Merger Model

Question 1

Walk me through a basic merger model

Answer 1

• 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

Question 2

What’s the difference between a merger and an acquisition?

Answer 2

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.

Question 3

Why would an acquisition be dilutive?

Answer 3

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.

Question 4

Is there a rule of thumb for accretion/dilution?

Answer 4

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.

Question 5

A company with a higher P/E acquires on with a lower P/E – is this acc. or dil.?

Answer 5

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.

Question 6

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?

Answer 6

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)

Question 7

What are the complete effects of an acquisition?

Answer 7

• 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

Question 8

Why would a strategic acquirer typically be willing to pay more for a company than a PE would?

Answer 8

Because strategist can realize revenue and cost synergies that boost the valuation, that the PE usually can’t.

Question 9

Why does Goodwill & Other Intangibles get created in an acquisition?

Answer 9

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.

Question 10

What’s the difference between Goodwill & Other Intangible Assets?

Answer 10

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.

Question 11

Is there anything else “intangible” besides Goodwill & Other Intangibles that could impact combined company?

Answer 11

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.

Question 12

What types of synergies are there?

Answer 12

Cost, Revenue

Question 13

How are synergies used in merger models?

Answer 13

• 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.

Question 14

Are revenue or cost synergies more important?

Answer 14

Cost synergies. They are much more predictable and more straightforward. Revenue synergies are very hard to predict so are also taken much less seriously.

Question 15

All else being equal, would you use cash, stock or debt for an acquisition?

Answer 15

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

Question 16

How much debt could a company issue in a merger or acquisition?

Answer 16

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.

Question 17

What happens after a company overpays for another?

Answer 17

Goodwill impairment

Question 18

A buyer pays $100m for the seller in an all-stock deal but a day later decides it’s only worth $50m. What happens?

Answer 18

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.

Question 19

Why do most M&A transactions fail?

Answer 19

• 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

Question 20

What role does a merger model play in deal negotiations?

Answer 20

Used as sanity check but a company would never decide to do a deal based on the output of the model.

Question 21

What types of sensitivities would you look at in a merger model?

Answer 21

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.

Question 22

What’s the difference between Purchase Accounting and Pooling Accounting in an M&A deal?

Answer 22

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.

Question 23

Walk me through the calculation of revenue synergies.

Answer 23

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.

Question 24

How do you take into account NOLs in an M&A deal?

Answer 24

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.

Question 25

Why do deferred tax assets (DTAs) and deferred tax liabilities (DTLs) get created in M&A deals?

Answer 25

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.

Question 26

How do DTLs and DTAs affect the BS adjustment in an M&A deal?

Answer 26

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

Question 27

Could you get DTLs and DTAs in an asset purchase?

Answer 27

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.

Question 28

How do you account for DTLs in forward projections in a merger model?

Answer 28

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 DTL and other way around.

Question 29

Explain the complete Goodwill formula

Answer 29

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

Question 30

Explain why we would write down the seller’s DTA in an M&A deal

Answer 30

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.

Question 31

What’s a Section 338(h)(10) election and why might a company use it?

Answer 31

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

Question 32

What’s an exchange ratio and when would companies use it in an M&A deal?

Answer 32

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.

Question 33

Walk me through important terms of Purchase Agreement in M&A deal

Answer 33

• 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

Question 34

What’s an Earnout and why would a buyer offer it?

Answer 34

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

Question 35

Why could Earnouts be problematic? Would you recommend their use?

Answer 35

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.

Question 36

How would an accretion/dilution model be different for a private seller?

Answer 36

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.

Question 37

How do I calculate “break-even synergies” and what does it mean?

Answer 37

Set the EPS accretion/dilution to 0 and then back-solve in Excel to get required synergies to make the deal neutral to EPS. It’s to get an idea of whether deal works mathematically and a high number for break-even synergies tells you that you need a lot of synergies to make it work.

Question 38

Normally in accretion/dilution you care most about combined IS but how would you combine all 3 statements?

Answer 38

• Combine IS as usual
• Combine BS (except for shareholders’ equity)
• Project combined BS using standard assumptions
• Project CFS and link everything together

Question 39

How do you handle options, convertible debt and other dilutive securities in a merger model?

Answer 39

Depends on Purchase Agreement – buyer might assume them or it might allow the seller to cash them out assuming per share purchase price is above exercise price of these dilutive securities. If they’re exercised you calculate dilution to equity purchase price like usual with Treasury Stock Method.

Question 40

What are the 3 main transaction structures you could use to acquire a company?

Answer 40

• Stock Purchase:
  o Buyer acquires all asset and liabilities of the seller as well as off-balance sheet items
  o Seller is taxed at capital gains tax rate
  o Buyer receives no step-up tax basis for new assets and can’t D&A them for tax purposes
  o Therefore, a DTL gets created
  o Most common for public companies and larger private ones
• Asset Purchase:
  o Buyer acquires only certain asset and assumes only certain liabilities
  o Seller is taxed on amount its asset appreciated and pays capital gains tax
  o Buyer receives step-up tax basis for new assets, and it can D&A them for tax purposes
  o Therefore, no DTL created
  o Most common for private companies, divestitures and distressed public ones
• Section 338(h)(10) Election:
  o Buyer acquires all asset and liabilities as well as off-balance sheet items
  o Seller is taxed on amount its assets appreciated and pays cap gains tax
  o Buyer receives step-up tax basis on new assets and it can D&A them
  o No DTL is created as a result
  o Most common for private companies, divestitures and distressed public ones
  o To compensate for buyer’s favorable tax treatment, buyer usually pays more

Question 41

Would a seller prefer stock or asset purchase? What about buyer?

Answer 41

A seller usually prefers stock purchase to avoid double taxation and to get rid of all liabilities. A buyer usually prefers asset deal so it can be more careful about what it requires and to get the tax benefit from D&A of asset write-ups for tax purposes.

Question 42

Explain what a contribution analysis is and why we might look at it in a merger model

Answer 42

Compares how much revenue, EBITDA, Pre-Tax Income, cash and other items the buyer and seller are contributing to estimate what the ownership should be. E.g. buyer has $100m rev. and seller has $50m rev., then ownership should be 66% and 33%. Typical for merger of equals.

Question 43

How do you account for transaction costs, financing fees, and miscellaneous expenses in a merger model?

Answer 43

Historically you capitalized these expenses and then amortize them. With new accounting rules, you’re supposed to expense them upfront but capitalize the fees and amortize them over the life of the debt. Expensed transaction fees come out of Retained Earnings when you adjust the BS, while capitalized financing fees appear as a new asset on the BS and are amortized each year according to the tenor of the debt.

Question 44

Which problems can occur in a mega-merger?

Answer 44

Antitrust approvals are needed

Question 45

Is Antitrust relevant for PEs or only for strategists?

Answer 45

As relevant for PEs as for strategists

Question 46

Company sells subsidiary and approves paying legal fees for following years. Buyer sends even smallest bills and causes mass administrative work. How could seller handle this better?

Answer 46

• De Minimis: Only bills above certain threshold are paid

- Basket: E.g. 500k and only once all bills are above that, seller starts to pay bills