earn-out will not be reflected on the Sources & Uses table since no cash payment has been paid out yet. However, the returns models from both the buy-side and sell-side perspective would have this earn-out modeled out as a contingency.
IS: The change in the value of the contingency payment would be reflected in the non-operating
gains/(losses) section. The amount will depend on the probability of the earn-out being paid out. A gain
would mean the probability of payout has decreased, while a loss means the probability has increased.
BS: The earn-out will be recorded as a contingent consideration in the liabilities section and recorded at its
measured fair value as of the acquisition date. An accountant will determine the liability’s fair value as the
present value of the probability-weighted expected amount of future payment. Thus, as targets are met (or
missed), the contingent liability is re-evaluated and adjusted periodically until the earn-out period ends.
CFS: If a target is met, the agreed-upon payout will be recorded here. The fluctuating changes in the
probability of payout are also shown here, but these non-cash changes in values are not actual cash
inflows/(outflows), unlike the payout when a target is met.
Which industries would you expect earnouts to be the more prevalent?
Healthcare:
Earn-outs are common due to regulatory complexity and compliance risks.
Often tied to milestones like FDA approvals, product trials, or patent production.
Reflects uncertainty around future events impacting asset value (e.g., regulatory outcomes, development pipelines).
Life Sciences (Biopharma):
High prevalence (e.g., over 90% of biopharma deals include earn-outs).
Metrics often involve clinical trial progress, regulatory approvals, or commercial sales milestones.
Technology:
Used for early-stage companies with volatile growth rates and valuation challenges.
Metrics may include revenue, intellectual property milestones, or customer acquisition targets.
Energy:
Earn-outs address valuation uncertainty due to commodity price volatility and regulatory changes.
Often tied to project development milestones or exceeding specific production thresholds.
General Trends:
Earn-outs are prevalent in industries with high growth potential, long development cycles, or unpredictable outcomes.
They help bridge valuation gaps where future performance is uncertain.
In M&A, what is the purpose of seller notes?
A seller note is when the seller has agreed to receive a portion of the purchase price in the form of debt. The
seller note is part of the purchase consideration, similar to an earn-out.
It’s the seller’s best interests for the new business to
be run well, as this increases the probability of receiving the agreed-upon installment payments of the loan
(and receive the full purchase price).
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. Therefore, a working capital peg ensures the business can continue operating with no more capital required upon closing.
(From the perspective of the buyer, the purpose of setting this target is to prevent the seller from taking
cash beyond NWC requirements.)
Can you name a scenario when the post-deal EPS accretion/dilution would not be a significant consideration?
If the buyer is publicly traded and the target is a startup being purchased for “acqui-hiring” purposes, the
strategic acquirer would pay little attention to the post-acquisition EPS. Instead, the focus would be the
onboarding of the new key personnel being brought on and the intellectual property (IP), since the impact on
EPS would be negligible given the size disparity
