Over the years, “synergy” has become quite the corporate buzzword, joining the likes of “disruptive” and “best practices” as favorites of the Digital Age. Few boardrooms can avoid its use over the course of a meeting, at times watering down its meaning with frequent use. When it comes to mergers and acquisitions, however, the importance of synergy can’t be overstated; assessing potential synergy is perhaps the most important task in a merger.
In this article, we’ll cover some of the main synergies unlocked by combining companies. These include cost reduction, greater market power, shared knowledge, and transformational synergy. We’ll also discuss the opportunities and execution risks associated with them.
When companies combine, two things are certain: the new company will be larger than it was, and there will be some redundancies to trim down. Where there were once two accounting departments, two executive teams, and two organizational systems, there need only be one. In reducing duplicate systems, you can unlock cost synergies.
This type of synergy works best when the merging companies are very similar, since they will often have parallel systems and roles. Of course, the newly combined company will need more administrative resources than it did before, but there should be plenty of redundancies. The result, ideally, is reduced operating costs as a percentage of revenue.
Challenge: It Hurts to Reduce Redundancies
Reducing redundancies after two companies have merged is hard. After a merger or buyout, firms often try to preserve morale by going easy on layoffs and intense restructuring. However, this can cause them to miss out on one of the main benefits of the merger in the first place: more efficient operations.
One company that arguably missed the opportunity to capitalize on this synergy is Dollar Tree, when it acquired Family Dollar in 2015. As you can see in the chart below, Dollar Tree’s Revenue more than doubled when Family Dollar, one of its biggest dollar store competitors, became a subsidiary. However, its operating margin fell hard after the deal and never could recover, as Dollar Tree likely could not optimize its former competitor and suffered lower profitability as a result.
Bigger is Better: Market Share and Balance Sheet
Despite falling margins, you can see that Dollar Tree did deliver on a major jump in sales after the merger. This is one of the most obvious benefits of merging two similar companies: their market becomes less competitive.
With large market share, companies can throw their weight around against the remaining large competitors. They can also obtain more attractive financing by borrowing against their combined revenue.
Challenges: Regulatory Oversight, Customer Loyalty
Large mergers between competitors are sure to attract greater legal scrutiny. Take the example of the recent merger between Sprint and T-Mobile. It took years for the telecom giants to get the government on board with the merger, with antitrust concerns looming from the start. Many of these mega deals are scuttled from the get-go.
Another issue is brand loyalty. Firms are often surprised that, following a merger, revenue is lower than their combined sales the year before. The truth is that mergers can also hurt a company’s brand, and customers may leave if they feel that the spirit of the company has been changed by a buyout. Perhaps more concerning for companies, workers jump ship for the same reason.
The Idea Effect
When two companies merge, so do the minds that drive them. Companies are comprised of a unique culture, personalities, and knowledge base. This knowledge can be publically available, such as the wisdom that comes with years of maintaining a strong corporate culture, or proprietary, such as a new technology developed in-house. After a merger, companies can combine their know-how to better solve problems.
Examples abound of these strategic buyouts, especially in the tech sector. Large tech companies are constantly gobbling up smaller tech firms, not for their revenue, but because they’ve found a unique way to solve their problems. Financial firms are also known for acquiring FinTech companies, as they struggle to stay ahead of a changing industry landscape.
Challenge: Putting (Not Butting) Heads Together
Two heads are better than one, except when those heads start butting. Figuring out which people and systems are redundant is naturally going to lead to a conversation about which ideas are redundant as well. There are real benefits to combining two talented teams to solve problems. However, there are many hazards to navigate, the most notable being culture clash.
Example: There are myriad examples of culture clash killing synergies. Often, we see this in the tech sector. The common refrain is of a young, innovative business getting acquired by a more mature, established company. Famous cases include Sprint’s acquisition of Nextel, as well as TimeWarner’s “old media meets new media” purchase of AOL.
Up to this point, each of the synergies we’ve discussed have been combinational in nature. In each case, two firms each contribute something in order to create a greater body of knowledge, an operational redundancy that led to lower costs, or a larger, more powerful firm.
Transformational synergy, on the other hand, gives the acquiring company the ability to completely change its business model, target market, or revenue make-up. Betting on transformational synergy entails larger risks and potential payoffs, because the company is striking out on unfamiliar territory. This synergy is unlocked when an acquisition target does something completely different from the parent company.
Example: When you think of transformational synergy, think of Amazon’s acquisition of Wholefoods. An ecommerce behemoth and an organic grocery store — it’s hard to imagine two more different businesses! In 2017, Amazon recognized that the grocery market was still fundamentally brick-and-mortar, and that the easiest way to enter it was through the acquisition of an established brand. Amazon therefore channeled transformational synergy in its acquisition of Whole Foods, staking its claim to a healthy chunk of the grocery market without starting from scratch.
Challenge: Execution Risk is High when Targeting Transformational Synergy
The obvious challenge is that the companies don’t know a great deal about the other’s business. In the case of acquisitions, it can be tempting for the acquiring firm to simply let the subsidiary keep doing its thing. However, this low-risk approach can cause firms to miss out on their potential to help one another compete more effectively.
Synergy can lose some of its meaning with repetition, but when it comes to M&A activity, you can’t say it enough. Merging brands can impact every aspect of a company’s performance, from operating margin to market power to the innovative edge. The executive team must take a deliberate, informed, and bold approach to valuing these synergies, and pick the best fit for the business and its environment. For investors, it is a valuable skill to recognize the signs of a future flop or a match made in heaven.