Merger model : the buyer writes off the seller's shareholder's equity balance, WHY ?
Hello,
I am currently preparing myself for interviews in IB in France. As I worked on subject like consolidation, I read that when combining the balance sheet ( M&A) of the seller&buyer, the buyer had to write off the seller's entire shareholder's equity balance before adding the rest of the seller's balance sheet to its own.
1) What a write-off of Shareholder's equity exactly means ?
2) Why do you have to do that in a merger model?
I did not find any response to my question on the forum but feel free to let me know if this subject has already been discussed.
Because you are valuing the equity at market value when you agree to purchase the equity.
Hello,
Thank you for your quick response :) But why do we have to erase the seller's shareholder's equity ? It does not disappear.. right? My question may sound silly but I just need to understand the logic behind that
Because you are valuing the equity of the shareholders equity in the open market...that is what you are buying. You are not erasing anything really, you are just saying that if my shareholder equity is $5 and somebody buys the equity for $100 then its $100 now, not $5.
It's all about ownership. Writing off the shareholder equity is almost like transferring ownership. Think of it like this - You and I are partners in a business. The two of us split things 50/50. I own 50% of the Equity in the company and you own 50% of the equity in the company. If I want to buy out your share, I pay you cash, you give me your equity and full control over all the company's assets. I now own 100% of the company and you own 0%. You're entire equity position has been zero'd out and you own nothing.
The same idea holds true for an M&A deal. The buyer purchases a target company and is effectively buying out the equity position to gain ownership over a company's assets and debts. Using Amazon as an example. They announced they are going to buy PillPack. If Amazon pays $1Bln in cash for PillPack, every dollar of shareholder equity is written off because there is no more Equity in the company. It's now a collection of assets to be integrated into Amazon's massive behemoth. Amazon doesn't, all of a sudden, grow by the value of PillPack's equity because the equity in PillPack (the Common Stock, APIC and and RE) are all paid out to the existing owners. Instead, the merged entity's Liabilities and Shareholder Equity increase by the financing used and decrease by the by the closeout of Common Stock, APIC, and RE that were once attributed to the target company.
You need to do this because the model won't balance if you don't. You're adjusting the combined balance sheet to reflect the combination of the two companies. Without making the adjustments for the retirement of the target's equity, you effectively say that there are more Liabilities and Shareholder Equity than there are Assets. That doesn't work.
THANK YOU very much for your detailed response. It is much clearer thanks to your explications regarding ownership. Just a last question : when you said "Amazon doesn't, all of a sudden, grow by the value of PillPack's equity because the equity in PillPack (the Common Stock, APIC and and RE) are all paid out to the existing owners" => what did you mean exactly? What happened to the Common stock, APIC and RE of pillpack ?
thanks a lot
So using the partnership example again, you and I own a company and own it 50/50. Common Stock is issued at $1/Share. We each pay in $1/Share and own 50 shares a piece. So there are 100 Shares of Common Stock valued at $100. In our first year of business, we have $400 in Net Income, take no distributions, etc. and put it back into the business as Retained Earnings. Our Shareholder Equity is $500. That's the value of our Ownership before liquidation. In the second year, we both buy another 50 shares a piece at $2/Share. The company has $600 in Net Income, and we agree to issue half of that, so $300, in dividends and put the remaining $300 into Retained Earnings. That means in Year 2, we have $100 of new Common Stock and $100 of Additional Paid In Capital, and $300 of Retained Earnings added to the balance sheet. After two years, our company has $200 of common stock, $100 of APIC, and $700 of Retained Earnings - for a total of $1000 of Shareholder Equity.
On the first day of year 3, I offer to buy you out for $600 and you agree to it. When we balance out the shareholder equity, $500 of that $600 represent your share of the Common Stock ($100), APIC ($50), and Retained Earnings ($350). The money I spend to buy you out reduces the value of the Common Stock, APIC and RE by the amount that's owed to you because I have effectively paid you out the entire value of your ownership. So I'm left holding 100 Shares of Common Stock, and the balance sheet shows that Common is worth $100, APIC is worth $50 and RE is worth $350. As a result, your share of the Common, APIC, and RE have been paid out and no longer exist.
The same holds true for PillPack. Amazon is buying out the current owners. The current owners are entitle to the value of their Shareholder Equity. Just like in the partnership example, the remaining Shareholder Equity in PillPack after the deal is completed would be 0 since there are non-Amazon shareholders left with a stake. We know that Amazon is buying PillPack for $1Bln. If PillPack has $500MM in Shareholder Equity (for simplicity sake, we assume it's Common Stock, APIC, and Retained Earnings), $500MM of the $1Bln purchase price is spent buying out the value of the common shares, the APIC, and Retained Earnings when the merger is approved. These are allocated on the balance sheet to reflect how the funds used in the purchase are spent. Just like in the partnership example, Amazon owns all of the equity in PillPack, but it doesn't own the value of Common Stock, APIC, and RE of the shareholders it has to pay out. Amazon just owns the equity of Amazon. In essence, the Common Stock, APIC and RE of PillPack are wiped out. When you make the adjustments, you end up adjusting PillPack's Shareholder Equity to 0. This means that Amazon cannot effectively add in PillPack's Shareholder Equity since it no longer exists.
Does that clarify things?
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