THE M&A PROCESS

Although there are many facets to M&A and the industry is constantly evolving, it is important to understand the possible steps an acquirer would take in order to pursue a target business. This will further help one understand the M&A process. The early stages of the process are considered “friendly”; the latter “hostile.”

1. Casual pass: A casual pass is an informal inquiry made to business management. This can literally be done via email, a letter, or a phone call. A solicitation to management to discuss a “strategic alternative” can be a suggestion for acquisition. Management can either respond or reject. A rejection would lead the acquirer to one of the next steps, and this can now be considered “hostile.”
2. Bear hug: A bear hug is a letter to company management regarding an acquisition and demanding a rapid response. The letter is not a proposal but rather a demand and arrives without warning. Often the bear-hug action is made public and is utilized to encourage management to negotiate in a friendly manner.
3. Open market purchase: In an open market purchase the acquirer purchases shares in the open market. Although an interesting tactic, this can often end up unsuccessful if not all shareholders are willing to sell their shares. However, if successful, this could lower the overall cost of the transaction as one blanketed control premium is no longer negotiated, among other reasons. We will discuss the control premium later in the book.
4. Proxy contest: In a proxy contest the acquirer seeks to gain shareholders' support to change a decision of the board of directors or management in some way that allows the acquisition to proceed. A proxy letter can be mailed out to every shareholder in an attempt to garner support in the form of “votes.” Although the proxy strategy comes in several forms, it can prove to be unsuccessful if the target company stock is held by a large number of individuals.
5. Tender offer: A tender offer is a direct solicitation to purchase shareholders' shares. Because a significant purchase premium is involved in order to try and ensure that enough shareholders would be willing to sell their shares and allow the acquisition to proceed, the tender offer is a costly method of acquiring a business.

It is also important to note, when acquiring assets, groups of assets, or business entities, there are three major methods of facilitating the acquisition:

1. Asset acquisition
2. Stock acquisition
3. 338(h)(10) election

ACCRETION/DILUTION ANALYSIS

An accretion/dilution analysis is a common analysis in mergers and acquisitions. The analysis helps determine if an acquiring company's earnings per share (EPS) will increase (demonstrating accretion) or decrease (demonstrating dilution) after combining financials with a target company. To help understand the process, it is important to note that in a simple asset acquisition, funds are expended, and the PP&E is increased by the value of the asset purchased. But in an acquisition of an entire business entity, more than just the core PP&E is acquired. When purchasing a business entity, one is effectively taking into consideration the entire balance sheet, the value of which is indicated by the total assets less the total liabilities, or the shareholders' equity. So, where in a simple asset acquisition the price paid represents the net asset value (potentially at a premium), the price paid for a business entity represents the shareholders' equity (potentially at a premium). So, in a merger or acquisition of a business entity, we are effectively buying out shareholders' interest in the target business, represented by its shareholders' equity: We are using funds to buy out the target shareholders, and so those shareholders go away, and so does the shareholders' equity on the balance sheet. If you feel you need a stronger background on the fundamentals of acquiring assets, please see the book Mergers, Acquisitions, Divestitures, and Other Restructurings. To better illustrate this let's discuss the process.

There are three major steps to conducting a merger or acquisition analysis:

1. Step 1: Obtaining a purchase price
2. Step 2: Estimating sources and uses of funds
3. Step 3: Creating a pro-forma analysis

STEP 1: OBTAINING A PURCHASE PRICE

Before conducting the analysis, we first need to obtain a potential purchase price of the entity. Conducting a valuation analysis on the entity will help us arrive at an approximate current value of the entity. Although a valuation analysis is helpful in providing an indication of what the appropriate value of the entity is today, one will most likely have to consider a control premium. A control premium is the percentage above current market value one would consider paying to convince the business owner or shareholders to hand over the business or shares.

STEP 2: ESTIMATING SOURCES AND USES OF FUNDS

Once a purchase price has been established, we have to determine the amount of funds we actually need raised to complete the acquisition (uses), and we need to know how we will obtain those funds (sources).

STEP 3: CREATING A PRO-FORMA ANALYSIS

Once we have our sources and uses of funds, we can now proceed to determine the financial impact of the transaction. A pro-forma analysis (“pro-forma” is Latin for “as a matter of form” or “for the sake of form”) is what we refer to as the process forecasting the results of a transaction. Once we have a financial summary of the two entities combined, we can analyze how the EPS has changed (accretion or dilution). An accretion/dilution analysis is a common way to assess the financial impact the combined entities have on EPS. If, after the combination, the EPS has increased, the transaction can be considered “accretive.” If, however, the EPS has reduced, the transaction can be considered “dilutive.”

So in order to proceed with determining the financial impact, we need to discuss how to combine two entities together. In short, you simply need to add the financials of Company B to the financials of Company A. The revenue of the combined entity, for example, is the revenue of Company A plus the revenue of Company B. From a general standpoint, it's that simple: To combine the income statements of two entities together, you would simply add each line item of entity A to entity B from revenue all the way down to net income.

However, adjustments need to be made based on transaction considerations. In order to understand these adjustments, it is important to reiterate and elaborate on the general concept discussed in the first paragraph of this chapter. In a merger or acquisition of a business entity, we are effectively buying out shareholders' interest in the target business. Note these funds can be in the form of cash on hand, equity or debt raised, or exchanging shares. However, to elaborate, as mentioned in the Uses of Funds section of this chapter, we often need to consider raising additional funds to pay down the target company's net debt. Although it may be unknown whether we truly need to do so (it depends on the debt contracts, which requires significant due diligence), it is conservative to assume we have to pay down those debts. Later, if we realize we do not need to pay down the company's debts, we can simply eliminate that assumption, which will only improve the outlook. So funds are needed not only to pay out target company shareholders, but to pay down the target company's net debt. Also, as per the Uses of Funds section, transaction fees need to be paid.

So when applying these concepts to an accretion/dilution analysis, where we are concerned with a combined (pro-forma) EPS, we simply add together everything from revenue down to net income, except for items relating to the target company's shareholders' equity and the target company's net debt. Again, this is because once merged or acquired, the target company's shareholders have been bought out and the debts have been paid down. And remember, we are working under the assumption that we are required to pay down the target company's net debts. So, on an income statement, the line items relating to the target company's net debt (net interest expense) and the line items relating to the target company's shareholders' equity (shares outstanding and dividends) will not be included in the analysis; they will be eliminated upon combination. Figure 6.2 is an example of two companies in the process of merging. Here I attempt to illustrate the core nature of a business combination from an income statement perspective and lay out the line items that typically need consolidation. Take a look at this example, then we will apply the consolidation process to GroceryCo.

Adjustment 2: Amortization of Newly Allocated Intangible Assets

Amortization is the accounting for the cost basis reduction of intangible assets (intellectual property such as patents, copyrights, and trademarks, for example) over their useful lives. When the purchase price for a business entity is greater than its book value, that difference can be allocated to several areas, including goodwill and intangible assets. The portion of that purchase price above book value that is allocated to intangible assets can be amortized, which results in an additional income statement expense. To fully understand this concept, let's clarify the concept of goodwill.

Goodwill

Goodwill is an intangible asset that typically arises as a result of an acquisition. In U.S. GAAP accounting rules, the price paid for a business above the book value (shareholders' equity) is generally defined as goodwill. But several other adjustments are often made based on tangible and intangible assets and deferred taxes, which will affect our amount of purchase price over book value allocated to goodwill.

More specifically these adjustments are:

Step-Up of Existing Assets

Notice the quote mentions the “fair values” of the acquired tangible and intangible assets. So, commonly pursuant to an acquisition, all of the assets are reevaluated and can be adjusted accordingly to their fair market values. This adjustment is called a “step-up” of assets. Note that a step-up of assets could result in additional deferred taxes.

New Intangible Assets

Often in a merger or acquisition a portion of the purchase price above book value can be allocated to new intangible assets. The conceptual idea is that the reason an acquirer could pay more for the target company than what is stated on the book value is because they are paying for some intangible assets (branding, intellectual property, for example) that had not previously been identified and accounted for. It is beneficial to allocate as much of the purchase price over book value to intangible assets because, according to U.S. GAAP rules, intangible assets can be amortized. And of course, amortization is an income statement expense that reduces taxes.

Deferred Tax Adjustments

In a purchase it is possible that a company's preexisting deferred tax assets and deferred tax liabilities will be adjusted or wiped out altogether. If that is the case, this will affect the amount of purchase price over book value allocated to goodwill. And again, a tangible asset step or new intangible assets could result in additional deferred taxes created.

In summary:

In modeling we often allocate 20 to 25 percent of the purchase price above book value toward intangible assets as a safe, conservative assumption. Let's take an example, conservatively assuming no additional asset step-ups or deferred tax adjustments:

An independent investor would like to buy a distribution business. The business has a book value of $20,000. The investor offers $30,000 for the company. This reflects a premium of $10,000 ($30,000 – $20,000 of shareholders' equity) of the purchase price over book value. The new balance sheet will have a shareholders' equity value of $30,000, reflecting the price paid. The investor estimates 25 percent of the $10,000 premium is attributable to intangible assets (e.g., the brand name “John's Trucks”) and will be amortized for 15 years. The remainder is goodwill. The new balance sheet looks like Table 6.3.

John's Trucking Company (in $US 000s)
	Before	After
Assets
Cash	$0.0	$0.0
Intangible Assets	0.0	2.5
Goodwill	0.0	7.5
Truck	20.0	20.0
Total Assets	$20.0	$30.0
Liabilities
Debt	$0.0	$0.0
Shareholders' Equity	$20.0	$30.0

Income Statement	Company A	Company B	Pro Forma Income Statement	Comment
Revenue	Revenue A	Revenue B	Revenue (A + B)
COGS	COGS A	COGS B	COGS (A + B)
Operating Expenses	OpEx A	OpEx B	OpEx (A + B)
Adjustment: Post-merger cost savings			Cost Savings	New adjustment based on post merger cost savings
EBITDA			Revenue − COGS − Operating Expenses + Cost Savings	Cost savings would increase EBITDA
Depreciation and Amortization	D&A A	D&A B	D&A (A + B)
Adjustment: New Amortization			New Amortization	New adjustment based on intangible asset allocation
EBIT			EBITDA − Depreciation and Amortization − New Amortization
Interest	Int. A	Int. B	Int. A	Company A Only (Assuming we are paying down Company B debt upon merger or acquisition)
Adjustment: New Interest Expense			New Interest	New adjustment if debt is raised to fund transaction
EBT			EBIT − Interest − New Interest	EBIT − Interest
Taxes			EBT × Tax%
Net Income			EBT − Taxes
Shares Outstanding	Shares A	Shares B	Shares A	Company A Only (Company B shareholders have been bought out)
Adjustment: New Shares Raised			New Shares	New adjustment if equity is raised to fund transaction
Total Shares Outstanding			Shares A + New Shares	Shares Outstanding + New Shares Raised
EPS			Net Income/Shares Outstanding

SUMMARY

In order to assess the financial impact of the combination of two entities, you first need to obtain the purchase price. Once the purchase price is obtained, the sources and uses of funds need to be analyzed. The use of funds is comprised of the purchase price plus potentially paying down the target company's net debt and transaction fees. The sources of funds will be some combination of equity, debt, or cash on hand. Once we know the sources and uses of funds, we can begin combining the two entities by adding together Company A and Company B line items from revenue down to net income except for items relating to the target company's net debt (if we are assuming we are paying down the target company's net debt) and the target company's shareholder's equity (because we are paying off the shareholders). These items relate to the target company interest expense and target company shares and dividends on the income statement. In addition, we need to consider four major transaction adjustments: (1) post-merger cost savings, (2) the amortization of new intangible assets if we have been able to allocate a portion of the purchase price above book value toward new intangible assets, (3) new interest expense if we have raised debt to fund the transaction, and (4) new shares if we have raised equity to fund the transaction. We can then calculate a new EPS and compare with the original company's EPS in order to assess accretion dilution.

This is an accretion/dilution analysis in a nutshell. I would recommend reading this over and over again until it starts to make conceptual sense. The importance of this accretion/dilution analysis is twofold: First, for practical purposes, it gives a great initial understanding of the financial impact of a combination before going into the complete detail of building a full-scale model; and second, for instructional purposes it summarizes the major movements behind a merger or acquisition. It's a great way to capture all of the major mechanical transaction components without getting bogged down by all the detail found in a full-scale analysis. That being said, once you have a good conceptual understanding of the accretion/dilution mechanics, it should be fairly easy to see the major drivers for such an analysis.

DRIVERS

To strengthen your understanding of a merger and acquisition analysis, it is important to highlight some key variables affecting the pro-forma EPS. First, of course, in an acquisition the addition of the target company's EPS will be accretive to the acquiring company's EPS as long as the target company's EPS is positive. But the following transaction adjustments affect the combined EPS, resulting in total accretion or dilution:

• Purchase price. Of course the purchase price plays a major role in a transaction. The higher the purchase price, the more sources of funds needed to meet the cost. More equity or more debt raised will most likely reduce the pro-forma EPS further.
• Sources of funds. The amount of debt versus equity raised to meet the acquisition cost will affect EPS. Debt is most commonly less dilutive than equity, although this depends on the interest rate and the share price, respectively. If the company's share price is so high that it takes significantly fewer shares raised to meet the acquisition cost, the EPS dilution will be significantly reduced.
• Post-merger cost savings. The more cost savings incurred post transaction, the better off the net income will be. This will help improve the pro-forma EPS.
• Amortization of newly identified intangible assets. The more purchase price over book value allocated toward intangible assets, the greater the potential amortization will be. The amortization rate (useful life) will also affect the amortization value. This additional amortization will reduce the EPS; however, since this amortization is a non-cash expense, it is often a desirable expense to have. Amortization will help reduce taxes, yet since it is non-cash, it will just be added back in the cash flow statement.
• New interest expense. If debt is raised to fund the transaction, new interest expense will cause EPS dilution.
• Interest rate. The interest rate on the debt raised to fund the transaction would affect the EPS. Of course, a lower interest rate would result in less dilution.
• New shares. If equity is raised to fund the transaction, the additional outstanding shares will cause EPS dilution.
• Share price. If equity is raised to fund the transaction, the share price helps determine how many shares need to be raised. Total funds divided by the share price equals the number of shares raised. So, the higher the share price, the fewer shares needed to raise desired funds, and therefore less dilution.

Now that you have a basic understanding of the accretion/dilution analysis, let's go through some M&A interview questions and cases.