Today, I’m going to briefly discuss one of the holy grails of corporate M&A, and the one that acquirers point to most often for justification in a strategic acquisition: synergies. Here’s how synergies are often considered and modeled in the real world.

Revenue Synergies: There are many reasons why one might think that 1+1 is going to equal 3 in an acquisition — maybe salesmen are going to cross-sell now, maybe one party has a stronger distribution channel, or maybe there will now simply be more manufacturing capacity – but how do you include this in the merger model and acquisition analysis? Very similar to what I’ve said before regarding projections, you should use a “bottom up” approach to calculate revenue synergies. Choose any of the most important metrics from the seller’s revenue model (such as average selling price, average customer value, or average units sold), goose it by a fixed percentage, and then add it to the buyer’s revenue model. You would include these calculations in a separate line item on the projected combined income statement called Revenue Synergies.

Expense Synergies: The thinking here, of course, is that 1+1 is presumably going to equal 1.5. Assumptions must be made regarding both variable and fixed expenses. The methodology will again be “bottom up”. The preferred technique is to estimate seller synergies as a percentage of seller revenues and then apply these to the combined entity. There are typically three main candidate categories for expense synergies — employees, facilities, and capital expenditures:

• For employees, a macro assumption (based on a more detailed analysis) may be made as to whether headcount falls or average expense per employee falls.

• For facilities, input from someone on the operating team should guide and inform assumptions as to when facilities will be combined and how much the resulting reduced overall facilities expense will be.

• For CAPEX, you will probably assume that the seller’s capital expenditures will fall as a result of the business combination. A percentage reduction in CAPEX should be reflected on the combined cash flow statement. Don’t forget that there will also be a corresponding reduction in related depreciation.

Add a COGS Synergies line to the model for variable expense reductions and an Operating Expense Synergies line to the model for fixed expense reductions.  Note that there may also be a need to model so-called “negative synergies” or scenarios where the combined expenses will actually go up.  Examples of this include existing customer overlap, differences in accounting, employee benefits, and conflicting suppliers.

Next time, I’ll discuss some methodology for combining the buyer and seller income statements.

Posted by: Mory Watkins