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Mergers and acquisitions (M&A) is a business term used to describe a transaction between two companies when they are combining in some way. Though the words “merger” and “acquisition” are often used together, each has a slightly different meaning.Here’s a look at what mergers and acquisitions are, examples of how these deals are structured, and the pros and cons of getting involved in a business merger or acquisition.
What Are Mergers and Acquisitions (M&A)?
Mergers and acquisitions is a general term that describes corporate consolidation activity in which firms come together to create a new entity. Mergers happen when two firms of the same or comparable size combine to form a new company. With acquisitions, on the other hand, a dominant acquiring entity purchases a smaller target business. M&A activity can be friendly in nature or hostile.
Understanding the Basics of How Mergers and Acquisitions Work
Generally, an acquisition is a transaction in which one firm absorbs another firm via a takeover, while a merger occurs when two companies voluntarily come together to form a new entity. But every one of these deals is structured in a unique way and, as a result, these terms can overlap – hence, the ubiquity of the term “M&A.”Companies engage in M&A transactions for a variety of reasons. In some cases, a company will seek to acquire a competitor so that they are no longer a threat. Companies also complete M&A deals to grow by acquiring new product lines, intellectual property, talent, and customer bases. In addition, companies may also look for synergies. Combining business activities can increase efficiency and reduce costs, since each company leverages off of the other company's strengths.
Types of Mergers and Acquisitions
M&A deals can be structured in different ways. Here’s a look at some of the different types of mergers and acquisitions.
Acquisitions
An acquisition is when one company purchases most or all of another company's shares to gain control of that company. By purchasing more than 50% of a target firm's stock and other assets, the acquirer is then able to make decisions about the direction of the target company without the approval of their other shareholders. Acquisitions can occur with the target company's approval, or in spite of its disapproval
Mergers
A merger is when two companies, typically around the same size, combine forces to form a new entity rather than remaining separately owned and operated. Often described as a combination of equals, the result is typically a bigger, more powerful company that can scale existing resources (such as assets and talent) to gain market share. Often the goal of a merger is to create synergies and boost overall profits.
Tender Offers
With a tender offer, one firm proposes to buy all outstanding stock of another company at a specified price rather than the market price. The acquirer goes straight to the target company’s shareholders for approval, bypassing the management and board of directors.
Acquisitions of Assets
With an acquisition of assets, one company acquires the assets of another company. Typically, the target company must get approval from its shareholders before it can sell off assets. This type M&A transaction often comes into play during bankruptcy proceedings. When a bankrupt firm is liquidated, several companies may bid for their assets.
Consolidations
A consolidation occurs when companies combine core businesses and give up their former corporate structures. Stockholders of both companies must approve of the deal and, after the consolidation, will receive equity shares in the new company.
Management Acquisitions
In a management acquisition, also known as a management-led buyout (MBO), a company’s management team purchases a controlling stake of the business they manage from the owner(s). MBOs generally occur as part of an effort to take a company private, then streamline operations and improve profitability.Recommended: Inorganic Business Growth Explained
Mergers vs Acquisitions
Mergers
Acquisitions
Two firms combine in a merger of equals
A large firm purchases a smaller firm
A new name is given
The acquired company comes under the name of the acquiring company
Leads to new stocks being issued
No new stocks are issued
Pros and Cons of Mergers
Pros of Mergers
Cons of Mergers
Increases market share
Reduced competition can lead to higher prices
Reduces operating costs through economies of scale
If there is little in common between the companies, it can be difficult to create synergies
Avoids duplication and eliminates competition
Can result in job losses
Pros and Cons of Acquisitions
Pros of Acquisitions
Cons of Acquisitions
Gain entry into new markets with a brand that is already recognized
Company cultures could clash
Quickly increase market share of your business
Employees may duplicate each other’s duties
Gain access to experts and resources you don’t currently have
The two companies may have conflicting objectives
Typical Merger Structures
Mergers and acquisitions happen through a variety of dealmaking structures. Here’s a closer look.
Purchase vs Consolidation Mergers
Purchase mergers occur when one company purchases another company, either with cash or by issuing some type of debt instrument. The buyer is the only surviving company at the end of the deal. By contrast, a consolidation merger occurs when two or more companies combine to create a new single company. Here’s a side-by-side comparison.
Purchase Merger
Consolidation Merger
One organization acquires the business of another
Often involves companies of equal size with similar strategies or products
Usually involves a financially stronger entity acquiring a smaller, relatively weaker one
Owners of both corporations continue on as owners of the new company
Acquired company ceases to exist in its previous name and operates under the name of the acquiring company
Owners often combine previous company names for the new company name
Horizontal Mergers
A horizontal merger is the merger of two companies that share the same product or service and are in competition with each other.
Vertical Mergers
A vertical merger is a union between two companies that are in the same industry but at different stages of the production process, such as a business and one of its suppliers.
Congeneric Mergers
A concentric merger is the merger of two businesses that sell to the same customers, but that sell different products.
Conglomerations
A conglomeration is a merger between companies in unrelated business activities that operate in distinct markets.
Product-Extension Mergers
A product-extension merger is a merger between companies in the same markets that sell different but related products or services. Often the hope is that the two comparable products (or services) can help cross-sell each other.
Market-Extension Mergers
A market-extension merger is a merger between companies in different markets that sell similar products or services.
Ways of Integrating Mergers and Acquisitions
It can sometimes be a challenge to integrate two businesses properly and effectively with mergers and acquisitions. Here are some of the ways it is done.
Consolidation
In a consolidation, both companies involved in the M&A transaction cease to exist after the deal and a completely new entity is formed.
Subsidiary
With a subsidiary M&A deal, the target becomes a subsidiary of the acquirer but continues to maintain its business.
Statutory
Statutory mergers typically happen when the acquirer is significantly larger than the target company and acquires the target’s assets and liabilities. After the deal, the target company ceases to exist as a separate entity.
Financing Acquisitions
An acquisition can be financed in a variety of ways, including cash, stock, debt (including different types of business loans), or any combination of the above.
Business Loans for Acquisitions
A company seeking acquisition financing can apply for a small business loan with a bank, credit union, or online lender. Banks and Small Business Administration (SBA) lenders tend to offer the best rates and terms, but also tend to have strict qualification requirements. Online lenders are generally more flexible (and fund loans faster) but may charge higher interest rates.A bank may be more likely to approve financing if the company to be acquired has a steady revenue and a steady or growing EBITDA (earnings before interest, taxes, depreciation, and amortization), along with valuable assets for collateral. Getting approved for a bank loan could be more challenging if the target company has receivables rather than cash flow.
Valuing Mergers and Acquisitions
In any M&A deal, the buyer will typically want to get the best possible deal, while the seller will generally be looking for the highest possible price. How do they meet in the middle? There are actually some objective ways to value mergers and acquisitions. Here are three.
Discounted Cash Flow
A discounted cash flow (DTF) analysis determines a company's current value by discounting its expected or estimated future cash flows. The goal of the DCF analysis is to understand the importance of an investment today based on the forecasted money it will generate.
Price-to-Earnings Ratios
With the use of a price-to-earnings ratio (P/E ratio), an acquiring company makes an offer that is a multiple of the earnings of the target company. For guidance on what the target's P/E multiple should be, the acquiring company will often examine the P/E ratio for stocks within the same industry.
EV/Sales
The enterprise-value-to-sales ratio (EV/sales) is a financial ratio used to value a company and compare it to its industry and competitors. It measures a company’s total value (in enterprise value terms) to its total sales revenue. A high EV/sales ratio can indicate that a company is overvalued.
Replacement Cost
Though not common, acquisitions are sometimes based on the cost of replacing the target company. This valuation method looks at the value of a company as the sum of all its equipment and staffing costs. However, it can take a long time to build a business and develop management and staff. As a result, this approach has limitations.Recommended: How to Value a Small Business
What Are Hostile Takeovers?
Also known as unfriendly acquisitions, hostile takeovers occur when the acquirer is making no headway negotiating with a management team of a target company. Despite this resistance, the acquirer decides to continue pursuing the acquisition by going directly to the shareholders and circumventing the board. Hostile takeovers are typically attempted through one of three ways: a direct tender offer to shareholders, a proxy fight, or a purchase on the open market of the majority of shares.
The Takeaway
Mergers and acquisitions involve the process of combining two companies into one. Mergers occur when two companies, often about the same size, join forces in order to enjoy advantages, such as increased efficiency, capacity, and sales. Acquisitions, occur when one company buys another company and folds it into its operations. Sometimes the purchase is friendly and sometimes it is hostile.If your company is considering an acquisition, there are a number of different ways to finance the deal, including taking out a business acquisition loan.
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Frequently Asked Questions
What are the types of mergers?
Are there different types of acquisitions?
How are business acquisitions financed?
Photo credit: iStock/Edwin Tan
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About the Author
Mike Zaccardi
Mike Zaccardi, CFA, CMT, is a finance expert and writer specializing in investments, markets, personal finance, and retirement planning. He enjoys putting a narrative to complex financial data and concepts; analyzing stock market sectors, ETFs, economic data, and broad market conditions; and producing snackable content for various audiences.
