M&A Questions and Answers

The term “mergers and acquisitions”, or M&A, describes the combination of two or more companies.

M&A, for a buyer, is an opportunity to achieve inorganic growth, rather than organic growth. In contrast, M&A to sellers is an opportunity to undergo a liquidity event, where the seller can either “cash out” and/or participate as a shareholder in the post-M&A, newly formed entity.

While the terms “merger” and “acquisition” are occasionally used interchangeably, there is a distinction:

Merger → In a merger, the combination occurs between similarly sized companies, i.e. “merger of equals”. The form of consideration – how the transaction is funded – is more often than not financed partially with stock. Usually, the two combined entities will then operate under a single name that blends their former standalone names. For instance, the merger between Chase Manhattan Corporation and J.P. Morgan & Co. led to the creation of JPMorgan Chase & Co.

Acquisition → On the other hand, an acquisition tends to imply that the target was of a smaller size compared to the acquirer. Unlike a merger, the acquired company’s name will either immediately fade away as the company is integrated into the acquirer’s operations, or it’ll continue operating under its original name in other cases. In the latter scenario, the target typically operates as a subsidiary and the acquirer hopes to leverage the target’s established branding and widespread recognition. For example, Salesforce completed an acquisition of Slack Technologies but chose to retain the “Slack” name considering how well-known Slack is among consumers.

A merger model can be broken into eight steps, as shown below.

• Step 1 → Calculate the total offer value by multiplying the offer value per share by the target’s fully diluted shares outstanding, inclusive of dilutive securities such as options and convertible debt instruments.

• Offer Value = Offer Price Per Share × Fully Diluted Shares Outstanding

• Step 2 → The transaction structure must then be determined, namely the purchase consideration (e.g. cash, stock, mixture).

• Step 3 → Numerous assumptions must then be made regarding interest expense, the number of new share issuances, the anticipated revenue and cost synergies, the transaction fees paid to investment banks for their advisory services, financing fees, and if the existing debt will be refinanced (or cash-free, debt-free).

• Step 4 → The next step is to perform purchase price accounting (PPA), where the key data points to calculate are goodwill, the incremental depreciation from the write-up of PP&E, and any deferred taxes.

• Step 5 → Once the purchase price accounting is complete, we’ll calculate the standalone earnings before taxes (EBT).

• Step 6 → From there, we’ll calculate the pro forma net income (the “bottom line”).

• Step 7 → We’ll divide the pro forma net income by the pro forma diluted shares outstanding to arrive at the pro forma EPS figure.

• Step 8 → In the final step, we have enough information to determine whether the impact on the pro forma EPS was accretive (or dilutive) by using the following equation:

Accretion / (Dilution) Formula

Accretion / (Dilution) = (Pro Forma EPS / Standalone EPS) – 1

Merger Model Questions in M&A Interview — Excel Template

M&A interview questions regarding accretion/dilution modeling are far more intuitive for those that have actually built one from scratch, as opposed to mere memorization.

Use the form below to access an example merger model to reference in your preparation for an M&A interview.

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After a merger or acquisition, when the pro forma EPS is greater than the acquirer’s pre-deal earnings per share (EPS), the transaction is accretive. But if the pro forma EPS is less than the acquirer’s standalone EPS, then the transaction was dilutive.

• Accretion → If a transaction is “accretive”, the pro forma earnings per share (EPS) of the combined post-merger entity exceeds the original EPS belonging to the acquirer.

• Dilution → On the other hand, if the pro forma EPS of the merged company is instead lower than the acquirer’s pre-merger EPS, that would represent a “dilutive” merger.

While the term “accretive” in M&A carries a positive connotation, it does not necessarily mean that the acquirer realized synergies or that there was significant value creation (and the same rule applies to dilutive deals).

Instead, the actual reason that corporates pay close attention to the post-deal EPS is because of the market reaction. For example, the market can perceive a dilutive transaction as a poor decision, which can cause the acquirer’s share price to decline because some investors will apply the pre-deal price-to-earnings (P/E) ratio to the now-reduced pro forma EPS.

In reality, public companies fear the reaction from the public markets (and a subsequent drop-off in their share prices). In fact, many dilutive deals are still completed, i.e. a transaction can be dilutive and still turn out to be a great strategic acquisition.

• Revenue and Cost Synergies
• Upselling/Cross-Selling Opportunities
• Proprietary Assets Ownership (Intellectual Property, Patents, Copyright)
• Talent-Driven Acquisitions (“Acqui-Hire”)
• Expanded Geographic Reach and Customers
• Enter New Markets to Sell Products/Services
• Revenue Diversification and Less Risk
• Horizontal Integration (i.e. Market Leadership and Less Competition)
• Vertical Integration (i.e. Supply Chain Efficiencies)

Buyer’s Perspective → If the buyer’s P/E ratio is significantly higher than the target’s P/E ratio, a stock transaction is a reasonable option because the deal will be accretive. On the other hand, the buyer’s access to debt financing from lenders, the cost of debt, and credit ratings are all influential factors that determine the buyer’s willingness to finance using debt.

Seller’s Perspective → Most sellers prefer cash (typically financed by debt) as opposed to a stock sale. The one exception would be if tax deferment (i.e. the avoidance of the taxable event) is a clear priority of the seller. For sellers, stock sales are most appropriate for transactions wherein the companies involved are of similar size and publicly traded.

The purchase consideration in M&A refers to how an acquirer intends to pay for an acquisition, i.e. the proposed payment method to the target’s shareholders by the acquirer.

The acquirer can use its cash on hand, raise additional debt capital to fund the purchase, issue equity securities, or any combination of these.

Cash on Balance Sheet (B/S) or Debt-Financed

Stock (i.e. Equity Shares)

Combination

When evaluating the purchase consideration, tax consequences are a decisive factor that shareholders must carefully consider.

• All-Cash Deal → If an acquisition is paid for using all cash, there is an immediate tax consequence because a taxable event has been triggered.

• All-Equity Deal → If the purchase consideration is all-equity and shares in the newly merged company were exchanged, there is no taxable event triggered until the shares are later sold at a capital gain.

Furthermore, the perception of the M&A transaction (and post-deal entity) can also impact the preferences and decisions of shareholders.

If the shareholders’ outlook on the post-merger company is negative, it is unlikely they would want to own shares in that company.

But if their outlook on the company is positive and they expect the company (and its share price) to perform well, the shareholders are inclined to accept stock as a form of consideration.

If an acquirer in an all-stock deal is trading at a lower P/E than the target company, the acquisition will be dilutive (i.e. pro forma EPS < acquirer EPS).

The reason for the dilution is that new shares must be issued, which creates an additional dilutive impact.

The pro forma EPS declines because the denominator – i.e. the pro forma share count of the combined entity – has increased.

But suppose the acquirer is valued at a higher P/E than the acquisition target, the acquisition would then be accretive under the same logic as before.

Generally, an all-stock deal results in a lower valuation compared to an all-cash deal because the target’s shareholders are able to participate in the potential upside of holding shares in the new entity.

While shareholders in an all-cash deal receive straight cash, shareholders in an all-stock deal receive equity in the new entity and can profit from share price appreciation (and in theory, the upside of equity is uncapped).

If the transaction consideration were an all-cash deal, the proceeds from the sale would be fixed, so the net gain to the shareholders is capped.

But an all-stock deal offers to chance for the shareholders to receive higher returns if the combined entity’s stock price performs well (and if the market views the acquisition or merger favorably).

• Synergies in M&A describe the estimated cost savings and incremental revenue generated from a merger or acquisition.

There are two types of synergies:

• Revenue Synergies → Revenue synergies assume the combined entity can generate more cash flows than if the cash flows produced on an individual basis were added together.
• Cost Synergies → Cost synergies entail corporate actions such as cost-cutting, consolidating overlapping functions, closing down unnecessary locations, and eliminating redundancies in employee roles.

Frequently, buyers reference the estimated synergies that they expect to realize from a potential transaction to rationalize offering higher purchase premiums.

In M&A, synergies are a key determinant in the purchase price, as the more post-deal synergies the buyer anticipates, the greater the control premium.

Conceptually, synergies state that the combined value of two entities is worth more than the sum of the individual parts.

Most companies tend to become actively engaged in M&A to realize synergies once their organic growth opportunities have diminished.

Once the deal closes, the assumption is that the performance of the combined entity (and the future valuation once the integration is complete) will exceed the sum of the separate companies.

Cost synergies are far more likely to be realized than revenue synergies.

While it might appear attainable initially, revenue synergies often do not materialize because these financial benefits are based on assumptions impacted by largely unpredictable variables.

For example, the introduction of a new product or service and how customers will react to it is affected by countless factors.

Even if realized, revenue synergies usually require more time to achieve than cost synergies, i.e. there is a so-called “phase-in” period that can last several years (and often may never result in the desired benefits).

Unlike revenue synergies, cost synergies are viewed with more credibility because there are concrete areas that can be addressed.

For instance, if an acquirer announces its intention to shut down a redundant office post-merger, the cost savings from shutting down the office are easily measurable and actionable.

• Vertical Integration → In vertical integration, two or more companies with different functions in the value chain decide to merge. Because the combined entity has increased control over the supply chain, the combined company should be able to eliminate operating inefficiencies with improved quality control, at least in theory.

• Horizontal Integration → In horizontal integration, two companies competing in the same (or closely adjacent) market decide to merge. After the completed horizontal integration, the competition in the market declines and the combined entity benefits from the increased pricing power and leverage over suppliers, among various other benefits.

• Forward Integration → If an acquirer moves downstream – i.e. closer to the end customer – the company purchased works near the final phases of the value chain, such as a distributor or product technical support.

• Backward Integration → If an acquirer moves upstream – i.e. away from the end customer – the purchased company is a supplier or manufacturer of the parts and components of a product.

Once an M&A transaction has closed, purchase price allocation (PPA) – or deal accounting – is required to assign the fair value to all of the acquired assets and liabilities assumed from the target in an M&A transaction.

Generally speaking, certain sections of the balance sheet can simply be consolidated, such as the working capital line items.

However, there is one crucial adjustment made to the pro forma combined balance sheet that is arguably the most important part of purchase price accounting: “goodwill”, or more specifically, the incremental goodwill created in the transaction.

PPA involves making assumptions about the fair value of assets, where if deemed appropriate, the target’s assets are written up to reflect their real fair value (and the creation of deferred taxes).

The objective of purchase price allocation (PPA) is to allocate the purchase price paid to acquire the target across the purchased assets and liabilities so that their fair values are reflected.

Goodwill is an intangible asset on the balance sheet that captures the premium paid in excess of the fair value of the net identifiable assets, i.e. the excess purchase price.

It is common for acquirers to pay more than the fair value of the target’s net identifiable assets, so goodwill is a common line item for companies that are active in M&A.

Overpaying for assets frequently occurs due to mistakenly overestimating potential synergies, not performing sufficient diligence, or competing in a competitive auction sale process.

As discussed previously, the carrying value of the purchased assets and liabilities are adjusted to their fair value post-acquisition.

But still, there can be residual value left over (i.e. the excess purchase price that far exceeds the fair value of the purchased assets).

Therefore, the purchase price is subtracted from the net amount, with the resulting value recorded as goodwill on the balance sheet.

Goodwill is recognized on the books of the acquirer and the value remains unchanged (i.e. goodwill is not amortized), but it can be reduced if the goodwill is determined to be impaired, i.e. if the acquirer overpaid for assets and now realizes just how much less it is actually worth.

The control premium in M&A is the difference between the offer price per share and the acquisition target’s market share price.

An important point here is that the “unaffected” market share price is used, which is before any speculative rumors or internal leaks of a potential M&A deal spread prior to the official announcement.

The control premium represents the approximate “excess” paid over an acquisition target’s unaffected share price by the purchaser, expressed most often as a percentage.

The reason for paying a premium is often inevitable – for instance, private equity firms in a take-private leveraged buyout (LBO) must convince existing shareholders to sell their shares. But no rational shareholder would give up their ownership stake without an adequate monetary incentive.

Without a sufficient control premium, it is rather unlikely that the private equity firm would be able to obtain a majority stake.

Since precedent transaction analysis – i.e. “transaction comps” – determines the value of a company using the prices paid to acquire comparable companies, the implied valuation is most often the highest relative to other valuation methodologies such as a discounted cash flow (DCF) or comparable company analysis because of the control premium.

Net identifiable assets equal the total value of a company’s identifiable assets minus the value of its liabilities. Identifiable assets and liabilities can be identified and a value can be ascribed at a specific point in time (i.e. quantifiable).

The net identifiable assets, more specifically, is the book value of assets belonging to an acquired company after liabilities have been deducted.

Formula

Net Identifiable Assets = Identifiable Assets – Total Liabilities

All identifiable liabilities that played a role in the acquisition must be considered and all identifiable assets – both tangible and intangible assets – must be included.

From the viewpoint of a seller, most would expect to fetch a higher offer price (and purchase premium) from a strategic buyer than a financial buyer.

• Strategic Buyers → Corporates, Competitors

• Financial Buyers → Private Equity Firms, Hedge Funds, Family Offices

Strategic buyers are corporate acquirers that often operate in the same industry (or an adjacent market) as the target. Thus, strategics are able to can benefit from synergies, which directly allows them to offer higher prices.

In comparison, financial buyers like private equity firms cannot benefit from synergies in the same manner that a strategic buyer is capable of. But the trend of add-on acquisitions has enabled financial buyers to fare much better in competitive auctions as these firms can place higher bids because their portfolio company (i.e. the platform company) can benefit from synergies similar to strategics.

• Broad Auction → In a broad auction, the sell-side advisor reaches out to as many potential buyers as possible to maximize the number of interested buyers. The objective is to cast as broad of a net as possible to increase the competitiveness of the auction and improve the odds of finding the highest possible offer (i.e. no risk of “leaving money on the table”).

• Targeted Auction → In a targeted auction, the sell-side advisor will have a shortlist of potential buyers to contact. The pool of potential buyers often already have a strategic fit with the seller (or a pre-existing relationship) that makes the process move quicker.

• Negotiated Sale → A negotiated sale involves only a couple of suitable buyers and is most appropriate when the seller has a specific buyer in mind. For instance, the seller might intend to sell a meaningful stake in their company but still continue running the company (and values the proposed partnership structure). Under this approach, the benefits include certainty of close and confidentiality, and the negotiations occur “behind closed doors” and usually on friendlier terms.

• Asset Sale → In an asset sale, the seller sells the assets to a buyer individually. Once the buyer owns all the assets, it controls the company because everything that made the seller’s equity hold value now belongs to the buyer. In an asset sale, the buyer receives the tax benefits related to the incremental D&A, meaning that the tax basis of the assets was written up (and tax-deductible D&A and future cash tax savings were created). However, the seller is at risk of facing double taxation at the corporate level and then at the shareholder level.

• Stock Sale → In a stock sale, the seller provides the buyer with shares and once the buyer possesses all the target shares, it controls the company as its new owner. Unlike an asset sale, the buyer in a stock sale does not receive the benefits from the step-up in seller assets, i.e. there are no benefits related to reduced future taxes from incremental D&A. The seller is taxed once only at the shareholder level, instead of there being the risk of double taxation.

• 338(h)(10) Election → A 338(h)(10) is a structure that the buyer and seller must jointly elect to do. In short, the tax treatment of an asset sale is received without the inconvenience of physically exchanging assets. The 338(h)(10) election applies to acquisitions of corporate subsidiaries or S-corps – and is normally the most appropriate for instances where the target has a significant amount of NOLs on its balance sheet. The 338(h)(10) election offers the benefits associated with stock sales, as well as the tax savings of an asset sale. Legally, a 338(h)(10) is categorized as a stock sale, yet it is treated as an asset sale for tax purposes. One drawback is that the seller remains subject to double taxation, however, since the buyer can benefit from the tax advantages of the asset step-up and the NOLs, the buyer can typically offer a higher purchase price.

In M&A, a pitchbook is a marketing document put together by investment banks to pitch prospective clients to hire them for a particular transaction.

The structure, format, and style of pitchbooks are unique to each investment bank, but the general structure is as follows:

• Introduction: Background of Investment Bank and the Staffed Deal Team Members

• Situational Overview → Transaction Summary and Context of the Represented Client’s Situation

• Market Trends → General Commentary on the Prevailing Market and Industry Trends

• Valuation → The Implied Valuation Range (i.e. Football Field Valuation Chart) and Combined Merger Model (Accretion/Dilution Analysis)

• Deal Structure → The Outline of the Proposed Deal Strategy and Other Key Considerations

• Credentials → The Credentials and Tombstones of Relevant Industry Experience (i.e. Closed Comparable Transactions)

• Appendix → The Supplementary Images of Valuation Models (DCF Model, Trading Comps, Transaction Comps)