Mergers vs. Acquisitions: Viable Options for Expanding or Exiting Your Business
Mergers and acquisitions might seem similar to the casual observer. However, there are key distinctions between the two transactions that can mean the difference between meeting the goals of an exit strategy and missing the mark.
Mergers and acquisitions differ in how they are typically financed, the continued involvement of a business owner, and the type of decision-making authority they have when they do stay involved.
Small business owners should consider these and other situations before deciding on which transaction strategy to use.
What Are Mergers and Acquisitions?
In a merger, two companies (usually of similar size and scale) join forces to create a new business entity with a new name, new ownership, and new management. A true merger is a friendly deal that the owners of both companies enter into voluntarily and equally for any number of reasons, including:
- To diversify a business
- To expand products or services
- To expand into new markets
- To gain new customers or market share
- To reduce costs and achieve economies of scale
- To boost revenues and profits
Oftentimes, however, a merger takes place in name only. That is, the companies might refer to an acquisition as a merger or a merger of equals to avoid any negative connotation and make employees and customers believe that nothing will change. In reality, these deals are acquisitions that leave little of one of the merged companies remaining.
An acquisition occurs when one company buys another and consolidates it into its existing business. The acquiring company (which is typically a larger company and financially stronger than the business acquired) continues to operate under its same company name—and usually with the same management—while the acquired company ceases to exist.
In an acquisition, the acquiring company calls all the shots. It might sell off some of the assets of the business acquired. It might dismiss employees and management whose jobs duplicate already existing functions and prune or consolidate business operations and locations.
Acquisitions can be voluntary. That is, one company agrees to be sold to another. Publicly traded companies (and some private ones), however, can be the targets of so-called hostile takeovers. The acquiring company purchases at least 51% of stock shares and gains ownership without the approval—and often over the objections of—the existing shareholders.
Types of Mergers and Acquisitions
Both mergers and acquisitions aim to create synergies that improve a business’s productivity and competitiveness, lower operational costs, or all three. Mergers or acquisitions can be structured in one of four ways based on the relationship between the two companies involved.
Horizontal Merger
A horizontal merger refers to two companies with the same product lines and markets. These mergers or acquisitions are typically used to eliminate competition, achieve economies of scale, or reduce operational costs. The merger of cell phone service providers T-Mobile and Sprint is an example of a horizontal merger.
Vertical Merger
A vertical merger refers to mergers between two companies that share customers in common, or between a company and its supplier. For example, a packaged goods company might acquire the packaging supplier it buys from to improve efficiency, lower costs, and ensure access to the materials used for packaging.
Congeneric Merger
A congeneric merger refers to two companies with a similar customer base, but different products. The merger between Citigroup and Travelers Group is an example of a congeneric merger. Citigroup sold banking services and credit cards, while Travelers sold insurance and brokerage services. By combining, both expanded their product offerings and their size.
Conglomerate Merger
A conglomerate merger refers to the merger of two companies with no business in common, such as the merger of Amazon and grocery chain Whole Foods. This merger provided cross-selling opportunities. Conglomerate mergers are also used to diversify a business and help insulate it from economic downturns.
How Valuations Differ in Mergers and Acquisitions
Before sellers put their business on the market for sale, they conduct a valuation that helps set a purchase price. The valuation can be based on a formula, such as price-to-earnings ratio, discounted cash flow, or an analysis of comparable business sales.
In a merger, both companies conduct a business valuation. The valuation methods used are the same as in an acquisition. Still, in a merger, the valuations of both companies are combined to create a valuation for the merged company.
Acquiring or Merging: Determining the Best Strategy
Choosing the right strategy for your business depends on your business, your goals, your resources, and the target company you choose. Both acquisitions and mergers can help a business owner to achieve the goals listed earlier. The key differences lie in the way the goals are accomplished.
When to Consider a Merger
Most business owners decide to sell to disengage from day-to-day operations. A merger generally won’t allow you to walk away from the business scot-free.
The rationale behind a merger is to strengthen both businesses involved by adding products, services, markets, expertise, and resources in one fell swoop. As a business owner, your expertise and experience will usually be considered a key reason for the merger.
Mergers between competitors, however, are sometimes used to gain a competitive advantage in the marketplace by eliminating competition, cutting expenses, and achieving economies of scale.
A merger between competitors allows the new company that’s formed to increase sales without a proportionate increase in costs for staff, rent, and other expenses because the two companies can consolidate and eliminate some of these expenses. In these instances, the merged company might retain the management team of only one of the companies.
While mergers can be an immediate shot in the arm for the merged companies, they don’t typically give owners and shareholders a quick cash infusion. Mergers are often transacted using a stock swap. Shareholders exchange their company’s stock shares for new shares in the merged company, usually getting the same number of shares they had before.
Another important consideration is that mergers can be complex. Because you are forming a new entity, you’ll have to figure out its operating and management structure, set up systems for accounting, inventory, and the like, and establish processes and procedures. You’ll also have to transition the existing systems into the new ones and decide how to assign management duties and share decision-making.
Most mergers don’t result in a company having two CEOs, so it’s also likely that a small business owner will give up some authority in a merger.
When to Consider an Acquisition
Selling your business or acquiring one is usually a simpler transaction than a merger.
As a seller, you’re usually able to walk away with cash you can use for retirement, a new venture, or any other purpose.
You won’t be required to continue running the business (although you might need to stay on for a period of time to train the new owners). On the other hand, you might choose to continue some involvement in the business as a consultant or by using seller financing to fund the acquisition.
As a buyer, you don’t need to worry about restructuring two companies into one. You can consolidate the operations of the company you acquire and the management in any way you see fit.
The single most important drawback of an acquisition is the cost to the buyer. If you pay too much, the cost of the buyout can outweigh the sales increase you get from the acquisition.
When You Want to Strengthen Your Existing Business
Mergers and acquisitions can help business owners fortify, expand, and support the businesses they already own.
For example, suppose you own a tech company with a single product that’s nearing the peak of its life cycle. The market is moving in a new direction, and you need new products to continue the growth you’ve achieved up to now.
By acquiring or merging with a company with a solid track record in new product development, you’ll give your business instant access to products that might take years to develop on your own. You might even be able to save on operating expenses through consolidation.
The only question is whether to acquire or merge the two companies. If you are acquiring a business, the target company might insist on a business valuation based on discounted cash flow (DCF), a formula that’s based on future cash flow. Your target might be a smaller company today, but the valuation formula won’t price it that way, and you’ll pay dearly.
But what if your target company is falling short on management expertise and needs your years of experience to stabilize the business and establish systems to help it grow? Maybe it also needs a partner to assume the burden of debts and liabilities it’s racked up to get its products to market.
In this case, the target company might be willing to entertain a merger that won’t take a chunk of your operating capital in exchange for your management expertise and you’ll still reach your objectives to expand your product line and boost your sales and earnings without a significant cash outlay.
Transacting Mergers and Acquisitions
The steps for completing mergers and acquisitions are similar. You’ll have to:
- Establish a valuation
- Conduct due diligence
- Prepare a merger or acquisition agreement
- Close the deal and file necessary documents with state and federal authorities and the IRS
In an acquisition, the acquiring company doesn’t have to create new formation documents. But, a merged company will have to close out the former business, apply for a new employer identification number (EIN), licenses and permits, and close bank accounts and open new ones.
Whether you use a merger or an acquisition, it’s a good idea to have a team of professionals, including an attorney, a CPA, and a business broker on your team. These professionals can play an important role in making sure the deal stands up to legal scrutiny and financial standards and protecting your interests. Visit BizBuySell’s Broker Directory to find a business broker to help you navigate the world of mergers and acquisitions.