All About M&A Modeling - 7 Steps to Build an M&A Model
M&A modeling can be a great way to ensure you and your willing buyer reach an agreement faster because each party can see the deal's potential impact on your financial position.
However, building an M&A model can be challenging. There are assumptions to make, valuations to perform, and financial metrics to project. The good news is that the buy side usually does the modeling.
In this guide, we’ll explore mergers and acquisitions modeling techniques your buyer may use and what you can learn from the process to improve your business exit.
TL;DR - 7 Steps to Build an M&A Model
M&A financial modeling typically follows the seven steps below:
Making assumptions
Financial projection
Valuing the acquiring and target companies
Estimating crucial financial items
Purchase price accounting
Combining the two companies' balance sheets
Accretion/Dilution analysis
Before we discuss these steps in detail in a later section, it's good to note that M&A experts can help you negotiate better if your buyer shares their M&A model to show you how they arrived at the proposed purchase price.
We at Exitwise can help you choose and collaborate with the best M&A experts in your industry to help you with internal M&A modeling or understanding your buyer's model.
Consult with us today to make the best of your business sale!
What is M&A Modeling?
M&A modeling refers to hypothetically analyzing a target company to help a buyer foresee its future value, financing needs, and cash flows before deciding to buy it.
While the buyer usually does the process, you can conduct your own internally if you have access to the buyer's financial information or can estimate the details reasonably.
M&A modeling helps you estimate the maximum purchase price you can expect or the lowest price you can accept when selling your company.
Different Types of Financial Models
While there are many financial models, we'll discuss the top four most commonly used in mergers and acquisitions:
1. Three-Statement Model
As the name suggests, the three-statement model uses three basic financial statements: income statement, cash flow statement, and balance sheet. The three are linked in an Excel sheet using dynamic formulas.
The model aims to sync the three accounts so that you can make different assumptions to observe how they can potentially change the entire model.
You'll need financial, Excel, and accounting skills to successfully link the three statements.
2. Discounted Cash Flow Model (DCF Model)
The DCF model is based on the three-statement model and is ideal for calculating the net present value of a company's future cash flows.
You can use the cash flows from the three-statement model and discount them to the present value using a discount rate.
The discount rate is usually the company's Weighted Average Cost of Capital.
3. M&A Model
Also called the merger model or accretion/dilution model, the M&A model is an advanced technique for evaluating the impact of a merger or acquisition on the combined entity's financials.
The model is advanced because you have to adjust accordingly using variables such as revenue synergies, capital expenses, and cost synergies.
You also have to perform accretion/dilution and sensitivity analysis to see the deal's impact on the combined company's valuation.
4. Leveraged Buyout Model (LBO Model)
The LBO model is an advanced financial modeling technique usually used by investment bankers and private equity firms to evaluate deals and target companies and measure their profitability when sold later.
LBO models focus more on debt scheduling since the purchase price is mainly paid using debt. They also emphasize profitability because the plan is to sell the target company later.
Detailed Valuation Techniques for M&A Analysis
Business buyers and sellers can use different valuation methods, including the DCF method and comparable company analysis, to analyze an M&A deal.
DCF Method
As mentioned, the discounted cash flow method considers the projected cash flows of the target company and discounts them back to present values using a predetermined discount rate when calculating the company's value.
Here's the formula:
Current business value = Sum of discounted projected cash flows + Discounted Terminal value
Where;
DCF = CF₁ ÷ (1 + r)¹ + CF₂ ÷ (1 + r)² + … + CFₙ ÷ (1 + r)ⁿ
CF₁, CF₂, are the projected cash flows for year 1, year 2, and so on
r is the discount rate
n is the final year of the projection period
Terminal value = EBITDA in the final year x The exit multiple (using the exit multiple valuation approach)
Discounted or present value of Terminal Value = Terminal value ÷ (1 + discount rate)^the number of the final year.
You can simulate different cash flow combinations to see the lowest, most favorable, and maximum purchase price you can get.
Comparable Company Analysis
The comparable company analysis method compares a target company or the combined entity with similar publicly traded companies or those whose recent sale details are in the public domain.
The comparison looks at different financial multiples and ratios, such as the EBITDA multiple, which shows how many times a company is worth its EBITDA.
You can use this method to see any gaps between your target company or the proposed combined entity and the competitors.
Alternatively, you can use our free business valuation calculator to get a rough idea of how much your company is worth.
How to Choose the Right M&A Financial Model
When selling your business, it can be hard to choose the right financial model.
You have to consider factors such as:
The Type of Buyer: They can be a strategic or financial buyer. A financial buyer would typically prefer the LBO model, while a strategic one would typically prefer the M&A model.
Company Information Available: Consider the information available about your company. You should also have some details about the buyer's company if you wish to do financial modeling internally.
Your Prior Valuation Expertise: If you’re doing the valuation on your own, you have to consider your knowledge and experience with different financial models and valuation methods. Valuation can be challenging on your own without the help of professional valuators.
Information Available on Other Companies: If you choose the comparable company analysis method, ensure you have enough information on similar companies.
It's advisable to work with M&A experts to help you choose the best financial model for your business sale. They can also help you negotiate the most favorable model with your buyer.
We can help you choose and manage the right M&A experts to maximize your exit. Schedule a consultation with our team today!
7 Steps to Build an M&A Model
Let's go over the seven typical steps in building a merger and acquisition model in detail:
1. Making Assumptions
The buyer will make several assumptions, depending on the deal. For example, they can set varying purchase prices or consider the number of shares you'll get in the combined company.
The assumptions form the basis for the whole modeling process.
2. Financial Projection
The buyer will use your cash flow statement, balance sheet, and income statement, as well as their own, to project the financial outlook of the pending acquisition or merger.
3. Valuing the Acquiring and Target Companies
Your buyer estimates the value of the two companies—the target company and the acquiring one.
They may use the financial projection above, the assumptions made, and the discounted cash flow method to evaluate the companies.
4. Estimating Crucial Financial Items
The buyer will estimate financial metrics such as:
Cash flows
Integration costs
Expected synergies
Fees for financing the purchase
Each company’s earnings before interest
Cost of repaying any debts they may assume after the purchase
Interest they'll pay on the money they borrow to finance the purchase.
5. Purchase Price Accounting
Purchase price accounting involves calculating the goodwill and allocating the purchase price. The buyer typically reassesses the value of the assets they acquire from your company and allocates them a fair market value.
The IRS requires both the buyer and seller to report how they allocated the purchase price. You’ll want to agree with your buyer on how to account for the purchase price.
Purchase price allocation reporting is important because it determines how goodwill is taxed, which can significantly affect your take-home from the sale.
6. Combining the Two Companies' Balance Sheets
The buyer can combine items from your balance sheet into their own while adjusting for synergies, differences in the two companies’ accounting practices, and the purchase price.
7. Accretion/Dilution Analysis
The buyer finally estimates the potential impact of the merger or acquisition on the acquiring company's pro forma earnings per share.
A deal is accretive if the earnings per share increase after the acquisition. If the deal is dilutive, the earnings per share will decrease.
However, dilution doesn't necessarily mean the deal is not worth it. Most deals are usually dilutive in the short term because of integration costs and the cost of financing the purchase.
As synergies kick in, the new entity becomes accretive.
Let Exitwise Hire the Right M&A Experts for Your Business
Hiring the right M&A experts can help you maximize your business sale, selling in good time and at the best purchase price possible.
At Exitwise, we can help you hire M&A attorneys, tax accountants, business brokers, wealth advisors, and M&A advisors.
After an initial consultation, during which you tell us more about your business and the potential sale, we connect you with M&A experts in your industry and help you choose the best.
We also help you interview, hire, and manage the experts throughout the sell-side M&A process. Our team also negotiates on your behalf with the experts regarding engagement letters, working terms, and fees.
Let Exitwise help you hire and manage your dream M&A experts today.
Frequently Asked Questions (FAQs)
Let's close the discussion with a few questions business sellers often have about M&A models:
What is the Difference Between the LBO Model and the M&A Model?
A leveraged buyout, or LBO, is a financial model that private equity firms use to evaluate a target company before acquiring it.
The emphasis is on debt and its cost because the firms usually use debt to pay the purchase price. Since the plan is to sell the company later, private equity firms often also consider the target's exit valuation to see the potential profit.
On the other hand, a merger and acquisition model emphasizes the purchase’s internal return rate rather than the return on investment.
What Are the Key Assumptions In M&A Models?
Here are the main assumptions made in merger and acquisition models:
Financial assumptions, such as capital expenditure, financing needs, expected revenue growth, deal structure, and interest expense
Market conditions and their impact, including the competitive landscape and industry trends
Expected synergies (cost savings and revenue increments)
Number and value of the shares to be given to the target
Accounting-related adjustments to the financials
Timing for the realization of expected synergies
Value of the cash to be paid to the target
Projected financials for both companies
Effective post-acquisition tax rate
Potential integration costs
Proposed purchase price.
How Do You Perform Sensitivity Analysis in M&A Models?
An M&A sensitivity analysis tests how sensitive the deal's outcome is to various changes in different crucial assumptions such as cost synergies, interest expense, or revenue growth.
Here are the quick steps:
Identify Crucial Variables: Select the variables that have a significant potential impact on the deal's outcome, such as revenue growth, capital expenditures, and profit margins.
Define Realistic Ranges: For each variable chosen, set a possible range of testable values, such as base-case, best-case, and worst-case scenarios.
Simulate Multiple Scenarios: Hold all the other variables but use different values of a given variable for various simulations to see the resulting impact on the target’s or new entity’s valuation and other key metrics.
Present the Results Visually: Use sensitivity tables, graphs, diagrams, and charts to physically represent how the deal is sensitive to changes in different variables. Note the most significant variables and their corresponding changes.
Conclusion
M&A modeling is an informed way to help you determine the minimum you can accept or the maximum you can get as your company's sale price.
You'll want to work with an experienced M&A team that can help you negotiate the most favorable financial model and purchase price with your potential buyer.
We can help you find and work with the best industry-specific M&A experts to get you the most out of your business sale. Reach out to us at Exitwise today to sell your company successfully.
