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What Is A Merger, and How Does It Work?

A merger is a mutual deal between companies to unite into a new business creating value for shareholders. Discover the different types, pros, and cons.

by | Last updated 27 Mar, 2023 | Mergers & Acquisitions

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A corporate merger is when two or more companies combine to form a new enterprise. They are typically large-scale, mutually beneficial deals. The aim behind every merger is to create a new corporate entity that is stronger than the original individual corporations.

What is a merger?

Generally, firms that engage in a merger agreement are relatively the same size. Each carries its unique value that benefits the other companies involved in the deal. The idea is that by combining forces, businesses can achieve superior long-term performance as a single business.

For example, a business may have an award-winning product but no distribution network, while another firm may have global logistics infrastructure but declining demand for its own products. Both companies can benefit from each other, and an initial partnership may evolve into something more permanent, like a corporate merger.

Of course, there are plenty of other reasons why companies, sometimes even rivals, will join forces.

  • Enter Foreign Markets – Penetrating international markets can be challenging. Beyond the cost of exporting or moving production, a lack of understanding of the local culture can make success very difficult. A merger with a firm that already has a foothold in a target market could drastically reduce the barriers to entry.
  • Access New Growth – A larger entity can benefit from economies of scale, paving the way for cost reduction and higher margins.
  • Decrease Competition – With mergers, companies grow in size. And with more resources at hand, the newly formed enterprise is often more capable of handling competition. These deals also help similar firms avoid product duplication within a market.
  • Gain New Technology/Resources – Some companies have access to unique resources such as a patent or regulatory license that’s near impossible to replicate. Through a merger, businesses can tap into these potentially lucrative resources to establish market dominance.
  • Avoid Bankruptcy – Mergers can save struggling companies from going under, protecting jobs and breathing new life into a business with long-term potential.

Acquisition vs Takeover vs Buyout vs Merger

Acquisition, Takeover, Buyout, and Merger all have one thing in common. In each scenario, two or more companies combine together to form one. However, despite the terms often being used interchangeably, they have some contrasting differences. And not all of them are pleasant.

  • Merger – A mutual union of two or more companies into one new corporation.
  • Acquisition – An acquisition is a friendly takeover between two firms that benefits all the parties. The acquiring company, individual, or asset management fund approaches a target company’s board of directors with a tender offer to acquire the company in its entirety. If the board, shareholders, and regulators agree to the deal, the acquisition is executed, and business ownership changes hands.
  • Takeover – Sometimes, acquisition offers are not welcome. But if the prospective buyer is persistent, a forced takeover may occur. This is when the board of directors are bypassed entirely, and the acquirer goes straight to the shareholders with an offer.
  • Buyout – A buyout is similar to a takeover. It’s often executed by purchasing or controlling majority equity in the company.

Types of mergers

While the desired end result of a merger is always the same, there are several different types that can occur.

  • Vertical Merger – A vertical merger is the joining of companies that operate in the same industry but at different levels in the supply chain. These deals are often pursued to create synergy in pursuing higher operating efficiency.
  • Horizontal Merger – A horizontal merger takes place between companies in the same industry. These firms are often direct competitors that agree to combine to achieve economies of scale.
  • Conglomerate Merger – A conglomerate merger is the combination of two businesses operating in different industries with no overlap. This type of merger agreement is fairly rare and usually can only be executed if it directly increases shareholders’ wealth.
  • Congeneric Merger – In a congeneric merger, companies from the same industry but involved in totally unrelated operations or services come together. This allows new products to be quickly brought to the market, access a wider pool of potential customers, and secure new market share.
  • Market Extension Merger – This is the combination of two businesses selling similar products in different geographic markets. The firms combine to access new markets respectively and expand their customer base.
  • SPAC Merger – A special purpose acquisition company will typically execute a reverse merger with a private business. This is often a cheaper method for a private company to go public compared to the traditional route of an initial public offering (IPO).

Disadvantages of a corporate merger

While a merger, no doubt, brings many benefits to the table, it’s not free from downsides. Some of the significant disadvantages of these deals are:

  • Integration Costs – Combining two businesses can be an expensive process with unforeseen complications when the deal is originally signed. Some common issues include:
    • Corporate Culture differences – When two companies join together, it also means two corporate cultures combine to form one. Contrasting mentalities and approaches can lead to tension among employees that can harm productivity as well as create internal conflict.
    • Job Redundancies – With mergers, many jobs, especially in administration, become redundant, ultimately resulting in unemployment.
    • Resignation of Key Personnel – Not every employee may be happy with the deal. And some workers often choose to part ways, potentially leading to the loss of valuable talent. Acquiring and training replacement staff be exceedingly expensive.
  • Raises Prices – With reduced market competition, mergers can increase product prices, making things more expensive for customers.
  • No Guarantee of Value creation – A merger aims to form a new company that can create value for shareholders. However, unforeseen complications and over-expectations can result in value being destroyed rather than created, leaving shareholders worse off.

The bottom line

A successful merger is a unanimous agreement between companies to combine their business to create better shareholder value. There are many types of mergers according to the variety of businesses in operations. While some investors favour mergers because of their huge benefits, others steer clear of such companies due to their potential drawbacks.

Nonetheless, mergers are a popular form of fusing companies to create bigger and more sustainable enterprises.

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This article contains general educational information only. It does not take into account the personal financial situation of the reader. Tax treatment is dependent on individual circumstances that may change in the future, and this article does not constitute any form of tax advice. Before committing to any investment decision, an investor must consider their individual financial circumstances and reach out to an independent financial adviser if necessary.

Written By

Saima Naveed

Saima spent the early days of her career advancing the finance office of a prominent manufacturing business. After taking a sabbatical, she decided to use her expert knowledge and apply it to the stock market. Now, 10 years later, she manages a substantial portfolio built using detailed and thorough analysis.

Outside The Money Cog, Saima is an avid supporter of empowering women in the workplace. She is currently working very closely with Women of Wonders Pakistan to help other women achieve their career goals.

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Edited & Fact Checked By
Zaven Boyrazian MSc

Zaven has worked in several industries throughout his career, from aircraft factories to game development studios. He has been actively investing in the stock market for the better part of a decade, managing over $1 million across multiple portfolios.

Specializing in corporate valuation, Zaven employs a modern take on the principles set out by Benjamin Graham to find new opportunities at fair prices.

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