Why Do Firms Merge?
Created | Updated Feb 10, 2006
Mergers – glorified acquisitions – are sought be firms for a combination of several different reasons, both generic and industry-specific. The long term goal for all mergers is to increase the firm’s value through growth, which in turn is achieved by increasing revenues whilst minimising costs. However, the short-term consequences of mergers may have the opposite (but intended effect) in order to secure better long-term growth.
The obvious advantage of merging a company is economies of scale. When two companies merge, their combined revenues should, in theory, remain the same. However, as a joint operation they can consolidate multiple departments and operations, lowering relative costs in comparison to the new, increased overall revenue. Thus, mergers should increase the profits of the new company beyond the combined profits of the originals.
Increased market share is another major incentive for firms to merge. This motive assumes that a company, in absorbing a major competitor, will increase its hold of the market for that good and thus increase its power to control prices. The increased market share also enables it to benefit from keener deals with suppliers through buying in larger quantities, as well as through industrial blackmail when suppliers become dependent of retailers for the majority of their sales.
Another motive for firms to merge is cross-selling – lateral diversification. For example, a bank merging with an insurance company to create a financial conglomerate would then be able to sell banking products directly to the insurance company’s customers, while the insurance company can sign up the bank’s customers for insurance deals. This is effectively revenue synergy - better use of complementary resources. Geographical or other types of diversification are also factors – these can smooth the revenues of a company as they are spread across multiple industrial sectors and markets. This, in the long term, should stabilise the stock price of a company, giving conservative investors more confidence in investing in the company.
Vertical acquisitions/mergers are attractive for firms as it means the combined firm can guarantee supply/demand of its goods and drop profits in the middle stage to lower overall costs and therefore charge lower prices to gain market share. Tax dodging can also play a role, as a profitable company can buy a loss maker in order to use its tax write-offs to improve the combined company’s profitability.
While all the above mentioned all have the goal of increasing a firm’s value (i.e. share value), firms may also merge for reasons beyond shareholder value. For example, “manager's hubris” - when the executives of a company will just buy others because doing so is newsworthy and increases the profile of the company. This links to the idea of “empire building” – where managers seek power and make larger companies in order to achieve these ends. Furthermore, while both diversification and extension of a business may be desirable in order to achieve greater long-term growth, the former can often be unprofitable due to conflict of interest while the latter could make the organisation hard to manage and severely lacking focus.
The obvious advantage of merging a company is economies of scale. When two companies merge, their combined revenues should, in theory, remain the same. However, as a joint operation they can consolidate multiple departments and operations, lowering relative costs in comparison to the new, increased overall revenue. Thus, mergers should increase the profits of the new company beyond the combined profits of the originals.
Increased market share is another major incentive for firms to merge. This motive assumes that a company, in absorbing a major competitor, will increase its hold of the market for that good and thus increase its power to control prices. The increased market share also enables it to benefit from keener deals with suppliers through buying in larger quantities, as well as through industrial blackmail when suppliers become dependent of retailers for the majority of their sales.
Another motive for firms to merge is cross-selling – lateral diversification. For example, a bank merging with an insurance company to create a financial conglomerate would then be able to sell banking products directly to the insurance company’s customers, while the insurance company can sign up the bank’s customers for insurance deals. This is effectively revenue synergy - better use of complementary resources. Geographical or other types of diversification are also factors – these can smooth the revenues of a company as they are spread across multiple industrial sectors and markets. This, in the long term, should stabilise the stock price of a company, giving conservative investors more confidence in investing in the company.
Vertical acquisitions/mergers are attractive for firms as it means the combined firm can guarantee supply/demand of its goods and drop profits in the middle stage to lower overall costs and therefore charge lower prices to gain market share. Tax dodging can also play a role, as a profitable company can buy a loss maker in order to use its tax write-offs to improve the combined company’s profitability.
While all the above mentioned all have the goal of increasing a firm’s value (i.e. share value), firms may also merge for reasons beyond shareholder value. For example, “manager's hubris” - when the executives of a company will just buy others because doing so is newsworthy and increases the profile of the company. This links to the idea of “empire building” – where managers seek power and make larger companies in order to achieve these ends. Furthermore, while both diversification and extension of a business may be desirable in order to achieve greater long-term growth, the former can often be unprofitable due to conflict of interest while the latter could make the organisation hard to manage and severely lacking focus.
