Mergers and acquisitions (M&As) are a common type of business transaction, with mergers reaching all-time-high levels in 2021, and that trend doesn’t look to change anytime soon. Just as there are many varieties of M&As, they all boil down to being a business and legal agreement in which both companies mutually agree to combine. In addition to the various types of M&As, there are just as many (or more) reasons companies wish to merge. These reasons are virtually almost always financial or business-related, with the endgame of creating value. One of the most important tools used in M&As is the M&A model, which is beneficial for the parties on both sides of the table.

What Is an M&A Model?

An M&A model (sometimes referred to as a “merger model”) is a type of analysis that is used when two companies combine through the M&A process. It gives an estimate of accretion or dilution to the acquirer’s earnings per share (EPS). It is designed to provide a simulation of the impact that the merger process will have on the finances of the combined company. Knowing what this means and why this is important is discussed below. An M&A model is important because it shows the assumptions made about the valuation of the deal and because of the financial figures that are required to drive the rest of the analysis.

Steps for Building an M&A Model

There are five steps required for any M&A model. These are the following:

1. Making the Acquisition Assumption

Deciding whether it’s going to be a cash deal, an equity deal or some combination of the two is the first step in creating an M&A model. A lot of that decision depends on the valuation of both the acquiring company and the target company. Depending on how these companies are valued at the time of the transaction, it may be more advantageous to go for an equity stake, rather than for cash or vice versa.

In addition, there are quite a few key assumptions that must be factored in. These include the following:

  • Price of the target company
  • Number of shares issued to the target company
  • Synergies (cost savings) from the merged companies
  • Costs for the integration process (which includes any adjustments to the financials)
  • Financial projections for both the target and acquiring companies

2. Forecasting and Making Projections

The projections made in an M&A model are the same as in any other type of financial model. These assumptions include the following:

  • Revenue growth
  • Profit margins
  • Fixed and variable costs
  • Capital structure
  • Capital expenditures
  • Other accounts, including balance sheets and cash flow

3. The Valuation of Both Businesses

These valuations will be a discounted cash flow (DCF) model, which will be compared against comparable analysis of the company as well as against precedent transactions. The steps in preparing the valuation are the following:

4. Business Combination and Pro Forma Adjustments

This step is where the financials of the companies are merged and scrutinized. As you would imagine, there will be some accounting adjustments performed here, such as the value of goodwill, stock shares and options and cash equivalents. The key assumptions in this step include the following:

  • Whether consideration is made in cash or shares
  • Purchase price allocation (PPA)
  • Changes in accounting practices between the two companies
  • Calculations of synergies and goodwill

Note that goodwill is when the acquiring company pays greater than the fair market value of net tangible assets from the target company’s balance sheet.

5. Deal Accretion and Dilution

This analysis determines the effect of the transaction on the acquirer’s pro forma earnings per share (EPS). The deal is considered accretive if the acquirer’s EPS increased post-transaction; however, if the EPS decreased, the merger is considered dilutive. The key assumptions here include the following:

  • Number of newly created shares
  • Earnings that are acquired from the target company
  • The overall impact of synergies

What are the common financial valuations and assumptions that are required?

As referenced above, there are many inputs and assumptions required in any type of M&A model. These are the following:

  • Valuation inputs: This includes share prices and number of outstanding shares, net debt and the current credit rating of both companies.
  • Financial statements: Data from the balance sheets and income states of both companies. Sales, EBITDA, EBIT and EPS as well as the different tax rates (marginal and effective).
  • Financing mix: Whether cash or equity is used for the transaction.
  • Cost of financing the deal: This includes measuring the costs of debt vs. the cost of equity.
  • Impact of debt financing: How this will affect the credit ratings of the company.
  • Impact of equity financing: How this can affect the post-deal earnings of the acquiring company.
  • Synergies: Cost reductions of the merged company.
  • Interest and financing: How the cost of financing and/or acquiring new debt will impact the company.

Where a Virtual Data Room Is Used in an M&A Deal

No matter what type of M&A deal you’re working on, one vital tool for completing any deal is a virtual data room (VDR). A VDR is a secure, online location where all the players that are involved in the M&A process can store and share the documentation that is required for the transaction. The features of a sophisticated VDR consist of secure access (which includes enterprise-level encryption), multiple layers of security and user-friendly admin controls. In addition, there are customizable digital rights management (DRM) controls that will grant only certain users access to certain documents.

How CapLinked Helps the Process

CapLinked, an industry leader in the VDR space, is a provider of secure virtual data rooms for all types of business transactions, including M&A deals. CapLinked VDRs feature a user-friendly interface that is compatible with virtually every OS, giving users the ability to upload and download documents from any type of computer, tablet or smartphone from anywhere around the globe. Start a free trial today to see how it can benefit your business transactions!

Chris Capelle is a technology expert, writer and instructor. For over 25 years, he has worked in the publishing, advertising and consumer products industries.