Mergers and acquisitions are means of expanding a business by combining with another company. While acquisitions can sometimes be harsh, both mergers and acquisitions have their own advantages and disadvantages.
Remember the days of childhood when we desperately wanted to grow up? All of us have, within ourselves, an innate urge to grow. When we grow, we are capable of being more, doing more and experiencing more in life. Businesses are also just like us.
Businesses crave growth for many reasons. Despite the risk, growth presents businesses with significant rewards in terms of profit and much more. A growing business enjoys economies of scale (a reduction in costs due to efficient production) and greater control over the market, which helps to outdo the competition. Moreover, the growth prospects of the business make owners and top management feel more satisfied and proud.
A company can expand its business in many ways. It could start producing more units of the product it is currently selling or it could launch a new range of products, either related or unrelated to the current product. However, this requires the business to invest a lot of resources in the form of money, time, skills, etc. Moreover, if the company wants to venture into a new market (i.e., start a new line of products), it also faces the risk of failure due to a lack of experience in that particular market.
In such a situation, mergers and acquisitions serve as an instant means of expanding the business by circumventing these risks.
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What Is A Merger?
A merger is a process by which two or more companies combine to form a single entity. The companies come together and decide the terms of the merger in a friendly manner. They start operating under united ownership and control, and share the profits together. Obviously, the original entities cease to exist and stop operating under their old names, while carrying out all their business activities by the new name.
For example, A Corp and B Corp amalgamate their businesses and form AB Corp, which holds the combined assets, liabilities, resources, capacities and experiences of both the merging companies. After the formation of AB Corp, the original companies—A Corp and B Corp—cease to exist.
A good example of a merger is the case of Glaxo Wellcome and SmithKline Beecham, two of the biggest British pharmaceutical companies, a merger that created the pharmaceutical giant, GlaxoSmithKline in the year 2000.
Two companies will decide to merge their businesses if they believe that the merger will result in a synergistic advantage in terms of physical facilities, skills, research and development, reduction in competition and so on. Depending on what the companies want to achieve, they could merge in one of the following three ways:
Merging With An Unrelated Business—Conglomerate Merger
Two companies that are unrelated to each other in any manner come together in a conglomerate merger. They belong to different industries, produce unrelated products, and target disjointed markets. This kind of merger is used when companies want to venture into a different industry and want to avoid the risks due to a lack of experience in the new industry.
Merging With A Competitor—Horizontal Merger
In a horizontal merger, two companies that sell the same kind of products and serve the same market merge to form a bigger company. This type of merger reduces the stress and cost of competition, since it is essentially a merger with a competitor company.
However, the main objective of horizontal mergers is to take advantage of economies of scale.
We can better understand this with the help of an example. Imagine that you’ve rented a machine that is capable of producing 100 units of a certain product every month. Now, regardless of whether you produce 1 unit of the product or 100 units of it, you will have to pay the fixed amount of rent at the end of the month. If you produce 1 unit, the entire amount of the rent, say $1000, will be allocated to that one unit of product as cost. However, if you produce 100 units, each unit will have only $10 (being $1000 /100 units) allocated to it.
An increase in the scale of operations therefore leads to a reduction in average costs. However, a company might not be in a position to produce the full capacity, due to a lack of funds needed to purchase the required quantity of raw materials. Sometimes, it does not produce more because it knows that it won’t be able to sell it all. Horizontal mergers help companies tackle this situation effectively.
Since both the merging companies produce similar products, it would be convenient to shed the duplication of machine installations and combine the production of both companies to achieve economies of scale.
Merging With Supplier/Consumer—Vertical Merger
Suppose that X Corp sells its products to Y Corp, which uses these as raw materials for producing something else. If these two companies merge, X Corp would never have to worry about its sales and Y Corp could rest assured that they could always get a guaranteed supply of raw materials. Thus, vertical mergers take place within the same industry, but at different stages of the process.
Theoretically, a merger takes place in a friendly manner between two equal companies, but such a situation is not that common in reality. This brings us to the topic of acquisitions.
What Are Acquisitions?
An acquisition is the less friendly twin of a merger. It also involves two companies combining into one, but the change happens in a more hostile manner. In an acquisition, a strong company overpowers a weaker company and takes over the entire control of its business by buying more than 50% of its shares at a high price. The acquirer absorbs the weaker company (target company) and the latter ceases to exist after the acquisition. The business is then operated under the sole name of the acquiring company.
A good example of a hostile acquisition is the takeover of Mannesmann, a German mobile phone company, by Vodafone, a British telecommunications company. This acquisition took place in 1999 after an intense three-month battle between the two.
However, not all acquisitions are forceful. Especially during a recession, a company can become so weak that it has no option but to sell its business to another company.
Just like mergers, acquisitions can happen between companies in the same industry (horizontal or vertical integration) or between companies in unrelated industries. Examples of horizontal integration are Marriott International’s acquisition of Starwood Hotels in 2016 and Facebook’s acquisition of Instagram in 2012. Ikea took vertical integration to another level when it bought an entire forest in Romania to ensure an abundant supply of timber. Microsoft acquired LinkedIn, an unrelated company, in 2016.
When we compare mergers with acquisitions, we see that, although they are similar in some ways, their impact is altogether different. When we think of mergers, we can picture a happily married couple helping each other grow. On the other hand, an acquisition gives us the impression of a ruthless king forcefully taking over a small, helpless kingdom.
In a merger, two companies co-exist and expand together (A+B=AB). However, in an acquisition, one consumes the other (A+B=A).
Is One Better Than The Other?
Acquisitions might seem harsh, leading one to think that mergers are the ideal way to go about expansion. However, just as there are two sides to every coin, both mergers and acquisitions have their own advantages and disadvantages.
The formation of a new company requires a lot of legal documentation and other formalities to be followed through, making mergers a relatively complicated and lengthy process. Acquisitions, on the other hand, do not involve forming a new company from scratch, and are therefore relatively simple.
When two companies come together, clashes are bound to occur, both in planning and execution. Since a merger leads to the dilution of each company’s power, neither of the companies can independently make decisions as they used to. However, they must work together, even when they don’t necessarily agree.
One must be even more careful about this during an acquisition, where the top management of the target company will typically resent the acquirer company from the very beginning. Moreover, the chaos leaves employees confused and constantly in fear of losing their jobs. The abrupt change in work culture may also adversely affect the productivity of employees. There is a smaller chance of this happening during a merger, since it is done with the consent and consideration of both merging companies.
Thus, there is no correct answer to this question. What works for one company may lead another company to bankruptcy. Therefore, the companies must decide what’s best for them only after carefully considering their capacities, situations and goals.
Basic Economics 2nd Ed: A Citizen’s Guide to the Economy, Revised and Expanded Edition By Thomas Sowell