M&A (Advanced) from BIWS 400

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 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.

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 an 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 (see the next question).

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

Section 338(h)(10) is a provision in the U.S. tax code that allows the buyer of a target corporation’s stock to elect to treat the transaction as a deemed asset purchase for tax purposes. This means that for tax purposes, the buyer is treated as if it acquired the target’s assets in a purchase transaction, rather than acquiring the target’s stock.

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 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.

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 new accounting rules introduced at the end of 2008, 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 are the advantages and disadvantages of each purchase method (Cash, Debt, and Stock) in M&A deals?

Answer 23

Cash tends to be the cheapest option; most companies earn little Interest Income on it, so they don’t lose much by using it to fund deals. It’s also fastest and easiest to close Cash-based deals. The downside is that using Cash limits the Buyer’s flexibility in case it needs the funds for something else in the near future.

Debt is normally cheaper than Stock but more expensive than Cash, and deals involving Debt take more time to close because of the need to find investors. Debt also limits the Buyer’s flexibility because additional Debt makes future Debt issuances more difficult and expensive.

Finally, Stock tends to be the most expensive option, though it can sometimes be the cheapest, on paper, if the Buyer trades at very high multiples. It dilutes the Buyer’s existing investors, but it also prevents the Buyer from paying any additional cash expense for the deal. In some cases, the Buyer can also issue Stock more quickly than it can issue Debt.

Question 24

Which purchase method does a Seller prefer in an M&A deal?

Answer 24

The Seller has to balance taxes with the certainty of payment and potential future upside.

To a Seller, Debt and Cash are similar because they mean immediate payment, but also immediate capital gains taxes and no potential upside if the Buyer’s share price increases. But there’s also no risk if the Buyer’s share price decreases.

Stock is more of a gamble because the Seller could end up with a higher price if the Buyer’s share price increases, but it could also get a lower price the share price drops. The Seller also avoids immediate taxes with Stock since it pays taxes only when the shares are sold.

So the preferred method depends on the Seller’s confidence in the Buyer: Cash and Debt are better when there’s uncertainty, while Stock may be better with large, stable Buyers.

Question 25

Isn’t the Foregone Interest on Cash in an M&A deal just an “opportunity cost”? Why do you include it?

Answer 25

No, it’s not just an “opportunity cost” because the Acquirer’s projected Pre-Tax Income already includes the Interest Income that the company expects to earn on its Cash balance. So if an Acquirer expects $90 in Operating Income and $10 in Interest Income for a total of $100 in Pre-Tax Income, its projected Pre-Tax Income will fall if it uses Cash to fund the deal.

Question 26

Isn’t it a contradiction to calculate the Cost of Stock by using the reciprocal of the Acquirer’s P / E multiple? What about the Risk-Free Rate, Beta, and the Equity Risk Premium?

Answer 26

It’s not a contradiction; it’s just a different way of measuring the Cost of Equity. The “Reciprocal of the P / E Multiple” method measures Cost of Equity in terms of EPS impact, whereas the CAPM method measures it based on the stock’s expected annual returns. Neither method is “the correct one”: You just use them in different contexts. In most cases, regardless of the method you use, Equity will be the most expensive funding source for a company.

Question 27

An Acquirer has an Equity Value of $1 billion, Cash of $50 million, EBITDA of $100 million, Net Income of $50 million, and a Debt / EBITDA ratio of 2x. Peer companies have a median Debt / EBITDA ratio of 4x. It wants to acquire another company for a Purchase Equity Value of $500 million. The Seller has a Net Income of $30 million, EBITDA of $50 million, and no Debt. What’s the best way to fund this deal?

Answer 27

The Acquirer would prefer to use its Cash balance to do this deal, but $50 million is likely close to the minimum balance for a company of this size. So this company is unlikely to use Cash. The Acquirer’s P / E multiple is 20x, so its Cost of Stock is 1 / 20, or 5%. That’s a fairly low Cost of Stock, so there’s a chance that the company’s After-Tax Cost of Debt might be higher (e.g., if the Interest Rate on Debt were above 8.33%). However, there’s no information on the Cost of Debt, so our best guess is that Debt is still cheaper than Stock. The company could afford to boost its Debt / EBITDA from 2x to 4x since peer companies have leverage in that range. The Combined Company has $150 million in EBITDA, and 4 * $150 million = $600 million. The Acquirer has $200 million in Debt before the deal takes place, so it could afford to issue $400 million in additional Debt. The remaining $100 million would be issued in Stock. If this company could use part of its Cash balance as well, the $100 million Stock portion would be reduced.

Question 28

An Acquirer has an Equity Value of $500 million, Cash of $100 million, EBITDA of $50 million, Net Income of $25 million, and a Debt / EBITDA ratio of 3x. Similar companies in the market have Debt / EBITDA ratios of 5x. What’s the BIGGEST acquisition this company might be able to complete?

Answer 28

You can’t answer this question precisely without knowing the Target’s Net Income and EBITDA, but you can make a rough estimate. The Acquirer couldn’t use its entire Cash balance to fund a deal, but it might be able to use a substantial portion of it, such as $50 million or $80 million.
It could afford to use leverage up to 5x EBITDA, which means that it could use $100 million in additional Debt to fund a deal. That number might change based on the Seller’s Debt and EBITDA as well. There’s no limit on how much Stock the company could issue, but it would be unlikely to give up control just to make an acquisition, so $500 million in Stock is likely the maximum. In reality, it probably wouldn’t issue anything close to that amount of Stock. A more realistic level might be about half its Current Equity Value ($250 million), or whatever amount turns the deal dilutive. So the best answer is: “In theory, the Acquirer might be able to fund a deal for up to $650 to $700 million. But in reality, unless it wants to issue a massive amount of Stock, the maximum level would be closer to $400 to $650 million.”