Reasons for Business Combinations

Reasons for Combining Businesses

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

Learning Objectives

Describe the reasons two businesses might combine

Key Takeaways

Key Points

  • The dominant rationale used to explain merging activity is that acquiring firms seek improved financial performance.
  • If used in a business application, synergy means that teamwork will produce an overall better result than if each person within the group was working toward the same goal individually.
  • Positioning involves combining two companies in order to exploit future opportunities.
  • Gap filling is a reason for merging, referring to the fact that the strength of one company may be the weakness of the other, and vice versa.

Key Terms

  • Synergy: Benefits resulting from combining two different groups, people, objects, or processes.
  • statutory merger: A type of merger whereby one of the companies remains a legal entity, rather than a part of an entirely new legal entity.

Reasons For Business Combinations

Business combinations are referred to as mergers. A merger happens when two firms agree to go forward as a single new company, rather than remain separately owned and operated. This kind of action is more precisely referred to as 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, actual mergers of equals don’t happen very often. Usually, one company will buy another and, as part of the deal’s terms, simply allow the acquired firm to proclaim that 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 triangular merger, statutory merger, etc.

Every merger has specific reasons why the combining of the two companies is a good business decision. The underlying principle is simple: 2 + 2 = 5. In other words, the combination of two companies will be worth more than the sum of its parts. The dominant rationale used to explain merging activity is that acquiring firms seek improved 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 that teamwork will produce an overall better result than if each person within the group was working 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 costs of the company 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 that the buyer will be absorbing a major competitor and thus increase its market power (by capturing increased market share) to set prices.
  • Cross-selling: For example, a bank buying a stock broker could then sell its banking products to the stock broker’s 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 their advantage by reducing their 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 over the long term balances out the stock price of a company, 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 simply hires the staff of the target private company, thereby acquiring its talent (if that is 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, the pay of certain executive management teams was 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 in order to exploit future opportunities.
  • Gap filling: The strength of one company may be the weakness of the other, and vice versa.