A merger takes place when two companies combine to form a new company. Companies merge to reduce competition, increase market share, introduce new products or services, improve operations, and, ultimately, drive more revenue.
Understanding mergers is essential if you’re considering a career path in mergers and acquisitions (M&A), a branch of investment banking or corporate law that oversees the purchase, sale, and incorporation of companies.
To help you understand mergers, we’ll cover:
- What Is a Merger?
- How Mergers Work
- Types of Mergers
- Pros and Cons of Mergers
- Merger vs. Acquisition
- Related Finance Skills
What Is a Merger?
A merger is a business deal where two existing, independent companies combine to form a new, singular legal entity. Mergers are voluntary. Typically, both companies are of a similar size and scope and both stand to gain from the transaction.
Mergers happen for a variety of reasons. They could allow each company to enter a new market, sell a new product, or offer a new service. They can also reduce operational costs, improve management, change their pricing models, or lower tax liabilities. Ultimately, however, companies merge to increase size, scale, and revenue. In other words, mergers help companies make more money.
How Mergers Work
Mergers are often spearheaded and facilitated by an investment banker. They source deals, value companies, forecast outcomes, and make sure both companies have their houses in order (a process known as due diligence). Corporate lawyers also oversee M&A deals, ensuring, among other things, that the transaction complies with federal and state regulations. Learn both sides of M&A with the following Forage courses:
- JPMorgan Chase Investment Banking Virtual Experience Program
- Latham & Watkins Mergers & Acquisitions Virtual Experience Program
Mergers are generally funded by cash, equity (stocks), or both. When two companies merge, shareholders in each company are issued stock (equal to the value of their old stock) in the new company.
Types of Mergers
There are a variety of ways for companies to merge. The most common types include:
A merger is considered horizontal if the two companies already offer the same products or services. Horizontal mergers help companies reduce competition and dominate the market. For example, gas giant Exxon combined with gas giant Mobil back in 1998 to form ExxonMobil. At the time, that horizontal deal valued the new company at $81 billion.
A market extension merger is a horizontal merger that allows two companies that sell the same product to operate in a new market. For example, if a U.S. regional bank in the east merged with a U.S. regional bank in the west to form the U.S. Bank of the East and West, that would be a market extension merger. These types of consolidations help companies drive more revenue by expanding where they do business.
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A merger is considered vertical if the two companies operate within each other’s supply chain. Think of a home construction company purchasing a window pane manufacturer or a winery buying a glass bottle manufacturer. Vertical mergers help companies reduce costs because they effectively cut out the middleman.
A merger is considered a conglomerate acquisition if the companies operate in separate industries and, at face value, have little to nothing in common from a business perspective. Think of a clothing company combining with a snack food manufacturer. Conglomerate mergers open up cross-selling opportunities, market extensions, and increased operational efficiencies.
A merger is considered cogeneric if the companies offer different products or services, but operate in the same sphere and sell to the same customer base. Cogeneric mergers allow companies to sell new products, which is why they’re also known as product extension mergers. So, for instance, famous ketchup manufacturer H. J. Heinz Co. was able to make revenue off of The Kraft Foods Group’s popular macaroni and cheese (and vice versa) once the companies merged to form The Kraft Heinz Company back in 2015.
A special purpose acquisition company (SPAC) is a publicly traded shell company made with the singular intent of merging with a private company. That merger allows the private company to go public. SPACs are an increasingly popular alternative to a traditional initial public offering (IPO). Learn more about SPACs.
Pros and Cons of Mergers
Here are some of the most common advantages and disadvantages of mergers from a business perspective.
- They can turbocharge growth. As we mentioned earlier, mergers help companies launch new products or enter new markets, often more cheaply or efficiently than they would be able to do so on their own.
- They help companies achieve economies of scale. That is, mergers enable companies to reach a size and scale that comes with cost reductions — essentially the business version of buying in bulk.
- They give companies access to capital, as they’re essentially pooling their budgets and resources together. Merging companies have the option of consolidating operations and, by extension, driving more dollars to the bottom line.
- They’re costly and time-consuming. Mergers are complex legal transactions and there are lots of steps both sides must take — and fund — before two companies can become one.
- They’re stressful. Mergers are often associated with layoffs or significant changes in existing workplace culture, so they can affect performance, turnover, and management of the companies’ respective workforce.
- They don’t always pan out. There are a number of ways in which a merger can go sideways. For instance, they’re subject to anti-trust laws. The federal government could take legal steps to block a deal if it was concerned the new company would form a monopoly and lessen competition in the market.
>>MORE: Practice assessing whether a merger is worth it with Forage’s Bank of America Investment Banking Virtual Work Experience Program.
Merger vs. Acquisition
A merger might sound a lot like an acquisition, but there are nuances that differentiate the two terms. In a merger, two separate legal entities come together to form a new joint legal entity.
In an acquisition, one company (the acquirer) buys another company (the target) and takes control of its assets and operations. After the acquisition, the two companies can continue to operate as separate legal entities or the acquiring company could simply absorb the target company. Acquisitions are more common than true mergers, as one party generally has the upper hand or more to gain when companies are consolidating.
Learn more about acquisitions.
Related Finance Skills
Understanding the ins and outs of M&A is crucial for finance professionals. If you plan to pursue this career path, you also might want to master the following concepts:
- Discounted cash flow valuation (DCF), a financial model used to determine whether an investment is likely to pay off
- Comparable Company Analysis, a method of determining how much a company is worth by comparing it to similar companies
- Additional methods of business valuation, including liquidation, book value, and market capitalization.
Take a deeper dive into these and other core financial topics by completing Forage’s Investment Banking Skills Passport.
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