M&A Deals and Merger Models

Question 1

Why do companies buy other companies?

Answer 1

Think the company is worth more than what it’s selling for (i.e.: asking price < implied value, IRR > WACC, etc.)

Think they will be better off (i.e.: increased profits/cash flows, shortcut to higher financial performance, etc.)

Question 2

Why does EPS matter? Why focus on EPS?

Answer 2

Reflects all the effects of an acquisition such as foregone interest on cash, interest paid on new debt, and the new shares issued to fund the deal

Easy-to-calculate metric that captures the deal’s full impact

Shareholders care about EPS - it impacts stock price and the value of their shares

Question 3

What does it mean if an acquisition is accretive to EPS?

Answer 3

The acquisition increases the companies’ EPS. Conversely, if a deal is dilutive to EPs, it decreases a company’s EPS

Said differently, the acquiring company’s EPS post-merger will be greater than its standalone EPS

Question 4

What are the two important criteria for deals?

Answer 4

The price paid for the target must be reasonable

The deal must have a decent chance of being neutral or accretive to EPS

Question 5

Be more specific, what are some financial reasons companies make acquisitions?

Answer 5

Consolidation/Economies of Scale (ie.: better bargaining power with suppliers, consolidated departments, etc.) - common in mature industries

Geographic Expansion - might result from market saturation

Gain Market Share - might result because not be able to grow organically

Seller is undervalued

Acquire Customers or Distribution Channels - might result from desire to increase sales

Product Expansion or Diversification - might be operating in a lower-growth area

Question 6

What are some “fuzzy” reasons why acquisitions take place?

Answer 6

Intellectual property, patents, key technology (because unsure how much revenue, profit or CF will actually result)

Defensive acquisition

Acqui-Hire

Office politics, ego, pride

Question 7

What are the steps IBers go through when selling a company?

Answer 7

1. Plan the process (i.e.: how many buyers to contact and when, etc.) and complete marketing materials (i.e.: 5-10 page teaser summarizing company, financial profile, and appeal, Confidential Information Memorandum (CIM) which is a much longer version of the teaser)
2. Contact initial buyers
3. Set up Mgmt Meetings (with potential buyers) and Presentations (i.e.: Management Presentation highlight company’s merits in presentation form)
4. Solicit initial and subsequent bids from buyers (via indications of interest aka letters of interest and term sheets containing purchase price, consideration, etc.)
5. (Buyer Due Diligence), Conduct final negotiations (i.e.: definitive agreement outlining deal terms), arrange financing, and close deal

Process for buying company is similar to above except step one is identifying acquisition targets

Question 8

What are the advantages and disadvantages of different financing methods?

Answer 8

Cash: cheapest method, seller gets cash immediately, not time-consuming, but seller also gets taxed immediately, seller doesn’t get potential upside

Debt: typically cheaper than stock, seller gets cash immediately, but can be expensive/time-consuming, seller also gets taxed immediately, no upside, increased debt profile for combined company

Stock: can be cheaper if buyer has high stock price, can be faster than raising debt, seller get to participate in upside, seller isn’t taxed until stock is sold, but more risk for seller bc share price could drop, might be lockup periods for the stock

Question 9

What is the difference between a merger and an acquistion?

Answer 9

No mechanical difference. Merger just tends to be used when buyer and seller are closer in size and acquisition for when the acquirer is much bigger than the target.

100% stock or majority-stock structure are more common in mergers because the Buyer is unlikely to have enough cash or debt capacity to acquire the Seller.

Question 10

Why do you create a merger model?

Answer 10

aka. EPS Accretion/Diluation Analysis

To assess the financial impact of an M&A deal.

The model summarizes the financial profiles of the company (incl. projects and each company’s EV and EqVal), list the purchase price and consideration, includes other key deal terms (i.e.: interest rates on cash/debt, synergy estimates), and shows what the buyer and seller will look like as a combined entity and how the combined EPS compares with the Buyer’s standalone EPS

Question 11

What are synergies?

Answer 11

Ways to boost revenue or cut costs

Question 12

What is the process for building an EPS Accretion / Dilution Analysis?

Answer 12

1. Get the financial stats for the companies
2. Determine the Purchase Price and Consideration
   - might be based on an EBITDA, revenue, etc. multiple for private companies
3. Combine both companies’ pre-tax incomes and adjust for acquisition effects
   - if using debt, buyer will have to pay interest expense on debt, reducing pre-tax income, NI and EPS
   - if stock, additional shares outstanding, reducing EPS
   - if cash, foregoing interest on cash, reducing pre-tax income, NI and EPS
4. Calculate the combined NI and EPS (note: use buyer’s tax rate here bc seller is a subsidiary of the buyer after deal closes)
5. Calculate EPS Accretion/Dilution and draw conclusions

Question 13

Is there a limit to how much stock a company can issues to fund a deal?

Answer 13

No, but companies will typically issue so much as to not lose control/majority ownership of the company or turn the deal dilutive

Question 14

What is the cost of debt? What is the cost of cash? What is the cost of equity?

Answer 14

The coupon rate the company would have to pay if it issued additional debt. Can estimate using YTM or buyer’s current debt or peer companies’ debt or could use the buyer’s interest rate and assume a slight premium.

• Pros: cheaper than equity and don’t dilute.
• Con: could be hard to raise additional debt if already highly levered

The interest rate the company is currently earning on its cash balance, which tends to be low (and similar to the risk-free rate)

• Pro: Cheapest and fastest and no dilution
• Con: cash limit and may want to use cash on B/S for other reasons; takes time to raise

Buyer’s Net Income / Buyer’s Equity value (aka the reciprocal of the Buyer’s P/E multiple)

• Con: equity is the most expensive because giving up ownership in the new combined company; takes time to raise
• Pro: high stock price = smaller issuance

Question 15

What is the weighted cost of acquisition?

Answer 15

Weighted Cost of Acquisition = % Cash Used * After-Tax Cost of Cash + % Debt Used * After-Tax Cost of Debt + % Equity Used * Cost of Equity

Tells you how much the buyer is giving up in percentage terms to acquire the seller

Question 16

What is the Seller’s Yield?

Answer 16

How much the Buyer gets in Net Income from each $1.00 it spends to acquire the Seller

Yield = Net Income / Purchase Equity Value

Question 17

What are the accretion/dilution rules for a deal using Weighted Cost of Acquisition and Yield of Seller? What if the deal is 100% stock?

Answer 17

Weighted Cost of Acquisition < Seller’s Yield = Accretive
Weighted Cost of Acquisition = Seller’s Yield = Neutral
Weighted Cost of Acquisition > Seller’s Yield = Dilutive (i.e.: Buyer paying more than what Seller is yielding)
–
100% Stock

Buyer’s P/E > Seller’s P/E at Purchase Equity Value = Accretive
Buyer’s P/E = Seller’s P/E at Purchase Equity Value = Neutral
Buyer’s P/E < Seller’s P/E at Purchase Equity Value = Dilutive

Combined EPS > Standalone EPS = Accretive
Combined EPS = Standalone EPS = Neutral
Combined EPS < Standalone EPS = Dilutive

Question 18

True or False: Companies decide to do deals based on merger models.

Answer 18

False. MM are supporting tools used to screen deals, pitch ideas/examine potential transactions, and back up deal negotiations.

Question 19

What are some of the problems with EPS Accretion/Dilution?

Answer 19

EPS is not always a meaningful metric (i.e.: private companies don’t care about EPS, negative NI, etc.)

NI and CF are very different (deals that look good based on EPS could look terrible based on CF)

MM doesn’t capture the risk of M&A Deals (100% cash deals are almost always accretive, but actually v risky to acquire another company (integration might go wrong, culture clash, legal issues, market reaction, etc.)

MM don’t reflect qualitative factors

Question 20

What determines purchase price?

Answer 20

For public companies, a premium to current share price is required.

For private companies, purchase price is based on revenue, EBITDA, P/E multiples and valuation

Question 21

How much cash can a company use to acquire a company?

Answer 21

Up to its cash limit (minimum cash balance needed to keep operations running)

Question 22

How much debt can a company issues to acquire a company?

Answer 22

Up to its debt limit (which is usually based on a maximum desired debt/ebitda, debt/total capital, etc.

Question 23

What does an Acquirer “really” pay for a Target?

Answer 23

Amount paid is usually somewhere in between the EqVal and EV

Price paid depends on the treatment of target’s cash and debt and transaction fees

Question 24

How can a Buyer treat a Seller’s existing debt?

Answer 24

1. Refinance/Replaced with new debt
2. Assumed with no changes
3. Repay with Acquirer’s cash

Question 25

If an Acquirer repays a Target’s existing debt using cash, what happens?

Answer 25

1. Interest expense and principal repayment go away
2. Interest income (on cash) goes down

The end result is an increase in real purchase price (i.e.: Purchase Equity Value + Seller’s Debt)

Question 26

If an Acquirer replaces a Target’s existing debt, what happens?

Answer 26

1. Interest expense in tact (although could vary slightly if coupon rate on new debt is different)
2. Interest Income in tact

Real purchase price closer to Purchase Equity Value

Question 27

What is a Sources and Uses Schedule?

Answer 27

Shows where capital (used to fund an acquisition/pay for the Seller) will come from and where the capital will be spent/what it will be used to purchase

Shows the treatment of the Target’s Cash and Debt; Used to determine what an acquirer truly pays

Cash, Stock and Debt are main sources

The biggest use of funds is the purchase equity value of the seller

Question 28

True or False: Unfunded Pensions, NCI, Capital/Operating Leases, and other components of TEV do not affect the real purchase price.

Answer 28

True. Unlike debt, these items do not have to be refinanced when the company’s ownership changes.

Question 29

What is a cash-free, debt-free deal?

Answer 29

Common for private company acquisitions. Essentially, after a private company is a purchased, its cash and debt both go to 0.

If Target’s debt > cash, Acquirer repays the rest upon deal completion

If Target’s cash > debt, Target might issue a special dividend to shareholders or repurchase its common stock upon paying off debt. If Target does nothing with remaining cash and Acquirer gets it, effective purchase price is lower

In the deal, the purchase EV is based on a multiple of EBITDA, EBIT or Revenue since the Target is a private company

Question 30

What is Combined Equity Value after an acquisition? Is it affected by how the Acquirer funds the deal (i.e.: 100% stock, 100% debt, etc.)?

Answer 30

Combined EqVal = Acquirer’s EqVal + MV of any stock issued to fund the deal - so yes, consideration matters

If no stock issues, then combined eqval = acquirer’s eqval

If 100% stock, then combined eqval = acquirers eqval + target’s eqval

Therefore, Combined EqVal is higher when stock is used/issued; Combined Equity Value changes based on the amount of stock issued

Question 31

What is Combined EV? Is it affected by how the deal is structured? How are EV-based multiples affected?

Answer 31

Combined EV = Acquirer’s EV + Target’s Purchase EV

Combined EV = Combined EqVal + Combined Debt (new and existing) - Combined Cash

Tells you how much the Combined Company’s core business is worth to all investors, regardless of how the Acquirer funds the deal (because the funding replaces target’s purchase EqVal)

Additional implication: EV-based multiples for the combined company stay the same regardless of financing method (because EV stays the same and denominator (EBIT, EBITDA, revenue,etc.) are capital-structure neutral)

Question 32

True or False: Combined P/E multiple will change based on financing method.

Answer 32

True because both the Combined EqVal and Combined Net Income (tends to be lowest for 100% debt deals because the interest rate on debt is far higher than interest on cash, increasing interest expense) change are based on the financing method.

Compined Equity value changes based on the amount of stock issued
Net Income changes based on the amount of cash and debt used and the interest rate on them

Question 33

How is a seller’s cash treated in an M&A deal.

Answer 33

1. Some might have to be retained to meet minimum cash balances required to continue operating
2. Some might be used fund the deal
3. Some might be used to pay for legal, advisory and financing fees in the deal

Question 34

Again, what is the value of Enterprise Value?

Answer 34

The value of all net operating assets to all investors

Question 35

True or False: The control premium in a M&A deal does not change once the deal is announced and between then and its closing.

Answer 35

False. The control premium may not last if the market does not like the deal and begins selling off shares, reflecting what the market thinks the Target should be worth.

Question 36

Walk me through an M&A Merger Model.

Answer 36

1. Project the statements of the Buyer and Seller (at a min, I/S and simplified CFS)
2. Estimate the purchase price and financing method
   - For public companies, assume a share-price premium and validate with valuation methodologies
   - For private companies, use a valuation multiple (i.e.: TEV/Revenue, TEV/EBITDA, P/E)
3. Create a Sources & Uses Schedule and Purchase Price Allocation Schedule
   - Give you insight into how much the company is really paying - the real purchase price
4. Combine the I/S of the Buyer and Seller and Calculate Accretion/Dilution

Note: Calculating synergies could be step 3b.

Question 37

What are revenue synergies?

Answer 37

Cross-selling, up-selling, geographic expansion, etc.

Question 38

What are expense synergies?

Answer 38

Employee/building consolidation/reduction, better deals with suppliers due to volume discounts or market power, etc.

Question 39

What is a Purchase Price Allocation schedule? Why do you need it?

Answer 39

In almost all M&A deals, the Buyer pays a premium to the Seller’s book value (its CSE) (i.e.: Purchase EqVal is $1,000, but CSE is $700).

Unlike the control premium, which is based on the Target’s MV share price, this premium is based on Target’s BV

This premium will throw the B/S out of balance so create two new assets: other intangible assets (for identifiable assets) and goodwill

Ultimately, you write off CSE and create Goodwill and other intangible assets to plug the gap

Question 40

Name some other intangible assets?

Answer 40

Trademarks, patents, customer relationships, etc.

Question 41

Which items frequently get written up and written down in M&A deals?

Answer 41

Written up: PPE, inventory, etc.

Written Down: DTA an DTLs (because they “eventually” reverse upon deal close)

Note: Depreciation of PPE write-ups and amortization of intangibles is not cash-tax deductible resulting in DTAs

Question 42

What reduces the amount of Goodwill created?

Answer 42

Asset write-ups

Liability write-downs (because L&E side of B/S gets smaller)

Question 43

What are some common mistake synergies?

Answer 43

Overlooking integration costs

Overlooking additional COGS/OpEx tied to Revenue synergies (i.e.: sales and market, upskilling people to be able to cross-sell, etc.)

Non-sensical logic (i.e.: costs reduced by 50%, revenue increased by 50% vs. single-digit percentage assumptions)

Question 44

When does an EPS Accretion / Dilution analysis make the most sense? When might it not make a lot of sense to use?

Answer 44

Buyer and Seller are fairly close in size, Both have positive EPS and CF, Deal is motivated by financial reasons vs. fuzzy reasons

Buyer is private (and thus less concerned with EPS) or EPS is extremely negative; small company with no profit, no CF and almost no revenue

Question 45

What is a (Relative) Contribution Analysis? When most relevant?

Answer 45

Focuses on post-deal ownership (i.e.: if an Acquirer contributes 80% of the Combined Company’s revenue, EBITDA, and other financial metrics, will it own 80% of the Combined company?)

If own less than contribution, perhaps paying too much and vice versa

Most relevant for 100% (or majority stock) stock deals, Merger of Equals Deals (because these deal types almost always are 100% stock), private company M&A deals’

Not relevant for 100% cash or debt deals because Seller won’t have any ownership in the combined company

Question 46

What is the Value Creation Analysis? What are some disadvantages?

Answer 46

Evaluates whether a M&A deal increases the Acquirer’s share price by estimating the valuation multiples the Combined Company might trade at

To start, find larger companies in the industry that trade at higher multiples due to greater scale, higher growth rates, more favorable market position, etc., average their multiples and apply them to the combined company. Modest multiple expansion indicates the acquirer’s share price will increase after the deal closes, otherwise it will decrease

Disadvantage: VCA is highly speculative

Note: VCA Might be important in certain industries such as REITs where larger companies might trade at larger multiples

Question 47

What other M&A analyses exist beyond EPS Accretion and Dilution?

Answer 47

Qualitative / Strategic Analysis (i.e.: is there a potential for extremely high growth, is a company posing a threat to our business, then might make a defensive acquisition)

M&A Valuation (Seller’s Implied Equity Value from DCF + PV of Synergies compared to Equity Purchase Price)

IRR vs. Discount Rate Analysis

Question 48

Again, what is IRR?

Answer 48

Represent the annualized returns the Buyer will earn on the deal

Question 49

Again, what is discount rate?

Answer 49

Buyer’s expected annualized returns

Question 50

If an Acquirer has a current EV of $3B and contributes 75% of revenue to the new combined entity, what should the new company’s Combined be?

Answer 50

$3B / 75% = $4B

Question 51

What are fixed exchange ratios? Whta are floating exchange ratios?

Answer 51

Number of shares is fixed, but purchase price can vary based on share price
- This is preferred by Buyers because greater control over dilution

Number of shares can vary (and thus ownership percentage), but purchase price is fixed
- This is sometimes favored by Sellers because potential for increased ownership if Buyer’s stock price falls

Question 52

What are earn-outs?

Answer 52

Buyer pays some amount upfront and an additional amount in the future based on whether or not the Seller achieves certain goals.

Common in acquisitions of private companies where Buyer and Seller might disagree about the Seller’s prospects

Earn-outs are liabilities for the Buyer, but if the probably of the earn-out decreases, then change is recorded on I/S because saving Buyer money, but not a real cash change, so gets adjusted on CFS; also creates a DTL because adjustments don’t affect cash taxes. Also increase the Goodwill Created.

Question 53

What is a tender offer?

Answer 53

Buyer proposes an offer price directly to the Seller’s shareholders and each shareholder decides whether or not to sell their shares for that price

Quicker than mergers because no long negotiations, but control premium tends to be higher

Question 54

What is a stock purchase?

Answer 54

Buyer purchases all the Seller’s shares outstanding and gets all its A, L and off-B/S items

Preferred by sellers because only pay taxes on the purchase price, less post-transaction risk, faster to execute vs. asset purchases because don’t need to specific treatment for every asset and liability

Some portion of NOLs can be used

Question 55

What is an Asset Purchase?

Answer 55

Buyer purchases only selected Assets of the Seller and assumed on selected liabilities and it gets on the off-balance sheet items listed in the agreement

Common for divestitures and acquisitions of smaller, private companies

Favored by buyers because reduce risk because can cherry-pick what want and can asset write-ups and goodwill/intangible amortization are cash and tax-deductible

Tax implications for sellers (pay taxes on purchase price + gain on net assets) and for buyers, NOLs are written off 100%

Question 56

What is a 338(h)(10) election?

Answer 56

Treats a stock purchase like an asset purchase

Buyer purchases all Seller’s shares and gets all its assets, liabilities, and off-B/S items, but taxes work the same way as they do in an asset deal

benefit to Seller: all assets/liabilities gone
Benefit to Buyer: D&A on write up is deductible as well as amortization of goodwill and intangibles

Question 57

What are some differences for private companies wrt merger models?

Answer 57

use multiples to calculate the purchase price

form of consideration likely won’t include stock if the buyer is private

earn-outs are common for the acquisition of private sellers

Cash-free,debt-free deals are common for private sellers

Buyer is more likely to use an asset purchase or 338(h)(10) election for the private seller because more risk is related to the company’s assets, liabilities, etc.

EPS A/D less useful is buyer is private (instead contribution analysis or IRR vs. WACC might be more useful)

Might have to make adjustment to financial statements to bring in-line with GAAP

Question 58

What is a Merger Model?

Answer 58

IBC: A MM assesses the impact of an M&A deal by evaluating pro format EPS, or the Acquirer’s EPS after they have acquired the target, and how it compares with the acquirer’s standalone EPS

Question 59

What is consideration?

Answer 59

What is being exchanged by the acquirer for ownership in/of the target

For a merger, this is cash, debt, or stock

Question 60

Why might a company pursue a dilutive deal?

Answer 60

Strategic, bragging rights, etc.

Question 61

Compare an all-stock and all-debt deal. Which do you prefer if you’re the buyer? Which do you prefer if you’re the seller?

Answer 61

Buyer: All-debt because cheaper and doesn’t dilute ownership

Seller: All stock because greater ownership in the new company and a greater share of the synergies

Question 62

What is the first step for any type of accretion / dilution math question?

Answer 62

Ask for the consideration! Is it 100% stock?