The M&A Model

In Mergers & Acquisitions, financial models are the analytical engine that drives decision-making, quantifies potential value, and assesses risk.

M&A models are sophisticated tools used by investment bankers, corporate development teams, private equity firms, and corporate finance professionals to evaluate the financial implications of a potential acquisition or merger.

These models go beyond simple valuation to project the combined financial performance of the acquirer and target, assess deal accretion/dilution, and determine the optimal financing structure.

What is an M&A Model?

An M&A model is a dynamic financial model that projects the financial performance of two or more companies after they combine.

Its primary purpose is to determine the potential financial impact of an acquisition on the acquirer's earnings per share (EPS), key financial ratios, and overall valuation.

It integrates the financial statements of both the acquirer and the target, incorporating various assumptions about the deal's structure, financing, and anticipated synergies.

Before building a detailed M&A model, the first step should be to complete a simple accretion/dilution analysis to determine if it's worth spending the time to build a detailed model. E.g., without significant synergies, does this deal make sense.

Typical Sections of an M&A Model

1. Merger Model Setup
   1. Target Share Dilution
      1. Calculates the impact of dilutive securities and helps find the Fully Dilutive Shares Outstanding (FDSO). These include stock options, RSUs, PSUs, Convertible Securities (which are added to shares outstanding to calculate FDSO).
   2. Purchase Price
      1. Public Companies - Offer premium: The difference between the current stock price and the price an acquirer offers to pay shareholders for their shares of stock. These are typically 25-30%.
      2. Private Companies: There is no publicly traded stock, so multiples are used to calculate purchase price.
   3. Key Transaction Assumptions
      1. Cash/Stock financing split
      2. Stock vs. Asset sale
      3. Maximum Leverage & Leverage Ratio: Maximum Leverage is typically 6-7x EBITDA.
      4. Minimum Cash Balance: Typically a % of SG&A expense or annual revenue.
      5. Transaction Fees: Typically 1-2% of enterprise value but caps out for larger deals.
   4. Sources & Uses
      1. Sources: Where the money will come from (debt, equity, excess cash).
      2. Uses: Where it will go (purchase price, fees).
   5. Financing Assumptions & Fees
      1. Fixed interest or Floating interest rate.
      2. Investment Banks underwriting fee for debt financing. Typically 1%.
      3. Debt Tranche.
2. Combined Three Statement Model
   1. Balance Sheet
   2. Income Statement
   3. Cash Flow Statement
   4. Associated Schedules (Debt, Working Capital etc)
3. Accretion / Dilution Analysis
   1. Shares Outstanding
   2. Accretion / Dilution Analysis
   3. Breakeven Analysis
      1. Calculate the $ amount of additional pretax synergies required to breakeven. Calculated using (-accretion/dilution per share / acquirer standalone EPS) / 1 - tax rate. This shows the $ amount of synergies we can lose to still breakeven if it is accretive (margin of safety).
   4. Sensitivity Tables
      1. This shows how our accretion/dilution % changes based on certain key inputs. Example inputs include EV/EBITDA multiple, % of purchase consideration in stock, Revenue synergies, Cost synergies etc.

Key Purposes of an M&A Model

1. Accretion/Dilution Analysis: An M&A model determines whether the acquisition will increase (accrete) or decrease (dilute) the acquirer's EPS.
2. Valuation: While not a standalone valuation model, it incorporates and synthesizes various valuation methodologies (e.g., DCF, Comps, Precedent Transactions) to arrive at a range of possible transaction values.
3. Deal Structuring & Financing: It helps determine the optimal mix of cash, stock, and debt to finance the acquisition, analyzing the impact of each on the combined (pro-forma) balance sheet and income statement.
4. Synergy Analysis: Models quantify the financial impact of anticipated cost savings and revenue enhancements resulting from the combination.
5. Risk Assessment: They allow for sensitivity analysis, testing how changes in key assumptions (e.g., purchase price, synergy realization, interest rates) impact the deal's outcome.
6. Negotiation Support: The model provides a robust analytical basis for deal negotiations, enabling bankers to justify valuations and deal terms.

Steps Involved in Building an M&A Model

Building a comprehensive M&A model is an iterative and detailed process. Here are the typical steps involved:

Step 1: Gather & Input Financial Data: 3-Statement Financial Model

• Objective: Collect historical and projected financial statements for both the acquirer and the target company.
• Content: Input historical Income Statements, Balance Sheets, and Cash Flow Statements (typically 3-5 years) for both companies. Also include current market data (share price, shares outstanding, debt, cash).
• Source: Public filings (10-K, 10-Q) for public companies; management accounts, audited financials, and internal projections for private companies.

Step 2: Create Standalone Projections

• Objective: Forecast the future financial performance of both the acquirer and the target independently, usually for 5-10 years.
• Content: Build detailed financial projections (revenue growth, gross profit margin, operating expenses, capital expenditures, depreciation, working capital changes, debt and interest) for each company based on historical trends, management guidance, and industry outlook. This involves creating a 3-statement financial model for each entity.

Step 3: Calculate Purchase Price & Deal Assumptions

• Objective: Determine the acquisition price and outline the key assumptions of the transaction.
• Content:
  • Equity Value: Calculate the value of the target's equity, often based on a premium to its current market price (for public targets) or a negotiated valuation (for private targets).
  • Enterprise Value: Calculate by adding net debt (debt - cash) to the equity value.
  • Sources & Uses of Funds: Where the money for the acquisition will come from (sources: new debt, equity issuance, excess cash) and where it will go (uses: purchase price, transaction fees, refinancing existing debt).
  • Transaction Fees: Estimate legal, advisory, and other costs associated with the deal.

Step 4: Determine Financing Structure

• Objective: Decide how the acquisition will be financed.
• Content:
  • Cash Consideration: Use the acquirer's excess cash or raise new cash.
  • Stock Consideration: Determine the number of new shares the acquirer will issue to the target's shareholders, based on an agreed-upon exchange ratio or fixed value.
  • Debt Consideration: Model new debt tranches (e.g., senior debt, mezzanine debt) that the combined entity will take on, including interest rates, repayment schedules, and associated covenants.

Step 5: Consolidate Financial Statements

• Objective: Combine the financial statements of the acquirer and target to create a pro forma (combined) entity.
• Content:
  • Income Statement Consolidation: Add revenues, operating expenses, etc. Adjust for new depreciation (from asset write-ups - increase book value to fair market value) and new interest expense (from acquisition debt).
  • Balance Sheet Consolidation: Combine assets and liabilities. This is the most complex part, involving:
    • Goodwill & Intangibles: Account for the purchase price allocation where the excess of the purchase price over the fair value of identifiable net assets is recorded as goodwill and identifiable intangible assets.
    • Debt & Equity Adjustments: Reflect new debt, cash usage, and changes in shareholder equity from stock issuance.
    • Existing Debt Refinancing: Model the repayment of the target's existing debt if applicable.
  • Cash Flow Statement Consolidation: Combine cash flows from operations, investing, and financing, reflecting the impact of the acquisition.

Step 6: Incorporate Synergies

• Objective: Model the financial benefits expected from combining the two companies.
• Content: Quantify and incorporate both cost synergies (e.g., reduction in redundant SG&A expenses) and revenue synergies (e.g., cross-selling opportunities, market expansion) into the pro forma projections. These are typically phased in over several years.
  • This will include different cases. Upside, Base, Downside.

Step 7: Perform Accretion/Dilution Analysis

• Objective: Calculate the impact of the acquisition on the acquirer's Earnings Per Share (EPS).
• Content:
  • Calculate the pro forma net income of the combined entity.
  • Determine the pro forma shares outstanding (acquirer's existing shares + new shares issued for the acquisition).
  • Divide pro forma net income by pro forma shares outstanding to get pro forma EPS.
  • Compare pro forma EPS to the acquirer's standalone EPS to determine if the deal is accretive (EPS increases) or dilutive (EPS decreases).

Step 8: Conduct Sensitivity Analysis

• Objective: Test the robustness of the model's conclusions under different scenarios.
• Content: Vary key assumptions such as:
  • Purchase Price: How does a higher or lower acquisition price impact accretion/dilution?
  • Synergy Realization: What if synergies are higher or lower than expected, or take longer to achieve?
  • Financing Mix: How does changing the proportion of cash, stock, or debt affect the outcome?
  • Interest Rates: Impact of fluctuating interest rates on debt financing costs.

Step 9: Present & Iterate

• Objective: Clearly communicate the model's findings and assumptions.
• Content: Summarize the accretion/dilution analysis, key valuation insights, and the impact of different financing structures. The model should be constantly updated and refined as new information becomes available or deal terms evolve.

Conclusion

M&A models provide a quantitative framework for evaluating strategic decisions, managing risk, and ensuring that mergers and acquisitions are accretive (create value) for shareholders.