If you’re looking to merge with another company you need to be fully aware of the opportunities and challenges such a move presents. One way to clarify this and other financial considerations for stakeholders is to create a merger model.

What is a merger model?

A merger model is an analysis of the combination of two companies. The main steps in building a merger acquisition model are:

  • Making acquisition assumptions – this involves examining the financial position of each parent company and estimating matters such as:
    • How many new shares need to be issued for the newly merged company?
    • Where cost savings can be made?
    • Integration costs
    • How shareholders of the parent company are to be paid out
    • Financial projections for the new company
  • Making projections – this involves the same process as creating a standard financial model, including making assumptions regarding fixed and variable costs, turnover, margins, and capital expenditure
  • Valuation of each parent business – a DFC analysis must be made of each parent business to reach a valuation
  • Business combination – the accounting adjustments required for combining the two parent companies’ financials
  • Deal Accretion and Dilution – determines if the post-transaction earnings per share (EPS) are increased or decreased by the merger

How are revenue synergies used in merger models?

When you are planning a merger, you need to understand the estimated cost savings and long-term revenue resulting from forming a new company. The underlying concept of potential synergies is that the combined value of the two companies will be greater than that of the parent companies as separate entities.

When creating a merger model, you need to be aware that revenue synergies based on new products and/or new markets often fail to come to pass. Furthermore, revenue synergies take longer to realise than cost synergies and this must be communicated to stakeholders.

What are the legal considerations for mergers?

Any merger will raise legal, tax and accounting challenges. There will also be some kind of merger or transfer agreement transferring the respective parties’ assets into the merged operation. In this case, the agreement must contain protections in favour of that operation. Merger partners may also need advice on a shareholder's or similar agreement setting out how the merged operation will be run.

How do I calculate a merger premium?

The premium in a merger or acquisition is defined as the difference between the price offered for the target company and its market price before the announcement of the transaction. 

What are the steps in valuing a merger?

Establishing the business valuation of the target company is one of the most important steps in the merger process. Valuing a small business encompasses several factors. As well as looking at the tangible and intangible assets (an example of the latter is the target’s intellectual property), factors such as the current economic climate, your brand’s reputation, competitors and the reasons behind the sale come into play. 

Popular valuation methods for small businesses include calculating:

  • The value of net assets such as land, plant equipment, and stock. This involves calculating the value of the business assets less its liabilities.
  • Working out the discounted cashflow, which equates to what the future cashflow would be worth today. This is calculated by adding up the dividends forecast for the next 15 years or so, plus a residual value at the end of the period. A 15-20% discount is then applied to establish what the amount would be worth in today’s money.
  • How much it would cost to build a similar business to the target company from scratch.

M&A valuation is incredibly complex, and it is always in your best interests to instruct an experienced valuer to undertake this exercise for you.

What is an accretion and dilution analysis?

An accretion and dilution analysis aims to answer the question, “Does the proposed merger increase or decrease the post-transaction earnings per share (EPS)"? The answer to this provides a reason for entering into the deal in the first place.

Does corporate performance improve after mergers?

A 1992 paper by Paul M. Healy, Krishna G. Palepu, and Richard S. Ruback, all of who are members of the faculty at Harvard Business School, found that:

“Merged firms show significant improvements in asset productivity relative to their industries, leading to higher operating cash flow returns. This performance improvement is particularly strong for firms with highly overlapping businesses. 

Mergers do not lead to cuts in long-term capital and R&D investments. There is a strong positive relation between postmerger increases in operating cash flows and abnormal stock returns at merger announcements, indicating that expectations of economic improvements underlie the equity revaluations of the merging firms.”

Get legal assistance from LawBite

Creating a merger model can be challenging, however, investing in expert advice can make the process easier and ensure your presumptions are as accurate as possible. LawBite has helped thousands of businesses achieve their commercial ambitions and deal with M&A legal issues. To find out how we can help you on all matters concerning mergers and acquisitions, book a free 15 minute consultation or call us on 020 3808 8314.


Additional resources

In closing

Nothing in this article constitutes legal advice on which you should rely. The article is provided for general information purposes only. Professional legal advice should always be sought before taking any action relating to or relying on the content of this article. Our Platform Terms of Use apply to this article.

Free legal support for businesses

The LawBite Free Essentials Plan acts as your very own legal assistant, ready to provide expertise and guidance on the common legal issues that SMEs and businesses face.

Free Templates
  • X 3 legal document templates
  • Drafted by our expert lawyers
  • New documents added every month
Legal Healthcheck Tools
  • Business-specific surveys
  • Understand how compliant you are
  • Checks in, GDPR, IP, Brexit and more
Resources, Webinars and Articles
  • Access to the latest LawBite events
  • Legal guides for businesses
  • Smarter business law videos