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Investment Banking Interview Guide, Advanced Merger Model – Quiz Questions

Answers in bold.

Table of Contents:

• Purchase Price Allocation and Sources & Uses

• Transaction Structures
• Net Operating Losses (NOLs) and Deferred Taxes
• Synergies
• Noncontrolling Interests, Equity Interests, and Divestitures
• Deal Structures and Legal Points
• More Advanced Analysis and Special Cases

Purchase Price Allocation and Sources & Uses

1. Which of the following statements below are TRUE regarding Purchase Price
Allocation (PPA) in a merger model?
a. The main purpose of PPA is to make the combined Balance Sheet balance
b. The PPA process requires all assets on seller’s Balance Sheet to be updated
from book value to fair market value (i.e. asset write-ups)
c. PPA allocation is required to determine how much of purchase price is
allocable towards assets – both tangible and intangible – with remaining
amount being allocated to Goodwill
d. The final numbers used for asset write-ups and intangibles created are the
responsibility of accountants and appraisers, not investment bankers
e. None of the above
i. Explanation: All of the statements above are true. A PPA is always
done in M&A transactions for a variety of reasons. One is that without
the PPA exercise, the combined Balance Sheet pro-forma will not
balance (as certain assets have been written-up or down and the entire
Shareholder’s Equity of seller has been wiped out). Also, US GAAP
and IFRS require that in business combinations, the selling company’s
Balance Sheet Assets and Liabilities all be re-recorded at current fair

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market value (as opposed to carrying value which approximates

historical cost basis). The by-product of the PPA is determining what
the new Goodwill balance will be on the combined Balance Sheet.
Finally, the ones who actually identify fair market value for each
individual Asset and Liability on the seller’s Balance Sheet are always
the accountants and appraisal / valuation specialists, NOT the actual
IBD Analysts or Associates. Investment bankers may make estimates
for these figures in merger models, but are not responsible for the final
numbers used in the deal closing documents.

2. Which of the following statements below are NOT true regarding the formula for
calculating Goodwill?
a. The seller’s Book Value (Shareholders’ Equity) is subtracted out when making
the calculation
b. The seller’s existing Goodwill is ‘reset’ to zero and you add it when making
the calculation
c. Asset write-ups are subtracted out of the calculation and reduce the amount
of purchase price allocable to goodwill
d. The seller’s existing deferred tax liabilities (DTLs) are written down to zero
and thus subtracted out of the calculation
e. None of the above – i.e. ALL of the statements above are true
i. Explanation: All of the statements above are true. Although already
provided in the M&A Guide, the full formula for reference purposes is
provided here: Goodwill = Equity Purchase Price – Seller Book Value +
Seller Existing Goodwill – Asset Write-Ups – Seller Existing DTLs +
Write-Down of Seller Existing DTA + Newly Created DTLs. You may
also factor in a few other items like the Elimination of Inter-Company
AR and AP. A couple key items to note are the following: 1) The
seller’s book value of equity is NOT added to buyer’s but rather zeroed
out and replaced by the new equity purchase price; 2) The seller’s
existing Goodwill is ‘reset’ to zero and recalculated based on purchase
price allocation done as part of M&A analysis; 3) Asset write-ups
decrease the amount of purchase price allocable to Goodwill; and 4)

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The seller’s existing DTLs are normally written down to zero and new
DTLs are added in the calculation.

3. Which of the following statements regarding the treatment of Deferred Revenue in

an M&A scenario are FALSE?
a. The seller’s deferred revenue balance is always written down immediately
when the transaction closes
b. Only the “profit portion” of the seller’s deferred revenue can be recognized
post-transaction
c. The seller’s deferred revenue may be written down over a number of years
d. Deferred revenue write-downs, just like asset write-ups or write-downs,
always impact the Goodwill created in an M&A deal
i. Explanation: B and C are both true, while A and D are both false. The
correct accounting treatment for the seller’s deferred revenue is to
ONLY write-down the expense portion, and thus only the profit
portion may be recognized by the buyer. It is also true that that same
expense portion of seller’s deferred revenue can be written down over
a number of years; usually practitioners write-down the value to zero
within a 1 to 2 year period. A and D are false because deferred revenue
is usually written down over a number of years rather than at
transaction close – so it may or may not affect Goodwill.

4. Which of the following statements below are TRUE regarding Deferred Tax
Liabilities (DTLs) and Deferred Tax Assets (DTAs)?
a. Asset write-ups and write-downs are the reason why DTLs and DTAs get
created in M&A transactions
b. An asset write-up results in the creation of DTAs, since it’s a tax benefit for
you, while asset write-downs result in the creation of DTLs, since you’ll owe
taxes
c. Asset write-ups result in a higher book depreciation expense, and therefore
the company will pay higher CASH taxes in the future until the book and
tax depreciation numbers equalize
d. Only asset write-ups on tangible assets (i.e. PP&E) create DTLs

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i. Explanation: Answer choice A is correct and is the main explanation

for why DTLs and DTAs get created in M&A transactions. Answer
choice B is incorrect and should be the opposite way around – that is,
asset write-ups create DTLs and asset write-downs create DTAs, and
not the other way around. Answer choice C is correct as well; DTLs are
the by-product of higher depreciation from the asset write-up, which
can be deducted for book purposes, but not for true cash tax purposes.
Answer choice D is false in that BOTH tangible AND intangible asset
write-ups result in DTLs being created.

5. Which of the following statements are TRUE regarding the treatment of the seller’s
Debt and Preferred Stock in a merger model?
a. You can build an option to repay these items in the merger model
b. Preferred Stock must always be paid off, but Debt could go either way
c. Acquirer Co. can simply assume the debt of the target in the Sources &
Uses section of the model
d. If you repay Target Co.’s debt, this will increase the funds required to
purchase the seller
i. Explanation: Answer choices A, C, and D are correct. Basically, when
the target already has debt outstanding, there are two ways to treat
this in an M&A model: 1) Buyer simply assumes the outstanding debt
of seller or; 2) Buyer pays off in full outstanding debt of seller. In the
latter case, this requires additional funds so the effective purchase
price increases for the target company. If the buyer simply assumes the
seller’s debt, then this item shows up in the Sources & Uses section of
the M&A model. It should be noted that most debt has provisions in
their indenture that requires the repayment in full in a ‘change-of-
control’ situation. B is false because the treatment of Preferred Stock
and Debt is the same – they may be repaid, or the buyer may simply
assume them, in which case there are no net changes.

6. Which of the following statements is correct regarding the treatment of transaction

and financing fees in a merger model?

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a. Transaction Fees = expenses as incurred; Financing Fees = expensed as

incurred
b. Transaction Fees = capitalized and amortized periodically; Financing Fees =
expensed as incurred
c. Transaction Fees = expensed as incurred; Financing Fees = capitalized and
amortized periodically
d. Both Transaction Fees and Financing Fees capitalized and amortized
periodically
i. Explanation: The correct answer choice is C. This is somewhat of a
trick question because financing fees are treated differently from
transaction fees. First, it should be noted that financing fees are
associated with debt issued to finance the acquisition, whereas
transaction fees typically consist of legal and financial advisory fees
(AKA investment banker fees). From an accounting standpoint the
nature of these two expenses are different, because a transaction only
takes place once but debt lasts for many years, and so GAAP and IFRS
call for different treatment. GAAP and IFRS require transaction fees to
be expensed immediately, and thus both Cash and Retained Earnings
will be reduced on the Balance Sheet. On the other hand, financing fees
are required to be capitalized as an asset on the Balance Sheet and
periodically amortized each year (somewhat similar to the treatment of
capitalizing PP&E as an asset and periodically reducing its book value
via Depreciation).

Transaction Structures

7. In M&A, the buyer typically prefers to structure deals as “Stock Purchases,” whereas
the seller typically prefers to structure deals as “Asset Purchases.”
a. True
b. False
i. Explanation: The correct answer choice is B; this statement is false. In
fact, the correct statement is the other way around – that is, buyers
prefer asset purchases whereas sellers prefer stock purchases. A big
reason, among others, for this has to do with the tax implications for

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the buyer – in an asset purchase the buyer will be able to step-up the
tax basis of assets (primarily PP&E) which will result in additional
depreciation on tax books and thus less cash taxes paid. Also, a buyer
prefers an asset purchase because it can specify which specific assets
they want and do NOT have to assume all the seller’s liabilities. On
the other hand, sellers almost always prefer to structure the sale as a
stock purchase, in which case the buyer will own all assets and
assume all of seller co.’s liabilities. Another way to think about this: if
the seller structures the deal as an asset purchase, then the seller will
no longer own the cash-flow producing assets and will be stuck with
liabilities that it will otherwise not be able to pay off, since it no
longer owns cash flow-producing assets which can pay off the
liabilities of the company.

8. In which types of deal are assets written up to fair market value for BOTH book and
tax purposes?
a. Stock Purchase
b. Asset Purchase
c. 338(h)(10) Election
i. Explanation: Assets are always written up to fair market value for
book purposes in an M&A deal, so that part is true for A through C
above. However, they are only written up for tax purposes in Asset
Purchases and 338(h)(10) Elections, meaning that buyers can only
deduct the new Depreciation & Amortization from those written-up
Assets for tax purposes in those deal types. In a Stock Purchase they
are not written up for tax purposes and no tax deductions for those
items are allowed.

9. Which of the following are likely to happen if the buyer and seller reach a
compromise in an M&A deal and decide to use a 338(h)(10) Election?
a. The buyer acquires all the seller’s Assets and Liabilities, plus all off-
Balance Sheet items
b. A Deferred Tax Liability (DTL) gets created on the combined company’s
Balance Sheet

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c. The seller pays higher taxes since it owes taxes on the purchase price, plus
gains on Assets
d. The buyer is likely to pay a slightly higher price to the seller to compensate
it for the increased tax savings the buyer can realize
i. Explanation: A 338(h)(10) deal is a blend of a traditional Stock
Purchase and Asset Purchase, and just like with a Stock Purchase, the
buyer acquires all Assets, Liabilities, and off-Balance Sheet items of
the seller. The tax treatment, however, is the same as with an Asset
Purchase: the seller pays taxes on the purchase price plus gains on
Assets, and the buyer can write up acquired Assets for tax purposes
and deduct D&A for cash tax purposes. No DTL is created since
Assets are written up for both book and tax purposes, so B is false. D
is true because while it’s not an official requirement, buyers often do
end up paying slightly higher prices to sellers to compensate them
for the double taxation they have to deal with and the fact that the
buyer can deduct D&A from Asset Write-Ups, which saves it on
taxes.

Net Operating Losses (NOLs) and Deferred Taxes

10. You always create a new Deferred Tax Liability in all M&A deals with: (PP&E
Write-Up + Intangible Assets Created) * (1 – Tax Rate).
a. True
b. False
i. Explanation: This is false because you only create DTLs in a “stock
purchase,” where the buyer acquires all assets, liabilities, and off-
balance sheet assets and liabilities of the seller. In an asset purchase
you do not create a DTL based on this formula because assets are
written up for both book and tax purposes, so there is no difference
between D&A on the book and tax versions of the statements, and the
taxes and Net Income are the same.

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11. Acquirer Co. purchases Target Co. for $500 million. The highest adjustable long-
term tax-exempt rate over the past 3 months is 5%. Target Co. has $75 million in Net
Operating Losses (NOLs). Which of the statements below are TRUE?
a. You would apply IRC Section 382 to determine how much of the seller’s
NOLs are usable each year
b. The maximum usable amount of the seller’s NOLs each year is $25 million
c. The usable amount each year does NOT depend on the equity purchase price
d. The usable amount each depends on whether it’s a stock, asset, or
338(h)(10) deal
e. It will take a total of 3 years, minimum, to use up all of the seller’s usable
NOLs after transaction close
i. Explanation: A, B, D, and E are all correct, while C is false. In general
there are two ways to calculate NOLs; however, in M&A situations
only the Section 382 method provides accurate guidance on NOL
usage. As per Section 382, the max amount of seller’s NOLs that can be
used per year is equal to the equity purchase price times the highest
adjustable long-term tax-exempt rate of the past 3 months. In this case,
that amount comes out to $25 million. Therefore, the buyer can use up
to a maximum of $25 million of seller’s NOLs to offset its own taxable
income when the two companies combine. As the seller has a total of
$75M in NOLs, if buyer uses the max allowable under Section 382,
within 3 years all of seller’s NOLs will have been used up. D is correct
because NOLs may be written down in asset or 338(h)(10) deals, while
they are not written down in stock deals. C is INCORRECT because
the usable amount always depends on the equity purchase price,
according to Section 382.

12. Which of the following statements are TRUE regarding how a deferred tax liability
(DTL) changes post-acquisition due to an asset write-up in a stock deal?
a. The seller’s existing DTLs are typically written-down to zero to ‘reset’ its
tax basis
b. The seller’s PP&E is usually written-up to fair market value, resulting in
the creation of new DTLs post-acquisition

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c. DTLs are also created when book and tax Depreciation & Amortization are
identical
d. DTLs always get created in stock deals, but never get created in asset or
338(h)(10) deals
i. Explanation: A and B are both correct, for the reasons stated. B results
in new DTLs because an asset write-up results in cash taxes that are
higher than book taxes, which is exactly the scenario that a Deferred
Tax Liability represents. C is incorrect because DTLs are not created
when future book and cash taxes are the same. D is a trick answer
choice – yes, usually you get DTLs in stock deals and never in asset or
338(h)(10) deals. However, if there are no asset write-ups or write-
downs in a stock deal, you will not get DTLs. That is admittedly a
rare scenario, but it is possible, so D is incorrect because of the word
“always.”

13. ACME Co. just purchased Target Co., its main competitor. Target Co. has $100
million of PP&E on its Balance Sheet, and it will be written-up by 20%. Target Co.
also has other long-term assets on its books at $50 million that need to be written-
down by 10% post-transaction to reflect fair market value. ACME Co.’s tax rate is
40%. What is the dollar amount of the net Deferred Tax Liability that will be created
as part of this acquisition?
a. $8 million
b. $2 million
c. $6 million
d. Not enough information to calculate
i. Explanation: The correct answer choice is C. The rule to keep in mind
is that asset write-ups result in deferred tax liabilities (DTLs), whereas
asset write-downs result in deferred tax assets (DTAs). We know from
the question that Target Co.’s PP&E will result in an asset write-up,
whereas its other long-term assets need to be written down. The other
formula to keep in mind is that DTA = Total Asset Write-Down * Buyer
Tax Rate and DTL = Total Asset Write-Up * Buyer Tax Rate. We have a
$20M asset write-up and a $5M asset write-down, for a net write-up of
$15 million. $15 million * 40% = $6 million.

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Synergies

14. ACME Co. sells 7,000 widgets per year in the US at an average sales price of $20. It
identifies a complementary target company that sells 3,000 widgets per year in Asia
Pacific at an average price of $5. ACME Co. believes if it acquires this target
company it can up-sell its own (more expensive) widgets to 30% of the target
company’s customers. Finally, 20% of all incremental sales revenues will go towards
total expenses associated with selling these additional widgets. What is the dollar
amount of revenue synergies that will trickle down to the combined company’s
operating income?
a. $18,000
b. $4,500
c. $14,400
d. $10,500
i. Explanation: The correct answer choice is C. This is a difficult question
because it has two parts; the first part is calculating the correct revenue
synergies from ACME Co. up-selling its products to the target
company’s customers. The second part requires reducing these total
gross revenue synergies by the expenses associated with the
incremental sales. ACME Co. wants to sell its widget – currently priced
at $20 – to 30% of the target company’s customers. Therefore, the total
revenue synergies from this deal for ACME Co. = 30% * 3,000 * $20 =
$18,000. However, this amount is just the gross amount and must be
reduced by the expense associated with these incremental sales. Both
COGS and Operating Expense for ACME Co. on these additional sales
represent 20%. Therefore, the amount of revenue synergies that will
contribute to ACME Co.’s EBIT = $18,000 (1 – 20%) = $14,400.

15. ACME Co. wants to acquire its fastest growing competitor, Target Co. Target Co has
a total of 1,000 SG&A employees, and ACME Co. wants to reduce the company’s
SG&A headcount by 10%. The all-in average compensation (including all benefits)
for SG&A employees is $120,000 per year. What is the total dollar amount of expense
synergies that ACME Co. will realize?

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a. $10 million per year

b. $12 million per year
c. $14 million per year
d. $11 million per year
i. Explanation: Simply multiply 10% by the 1,000 SG&A employees to
determine that 100 employees will be cut. 100 * $120,000 = $12 million,
so B is the correct answer. This is a relatively simple question designed
to test whether you understand the concept of an expense synergy
more than anything else.

Noncontrolling Interests, Equity Interests, Divestitures, and Calendarization

16. A buyer acquires only 25% of a seller. How would the Combined Balance Sheet be
different compared to standard M&A purchase price allocation?
a. You would still combine 100% of the target’s Assets and Liabilities with the
buyer’s Assets and Liabilities
b. You would create an account called Noncontrolling Interests for the
remaining 75% that the buyer does NOT own
c. You would create a line item called Investments in Equity Interests on the
Assets side of the Balance Sheet that represents the 25% the buyer owns
d. Deferred tax assets and liabilities would have to be incorporated into the
calculation of Goodwill
i. Explanation: The correct answer choice is C. All of the above
statements with the exception of answer choice C are false statements.
Answer choice A is false because you only use full consolidation
accounting when buyer acquires 50% or greater control of target. For
investments made between 20% to 50% ownership, the equity method
of accounting is used, NOT full consolidation accounting. Answer
choice B is false as there is no recognition of Noncontrolling Interests
(AKA Minority Interests) with the equity method of accounting.
Answer choice D is false as there would be no asset-write ups or write-
downs, since the target’s Balance Sheet items are NOT added to the
buyer’s in this case.

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17. Which of the statements below are TRUE regarding how the combined Balance
Sheet would change if the buyer purchased only 80% of the target company?
a. An item called Noncontrolling Interests would be created on the Liabilities
side of buyer’s Balance Sheet
b. Noncontrolling Interests would represent the 20% of the target company
that the buyer does NOT own
c. A purchase price allocation would NOT be done and no Goodwill recognized
d. A full purchase price allocation would be completed and 100% of the
seller’s Assets and Liabilities would be added to the buyer’s Balance Sheet
e. The Goodwill created would be based on the value for the 80% that the buyer
acquires
i. Explanation: Only answer choices A, B, and D are true statements.
Whenever a buyer purchases 50% or more control of a target company,
the buyer is required to consolidate 100% of the target co. Assets and
Liabilities to its own Balance Sheet. In this case, the buyer has control
but did not purchase 100% of the target. Therefore, an item called
Noncontrolling Interests is created on the Liabilities side of the buyers
Balance Sheet and reflects the portion of seller that buyer does NOT
own. Answer choice C is false because anytime 50% or greater
ownership is purchased, buyer must always consolidate 100% of
target’s financials into its own, and thus there would always be a
purchase price allocation and Goodwill created. E is false because you
base the Equity Purchase Price for use in the Goodwill calculation on
the value of 100% of the company, even if the buyer acquires LESS
than 100%. Be careful because that is a very tricky point.

18. We’re buying 100% of a subsidiary (SubCo.) for $1,000 in cash. SubCo has $500 in
Assets and $300 in Liabilities, and we acquire all the Assets and assume all the
Liabilities. Which of the following statements is FALSE?
a. We would recognize a $1,000 line item called “Acquisitions” under Cash
Flow from Investing (CFI) and cash would go down by the same amount
b. We would create new Goodwill in the amount of $800
c. Once we add SubCo’s $500 in Assets, $300 in Liabilities, and $800 in newly
created Goodwill, our combined Balance Sheet will balance

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d. None of the above

i. Explanation: The correct answer choice is D. All of the above
statements are true. This is an example of what happens when we
acquire a subsidiary. There would be no changes on the Income
Statement. On the Cash Flow statement, we would record the line item
“Acquisitions” under CFI, which would reduce our ending cash
balance. We know SubCo’s Asset and Liability balance, so we can infer
that its Equity balance is $200 (as A = L + SE). The newly created
Goodwill of $800 represents the difference between what we paid for
SubCo ($1,000) and SubCo’s book value of equity ($200). Once we add
SubCo’s Assets and Liabilities to our own Balance Sheet and include
Goodwill, our Balance Sheet will be in balance since the Assets side has
changed by ($500 + $800 - $1,000), or $300, and the Liabilities side has
also increased by $300. Remember that the seller’s Shareholders’
Equity still gets wiped out here.

19. The Buyer’s Fiscal Year End (FYE) is Dec. 31st and it purchases Seller, which has a
FYE of June 30th. The deal closes on Sept. 30th. Which of the following statements are
TRUE?
a. The ‘stub period’ in this example is the 3-month period from the date when
the deal closes (9/30) until Buyer’s FYE (12/31)
b. You change the Seller’s FYE (6/30) to match the Buyer’s (12/31) by adding
Q3 (Jan – Mar) and Q4 (Apr – Jun) from the Seller’s most recent FY and Q1
(Jul – Sep) and Q2 (Oct – Dec) from the Seller’s current FY
c. You would need to show quarterly financials for buyer and seller during
the ‘stub period’ (9/30 through 12/31)
d. You show the combined Balance Sheet as of 9/30 immediately after the
transaction, but may also show the combined, projected Balance Sheet as of
12/31
i. Explanation: All of the statements above are true regarding
calendarization. In an M&A context you need to make the seller’s FYE
match the buyer’s FYE. To complicate matters, there is often a 3rd date
to consider, which is the deal close date. In this example above, the
Buyer’s FY ends on 12/31 and the Seller’s FY ends on 6/30. The first

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step to consider is adding and subtracting various fiscal quarters to

make the seller’s FYE match the buyer’s. The second consideration is
the ‘stub period’, which occurs because the deal close date is different
from both the buyer and seller’s FYE. In this case the ‘stub period’ is
the 3-month period from when the deal closes until the FYE date for
the Buyer. This 3-month ‘stub period’ must be accounted for since
technically both the Buyer and Seller were one combined entity during
that period. You normally show the combined Balance Sheet when the
transaction closes, and also at the end of the combined company’s first
fiscal year post-transaction (which will match the Buyer’s FYE).

Deal Structures and Legal Points

20. Generally, would the buyer or the seller prefer to use an exchange ratio in an M&A
deal as opposed to a fixed consideration?
a. The buyer
b. The seller
c. It depends on the direction that both parties think the buyer’s stock price is
headed in
d. An exchange ratio and fixed consideration work out equally well for both
parties
i. Explanation: With an exchange ratio, a buyer promises to issue a
certain number of its own shares for each of the seller’s shares (e.g.
the seller receives 2 buyer shares for each of its shares). If the buyer’s
stock price increases, this greatly benefits the seller because it now
receives a higher effective price. If the buyer’s stock price declines, it
benefits the buyer because it now pays a lower effective price since
the total consideration is worth less. So A and B are both wrong, and
D is certainly wrong – C is correct because it really depends on the
direction that both parties think the buyer’s stock price will go in
after the transaction announcement.

21. A FIXED exchange ratio results in a variable value being received by Target Co.
shareholders but a fixed ownership split, but the FLOATING exchange ratio results

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in a fixed value being received by Target Co. shareholders but a variable ownership
split post-acquisition.
a. True
b. False
i. Explanation: The correct answer choice is A. In general, there are two
different types of exchange ratio structures for all-stock deals: fixed
and floating. A fixed exchange ratio means that regardless of how the
Acquirer Co.’s stock price fluctuates from deal announcement to
closing, the number of Acquirer Co. shares provided to Target Co.
shareholders is fixed. As a result, the deal value received by Target
Co. shareholders will be uncertain because Acquirer Co. stock price
is a ‘moving target’. However, the ownership split between Acquirer
Co. and Target Co. shareholders is certain and will not change. As a
result, when using a fixed exchange ratio, the accretion / dilution
impact is known and fixed at deal announcement. On the other hand,
a floating exchange ratio means that the number of Acquirer Co.
shares given to Target Co. shareholders is not fixed and constant but
rather will fluctuate up or down based on changes in Acquirer Co.
stock price so as to provide a fixed and certain offer value to Target
Co. shareholders. Furthermore, with a floating exchange ratio the
ownership split of the combined company is not certain, and as a
result, the accretion / dilution impact of this type of exchange ratio
fluctuates between deal announcement and deal close.

22. Which of the following choices below are considered key items in a typical M&A
Purchase Agreement?
a. Reps & Warranties
b. Purchase Price
c. Valuation of the seller
d. Form of consideration
e. Strategic rationale for the transaction
f. Transaction structure
g. Break-up fees

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i. Explanation: A, B, D, F, and G are key items listed in the Purchase

Agreement. Reps & Warranties are one of the most important items
which represent claims and warranties made by both the buyer and
seller – if they are not met, the deal may be broken off. B is important
for obvious reasons, as is D. F refers to whether it’s a stock deal, asset
deal, or 338(h)(10) deal, and needs to be noted. Finally, G refers to the
fees that either party (or both parties) will pay if the transaction does
NOT go through properly. C and E, by contrast, are not actually part of
the Purchase Agreement. They will appear in the “Fairness Opinion”
issued by the banks advising the buyer and seller, but not in the actual
legal document that consummates the transaction.

23. Which of the following statements is FALSE regarding “Earnouts” and their use in
M&A deals?
a. An Earnout is a form of ‘deferred compensation’ that the buyer offers to the
seller
b. Receiving Earnout payments is contingent on the seller reaching certain
financial ‘milestones’
c. Buyers use Earnouts as a means of aligning the interest of the seller’s
management once the buyer takes over the combined company
d. Earnouts are most commonly used for publicly traded sellers
i. Explanation: The correct answer choice is D. Earnouts are primarily
offered to private sellers – it’s very difficult to get institutional
investors that own a public company to accept deferred payment for
an acquisition. Earnouts are a form of “deferred compensation,” which
is contingent on reaching certain future financial milestones. An
example would be for a buyer to offer an additional $50 million as
consideration in the form of an Earnout if the target company manages
to earn $200 million in EBITDA for the next 3 years, for instance.
Earnouts also protect the buyer from having the seller’s management
take the proceeds and run away immediately after the deal closes.

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24. Which of the following statements below are TRUE regarding contribution analysis
within the context of M&A?
a. Contribution analysis is most common for Mergers of Equals (MOEs) and
is less common if the buyer is much larger than the seller
b. It compares how much in revenue, EBITDA, etc. the buyer and seller are
contributing to the combined company to determine what the ownership
split should be
c. Contribution analysis cannot be used if stock is used to finance the deal
i. Explanation: Only answer choices A and B are correct. Contribution
analysis is most relevant for merger of equals (MOE) deals, where both
parties exchange stock and need to determine what the post-
transaction ownership split should be based on how much both buyer
and seller contribute to combined EBITDA, revenue, or other financial
metrics. Answer choice C is false – in fact, contribution analysis is
MOST meaningful for deals financed with stock because the seller only
receives ownership in the combined entity if the buyer issues stock to
acquire it.

25. Which of the following adjustments are made to GAAP / IFRS numbers when
calculating “Pro Forma” figures in a merger model?
a. Amortization of newly created intangibles
b. Amortization of capitalized financing fees
c. Deferred revenue write-down
d. Legal and advisory fees
e. Additional depreciation from PP&E write-ups
i. Explanation: A, B, C, and E are all correct. All that is meant by “Pro
Forma” numbers in a merger model is that certain non-cash acquisition
effects are excluded from the calculation. Answer choices A, B, C, and
E all represent not only acquisition effects but are also all non-cash,
and thus excluded in the Pro Forma numbers. Answer choice D is
definitely an acquisition effect, but it is paid out in cash immediately
and deducted from Retained Earnings. Hence, since it is an actual cash
expense and since it does not impact the Income Statement at all, it is
excluded from Pro-Forma numbers.

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