A merger model is a pro forma consolidation that translates a term sheet into earnings, cash flow, and balance sheet outcomes. Think of it as the scorecard for how a deal will hit your P&L and cash, not the tool that sets the sticker price. Purchase price allocation is the accounting bridge that assigns the price you pay to tangible and intangible assets and to goodwill, while accretion and dilution tell you how the deal lands on per share metrics.
In practice, the payoff is clear: a well built merger model gives decision makers confidence on price, structure, accretion, ratings, and closing certainty, and it surfaces the few variables that actually move value so you can negotiate and execute with focus.
What a Merger Model Actually Answers
A merger model addresses three questions that matter to boards and investment committees. First, who pays what and in what form. Second, how the combined entity will report under GAAP or IFRS. Third, whether the deal clears the credit and equity hurdles, including closing certainty, ratings, and EPS optics. Valuation tools such as a DCF, an LBO, and trading or transaction comps set the price. The merger model then tests the structure and the accounting against timing, cost, and risk.
Six Mechanics Interviewers and Models Focus On
Six mechanics drive most interview questions and most modeling misses: purchase price and sources and uses; business combination accounting; pro forma construction and adjustments; financing and share issuance; accretion or dilution and value creation; and tax and structuring levers. Nail these, and your model will hold up under diligence and public scrutiny.
Price, Sources and Uses, and Ownership Math
Always start with equity value paid to sellers and what you refinance. Enterprise value can triangulate, but real cash leaves based on equity value and the uses you commit to pay at close.
Uses include equity consideration, debt payoffs and make wholes, preferred redemptions, change of control costs, option and RSU settlements, transaction fees for both sides, and any cash added back to the target’s balance sheet for optics. Leases usually carry, and you do not write a check at close for operating lease liabilities except in targeted remeasurements.
Sources include new debt tranches, acquirer stock if used as consideration, seller rollover equity, target cash if permitted for fees or paydowns, and pre close asset sale proceeds. Fees matter for EPS and covenants. Capitalize debt fees and amortize them to interest expense. Reduce APIC for equity issuance costs.
Share math sets dilution. Fixed exchange ratios lock share count at signing and let value float with the acquirer’s stock price to closing, shifting market risk to both sides. Fixed value deals flex the ratio and shift dilution risk to target holders. Collars and walk away rights cap pain and should sit in your sensitivities. For options and RSUs, decide if they vest and cash out or are assumed and rolled, since that choice drives cash, share count, and post close comp expense.
Rollover equity reduces cash paid and can be preferred or common with bespoke terms. Earnouts and contingent consideration, common in carve outs and growth assets, should be recorded at fair value at close. If liability classified, remeasure them through earnings after close, which adds EPS volatility you must communicate.
Always reconcile sources and uses to the flow of funds. Build a clean waterfall for cash to common, options and RSUs, debt and accrued interest, make wholes, transaction taxes if any, fees, and residual cash. The working capital peg and true up are post close items. Treat them as timing unless fixed by agreement. Include consent fees for debtholders if change of control consents are needed.
Let the paperwork drive your inputs. The merger agreement governs price, consideration, collars, pegs, and award treatment. Debt commitment and fee letters set net proceeds, OID, ticking fees, and flex. Indentures and credit agreements specify change of control and make whole formulas. Equity plans determine vesting, and regulatory approvals determine timing and hedging needs. For accounting bases across regimes, see IFRS 3 vs ASC 805 for common differences.
Business Combination Accounting You Cannot Skip
Acquisition accounting under ASC 805 and IFRS 3 requires fair value at the acquisition date. Identify the acquirer, measure consideration at fair value, then allocate value to assets and liabilities.
- Consideration at close: Cash is straightforward. Stock is measured at closing price. Contingent consideration is recorded at fair value and may be liability or equity classified. Liability classification triggers P&L remeasurement.
- Identifiable intangibles: Value customers, technology, trade names, and backlog. Assign useful lives and straight line amortization. Goodwill is the residual. It is not amortized, but it is tested for impairment, which matters for ratings and covenants.
- Inventory step up: The step up runs through COGS as inventory turns. Model burn off by turns to capture near term margin pressure.
- Deferred revenue haircut: Acquired contract liabilities reflect only remaining performance obligations. That often reduces deferred revenue and near term revenue, which can make subscription deals look soft early.
- Leases and debt: ROU assets and lease liabilities carry over. Debt marks to fair value and accretes to par. If you refinance at close, old debt is extinguished and new debt is booked at issue price.
- Deferred taxes: Step ups often create DTLs, while NOLs and credits create DTAs. Compute by jurisdiction using enacted rates. Net DTAs and DTLs often explain a large share of goodwill.
- Noncontrolling interests: Record at fair value when you own less than 100 percent, and split income accordingly.
Public pro forma rules constrain what you can show. SEC Article 11 allows adjustments that are directly attributable, factually supportable, and expected to continue. Build two views: an Article 11 GAAP pro forma and a management view with run rate synergies and costs to achieve for governance and investor messaging.
Constructing the Pro Forma Without Surprises
Sequence matters for clarity and accuracy. Start with clean standalone forecasts for both companies and normalize out non recurring items using QoE work. Then layer the PPA, including intangible amortization, inventory step up burn off, debt fair value accretion where material, and any deferred revenue haircut.
Next, add financing. Model interest on new debt, amortization of OID and fees, revolver swings and hedges, and if issuing stock, update shares and dividends. Link your revolver to free cash flow so liquidity is realistic, and maintain a simple debt schedule that breaks out tranches.
Then add synergies and dis synergies with a ramp, costs to achieve, and clear placement across COGS and opex. Avoid double counting with PPA amortization. For structure changes, carve outs require standalone costs and TSA fees. Equity accounted holdings may flip to consolidation, which changes optics. Taxes come last. Compute the effective tax rate with interest limits and permanent differences, and model deferred versus cash tax timing. Finally, tie out the balance sheet. Close cash equals sources and uses, and goodwill equals consideration plus NCI plus fair value of any previously held interest, less the fair value of net identifiable assets.
Financing and Share Issuance Drive EPS More Than You Think
Financing choices often swing accretion more than the purchase multiple. For debt, break out tranches, base rates, spreads, floors, resets, and forward curves. Include ticking and commitment fees and OID amortization. Model amortization, call protection, make wholes, and cash sweeps. If cash is trapped abroad, gate availability for paydown. Capitalize issuance costs and amortize them to interest expense. If you have a bridge, include step ups and the bond take out path with timing and fees. Show leverage on covenant, rating agency, and economic bases, including leases and pensions where relevant.
For equity, compute new shares via the exchange ratio for stock consideration. For cash deals, adjust diluted shares for option settlements and any equity raise. Options and RSUs may cash out or convert to acquirer awards; the treasury method applies to EPS post close, not to shares issued for consideration. For preferreds and hybrids, capture coupon, participation, convertibility, and EPS treatment under the two class method. Confirm dividend and buyback pauses in covenants, since freezes change per share math.
Finally, trace rating and covenant interactions. Project leverage and coverage on reported and adjusted definitions, and sensitize one notch downgrades on interest cost. Maintain a revolver roll forward with any borrowing base or springing tests, and respect minimum cash that cannot be swept.
Accretion, Dilution, and Real Value Creation
EPS accretion sells a deal, but it does not guarantee value. Show GAAP and adjusted EPS, with an explicit reconciliation. Compute unlevered and levered free cash flow, and consider per share free cash flow in stock deals. Measure ROIC against WACC using fair value invested capital, including goodwill. If steady state ROIC cannot clear WACC, set a synergy hurdle and clock. For capital allocation discipline, compute IRR to the acquirer, including earnouts and planned divestitures. Use sensitivities on purchase multiple, synergy ramp and realization, cost of debt and base rates, tax rate, and revenue retention. Build a simple value bridge to show whether accretion comes from financing, tax shields, amortization add backs, or genuine operating gains. If accretion leans on accounting add backs or a low tax rate, label that fragility clearly. For contingent payouts, review earnout valuation considerations to price and communicate risk.
Tax and Structuring Levers That Move Cash
Structure and local rules shape cash taxes and accretion. Asset deals and 338(h)(10) or 336(e) elections can create a step up and Section 197 amortization over 15 years. Value that shield in ROIC and IRR. NOL usage can be capped under Section 382 after ownership changes, and state rules vary. Section 163(j) limits net interest deductions to a percentage of ATI, which can lift cash taxes for leveraged, low margin assets. Cross border flows add withholding on interest, dividends, and royalties, where treaties can help. Pillar Two minimums may raise the effective tax rate for large groups. Integration often moves IP and services, so build royalties or cost sharing and the advisory costs if APAs are likely. In Up C and partnership deals, TRAs share tax benefits with legacy owners, so model those cash outflows.
Reporting, Controls, and Timing Impacts
Consolidation is driven by control, while equity method stakes remain below operating income. For US registrants, build SEC Article 11 pro forma with clear bases for all adjustments. Track goodwill impairment headroom by reporting unit, since impairment can affect tangible net worth covenants and ratings outlook. Acquired leases lift ROU assets and liabilities, and you should include ROU assets in invested capital for ROIC. Plan for lease modifications as integration proceeds. Regulatory reviews determine timing between signing and closing. Build timing ranges and include ticking fees, hedges, and interim operating covenants that may limit actions.
Risks, Edge Cases, and Practical Kill Tests
Synergies should not be credited until supported by contract level or site level proof. Front load costs to achieve and push the benefit ramp when approvals or union talks are required. Software and subscription deals will see early revenue softness from a deferred revenue haircut, and consumer or industrial targets often suffer a few quarters of margin pressure from inventory step up. Liability classified earnouts can move earnings and should be flagged in adjusted EPS. Working capital can spike post close as terms reset, so build a bridge and test revolver headroom under stress. Pensions, OPEB, and cyber remediation can be material cash drags.
- Kill test 1: Steady state ROIC fails to clear WACC without synergies on a reasonable timeline.
- Kill test 2: Leverage or coverage breaches covenant or rating headroom under a mild downturn.
- Kill test 3: Share issuance and collars create dilution no synergy plan can offset with reasonable confidence.
A Practical QA Pack Investment Committees Expect
Beyond the math, an IC ready pack proves your model is traceable, comparable, and decision useful. Include three elements that add credibility fast.
- Traceability map: A one page map from term sheet to model inputs, with document citations for price, consideration, fees, and award treatment.
- Earnings bridge: A clean earnings bridge from reported results to pro forma, separating PPA, financing, and operational drivers.
- Liquidity drill: A 12 month weekly cash view tied to the revolver, springing tests, and minimum cash policies so treasury can run Day 1.
Implementation Roadmap and Ownership
Ownership makes the difference between a good model and a good deal. Early stage, build a shell model from teaser or CIM with baseline price and financing cases. Owner is the deal team with inputs from coverage. From IOI or LOI to exclusivity, load QoE adjustments, standalone costs, an initial PPA proxy, synergy ranges, and regulatory timing. Owner is the deal team with FP&A; advisors include accounting diligence, tax, and legal. During confirmatory diligence, lock financing, refine PPA with third party valuations, and prepare SEC pro forma if relevant. Owners are the deal team and controllership. From signing to close, update for interim results, finalize exchange ratio and share count, prepare the opening balance sheet, and load TSA charges and integration budgets. Owners are controllership and treasury. Day 1 to 100, complete PPA within the measurement period, track synergy realization and costs to achieve, and update bank cases and covenant forecasts. Owners are IMO and FP&A. If closing certainty is at risk, understand reverse termination fees and walk away protections early.
Small Numerical Illustration
Assume you pay 1,000 cash for 100 percent of a target with 100 cash, 200 debt, and a 50 working capital deficit. Uses are 1,000 to equity, 200 debt payoff, and 30 fees. Sources are 1,000 new debt and 230 acquirer cash. The PPA includes 300 intangibles amortized over 10 years, 50 inventory step up, and a 60 DTL at 20 percent. Goodwill is the plug. Year 1 includes 30 amortization and a one time 50 COGS hit as inventory turns. At a 7 percent blended cost on 1,000 new debt, interest is 70, partly shielded by taxes. If you realize 20 of a 40 synergy plan in Year 1 with 30 costs to achieve, GAAP EPS may be soft while adjusted EPS trends positive. Cash EPS improves as the inventory burn off ends and synergies ramp.
Close the Loop With Data, Controls, and Retention
Close the loop by archiving the full record. Index versions, Q&A, user access, and immutable audit logs. Hash files, apply retention, and obtain vendor deletion plus a destruction certificate. Legal holds override deletion. For repeatability, document model checks, including three statement tie outs, cash flow sign tests, and sensitivity sweeps. When possible, reuse your three statement model layout so reviewers navigate quickly.
Conclusion
A merger model is the disciplined link between valuation and decision. Build it to reflect consideration, accounting, financing, taxes, and timing, then judge the deal on ROIC, free cash flow, and resilience. If the model is traceable and the kill tests pass, you have a deal you can sign, finance, and explain.