How to Model Synergy Capitalization in Purchase Accounting

What are Synergies?

When two companies merge, there are certain things that they can do better than if they were standalone businesses. This additional value is called synergy. It can be thought of as the equation “1 + 1 = 3”. The result is greater than the sum of its individual parts.

Synergies create value for a new company by increasing revenues and/or through cost savings, all of which increase operating profits and cash flows.

What is Synergy Capitalization in Purchase Accounting?

It is not enough to say a merger created synergies. Synergy capitalization is how financial professionals quantify that value. This process means estimating the present value of all synergies. This number is then added to the company’s final valuation in purchase accounting.

Capitalizing synergies means building the expected benefits of a merger into the M&A valuation model. Those benefits increase the combined company’s projected free cash flows and can influence the acquisition price paid for the target company.

This helps buyers determine a reasonable acquisition premium they are willing to pay for the company, allowing sellers to narrow down which bid they are willing to pursue.

This process also helps analysts, investors, and other stakeholders evaluate the viability and expected outcomes of a company.

Types of synergies

There are three types of synergies used in synergy valuation models:

1. Cost synergies: reduction in operating costs and broader improvements to a company’s cost structure. These include eliminating redundant facilities or overlapping functions post-deal.
2. Revenue synergies: higher revenue from reaching new markets the individual companies could not access alone. These can also result in strong cross-selling power.
3. Financial synergies: the merged company can improve its capital structure compared to when the companies were separate. This gives it greater debt capacity. More debt capacity puts the company in a better tax position.

Where synergies fit in purchase accounting

Once synergies are evaluated, they are documented in purchase accounting. This framework records the fair market value of the seller’s assets and liabilities. Any purchase price above this value is recorded as goodwill on the balance sheet. Goodwill is where synergies are implicitly recorded in purchase accounting.

Expected synergies are one of the main reasons a buyer may be willing to pay an acquisition premium. Because synergies are not separately identifiable assets like patents, trademarks, or customer lists, their value is typically reflected indirectly through goodwill after the purchase price allocation is completed.

Synergies may also affect the combined company’s future income statements. As synergies are realized, they can result in lower operating costs, higher revenue, or improved financing efficiency. Yet these effects are often embedded within the company’s overall operating results rather than presented as a separate line item

Synergies are not their own line item on the balance sheet because they are not existing, owned economic resources. This is why it is crucial for analysts to properly model synergies. Because they are not explicit in financial statements, the way to see their true impact is through synergy validation models.

How to model synergy capitalization

Calculating and modeling synergies can be a complex process. Micro and aggregate assumptions may prove to be false. Some synergies may take longer to appear. There may also be internal complexities that can reduce or delay the expected benefits from a merger.

Regardless of these risks, modeling synergy capitalization matters. It turns expected merger benefits into measurable financial values that help shape the acquisition price a buyer is willing to pay for a company. Follow the steps below to properly value synergies in an M&A transaction.

Step 1: Calculate Run Rate Synergies

Run rate synergies are the synergies a company expects to reach every year once the combined business stabilizes after the merger. These are calculated with a precedent transaction analysis. This analysis looks at similar past deals in the same industry. The following are the steps to calculate run rate synergies:

1. Identify relevant transactions in the past few years. Analysts usually choose five relevant M&A deals.
2. Identify each transaction’s LTM revenue and run-rate synergies. Divide the synergies by LTM revenue to get a synergy percentage for each deal.
3. Take the average synergy percentage of the deals. This will become the synergy multiple for the company being evaluated.
4. Calculate run rate synergies for the target company by multiplying its LTM revenue by the average synergy percentage. The result is the estimated run rate synergies for the target company.

Example:

Suppose we are running a precedent transaction analysis to determine a target company’s run rate synergies. We found five similar past transactions with the following data, which will be used to calculate the average synergy percentage of LTM revenue for this analysis. The following data were compiled:

Once we find the average synergy percentage of LTM revenue, we calculate the run rate synergies for the target company. Assume the target company being evaluated has a LTM revenue of $2,200 million:

This means the merger is expected to realize $136,400,000 in synergies annually, assuming it grows at a steady rate.

Step 2: Determine Synergy Schedules

Mergers do not realize synergies right away. It can take years for synergies to fully emerge. That is why analysts study precedent transactions to identify when synergies typically appear. They do this by creating synergy schedules.

Before building synergy schedules, analysts should rely on management guidance, integration plans, public transaction disclosures, investor presentations, and industry benchmarks for reliable data. Cost synergies often begin appearing in years 1-2, though full realization may take longer depending on industry and transaction.

A simple synergy schedule for the deals mentioned above could look like this:

Step 3: Calculate the Present Value of Synergies

Using the run-rate synergies estimated from the precedent transaction analysis, the present value of the target company’s synergies can be calculated.

Calculation assumptions:

It is worth noting that this value is based on a few assumptions, such as:

• Synergies are assumed to remain the same each year once they have been fully realized, so this example assumes a 0% growth rate.
• Synergies get an extra discount on top of the weighted average cost of capital (WACC) of both companies, which is assumed to be 9% in this example. This is because they are often optimistic and may be difficult to realize. The additional discount in this example is assumed to be 2%.
• Synergies are treated as cash flows. This keeps synergy valuations simple and meaningful.
• Apply either the acquirer’s or seller’s marginal tax rate (MTR) to the synergies. This rate depends on which entity is expected to realize most of the taxable synergy benefits.

Because most synergies above were realized after three years, that will be used in the calculations below.

Calculation:

Since synergies here start in year 3, the calculation happens in two steps. First, find the synergy value in year 3, assuming zero growth. Then, discount that number back two years to determine what it is worth today.

The formulas for each are:

PV at the start of year 3 = (run rate synergies/discount rate)
PV at the start of year 1 = (PV at the start of year 3) x (1/(1+discount rate)^2)

Example:

Now that we have the required information, let us use it to calculate the post-tax present value of synergies for the target company. We will use the previous information for the precedent transactions analysis, as well as assumed WACC and MTR values.

The post tax PV of synergies means the target company’s synergies are worth about $734 million today. This number represents the PV of all future free cash flows the synergies are expected to generate. It already accounts for delayed realizations, discounts, and taxes. It is the value added to the target’s overall valuation.

Step 4: Add PV of Synergies to Target’s Valuation

Once the post tax PV synergies are calculated, they get added to the target’s valuation. This combined number shows what the company is worth to the buyer beyond tangible and intangible assets and liabilities in purchase price allocation (PPA).

The total valuation number is the ceiling for the maximum price the buyer is willing to pay. Let us incorporate this practice using the numbers from previous examples:

Example:

Say our target company’s final valuation using a discounted cash flow (DCF) model is $3,000 million. The target’s valuation with the synergies built in would then be:

$3,000 + $734 = $3,734 million

If the buyer pays more than $3,734 million, it gives away the synergy value to the target’s shareholders. This would reduce or eliminate the buyer’s expected value creation from a deal, but it does not automatically mean the buyer is losing money. The buyer could still gain additional strategic benefits not captured in the model.

The buyer also paid a $734 million premium. This means it paid $734 million above the target’s fair market value.

This premium does not become goodwill in full. Theoretically, Goodwill = Purchase Price - Fair Value of Identifiable Net Assets Acquired, but part of the premium is often allocated elsewhere first.

During purchase price allocation, some of the value may be allocated to identifiable intangible assets, such as customer relationships, brands, or technology.

Whatever remains after the allocation becomes goodwill on the balance sheet, appearing as a separate line item.  

A few things to keep in mind:

• Buyers do not always pay the full synergy value. Risks and uncertainty about the business’s future often hold that price back.
• A target’s standalone value should be estimated separately from any expected merger synergies. Synergies are typically built into the buyer’s transaction valuation. The buyer may share some of that value with a seller through a premium.
• The $3,734 million in this example is the most the buyer is willing to pay before the deal evolves financial negatives. It is not necessarily what the buyer wants to pay.

Common mistakes in Synergy Capitalization

Calculating and valuing synergies is a multi-tiered process of assumptions. This is why mistakes are commonly made in M&A transactions when synergies are involved.

Common mistakes:

• Overestimating synergies → buyers sometimes inflate synergies to strengthen their bid for a seller. This mistake is so common that studies show announced synergies are often realized lower than expected. This is especially true for revenue synergies.
• Overlooking dis-synergies → not accounting for merger losses, like client drop-off or executives leaving, can distort synergy estimates.
• Incorrect discount rates → using the WACC of one firm instead of both in a deal can result in unreliable synergy values.
• Ignoring culture → treating company culture as a minor factor in synergy capitalization can lead to synergies that take longer to realize than expected.
• Forgetting integration costs → not accounting for merger costs, like severance, advisory fees, or IT system upgrades, can inflate synergies.
• Double counting synergies → counting the same synergy value more than once, like adding cost savings into both the buyer’s standalone projections and the deal’s synergy schedule, can inflate a deal’s perceived value.

Conclusion

Synergy capitalization in purchase accounting is a method financial professionals use to quantify the extra value a merger creates. It is used across many M&A transactions. It is prominent in corporate finance, investment banking, and even private equity.

Synergy valuation is based on estimating future cost savings, revenue growth, and improved capital structure gains. These savings and gains are discounted back to their present value. This value is then added to the target company’s valuation, giving it a value beyond its assets and liabilities.

Synergies are not a distinct asset, so they are not recorded as their own line item. They are often reflected in goodwill after identifiable assets and liabilities are allocated during purchase price allocation. If synergies do not materialize as planned, this can show up later through a goodwill impairment charge, signaling that the acquired business did not perform as expected.

Although synergy capitalization is widely used to gain an extrinsic value of a merger, it has its drawbacks. It is widely based on assumptions, and synergies are subject to bias or errors.

Because of this, synergy valuation is often used alongside DCF modeling and precedent transaction analyses. This creates a bigger picture for a deal’s full value.

Analysts must carefully consider the strengths and weaknesses of synergy capitalization in purchase accounting to make sound M&A decisions.

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