Merger Model Advanced Flashcards
- 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 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.
- 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.”
- Walk me through an example of how to calculate expense synergies.
“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.”
- How do you take into account NOLs in an M&A deal?
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.
- 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,
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.
- 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
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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.
- Could you get DTLs or DTAs in an asset purchase?
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.
- How do you account for DTLs in forward projections in a merger model?
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.
- Explain the complete formula for how to calculate Goodwill in an M&A deal.
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).
- 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.”
- 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:
• 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.
- 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.
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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.
- 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.
- 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.
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Note that accretion / dilution makes no sense if you have a private buyer because private
companies do not have Earnings Per Share.
