Mergers and Acquisitions: Definition

The key principle behind M&A is that two companies together are more valuable than two separate companies—at least, that's the reasoning. This rationale is particularly alluring to companies when times are tough. Strong companies will act to buy other companies to create a more competitive, cost-efficient company and, theoretically, more shareholder value. Meanwhile, target companies will often agree to be purchased when they know they cannot survive alone.

Distinction between Mergers and Acquisition

The terms merger and acquisition mean slightly different things, though they are often used interchangeably.  

When one company takes over another and clearly establishes itself as the new owner, the purchase is called an acquisition. From a legal point of view, the target company ceases to exist, the buyer absorbs the business and the buyer's stock continues to be traded while the target company’s stock does not.

In the pure sense of the term, a merger happens when two firms, often of about the same size, 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." Both companies' stocks are surrendered and new company stock is issued in its place. For example, both Daimler-Benz and Chrysler ceased to exist when the two firms merged, and a new company, Daimler Chrysler, was created.

A purchase deal will also be called a merger when both CEOs agree that joining together is in the best interest of both of their companies. But when the deal is unfriendly—that is, when the target company does not want to be purchased—it is always regarded as an acquisition.

Whether a purchase is considered a merger or an acquisition really depends on whether the purchase is friendly or hostile and how it is announced. In other words, the real difference lies in how the purchase is communicated to and received by the target company's board of directors, employees and shareholders.

Synergy of M & A

Synergy is often cited as the force that allows for enhanced cost efficiencies of the new business and a reason to justify the transaction. Synergy takes the form of revenue enhancement and cost savings. By merging, the companies hope to benefit from the following:

• Staff reductions. As every employee knows, mergers tend to mean job losses. Consider all the money saved from reducing the number of staff members from accounting, marketing and other departments. Job cuts will also include the former CEO, who typically leaves with a compensation package.

• Economies of scale. Yes, size matters. Whether it's purchasing stationery or a new corporate IT system, a bigger company placing the orders can save more on costs. Mergers also translate into improved purchasing power to buy equipment or office supplies. When placing larger orders, companies have a greater ability to negotiate prices with their suppliers.

• Acquiring new technology. To stay competitive, companies need to stay on top of technological developments and their business applications. By buying a smaller company with unique technologies, a large company can maintain or develop a competitive edge.

• Improved market reach and visibility. Companies buy other companies to reach new markets and grow revenues and earnings. A merger may expand two companies' marketing and distribution, giving them new sales opportunities. A merger can also improve a company's standing in the investment community: bigger firms often have an easier time raising capital than smaller ones.

Achieving synergy is easier said than done. Achieving synergy takes:

• Planning. How will the combined entity actually go about achieving the synergies touted during the process?
• Preparation and analysis. Ideally planning is done during the M&A due diligence process to ensure that these synergies are real and what it will take to achieve them after the culmination of the transaction.
• Execution. Once the transaction is finalized, critical decisions have to be made. Which operations will be kept or closed? How will you entice key employees to stay? Who will be accountable to see that these synergies are actually realized?

Varieties of Mergers

From the perspective of business structures, there is a whole host of different types of mergers. Here are a few types, distinguished by the relationship between the two companies that are merging:

• Horizontal merger - Two companies that are in direct competition and share the same product lines and markets.

• Vertical merger - A customer and company or a supplier and company. Think of a cone supplier merging with an ice cream maker.

• Market-extension merger - Two companies that sell the same products in different markets.

• Product-extension merger - Two companies selling different but related products in the same market.

• Conglomeration - Two companies that have no common business areas.

There are also two types of mergers that are distinguished by how the merger is financed. Each has certain implications for the companies involved and for investors:

• Purchase Mergers - As the name suggests, this kind of merger occurs when one company purchases another. The purchase is made with cash or through the issue of some kind of debt instrument; the sale is taxable. Acquiring companies often prefer this type of merger because it can provide them with a tax benefit. Acquired assets can be written-up to the actual purchase price, and the difference between the book value and the purchase price of the assets can depreciate annually, reducing taxes payable by the acquiring company. We will discuss this further in part four of this tutorial.

• Consolidation Mergers - With this merger, a brand new company is formed and both companies are bought and combined under the new entity. The tax terms are the same as those of a purchase merger.

Acquisitions

An acquisition may be only slightly different from a merger. In fact, it may be different in name only. Like mergers, acquisitions are actions through which companies seek economies of scale, efficiencies and enhanced market visibility. Unlike mergers, all acquisitions involve one firm purchasing another — there is no exchange of stock or consolidation as a new company. Acquisitions are often congenial, and all parties feel satisfied with the deal. Other times, acquisitions are more hostile.

In an acquisition, a company can buy another company with cash, stock or a combination of the two. Another possibility, which is common in smaller deals, is for one company to acquire all the assets of another company. Company X buys all of Company Y's assets for cash, which means that Company Y will have only cash (and debt, if they had debt before). Of course, Company Y becomes merely a shell and will eventually liquidate or enter another area of business.

Another type of acquisition is a reverse merger, a deal that enables a private company to get publicly-listed in a relatively short time period. A reverse merger occurs when a private company that has strong prospects and is eager to raise financing buys a publicly-listed shell company, usually one with no business and limited assets. The private company reverse merges into the public company, and together they become an entirely new public corporation with tradable shares.

Regardless of their category or structure, all mergers and acquisitions have one common goal: they are all meant to create synergy that makes the value of the combined companies greater than the sum of the two parts. The success of a merger or acquisition depends on whether this synergy is achieved.