Two buyers want your shops. Why can both pay more than they're worth?
The story so far Your DCF and your comps both say your bike shops are worth about $660,000 (Lessons 15.1 and 15.2). Word gets out, and now two buyers are bidding. The bike chain raises its offer to $700,000; it says it can save $20,000 a year by running your shops with its own. A private equity firm offers $660,000, and says it will borrow most of the money. This lesson shows how each buyer does the math, and why neither is crazy.
Mergers and acquisitions (M&A) are deals where one company buys another or two combine. A leveraged buyout (LBO) is a purchase paid for mostly with borrowed money.
Companies buy others to grow faster or cut costs. Private equity firms buy companies to improve them and sell them a few years later at a profit.
Start with what the target is worth on its own, add the value of combining, and decide how much to pay with cash, debt or stock.
M&A bankers advise buyers and sellers and run the sale. Private equity associates build LBO models to decide what to bid. Corporate development teams find companies for their employer to buy.
What you're looking at: why a buyer can pay more than a company is worth on its own. Your shops (blue) are worth $660,000 alone. Combined with the chain (green), they save $20,000 a year. At the 6x multiple from Lesson 15.2, those savings are worth 6 × $20,000 = $120,000. That extra is the overlap.
Buying a company is buying its future cash.
Everything from Lessons 15.1 and 15.2 still applies: a company is worth its future cash. A deal adds two questions. What extra value does the buyer create? And how is the buyer paying?
Mergers and acquisitions
In an acquisition, one company, the acquirer, buys another, the target. In a merger, two companies combine into one. Together they're called M&A. Before any deal closes, the buyer does due diligence: a deep check of the target's books, contracts and risks.
- Acquirer
- The bike chain (or the private equity firm).
- Target
- Your two bike shops.
- Due diligence
- The buyer checks your three financial statements, your $40,000 loan and your shop leases.
The control premium
Owners rarely sell at today's price; why would they? Buyers usually pay more than the company's current value to get control. That extra is the control premium. For public companies it's often 20% to 40% above the share price.
- The chain's offer
- $700,000 − $660,000$660,000 = $40,000$660,000 = about 6%.
- A public company
- A stock trades at $20, and a buyer offers $25 a share: $25 − $20$20 = a 25% premium.
Synergies: why buyers can pay more
How can the chain pay more than your shops are worth? Because together they'll make more than apart. That extra value is synergies: cost savings, like buying parts in bulk or sharing one accounting team, or extra sales. The most a buyer should pay is the target's own value plus the synergies. Pay more, and the buyer loses value.
- Synergies
- $20,000 a year of savings × the 6x multiple = $120,000.
- The chain's most
- $660,000 + $120,000 = $780,000. Paying $700,000 still leaves the chain $80,000 ahead.
Promised synergies often don't fully arrive, and many studies find most acquirers end up paying too much. Experienced buyers count only the savings they're sure of.
Two kinds of buyers
A strategic buyer is a company in the same or a related business, like the chain. It can get synergies, so it can often pay more. A financial buyer, usually a private equity (PE) firm, buys companies to improve them and sell them, usually 3 to 7 years later.
The leveraged buyout
PE firms usually pay with mostly borrowed money. That's a leveraged buyout (LBO). The loan sits on the company being bought, and the company's own cash pays it down. When the firm sells, it keeps whatever is left after repaying the debt.
- The PE firm buys
- Price $660,000 (6x your $110,000 EBITDA). It borrows 60%, $396,000, and puts in $264,000 of its own money.
- Over 5 years
- To keep the math simple, say the shops produce $200,000 of cash after interest. All of it pays down the loan: $396,000 − $200,000 = $196,000 left.
- The sale
- EBITDA grows to $140,000. At the same 6x: 6 × $140,000 = $840,000.
- The firm keeps
- $840,000 − $196,000 of debt = $644,000.
Measuring the return: MOIC and IRR
PE firms judge a deal two ways. The MOIC (multiple on invested capital, say "moe-ick") is money out divided by money in. The IRR (Lesson 13.2) is the yearly return that turns money in into money out. Two quick rules: doubling your money in 5 years is about 15% a year; tripling it is about 25%.
- With 60% debt
- $644,000$264,000 = 2.44x in 5 years, an IRR of about 19.5%.
- With no debt
- Put in all $660,000, keep the $200,000 of cash, sell for $840,000: $1,040,000$660,000 = 1.58x, an IRR of about 9.5%.
Debt cuts both ways
Debt makes the return bigger because the firm uses less of its own money, but the lenders still only get their fixed amount back. In a bad year, the same debt makes losses bigger, and if the company can't make its payments, the owners can lose everything. Toys "R" Us was bought in a $6.6 billion LBO in 2005; buried in debt, it went bankrupt in 2017 and closed its U.S. stores in 2018. Slide the debt and compare a good case with a bad case.
- Bad case
- EBITDA falls to $70,000, so the shops sell for 6 × $70,000 = $420,000. With 60% debt, the firm gets back $420,000 − $196,000 = $224,000 of its $264,000: 0.85x, a loss.
What you're looking at: the PE firm's MOIC after 5 years for each amount of debt. Green is the good case (EBITDA grows to $140,000); orange is the bad case (EBITDA falls to $70,000). Both assume $200,000 of cash pays down the loan. The dashed line at 1x means getting back exactly what you put in.
Two minutes. Just listen.
Tap any line to jump to it.
Deal room.
Eight questions you'd face working on a deal. Each one gives you the numbers. One try each.
What you're looking at: made-up deals. Each lists the numbers, then asks one question.
The logic, step by step.
Every buyer runs the same four checks.
Step 1: What is the target worth on its own?
- Your shops
- About $660,000.
Step 2: What are the synergies worth?
- For the chain
- 6 × $20,000 = $120,000. For the PE firm: none.
Step 3: Set the most you'd pay
- The chain
- $780,000. The PE firm: whatever price still reaches its target return.
Step 4: Decide how to pay
- The PE firm
- 60% debt: 2.44x if things go well, 0.85x if they don't.
Worked example: which offer do you take?
You have two offers on the table. Here are the facts:
- The chain: $700,000. It can afford up to $780,000 because of synergies.
- The PE firm: $660,000, with 60% debt. It wants an IRR of 20% or more.
- Your loan: $40,000. Cash in the bank: $20,000.
- Compare prices. The chain offers $700,000 − $660,000 = $40,000 more.
- Find the room. The chain could go up to $780,000 and still come out ahead, so there's up to $80,000 more to ask for.
- Check the PE firm's limit. At $660,000 its IRR is about 19.5%, just under its 20% goal. It can't raise its bid much.
- What you keep. At $700,000, you repay the $40,000 loan and keep the $20,000 cash: $700,000 − $40,000 + $20,000 = $680,000.
- The answer. Use the PE bid to push the chain higher. Ask for about $740,000, which splits the synergies with the chain: it still gains $40,000, and you get paid for value your shops help create.
Lichen: a merger that conquered rock.
A lichen looks like one living thing, but it's two: a fungus and a tiny alga living as a team. The alga makes food from sunlight; the fungus builds the body, holds water and grips the stone. Neither could survive alone on bare rock or Arctic tundra. Together they cover about 6% of Earth's land.
What you're looking at: an illustration, not data. A fungus and an alga on their own, then joined as a lichen growing on bare rock, where neither could live alone.
Why this sticks. A good merger is a lichen: each side brings what the other lacks, and together they can do something neither could alone. That extra is the synergy. A deal with no real synergy is just two companies sharing a rock.
The page you'd copy down.
- M&A: an acquirer buys a target, after due diligence.
- Control premium = offer − current pricecurrent price: $25 − $20$20 = 25%.
- Synergies: savings or extra sales from combining. 6 × $20,000 = $120,000.
- Most to pay = value on its own + synergies: $660,000 + $120,000 = $780,000.
- Strategic buyer: a company in the business, gets synergies. Financial buyer: private equity, improves and sells in 3 to 7 years.
- LBO: buy with mostly debt; the company's cash pays it down. $396,000 debt + $264,000 equity.
- MOIC = money outmoney in: $644,000$264,000 = 2.44x, IRR about 19.5%. 2x in 5 years ≈ 15%; 3x ≈ 25%.
- Debt cuts both ways: bigger wins, bigger losses (bad case 0.85x). Toys "R" Us.
Fill in the blanks
Grab a friend or a study group.
Find the synergies
Pick two real companies that could merge, like a coffee chain and a bakery chain. List every cost they could share and every new sale they could make.
Bidding war
One person sells a business worth $1 million. Two others bid: one with $200,000 of yearly synergies, one without. How high does each go?
Deal in the news
Find a recent acquisition. What premium was paid? What synergies did the buyer promise? Do you believe them?
Just you and your money.
These stay on this device. Nobody else sees them.
Exam-style questions.
Written the way a college exam would ask them. Each right answer on the first try is worth 10 xp.
On the job: you're a private equity associate
Your firm wants to buy a company that makes pet food. The partner asks if the deal works. Here's the situation:
- EBITDA today: $10 million. Price: 8x, so $80 million.
- Paid with: 60% debt ($48 million) and $32 million of the fund's money.
- In 5 years: EBITDA grows to $13 million, and the company's cash pays the debt down to $28 million.
- The fund's goal: an IRR of at least 20%.
Your task: if you sell at the same 8x, what does the fund get back? What's the MOIC? Does it reach about 20%? What if you could sell at 9x? What would you tell the partner?
See a model answer
Sale at 8x: 8 × $13 million = $104 million. Minus $28 million of debt: the fund gets $76 million.
MOIC: $76 million$32 million = about 2.4x, an IRR of about 19%: between doubling (15%) and tripling (25%), just under the goal.
Sale at 9x: 9 × $13 million = $117 million − $28 million = $89 million. $89 million$32 million = about 2.8x, an IRR of about 23%.
To the partner: at the same multiple, the deal falls just short of 20%. It only clears the bar if we can sell at a higher multiple or grow EBITDA faster, and we shouldn't count on a higher multiple. I'd try to buy at a lower price, around 7.5x, or find real cost savings before we bid.
Every deal is a bet on the future.
What you're looking at: a map of where this lesson fits in the course. Read it left to right: the lessons it builds on, this lesson in the middle, and the lesson that comes next.
- Back · Unit 13Raising money
- Back · Unit 15Valuing a company with DCF
- Back · Unit 15Comparables and multiples
- You are hereMergers and buyouts
- Next · Unit 16Who does what on Wall Street