Mergers and Acquisitions

Business combinations seek to unlock value within either firm that would not be realized if the firms continued separately.

Reasons for Business Combinations

Business combinations are called mergers. A merger happens when two firms agree to form one new company rather than remain separately owned and operated. This action is a merger of equals. The firms are often approximately the same size.

Both companies' stocks are surrendered, and new company stock is issued in its place. In practice, however, mergers of equals do not occur very often. Usually, one company buys another and, as part of the deal's terms, allows the acquired firm to proclaim the action is a merger of equals, even if it is technically an acquisition. A merger can also be achieved independently of the corporate mechanics through various means – such as a triangular merger, statutory merger, etc.

Every merger has reasons why combining two companies is a good business decision. The underlying principle is simple: 2 + 2 = 5. In other words, combining two companies will be worth more than the sum of its parts. The dominant rationale used to explain merging activity is that acquiring firms improves financial performance.

The following factors are considered to improve financial performance:

• Synergy: Synergy is two or more things functioning together to produce a result not independently obtainable. If used in a business application, synergy means teamwork will produce a better result than if each group member worked toward the same goal individually. Synergy can take the form of higher revenues, lower expenses, or a lower overall cost of capital.
  
  
• Economy of scale: The combined company can often reduce its fixed costs by removing duplicate departments or operations, or lowering the company's costs relative to the same revenue stream, thus increasing profit margins.
  
  
• Economy of scope: This refers to the efficiencies primarily associated with demand-side changes, such as increasing or decreasing the scope of marketing and distribution, of different types of products.
  
  
• Increased revenue or market share: This assumes the buyer will absorb a major competitor and increase its market power (by capturing increased market share) to set prices.
  
  
• Cross-selling: For example, a bank buying a stock broker could sell its banking products to their customers, while the broker can sign up the bank's customers for brokerage accounts.
  
  
• Taxation: A profitable company can buy a loss maker to use the target's loss to reduce its tax liability. In the United States and many other countries, rules are in place to limit the ability of profitable companies to shop for loss-making companies, limiting the tax motive of an acquiring company.
  
  
• Geographical or other diversification: This is designed to smooth the earnings results of a company, which balances the company's stock price over the long term, giving conservative investors more confidence in investing in the company.
  
  
• Hiring: Some companies use acquisitions as an alternative to the normal hiring process. This is especially common when the target is a small private company or is in the start-up phase. In this case, the acquiring company hires the staff of the target private company, thereby acquiring its talent (its main asset and appeal).
  
  
• Diversification: A merger may hedge a company against a downturn in an industry by providing the opportunity to make up profits in the industry of the target company.

Additional motives for a merger that may not add shareholder value include:

• Manager's hubris: A manager's overconfidence about expected synergies from a merger may result in overpayment for the target company.
  
  
• Empire-building: Managers have larger companies to manage and hence more power.
  
  
• Manager's compensation: In the past, executive management teams were paid based on the total profit of the company instead of the profit per share. This would give management the incentive to buy companies to increase the total profit while decreasing the profit per share (which hurts the owners of the company, the shareholders).
  
  
• Positioning: This involves combining two companies to exploit future opportunities.
  
  
• Gap filling: The strength of one company may be the weakness of the other, and vice versa.

Source: Boundless, https://courses.lumenlearning.com/boundless-finance/
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