M&A Deep Dive: Mergers

Most successful companies see mergers and acquisitions (M&A) as a strategy to attain business growth quickly. Their specialized teams look for suitable target companies, mainly small- and middle-market firms, to acquire at the lowest price possible. Therefore, business owners like you must know about M&A to get the best price for your company.

What Is M&A (Mergers and Acquisitions)?

Mergers and acquisitions are different corporate strategies referring to combining two companies. The two companies’ assets, liabilities, and brand images join to leverage the benefits arising from this corporate action.

While mergers and acquisitions are often considered the same, they have distinct and important differences.

An acquisition happens when a big, financially strong company purchases a smaller or weaker company, fully or partially, to attain a controlling stake. Both the companies continue to exist as separate entities: however, the purchasing company controls the acquired company.

An acquisition may be friendly or hostile, depending on acquisition terms. Unlike a merger which usually involves share allocation, acquisition involves a cash transaction in return for the controlling stake.

Pfizer acquired Warner-Lambert for $90 billion in 2000, one of the most hostile acquisitions in history. American Home Products wanted to acquire Warner-Lambert, but it walked away, leaving behind a significant break-up fee. Pfizer swooped in.

A merger is a corporate strategy in which two companies, usually equal in size and scale, agree to combine and operate as a single legal entity. As the two companies mutually decide to merge after careful discussions and planning, there are lesser chances for hostility and chaos after the deal gets through.

The merging companies usually consider each other of equal stature and combine forces to create synergy. Mergers require more paperwork, procedures, and legal formalities as the new legal entity forms.

For example, H.J. Heinz Co. and Kraft Foods Group merged in 2016 to form The Kraft Heinz Company, the third-largest food, and beverage company in North America.

Why Mergers?

Companies enter into mergers for several reasons.

  • For instance, a business owner seeking to exit can enter into a merger transaction to ensure the well-being of employees and the continuation of the business post-exit.
  • When companies find that developing certain assets is time-consuming and expensive, they take the merger route to acquire those assets.
  • A merger helps companies benefit their shareholders. The shareholders of the merging companies receive new shares of the merged entity in exchange for their old shares.
  • After the merger, the merging companies stop competing against each other, which reduces their marketing costs. They may pass on the cost reduction benefits to their customers by lowering the prices of their products and services and, in turn, enhancing their sales.
  • A merger helps companies gain advantages such as better utilization of financial resources, the scale of operations, increased market share, entry into new markets, diversification of products and services, better planning, etc.

Merger Benefits

A merger provides many benefits to the companies in the transaction. These include:

  • Reducing the cost of operation
  • Expanding the business
  • Saving an unprofitable business
  • Avoiding duplication of products or services
  • Access to talent
  • Reducing risk.

Reducing the cost of operations: Companies achieve economies of scale after the merger. For instance, the merged company can buy raw materials in bulk and benefit from increased volume to reduce average costs. It also improves its bargaining power with suppliers. A merger can realize technical economies by using machines and investment efficiently over a larger output. The new company can also benefit from marketing economies by combining both companies’ marketing strengths, reputation, and brand images.

Expanding business. A merger enables access to a larger market share and brings economies of scope. Organic growth cannot give these economies of scale, which the newly merged entity enjoys a much larger customer base.

Saving an unprofitable business. An unprofitable business can save itself from bankruptcy by merging with a profitable company. Similarly, the profitable business can save taxes by absorbing an unprofitable company’s losses, reducing its taxable income.

Avoiding duplication of products and services. When companies producing similar products merge, they remove duplication in the marketplace and reduce costs by eliminating competition. Elimination of rivals reduces the cost of marketing and possibly production, allowing the new entity to reduce prices, making those products/services more attractive to more customers.

Access to talent. Big companies always have better access to talent. Smaller companies cannot hire the best talent because those individuals work for the big companies, which pay commensurately higher wages. By merging two companies, the resultant entity increases its recruitment power and access to the right talent.

Reducing risk. A merger leads to diversification of the new entity’s product and service portfolio or into new markets and geographical areas. Diversification and expansion spread the risk for the merged company. For example, the business may not be doing so well in one country but making enormous profits in another. So, one part of the business offsets the losses of the other. Similarly, a company operating in different niches like detergents, cosmetics, packaged foods, etc., can recover the losses of one area while others generate profits.

Merger Challenges

A merger may also bring challenges, resulting in:

  • Unemployment
  • A monopoly and increased prices
  • Communication gaps/culture clashes
  • Obstacles to economies of scale
  • Financial burdens
  • Legal and accounting costs.

Unemployment. Sometimes, the merged entity wants to eliminate underperforming assets or consolidate overlapping services and departments. That leads to jobs being cut and stressed employees. However, economists argue that the loss of employment is temporary, with employees soon moving to more efficient companies.

A monopoly and increased prices. A merger could give the new company monopoly power by eliminating competition and dominating the market. The company may manipulate the situation to its advantage by raising the prices of its products and services.

Communication gaps/culture clashes. When two companies with different cultures merge, employees may struggle to communicate effectively. The communication gap leads to a decline in employee performance. Also, two companies with opposite cultures merge, and the combined entity tries to standardize working procedures, employee morale drops as they find the working conditions different.

Obstacles to economies of scale. The combined company may not gain synergy if the merging firms have little in common. Also, as the combined company gets bigger, management may find it tough to motivate the employees and exercise control.

Financial burdens. The combined entity may incur debt due to one of the two companies’ high level of debt and later find it difficult to get rid of that debt.

Legal and accounting costs. A merger usually involves high legal and accounting costs. If the merger transaction fails, the companies could incur huge losses over this expense.

A Powerful Option

Mergers help companies grow and leverage the many advantages of both companies involved. They also come with challenges. Consult professional advisors to understand how a merger may benefit your business. Value Scout can help you connect with experienced advisors.

Get in touch to know more.

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Author Summary:
Dan Doran

Dan Doran

Is the Founder of Value Scout, Quantive and the 2019 Exit Planner of the Year. He is a recognized expert and speaks frequently about M&A, valuations, and developing more deliberate value creation strategies.

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