Deal Design

yedlu, Winter 2024

Notation

Symbol	Meaning
\(P_T\)	Target’s standalone price per share
\(P_B\)	Buyer’s standalone price per share
\(S_T\)	Number of target shares outstanding
\(S_B\)	Number of buyer shares outstanding
\(ER\)	Exchange ratio (buyer shares per target share)
\(PV_B\)	Present value of buyer (standalone)
\(PV_T\)	Present value of target (standalone)
\(PV_{BT}\)	Present value of the combined entity post-merger
\(P^*\)	Offer price per target share, including premium/synergies
\(\alpha\)	Fraction of combined firm owned by target shareholders
\(PV(\text{synergies})\)	Present value of synergies from the merger

Choosing the Form of Payment

Considerations

• Cash:
  • Buyer pays with cash, often raised via debt.
  • Taxable for target shareholders.
  • Acquirer benefits from a tax basis step-up for depreciation/amortization.
• Stock Swaps:
  • Target shareholders receive acquirer shares.
  • Nontaxable if stock exceeds 50% of consideration.
  • Avoids immediate tax but can dilute acquirer EPS.
• Earnouts/Contingent Payments:
  • Payments based on future performance metrics (e.g., revenue, EBITDA).
  • Useful for bridging valuation gaps in private company deals.

Factors

• Taxes: Stock offers are tax-advantaged for targets.
• Financing: Stock offers avoid additional debt.
• EPS Impact: Stock issuance dilutes acquirer EPS.
• Information Asymmetry: Stock offers align seller incentives with deal success.

Stock Swaps and Exchange Ratios

Exchange Ratio (ER)

Defines the number of acquirer shares exchanged per target share. Key formulas:

• ER = Acquirer Shares Issued / Target Shares Outstanding.
• Fraction Target Owns Post-Merger: \[\begin{aligned} \alpha = \frac{\text{ER} \cdot S_T}{\text{ER} \cdot S_T + S_B} \end{aligned}\]

Determining ER

• Minimum ER (target’s threshold): \[\begin{aligned} \text{ER}_{\text{min}} = \frac{P_T \cdot S_B}{PV_{BT} - P_T \cdot S_T} \end{aligned}\]
• Maximum ER (acquirer’s threshold): \[\begin{aligned} \text{ER}_{\text{max}} = \frac{PV_{BT} - P_B \cdot S_B}{P_B \cdot S_T} \end{aligned}\]
• Synergy-Sharing ER (e.g., target receives 30% of synergies): \[\begin{aligned} P^* = P_T + \frac{\% \text{Synergy} \cdot PV(\text{synergies})}{S_T} \end{aligned}\] \[\begin{aligned} \text{ER} = \frac{P^* \cdot S_B}{PV_{BT} - P^* \cdot S_T} \end{aligned}\]

Key Insights

• A higher ER increases target shareholder ownership, reducing acquirer shareholder control and share price.
• Use post-merger acquirer share price (\(P_{BT}\)) to avoid overpayment if stock price fluctuates.

Practice Problem Example

Sirius-XM Merger:

• Sirius (buyer): \(P_B = 3.7\), \(S_B = 1,460M\).
• XM (target): \(P_T = 14\), \(S_T = 314M\), synergies = $1B.
  • Minimum ER: \(3.19\).
  • Maximum ER: \(4.64\).
  • ER (30% synergy to Sirius): \(4.15\).

Earnouts

Definition

Contingent payments tied to future performance metrics.

Advantages

• Aligns seller incentives post-acquisition.
• Bridges valuation gaps between optimistic sellers and skeptical buyers.

Earnout Valuation

• Valued like a call option, sensitive to target performance variability.
• Can resolve disagreements over growth projections and profitability.

Example

A target with $10M sales: - Buyer valuation: 5% growth, 5% profit margin = $3M. - Seller valuation: 15% growth, 10% profit margin = $5M. - Earnout terms: $2M upfront, contingent on sales/profit thresholds over five years.

Collars

Purpose

Hedges against acquirer stock price volatility in stock-for-stock deals.

Types

1. Fixed Exchange Ratio with Collar:
   • Limits target gains/losses to a floor and cap.
   • Below floor: Adjust ER upwards (more shares issued).
   • Above cap: Adjust ER downwards (fewer shares issued).
2. Floating Exchange Ratio with Collar:
   • Maintains fixed value per target share, adjusting ER dynamically.
   • Stops floating when price hits floor/cap, locking value.

Valuation

• Collar resembles a combination of options: \[\begin{aligned} \text{Value} = \text{Stock Price} + \text{Long Put Value} - \text{Short Call Value} \end{aligned}\]

Example:

Fixed Value Collar:

• \(P = 20\), cap = 25, floor = 15.
  • Below 15: \(ER = \frac{20}{P}\).
  • Above 25: \(ER = \frac{20}{P}\).

Risk Management in Deal Design

Strategies

• Fixed Exchange Ratios: Simpler but exposes targets to acquirer stock risk.
• Floating Ratios: Protect target value but dilute acquirer shares.
• Caps/Floors: Mitigate extreme risks while providing predictable payouts.

Application

Collars ensure a balance between risk sharing, target protection, and acquirer cost predictability.