Merger Model - Advanced Flashcards
Walk me through the most important terms of a Purchase Agreement in an M&A deal.
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?
What’s an Earnout and why would a buyer offer it to a seller in an M&A deal?
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.
What is an exchange ratio and when would companies use it in an M&A deal?
- 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 posttransaction – 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.
Explain why we would write down the seller’s existing Deferred Tax Asset in an M&A deal.
- 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.”
How would an accretion / dilution model be different for a private seller?
- 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.
How would I calculate “break-even synergies” in an M&A deal and what does the number mean?
- You would set the EPS accretion / dilution to $0.00
- 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
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?
You combine the Income Statements like you normally would (see the question on this), and then you do the following:
- Combine the buyer’s and seller’s balance sheets (except for the seller’s Shareholders’ Equity number).
- Make the necessary Pro-Forma Adjustments (cash, debt, goodwill/intangibles, etc.).
- Project the combined Balance Sheet using standard assumptions for each item (see the Accounting section).
- Then project the Cash Flow Statement and link everything together as you normally would with any other 3-statement model.
How do DTLs and DTAs affect the Balance Sheet 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.
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 down by $150 million.
- Then, Cash on the Assets side goes down by $500 million.
- You have an asset write-up of $100 million, so Assets go up by $100 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 $200 million total and Liabilities & Shareholders’ Equity are up by $690 million ($500 + $40 + $150).
- So you need Goodwill & Intangibles of $890 million on the Assets side to make both sides balance.
How do you handle options, convertible debt, and other dilutive securities in a merger model?
• 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.
Why do deferred tax liabilities (DTLs) and deferred tax assets (DTAs) get created in M&A deals?
- 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
- An Asset Write-Down creates a Deferred Tax Asset.
– You write down and write up assets because their book value often differs substantially from their “fair market value.” Book value is what’s on the Balance Sheet!
- An Asset Write-Up creates a Deferred Tax Liability b/c 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.
What’s a Section 338(h)(10) election and why might a company want to use it in an M&A deal?
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:
A. 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).
B. 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.
C. 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.
Walk me through a concrete example of how to calculate revenue synergies.
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.
Explain what a contribution analysis is and why we might look at it in a merger model.
Contribution Analysis compares the following from what the buyer and seller are “contributing” to estimate what the ownership of the combined company should be:
- Revenue
- EBITDA
- Pre-Tax Income
- Cash and possibly other items
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.
What’s the difference between Purchase Accounting and Pooling Accounting in an M&A deal?
- In Purchase Accounting the:
- Seller’s Shareholders’ Equity number is wiped out (seller’s Book Value)
- Premium Paid over that wiped out value is recorded as Goodwill on the combined BS
- 99% of M&A Deals use Purchase Accounting
- In Pooling Accounting you:
- Combine the Shareholders’ Equity numbers from the Buyer AND Seller
- Rather than worrying about Goodwill and the related items that get created
Explain the complete formula for how to calculate Goodwill in an M&A deal.
Goodwill =
Equity Purchase Price
– (Less) Seller Book Value
+ (Plus) Seller’s Existing Goodwill
– (Less) Asset Write-Ups
– (Less) Seller’s Existing Deferred Tax Liability
+ (Plus) Write-Down of Seller’s Existing Deferred Tax Asset
+ (Plus) Newly Created Deferred Tax Liability
5 Key Points
- 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.
