Merger Model - Advanced

Question 1

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

Answer 1

In purchase accounting the seller’s shareholders’ equity number is wiped out and the premium paid over that value is recorded as Goodwill on the combined balance sheet post-acquisition. In pooling accounting, you simply combine the 2 shareholders’ equity numbers rather than worrying about Goodwill and the related items that get created.

There are specific requirements for using pooling accounting, so in 99% of M&A deals you will use purchase accounting.

Question 2

Walk me through a concrete example of how to calculate revenue synergies.

Answer 2

“Let’s say that Microsoft is going to acquire Yahoo. Yahoo makes money from search advertising online, and they make a certain amount of revenue per search (RPS). Let’s say this RPS is $0.10 right now. If Microsoft acquired it, we might assume that they could boost this RPS by $0.01 or $0.02 because of their superior monetization. So to calculate the additional revenue from this synergy, we would multiply this $0.01 or $0.02 by Yahoo’s total # of searches, get the total additional revenue, and then select a margin on it to determine how much flows through to the combined company’s Operating Income.”

Question 3

Walk me through an example of how to calculate expense synergies.

Answer 3

“Let’s say that Microsoft still wants to acquire Yahoo!. Microsoft has 5,000 SG&A-related employees, whereas Yahoo has around 1,000. Microsoft calculates that post-transaction, it will only need about 200 of Yahoo’s SG&A employees, and its existing employees can take over the rest of the work. To calculate the Operating Expenses the combined company would save, we would multiply these 800 employees Microsoft is going to fire post-transaction by their average salary.”

Question 4

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

Answer 4

You apply Section 382 to determine how much of the seller’s NOLs are usable each year.

Allowable NOLs = Equity Purchase Price * Highest of Past 3 Months’ Adjusted Long Term Rates

So if our equity purchase price were $1 billion and the highest adjusted long-term rate were 5%, then we could use $1 billion * 5% = $50 million of NOLs each year.

If the seller had $250 million in NOLs, then the combined company could use $50 million of them each year for 5 years to offset its taxable income.

You can look at long-term rates right here: http://pmstax.com/afr/exemptAFR.shtml

Question 5

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

Answer 5

These get created when you write up assets – both tangible and intangible – and when you write down assets in a transaction. An asset write-up creates a deferred tax liability, and an asset write-down creates a deferred tax asset.

You write down and write up assets because their book value – what’s on the balance sheet – often differs substantially from their “fair market value.”

An asset write-up creates a deferred tax liability because you’ll have a higher depreciation expense on the new asset, which means you save on taxes in the short-term – but eventually you’ll have to pay them back, hence the liability. The opposite applies for an asset write-down and a deferred tax asset.

Question 6

How do DTLs and DTAs affect the Balance Sheet Adjustment in an M&A deal?

Answer 6

You take them into account with everything else when calculating the amount of Goodwill & Other Intangibles to create on your pro-forma balance sheet. The formulas are as follows:

• Deferred Tax Asset = Asset Write-Down * Tax Rate
• Deferred Tax Liability = Asset Write-Up * Tax Rate

So let’s say you were buying a company for $1 billion with half-cash and half-debt, and you had a $100 million asset write-up and a tax rate of 40%. In addition, the seller has total assets of $200 million, total liabilities of $150 million, and shareholders’ equity of $50 million.

Here’s what would happen to the combined company’s balance sheet (ignoring transaction/financing fees):

• First, you simply add the seller’s Assets and Liabilities (but NOT Shareholders’ Equity – it is wiped out) to the buyer’s to get your “initial” balance sheet. Assets are up by $200 million and Liabilities are up by $150 million.
• Then, Cash on the Assets side goes down by $500 million.
• Debt on the Liabilities & Equity side goes up by $500 million.
• You get a new Deferred Tax Liability of $40 million ($100 million * 40%) on the Liabilities & Equity side.
• Assets are down by $300 million total and Liabilities & Shareholders’ Equity are up by $690 million ($500 + $40 + $150).
• So you need Goodwill & Intangibles of $990 million on the Assets side to make both sides balance.

Question 7

Could you get DTLs or DTAs in an Asset Purchase?

Answer 7

No, because in an asset purchase the book basis of assets always matches the tax basis. They get created in a stock purchase because the book values of assets are written up or written down, but the tax values are not.

Question 8

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

Answer 8

You create a book vs. cash tax schedule and figure out what the company owes in taxes based on the Pretax Income on its books, and then you determine what it actually pays in cash taxes based on its NOLs and newly created amortization and depreciation expenses (from any asset write-ups).

Anytime the “cash” tax expense exceeds the “book” tax expense you record this as a decrease to the Deferred Tax Liability on the Balance Sheet; if the “book” expense is higher, then you record that as an increase to the DTL.

Question 9

Explain the complete formula for how to calculate Goodwill in an M&A deal.

Answer 9

Goodwill = Equity Purchase Price – Seller Book Value + Seller’s Existing Goodwill – Asset Write-Ups – Seller’s Existing Deferred Tax Liability + Write-Down of Seller’s Existing Deferred Tax Asset + Newly Created Deferred Tax Liability

A couple notes here:

• Seller Book Value is just the Shareholders’ Equity number.
• You add the Seller’s Existing Goodwill because it gets written down to $0 in an M&A deal.
• You subtract the Asset Write-Ups because these are additions to the Assets side of the Balance Sheet – Goodwill is also an asset, so effectively you need less Goodwill to “plug the hole.”
• Normally you assume 100% of the Seller’s existing DTL is written down.
• The seller’s existing DTA may or may not be written down completely.

Question 10

Explain why we would write down the seller’s existing Deferred Tax Asset in an M&A deal.

Answer 10

You write it down to reflect the fact that Deferred Tax Assets include NOLs, and that you might use these NOLs post-transaction to offset the combined entity’s 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 Deferred Tax Asset 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 formula is saying, “If we’re going to use up all these NOLs post transaction, let’s not write anything down. Otherwise, let’s write down the portion that we cannot actually use post-transaction, i.e. whatever our existing NOL balance is minus the amount we can use per year times the number of years.”

Question 11

What’s a Section 338(h)(10) election and why might a company want to use it in an M&A deal?

Answer 11

A Section 338(h)(10) election blends the benefits of a stock purchase and an asset purchase:

• Legally it is a stock purchase, but accounting-wise it’s treated like an asset purchase.
• The seller is still subject to double-taxation – on its assets that have appreciated and on the proceeds from the sale.
• But the buyer receives a step-up tax basis on the new assets it acquires, and it can depreciate/amortize them so it saves on taxes.

Even though the seller still gets taxed twice, buyers will often pay more in a 338(h)(10) deal because of the tax-savings potential. It’s particularly helpful for:

• Sellers with high NOL balances (more tax-savings for the buyer because this NOL balance will be written down completely – and so more of the excess purchase price can be allocated to asset write-ups).
• If the company has been an S-corporation for over 10 years – in this case it doesn’t have to pay a tax on the appreciation of its assets.

The requirements to use 338(h)(10) are complex and bankers don’t deal with this – that is the role of lawyers and tax accountants.

Question 12

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

Answer 12

An exchange ratio is an alternate way of structuring a 100% stock M&A deal, or any M&A deal with a portion of stock involved.

Let’s say you were going to buy a company for $100 million in an all-stock deal. Normally you would determine how much stock to issue by dividing the $100 million by the buyer’s stock price, and using that to get the new share count.

With an exchange ratio, by contrast, you would tie the number of new shares to the buyer’s own shares – so the seller might receive 1.5 shares of the buyer’s shares for each of its shares, rather than shares worth a specific dollar amount.

Buyers might prefer to do this if they believe their stock price is going to decline post- transaction – sellers, on the other hand, would prefer a fixed dollar amount in stock unless they believe the buyer’s share price will rise after the transaction.

Question 13

Walk me through the most important terms of a Purchase Agreement in an M&A deal.

Answer 13

There are dozens, but here are the most important ones:

• Purchase Price: Stated as a per-share amount for public companies.
• Form of Consideration: Cash, Stock, Debt…
• Transaction Structure: Stock, Asset, or 338(h)(10)
• Treatment of Options: Assumed by the buyer? Cashed out? Ignored?
• Employee Retention: Do employees have to sign non-solicit or non-compete agreements? What about management?
• Reps & Warranties: What must the buyer and seller claim is true about their respective businesses?
• No-Shop / Go-Shop: Can the seller “shop” this offer around and try to get a better deal, or must it stay exclusive to this buyer?

Question 14

What’s an Earnout and why would a buyer offer it to a seller in an M&A deal?

Answer 14

An Earnout is a form of “deferred payment” in an M&A deal – it’s most common with private companies and start-ups, and is highly unusual with public sellers.

It is usually contingent on financial performance or other goals – for example, the buyer might say, “We’ll give you an additional $10 million in 3 years if you can hit $100 million in revenue by then.”

Buyers use it to incentivize sellers to continue to perform well and to discourage management teams from taking the money and running off to an island in the South Pacific once the deal is done.

Question 15

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

Answer 15

The mechanics are the same, but the transaction structure is more likely to be an asset purchase or 338(h)(10) election; private sellers also don’t have Earnings Per Share so you would only project down to Net Income on the seller’s Income Statement.

Note that accretion / dilution makes no sense if you have a private buyer because private companies do not have Earnings Per Share.

Question 16

How would I calculate “break-even synergies” in an M&A deal and what does the number mean?

Answer 16

To do this, you would set the EPS accretion / dilution to $0.00 and then back-solve in Excel to get the required synergies to make the deal neutral to EPS.

It’s important because you want an idea of whether or not a deal “works” mathematically, and a high number for the break-even synergies tells you that you’re going to need a lot of cost savings or revenue synergies to make it work.

Question 17

Normally in an accretion / dilution model you care most about combining both companies’ Income Statements. But let’s say I want to combine all 3 financial statements – how would I do this?

Answer 17

You combine the Income Statements like you normally would (see the previous question on this), and then you do the following:

1. Combine the buyer’s and seller’s balance sheets (except for the seller’s Shareholders’ Equity number).
2. Make the necessary Pro-Forma Adjustments (cash, debt, goodwill/intangibles, etc.).
3. Project the combined Balance Sheet using standard assumptions for each item (see the Accounting section).
4. Then project the Cash Flow Statement and link everything together as you normally would with any other 3-statement model.

Question 18

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

Answer 18

The exact treatment depends on the terms of the Purchase Agreement – the buyer might assume them or it might allow the seller to “cash them out” assuming that the per-share purchase price is above the exercise prices of these dilutive securities.

If you assume they’re exercised, then you calculate dilution to the equity purchase price in the same way you normally would – Treasury Stock Method for options, and assume that convertibles convert into normal shares using the conversion price.

Question 19

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

Answer 19

Stock Purchase, Asset Purchase, and 338(h)(10) Election. The basic differences:

Stock Purchase:

• Buyer acquires all asset and liabilities of the seller as well as off-balance sheet items.
• The seller is taxed at the capital gains tax rate.
• The buyer receives no step-up tax basis for the newly acquired assets, and it can’t depreciate/amortize them for tax purposes.
• A Deferred Tax Liability gets created as a result of the above.
• Most common for public companies and larger private companies.

Asset Purchase:

• Buyer acquires only certain assets and assumes only certain liabilities of the seller and gets nothing else.
• Seller is taxed on the amount its assets have appreciated (what the buyer is paying for each one minus its book value) and also pays a capital gains tax on the proceeds.
• The buyer receives a step-up tax basis for the newly acquired assets, and it can depreciate/amortize them for tax purposes.
• No Deferred Tax Liability is created as a result of the above.
• Most common for private companies, divestitures, and distressed public companies.

Section 338(h)(10) Election:

• Buyer acquires all asset and liabilities of the seller as well as off-balance sheet items.
• Seller is taxed on the amount its assets have appreciated (what the buyer is paying for each one minus its book value) and also pays a capital gains tax on the proceeds.
• The buyer receives a step-up tax basis for the newly acquired assets, and it can depreciate/amortize them for tax purposes.
• No Deferred Tax Liability is created as a result of the above.
• Most common for private companies, divestitures, and distressed public companies.
• To compensate for the buyer’s favorable tax treatment, the buyer usually agrees to pay more than it would in an Asset Purchase.

Question 20

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

Answer 20

A seller almost always prefers a stock purchase to avoid double taxation and to get rid of all its liabilities. The buyer almost always prefers an asset deal so it can be more careful about what it acquires and to get the tax benefit from being able to deduct depreciation and amortization of asset write-ups for tax purposes.

Question 21

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

Answer 21

A contribution analysis compares how much revenue, EBITDA, Pre-Tax Income, cash, and possibly other items the buyer and seller are “contributing” to estimate what the ownership of the combined company should be.

For example, let’s say that the buyer is set to own 50% of the new company and the seller is set to own 50%. But the buyer has $100 million of revenue and the seller has $50 million of revenue – a contribution analysis would tell us that the buyer “should” own 66% instead because it’s contributing 2/3 of the combined revenue.

It’s most common to look at this with merger of equals scenarios, and less common when the buyer is significantly larger than the seller.

Question 22

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

Answer 22

In the “old days” you used to capitalize these expenses and then amortize them; with the new accounting rules, you’re supposed to expense transaction and miscellaneous fees upfront, but capitalize the financing fees and amortize them over the life of the debt.

Expensed transaction fees come out of Retained Earnings when you adjust the Balance Sheet, while capitalized financing fees appear as a new Asset on the Balance Sheet and are amortized each year according to the tenor of the debt.

Question 23

What’s the purpose of Purchase Price Allocation in an M&A deal? Can you explain how it works?

Answer 23

The ultimate purpose is to make the combined Balance Sheet balance.

This harder than it sounds because many items get adjusted up or down (e.g. PP&E), some items disappear altogether (e.g. the seller’s Shareholders’ Equity), and some new items get created (e.g. Goodwill).

To complete the process, you look at every single item on the seller’s Balance Sheet and then assess the fair market values of all those items, adjusting them up or down as necessary.

So if the buyer pays, say, $1 billion for the seller, you figure out how much of that $1 billion gets allocated to each Asset on the Balance Sheet.

Goodwill (and Other Intangible Assets) serves as the “plug” and ensures that both sides balance you’ve made all the adjustments. Goodwill is roughly equal to the Equity Purchase Price minus the seller’s Shareholders’ Equity and other adjustments.

Question 24

Why do we adjust the values of Assets such as PP&E in an M&A deal?

Answer 24

Because often the fair market value is significantly different from the Balance Sheet value. A perfect example is real estate – usually it appreciates over time, but due to the rules of accounting, companies must depreciate it on the Balance Sheet and show a declining balance over time to reflect the allocation of costs over a long time period.

Investments, Inventory, and other Assets may have also “drifted” from their fair market values since the Balance Sheet is recorded at historical cost for companies in most industries (exceptions, such as commercial banking, do exist).

Question 25

What’s the logic behind Deferred Tax Liabilities and Deferred Tax Assets?

Answer 25

The basic idea is that you normally write down most of the seller’s existing DTLs and DTAs to “reset” its tax basis, since it’s now part of another entity.

And then you may create new DTLs or DTAs if there are Asset Write-Ups or Write-Downs and the book and tax Depreciation and Amortization numbers differ.

If there are write-ups, a Deferred Tax Liability will be created in most deals since the Depreciation on the write-ups is not tax-deductible, which means that the company will pay more in cash taxes; the opposite applies for write-downs and there, a Deferred Tax Asset would be created.

Question 26

How do you treat items like Preferred Stock, Noncontrolling Interests, Debt, and so on, and how do they affect Purchase Price Allocation?

Answer 26

Normally you build in the option to repay (or in the case of Noncontrolling Interests, purchase the remainder of) these items or assume them in the Sources & Uses schedule.

If you repay them, additional cash/debt/stock is required to purchase the seller.

However, that choice does not affect Purchase Price Allocation.

You always start with the Equity Purchase Price there, which excludes the treatment of all these items.

Also, you only use the seller’s Common Shareholders’ Equity in the PPA schedule, which excludes Preferred Stock and Noncontrolling Interests.

Question 27

Do you use Equity Value or Enterprise Value for the Purchase Price in a merger model?

Answer 27

This is a trick question because neither one is entirely accurate. The PPA schedule is based on the Equity Purchase Price, but the actual amount of cash/stock/debt used is based on that Equity Purchase Price plus the additional funds needed to repay debt, pay for transaction-related fees, and so on.

That number is not exactly “Enterprise Value” – it’s something in between Equity Value and Enterprise Value, and it’s normally labeled “Funds Required” in a model.

Question 28

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

Answer 28

You expense transaction and miscellaneous fees (such as legal and accounting services) upfront and capitalize the financing fees and amortize them over the term of the debt.

Expensed transaction fees come out of Retained Earnings when you adjust the Balance Sheet (and Cash on the other side), while Capitalized Financing Fees appear as a new Asset on the Balance Sheet (and reduce Cash immediately) and are amortized each year according to the tenor of the debt.

In reality, you pay for all of these fees upfront in cash. However, since financing fees correspond to a long-term item rather than a one-time transaction, they’re amortized over time on the Balance Sheet. It’s similar to how new CapEx spending is depreciated over time.

None of this affects Purchase Price Allocation. These fees simply increase the “Funds Required” number discussed above, but they make absolutely no impact on the Equity Purchase Price or on the amount of Goodwill created.

Question 29

How would you treat Debt differently in the Sources & Uses table if it is refinanced rather than assumed?

Answer 29

If the buyer assumes the Debt, it appears in both the Sources and Uses columns and has no effect on the Funds Required.

If the buyer pays off Debt, it appears only in the Uses column and increases the Funds Required.

Question 30

How do you factor in DTLs into forward projections in a merger model?

Answer 30

You create a book vs. cash tax schedule and figure out what the company owes in taxes based on the Pre-Tax Income on its books, and then you determine what it actually pays in cash taxes based on its NOLs and its new D&A expenses (from any Asset Write-Ups).

Anytime the “cash” tax expense exceeds the “book” tax expense you record this as a decrease to the Deferred Tax Liability on the Balance Sheet; if the “book” expense is higher, then you record that as an increase to the DTL.

Question 31

Can you give me an example of how you might calculate revenue synergies?

Answer 31

“Sure. Let’s say that Company A sells 10,000 widgets per year in North America at an average price of $15.00, and Company B sells 5,000 widgets per year in Europe at an average price of $10.00. Company A believes that it can sell its own widgets to 20% of Company B’s customers, so after it acquires Company B it will earn an extra 20% * 5,000 * $15.00 in revenue, or $15,000.

It will also have expenses associated with those extra sales, so you need to reflect those as well – if it has a 50% margin, for example, it would reflect an additional $7,500, rather than $15,000, to Operating Income and Pre-Tax Income on the combined Income Statement.”

This last point about expenses associated with revenue synergies is important and one that a lot of people forget – there’s no such thing as “free” revenue with no associated costs.

Question 32

Should you estimate revenue synergies based on the seller’s customers and the seller’s financials, or the buyer’s customers and the buyer’s financials?

Answer 32

Either one works. You could assume that the buyer leverages the seller’s products or services and sells them to its own customer base – but typically you assume an uplift to the seller’s average selling price, or something else that the buyer can do with the seller’s existing customers.

You approach it that way because the buyer, as a larger company, can make more of an immediate impact on the seller than the seller can make on the buyer.

Question 33

Walk me through an example of how to calculate expense synergies.

Answer 33

“Let’s say that Company A wants to acquire Company B. Company A has 5,000 SG&A-related employees, whereas Company B has around 1,000. Company A calculates that post-transaction, it will only need about 800 of Company B’s SG&A employees, and its existing employees can take over the rest of the work. To calculate the Operating Expenses the combined company would save, we would multiply these 200 employees that Company A is going to fire post- transaction by their average salary, benefits, and other compensation expenses.”

Question 34

How do you think about synergies if the combined company can consolidate buildings?

Answer 34

If the buildings are leased, you assume that both lease expenses go away and are replaced with a new, larger lease expense for the new or expanded building. So in that case it is a simple matter of New Lease Expense – Old, Separate Lease Expenses to determine the synergies.

If the buildings are owned, it gets more complicated because one or both of them will be sold, or perhaps leased out to someone else. Then you would have to look at Depreciation and Interest savings, as well as additional potential income if the building is rented out.

Question 35

What if there are CapEx synergies? For example, what if the buyer can reduce its CapEx spending because of certain assets the seller owns?

Answer 35

In this case, you would start recording a lower CapEx charge on the combined Cash Flow Statement, and then reflect a reduced Depreciation charge on the Income Statement from that new CapEx spending each year.

You would not start seeing the results until Year 2 because reduced Depreciation only comes after reduced CapEx spending. This scenario would be much easier to model with a full PP&E schedule where you can adjust the spending and the resulting Depreciation each year.

Question 36

What happens when you acquire a 30% stake in a company? Can you still use an accretion / dilution analysis?

Answer 36

You record this 30% as an “Investment in Equity Interest” or “Associate Company” on the Assets side of the Balance Sheet, and you reduce Cash to reflect the purchase (assuming that Cash was used). You use this treatment for all ownership percentages between 20% and 50%.

You can still use an accretion / dilution analysis; just make sure that the new Net Income reflects the 30% of the other company’s Net Income that you are entitled to.

Question 37

What happens when you acquire a 70% stake in a company?

Answer 37

For all acquisitions where over 50% but less than 100% of another company gets acquired, you still go through the purchase price allocation process and create Goodwill, but you record a Noncontrolling Interest on the Liabilities side for the portion you do not own. You also consolidate 100% of the other company’s statements with your own, even if you only own 70% of it.

Example: You acquire 70% of another company using Cash. The company is worth $100, and has Assets of $180, Liabilities of $100, and Equity of $80.

You add all of its Assets and Liabilities to your own, but you wipe out its Equity since it’s no longer considered an independent entity. The Assets side is up by $180 and the Liabilities side is up by $100.

You also used $70 of Cash, so the Assets side is now only up by $110.
We allocate the purchase price here, and since 100% of the company was worth $100 but its Equity was only $80, we create $20 of Goodwill – so the Assets side is up by $130.

On the Liabilities side, we create a Noncontrolling Interest of $30 to represent the 30% of the company that we do not own. Both sides are up by $130 and balance.

Question 38

Let’s say that a company sells a subsidiary for $1000, paid for by the buyer in Cash. The buyer is acquiring $500 of Assets with the deal, but it’s assuming no Liabilities. Assume a 40% tax rate. What happens on the 3 statements after the sale?

Answer 38

Income Statement: We record a Gain of $500, since we sold Balance Sheet Assets of $500 for $1,000. That boosts Pre-Tax Income by $500 and Net Income by $300 assuming a 40% tax rate.

Cash Flow Statement: Net Income is up by $300, but we subtract the Gain of $500 in the CFO section, so cash flow is down by $200 so far. We add the full amount of sale proceeds ($1000) in the CFI section, so cash at the bottom is up by $800.

Balance Sheet: Cash on the Assets side is up by $800, but we’ve lost $500 in Assets, so the Assets side is up by $300. On the other side, Shareholders’ Equity is also up by $300 due to the increased Net Income.

In this scenario, you’d also have to go back and remove revenue and expenses from this sold-off division and label them “Discontinued Operations” on the financial statements prior to the close of the sale.

Question 39

Now let’s say that we decide to buy 100% of another company’s subsidiary for $1000 in cash. This subsidiary has $500 in Assets and $300 in Liabilities, and we are acquiring all the Assets and assuming all the Liabilities. What happens on the statements immediately afterward?

Answer 39

Income Statement: No changes.

Cash Flow Statement: We record $1000 for “Acquisitions” in the CFI section, so
cash at the bottom is down by $1000.

Balance Sheet: Cash is down by $1000 on the Assets side, but we add in the subsidiary’s Assets of $500, so this side is down by $500 so far. We also create $800 worth of Goodwill because we bought this subsidiary for $1000, but (Assets Minus Liabilities) was only $200. So the Assets side is up by $300. The other side is up by $300 because of the assumed Liabilities, so both sides balance.

Question 40

What’s the purpose of calendarization in a merger model?

Answer 40

You need to make sure that the buyer and seller use the same fiscal years post- transaction. Normally you change the seller’s financial statements to match the buyer’s.

If the buyer’s fiscal year ends on December 31 and the seller’s ends on June 30, for example, you would have to take quarter 3 (Jan – Mar) and quarter 4 (Apr – Jun) from the seller’s most recent fiscal year and then add quarters 1 (Jul – Sep) and 2 (Oct – Dec) from the seller’s current fiscal year to match the buyer’s current fiscal year.

The second point here is that you may also need to create a stub period from the date when the deal closes to the end of the buyer’s current fiscal year.

For example, if the deal closes on September 30 but the buyer’s fiscal year ends on December 31, the buyer and seller are still one combined company for that 3-month period and you need to account for that, normally via a separate “stub period” right before the start of the first full fiscal year as a combined entity.

Question 41

Let’s say that the buyer’s fiscal year ends on December 31, the seller’s fiscal year ends on June 30, and the transaction closes on September 30. How would you create a merger model for this scenario?

Answer 41

You would need to create quarterly financial statements for both the buyer and sell for the September 30 – December 31 period, and you would show that as the first “combined” period in the merger model.

So you would combine the Income Statements, Balance Sheets, and Cash Flow Statements for that 3-month period, and then keep them combined for the rest of the time after that (adjusting the seller’s financial statements to match the fiscal year of the buyer, as in the example above).

Normally you do not care much about accretion / dilution for stub periods like this, so you would just calculate it for the first full fiscal year after the transaction close.

Question 42

Does anything change if the transaction closes on March 31 instead?

Answer 42

The only difference is that now you need a 9-month stub period rather than a 3- month stub period.

So you would need to find or create financial statements for Q4 of the seller’s fiscal year ending June 30, and then Q1 and Q2 for the next year.

You would also take the last 3 quarters of the buyer’s fiscal year and combine the statements from that period with the seller’s, taking into account all the normal acquisition effects for that period.

Question 43

What if the deal closes on a more “random” date, like August 17?

Answer 43

There are a couple options here; you could attempt to “roll-forward” the financial statements to this date in between quarterly end dates. For example, you might create an August 17 Balance Sheet by looking at the Balance Sheet as of June 30 and the Balance Sheet as of September 30 and averaging them (since August 17 is roughly in the middle).

For the Income Statement and Cash Flow Statement, you could just take the July 1 – September 30 quarterly numbers and multiply by (43 / 90) since 43 days of the quarter will pass in the “combined” period between August 17 and September 30.

The main problem is that this method creates a lot of extra work, because now you have to roll forward all the statements to this random date, figure out the numbers from that date to the end of the quarter, and then add additional quarters until the end of the buyer’s fiscal year.

So in practice, you usually assume a cleaner close date in merger models unless you need 100% precision for some reason.

Question 44

Isn’t there still some risk with an exchange ratio? If the stock price swings wildly in one direction or the other, the effective purchase price would be very different. Is there any way to hedge against that risk?

Answer 44

Yes. You can use something called a collar, which guarantees a certain price based on the range of the buyer’s stock price to the seller’s stock price. Here’s an example:

Suppose that we had a 100% stock deal with a 1.5x exchange ratio, i.e. the seller receives 1.5 of the buyer’s shares for each 1 of its own shares. The buyer’s share price is $20.00 and the seller has 1,000 shares outstanding. Right now, it’s worth $30,000 (1,000 * 1.5 * $20.00) to the seller. Here’s how we could set up a collar:

• If the buyer’s share price falls below $20.00 per share, the seller still receives the equivalent of $20.00 per buyer share in value. So if the buyer’s share price falls to $15.00, now the seller would receive 2,000 shares instead.
• If the buyer’s share price is between $20.00 and $40.00 per share, the normal 1.5x exchange ratio is used. So the value could be anything from $30,000 to $60,000.
• If the buyer’s share price goes above $40.00 per share, the seller can only receive the equivalent of $40.00 per buyer share in value. So if the buyer’s share price rises to $80.00, the seller would receive only 750 shares instead.

Collar structures are not terribly common in M&A deals, but they are useful for reducing risk on both sides when stock is involved.

Question 45

Walk me through the most important terms of a Purchase Agreement in an M&A deal.

Answer 45

There are dozens, but here are the most important points:

• Purchase Price: Stated as a per-share amount for public companies; just a number (the Equity Purchase Price) for private companies
• Form of Consideration: Cash, Stock, Debt…
• Transaction Structure: Stock, Asset, or 338(h)(10)
• Treatment of Options: Assumed by the buyer? Cashed out? Ignored?
• Employee Retention: Do employees have to sign non-solicit or non-
  compete agreements? What about management?
• Reps & Warranties: What must the buyer and seller claim is true about
  their respective businesses?
• No-Shop / Go-Shop: Can the seller “shop” this offer around and try to get
  a better deal, or must it stay exclusive to this buyer?

Question 46

Normally we create Goodwill because we pay more for a company than
what its Shareholders’ Equity says it’s worth. But what if the opposite happens? What if we paid $1000 in Cash for a company, but its Assets were worth $2000 and its Liabilities were worth $800?

Answer 46

First off, you would reverse any new write-ups to Assets to handle this scenario the easy way, if possible. So if we had Asset Write-Ups of $300 then it would be easy to simply reverse those and make it so the Assets were only worth $1700, which would result in positive Goodwill instead.

If it is not possible to do that – e.g. there were no Asset Write-Ups or they cannot be reversed for some reason – then we need to record a Gain on the Income Statement for this “Negative Goodwill.”
In this case, the company’s Shareholders’ Equity is $1200 but we paid $1000 for it, so we do the following:

Income Statement: Record a Gain of $200, boosting Pre-Tax Income by $200 and Net Income by $120 at a 40% tax rate.

Cash Flow Statement: Net Income is up by $120, but we subtract the Gain of $200, so Cash is down by $80 so far. Under CFI we record the $1000 acquisition, so Cash at the bottom is down by $1080.

Balance Sheet: Cash is down by $1080. But we have $2000 of new Assets, so the Assets side is up by $920. On the other side, Liabilities is up by $800 and Shareholders’ Equity is up by $120 due to the increased Net Income, so both sides are up by $920 and balance.

Question 47

What if Shareholders’ Equity is negative?

Answer 47

Nothing is different. You still wipe it out, allocate the purchase price, and create Goodwill.

Question 48

Can you explain what “Pro Forma” numbers are in a merger model?

Answer 48

This gets confusing because there are contradictory definitions. The simplest one is that Pro Forma numbers exclude certain non-cash acquisition effects:

• Amortization of Newly Created Intangibles
• Depreciation of PP&E Write-Up
• Deferred Revenue Write-Down
• Amortization of Financing Fees

Some people include all of these, other people include only some of these, and companies themselves report numbers in different ways. Excluding Amortization of Intangibles is the most common adjustment here.

While a lot of companies report numbers this way, the concept itself is flawed and inconsistent because companies themselves already include existing non- cash charges like Depreciation, Amortization, and Stock-Based Compensation. To make things even more confusing, some people will also add back some or all of those items as well.

Question 49

If you’re looking at a reverse merger (i.e. a private company acquires a public company), how would the merger model be different?

Answer 49

Mechanically, it’s similar because you still allocate purchase price, combine and adjust the Balance Sheets, and combine the Income Statements, including acquisition effects.

The difference is that accretion / dilution is not meaningful if it’s a private company because it doesn’t have an EPS number; so you would place more weight on a contribution analysis, or even on something like the IRR of the acquisition.