M&A Flashcards
Walk me through a basic merger model
- Used to analyse financial profiles of 2 companies and determines whether the buyer’s EPS increases or decreases.
- Make up the assumptions, the price, whether it was cash, stock, debt or some combination.
- Sources and Uses Table
- Determine the valuations and share outstanding as well as the Income Statement of Buyer and Seller
- New valuation of Target BS
- Modelling of Debt Schedules across financing period
- Combine ISs adding up the line items and apply the buyer’s tax rate to get to combined NI
- Divide it by the new share count to determine combined EPS
- (Combination of CFS on basis of IS, BS and Debt Schedule)
- Evaluation of relevant metrics (ROE, Leverage, CF Conversion, Accretion/Dilution etc.)
- Contribution-Analysis: Which part of new Financials (Rev. or EBITDA) comes from target, synergies or buyer
What’s the difference between a merger and an acquisition?
There’s always a buyer and seller in M&A deal. The difference between merger and acquisition is more semantic. In a merger companies are more close to the same size, in an acquisition, one is significantly larger.
Why would an acquisition be dilutive?
Additional NI of seller is not enough to offset the buyer’s foregone interest on cash, additional interest paid on debt and the effects of issuing additional shares. Acq. Effects such as amortization of intangibles can also make transaction dilutive.
Is there a rule of thumb for accretion/dilution?
If only debt and cash is used you can sum up interest expense and foregone interest on cash then compare it to seller’s pre-tax income.
If it’s an all stock deal, if the buyer has a higher P/E than the seller it will be accretive (otherwise dilutive)
If it’s a combination of both then you can’t.
A company with a higher P/E acquires on with a lower P/E – is this acc. or dil.?
You can’t tell unless it’s an all-stock deal. If it’s all cash or all debt P/Es don’t matter as no stock is being used.
100% stock deal. Buyer has 10 shares @$25 and $10 Net Income. Acquires Seller for purch. Equity value of $150 and $10 Net Income. Both have the same tax rate. How accretive is this deal?
Buyer EPS is $1 ($10 Net Income / 10 shares). Needs 6 new shares to acquire Seller ($150/$25). Total EPS is $1.25 ($20 Net Income / 16 shares). So the deal is 25% accretive ($1.25 / $1)
What are the complete effects of an acquisition?
- Foregone Interest on Cash: Buyer loses Interest it would have otherwise earned if it uses cash for the acquisition
- Additional Interest on Debt: The buyer pays additional Interest Expense if it uses debt
- Additional Shares Outstanding: If paying with shares, it has to issue new ones
- Combined Financial Statements
- Creation of Goodwill & Other Intangibles: Represent premium to FMV
Why would a strategic acquirer typically be willing to pay more for a company than a PE would?
Because strategist can realize revenue and cost synergies that boost the valuation, that the PE usually can’t.
Why does Goodwill & Other Intangibles get created in an acquisition?
To represent the value over FMV that the buyer has paid (diff. between book value and equity purch. Price). More specifically it means customers relationships, brand names, intellectual property, etc. but not financial assets on the BS.
What’s the difference between Goodwill & Other Intangible Assets?
Goodwill typically stays the same and is not amortized. It changes only if there is a goodwill impairment or other acquisition. Other Intangibles are amortized over several years.
Is there anything else “intangible” besides Goodwill & Other Intangibles that could impact combined company?
Yes, you could have a Purchased In-Process R&D Write-off and a Deferred Revenue Write-Off.
First is R&D project that were purchased but which have not been completed yet. They still require resources and therefore the expense has to be recognized.
The second refers to the case where the seller has collected cash for a service but not yet recorded it as revenue. The buyer must write it off to avoid double counting revenue.
What types of synergies are there?
Cost, Revenue
How are synergies used in merger models?
- Revenue synergies: Add these to combined revenues and assume a certain margin
- Cost synergies: You normally reduce combined COGS or Opex by this amount, which then boosts pre-tax income and thus NI, raising EPS and making the deal more accretive.
Are revenue or cost synergies more important?
Cost synergies. They are much more predictable and more straightforward. Revenue synergies are very hard to predict so are also taken much less seriously.
All else being equal, would you use cash, stock or debt for an acquisition?
Assuming unlimited resources, company would always prefer cash:
- Cash is usually cheaper than debt (foregone interest < debt expense)
- Cash is less risky from default perspective and a volatile share price coming with new issuance
- Hard to compare, but generally stock is most expensive
How much debt could a company issue in a merger or acquisition?
Generally, you would look at Comparables/Precendent Transaction and would use combined company’s LTM EBITDA figure to find Debt/EBITDA to apply to your own EBITDA. You would also look at “Debt Comps” for companies in the same industry and see what type of debt and how many tranches they have used.
What happens after a company overpays for another?
Goodwill impairment
A buyer pays $100m for the seller in an all-stock deal but a day later the market decides the acquiring company is only worth $50m. What happens?
The share price would fall by the per-share dollar amount corresponding to the $50m. Depending on deal structure, seller would possibly get less that what originally negotiated. That’s one major risk of all-stock deals.
Why do most M&A transactions fail?
- Easier said than done and very difficult to integrate a different company and realize synergies.
- Many deals are also done for the wrong reasons (imperialistic CEOs etc.)
- Lack of DD
- Non-compatible culture
- Bad management
What role does a merger model play in deal negotiations?
Used as sanity check but a company would never decide to do a deal based on the output of the model.
What types of sensitivities would you look at in a merger model?
Purchase Price, %Stock/Cash/Debt, Revenue Synergies, Expense Synergies, (Revenue Growth, EBITDA Margin). You might look at accretion/dilution at different ranges for these variables.
What’s the difference between Purchase Accounting and Pooling Accounting in an M&A deal?
In purchase accounting (99% of deals) the seller’s shareholders’ equity is wiped out and the premium paid is recorded as Goodwill on the combined BS.
In pooling accounting, you simply combine the two equity numbers and don’t worry about Goodwill.
Walk me through the calculation of revenue synergies.
E.g. if Microsoft buys Yahoo to make money from advertising online. Yahoo makes $0.10 per search now but with Microsoft’s superior monetization they could boost that by $0.02. We would multiply these $0.02 by the number of total searches to get the additional revenue and would then apply a certain margin.
How do you take into account NOLs in an M&A deal?
You apply Section 382 to determine how much of seller’s NOLs are usable each year:
Allowable NOLs = Equity Purch. Price * Highest of Past 3 months adj. long-term rates
E.g. $1b purch. Price and highest adj. long-term rate is 5%, then we could have $50m of NOLs each year. If the seller had $250m of NOLs, then the company could use $50m of them each year for 5 years to offset taxable income.
Why do deferred tax assets (DTAs) and deferred tax liabilities (DTLs) get created in M&A deals?
Because asset book value does not necessarily correspond to FMV, so you write assets down and up. Asset write-up creates DTL because you’ll have higher depreciation expense on new asset, which means you save taxes in the short-term but eventually you’ll have to pay them back.
How do DTLs and DTAs affect the BS adjustment in an M&A deal?
You take them into account with everything else when calculating the amount of Goodwill & Other Intangibles to create on your pro-forma balance sheet. (DTA = Asset write-down * tax rate).
If you buy a company for $1b with 50% cash/50% debt and had a $100m asset write-up and tax rate of 40%. In addition, the seller has total assets of $200m, total liabilities of $150m and $50m of equity, here’s what happens:
- First you add seller’s asset and liabilities (but not equity since it’s wiped out). Assets increase by $200, liabilities are up by $150.
- Cash goes down by $500
- Debt goes up by $500
- New DTL of $40m ($100m * 40%) on liabilities side
- Assets are down by $300; liabilities & equity are up by $690 ($150 + $500 + $40)
- We need $990 of Goodwill & Intangibles on Asset side to make both balance
Could you get DTLs and DTAs in an asset purchase?
No, because in asset purchase the book basis always matches the tax basis. They get created in a stock purchase because book values of asset are written up or down but the tax values are not.
How do you account for DTLs in forward projections in a merger model?
You create a book vs. cash tax schedule and figure out what the company owes in taxes based on pretax income on its books. Then you determine what it actually pays in cash taxes based on its NOLs and newly created D&A expenses (from asset write-ups). If the cash tax expense exceeds the book cash expense you create a DTA and other way around.
Explain the complete Goodwill formula
Goodwill = Equity Purch. Price – Seller Book Value \+ Seller Existing Goodwill – Asset Write-Ups – Seller’s Existing DTL \+ Write-Down of Seller’s Existing DTA -? Newly Created DTA
- Seller BV is just shareholders’ equity
- You add Seller Goodwill because it gets written down to 0
- You subtract asset write-ups because they are additions to asset side
- Normally you assume 100% of the Seller’s Existing DTL is written down
Explain why we would write down the seller’s DTA in an M&A deal
To reflect that DTAs include NOLs and you might use these NOLs post-transaction to offset taxable income. In an asset (or 338(h)(10)) purchase you assume that the entire NOL balance goes to 0 in the transaction and then you write down the existing DTA by this NOL write-down.
In a stock purchase the formula is: DTA Write-Down = Buyer Tax Rate * Max(0, NOL Balance – Allowed Annual NOL Usage * Expiration Period in Years)
This means we use all NOLs post transaction if we can use them. If we can’t, we write down the portion that we cannot use.
What’s a Section 338(h)(10) election and why might a company use it?
Blends the benefits of a stock purchase and an asset purchase:
- Legally a stock purchase but accounting-wise and asset purchase
- Seller still double-taxed on asset that have appreciated and on proceeds from sale
- Buyer receives step-up tax basis on newly acq. Assets and it can D&A them to save tax
Even though seller still get taxed twice, buyers will often pay more because of their tax-saving potential. It’s helpful for:
- Sellers with high NOL balances (more can be written down)
- If company was an S-corp for >10y it doesn’t have to pay tax on asset appreciation
What’s an exchange ratio and when would companies use it in an M&A deal?
Alternative way of structuring stock M&A deal. Buyer doesn’t calculate how many new shares to issue as a specific number but as a ratio for how many shares compared to existing shares, e.g., instead of 25m shares the seller might receive 1.5 shares of the buyer’s shares for each of its shares.
Walk me through important terms of Purchase Agreement in M&A deal
- Purch. Price: Per-share amount
- Form of Consideration: Cash/Stock/Debt
- Transaction Structure: Stock/Asset/338(h)(10)
- Treatment of Options: Cashed out/Ignored,…
- Employee Retention: Do employees or management have to sign non-solicit or non-compete agreements?
- Reps & Warranties: What buyer and seller claim to be true about their business
- No-Shop/Go-Shop: Can seller try to get a better deal or must it stay exclusive
What’s an Earnout and why would a buyer offer it?
Form of deferred payment in M&A deal typical for private companies and start-ups. Usually contingent on financial performance or other goals. Buyers use it to incentivize seller to do well after deal
Why could Earnouts be problematic? Would you recommend their use?
Clear definition is very hard. Adjustments of financials etc. can lead to discussions. Additionally, buyer is incentivized to display performance worse than it is after acquisition (to not pay extra). Needs to be well structured and clearly defined to function.
How would an accretion/dilution model be different for a private seller?
Mechanics are same but structure more likely an asset purchase or 338(h)(10) election. Private sellers don’t have EPS so you would only project down to NI on its IS. Therefore Accr./Dil. doesn’t make sense for private buyer because they don’t have EPS.
