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Mergers vs. Acquisitions: An Overview
While the terms “merger” and “acquisition” refer to the joining of two companies, they are very different concepts with several key differences. Both mergers and acquisitions can expand an organization’s reach or increase its market share, but how the participating companies interact and the end result of the process can vary dramatically.
Many view the difference between a merger and an acquisition as two ends of a spectrum, where mergers are generally amicable and voluntary, while acquisitions are hostile and one-sided. However, several other aspects of the two also differ, especially regarding valuations and financing.
Understanding the difference between a merger and acquisition is essential, especially if your business wants to combine with another entity. Knowing the advantages and disadvantages of each approach can help you plan your strategy accordingly to maximize your opportunities and benefits.
The Main Difference Between a Merger and an Acquisition
What Is a Merger?
A merger is when two entities voluntarily combine to create a completely new organization. Entities will merge in one of three different ways:
- Horizontal mergers are when two similar-sized businesses operating in the same industry join forces to reduce costs and take advantage of better economies of scale.
- Vertical mergers occur when two companies at different stages of a product cycle within the same industry merge. These mergers typically consist of vendors and sellers combining to get a competitive advantage and create more favorable economies of scale. They also allow the companies to consolidate more of the supply chain for their particular product.
- Conglomerate mergers happen when two businesses in different industries merge to offset disadvantages such as seasonality or to diversify into new markets. An example is the Philip Morris Company, which started as a tobacco company and merged with the Miller Brewing Company to diversify its holdings and expand into the food industry. The company solidified its foothold in this new market by merging with General Foods, Kraft Foods, and Nabisco.
What Is an Acquisition?
An acquisition is a more aggressive takeover of one company by another entity. The purpose of an acquisition is the same as a merger — to expand an organization’s reach into new markets or to take advantage of better economies of scale. An example of an organization using an acquisition to move into a new market would be Amazon’s purchase of Whole Foods in 2017.
Most acquisitions offer some strategic or synergistic value for the purchasing entity. Larger players often buy up smaller businesses in the same niche to reduce or eliminate their competition while also picking up skilled employees, new equipment, and an existing customer base.
Acquisitions are grouped based on how the acquiring company will integrate the purchased business into its operations. The two most common types of acquisition scenarios are:
- Tuck-in Acquisitions occur when the larger company incorporates the smaller business into its existing operations, resulting in a significant loss of control for the owner of the smaller company.
- Standalone Acquisitions are those in which the purchased company will continue to operate as a standalone facility. While this type of acquisition may result in more independence for the smaller organization, many of the most important decisions will remain in the domain of the purchasing entity.
While acquisitions tend to be larger businesses buying up smaller companies, horizontal acquisitions are also relatively common. Horizontal and vertical acquisitions frequently happen between organizations of similar sizes in the same industry. Horizontal acquisitions allow the acquiring company to reduce its competition and increase its market share significantly, while a vertical acquisitions involving a company buying up vendors and suppliers can dramatically reduce the entity’s operating cost while gaining new customers, equipment, and employees.
Why Merge Businesses?
Benefits of Merging
Some of the main benefits of merging companies include:
- Reduced costs
- Negotiating better rates for contract services
- Consolidating employee benefits and insurance programs
- Cutting accounting and bookkeeping costs
For many companies, becoming larger results in stronger purchasing power and the ability to provide better services and products to customers.
Some businesses suffer from seasonality — they may be very busy during summer but have almost no income during winter. Merging with another organization can offset this loss of income by ensuring that at least one aspect of the business is income-generating at a particular time.
Disadvantages of Merging
Every small business owner has their own way of running their organization, which may lead to conflicts during or after the merger. While it may not be a problem for all merging entities, many face a period of turmoil while the companies figure out the new system. Challenges often result from a disparity in corporate culture and governance and can lead to clashes, especially at the more senior decision-making levels.
One way to negate this disadvantage is to have a clear transition plan before implementing the merger. This plan will often contain outlines of decision-making processes, corporate culture, values, and vision, as well as clear guidance for existing employees.
Merger Valuations
Most mergers between small organizations rely on negotiations of mutual agreement between the owners. Publicly-traded companies may be slightly easier to value, as valuations tend to depend mostly on the stock price.
Unlike acquisitions, where one individual company will outright determine the market price of the other, mergers require cooperation between the two organizations. Both parties have to come to a mutual agreement on what the merger is worth to them, as both parties will continue their involvement with the newly formed entity.
Financing a Merger
Since both entities will combine into a new third entity, most mergers obtain financing in the form of equity instead of cash. The most common form is stock shares within the newly formed company.
The two (or more) individual business owners must prorate these stock shares based on the valuation of the two merging entities before the merger, which often isn’t an even 50/50 split. For instance, if one business is smaller than the other, such as in a 30/70 split, the owner of the smaller company would receive 30% of the shares, while the owner of the larger entity would receive 70%
Why Acquire a Business?
Benefits of Business Acquisition
Acquisitions can offer small businesses a host of benefits. While the larger company gets the majority of the benefits, including improved efficiencies and larger market share, smaller businesses may also see many upsides, including:
- Increased job stability
- Larger range of offerings for the existing customer base
- Reduced overhead costs
- Stronger negotiating position
- Better profit margins
Disadvantages of Acquisition
As with mergers, the largest disadvantage of an acquisition is the adjustment period after the purchase. Regardless of whether the acquisition is a tuck-in or standalone purchase, the company will experience a substantial change in the way it operates. This change may also impact the organization’s vendors, staff, and customers, especially in terms of payment agreements, scheduling priority, and pricing.
Acquisition Valuation
Determining the purchase price of the target company requires examining many factors influencing its value for the larger company. The main factor in calculating fair market value is the smaller entity’s cash flow, but other factors such as the state of the industry, industry trends, comparative business sales, and closed transactions come into play.
Ultimately, the acquisition value is the value that the purchasing company expects to gain from the transaction. Much of the conflict during an acquisition comes from the seller’s expected market value and the purchasing company’s perception of the target’s value. For instance, while proprietary processes may be an advantage for an organization, they may not be that valuable for a business already within the industry that has its own established processes.
While potential sellers may face the potential risk of a lower valuation than they expect, they may also receive a higher price due to the acquiring company’s needs. Purchasing organizations are often willing to absorb some added costs since they know they’ll reduce the overhead burden of their target company and pay back the cost of the acquisition more quickly.
Financing an Acquisition
Acquisition financing consists of several options, including cash at the closing of the transaction, stock or equity rollover, bank financing, and asset-based lending.
The most common form of financing is a combination of cash at closing and a seller’s note or earn-out component.
A seller’s note guarantees a payable amount to the seller over. This payout happens over a period of time, with set payments during that term.
An earn-out is similar but has variable, performance-based payments instead of a set amount. The amount of an earn-out payment is dependent on metrics, such as cash flow, EBITDA, growth, or revenue.
Key Takeaway
The key difference between mergers and acquisitions is what the final result looks like. Mergers often result in the creation of a new, third entity, while acquisitions end up with the purchased entity absorbed into the acquiring company. Other differences include how the company or companies value and finance the transaction — mergers tend to be more equity-based, while most acquisitions have a cash component.
However, most contemporary joinings of two companies are simply called “merger and acquisition (M&A),” and the differences are becoming smaller, especially in M&As of larger companies.
Joining forces with another company makes a lot of sense for many small business owners, but the complexities of the process put many individuals off the idea.
Reach Out to Us at NEO Business Advisors
At NEO Business Advisors, one of the best brokerage firms in Ohio, we’re ready to help you whether you’re buying or selling. Our multi-faced services include business valuations, development of exit strategies, and brokerage services to streamline the process while keeping your best interests in mind. For more information, set up an intro call today!