A Beginner's Guide to Mergers and Acquisitions

Corporations merge for many reasons but not always successfully

Mergers and Acquisitions
••• Getty Images

 Mergers and acquisitions have one underlying motive in common: to protect or improve the strength or profitability of the dominant company. In other words, they maximize shareholder wealth.

At least that's the theory. Sometimes the motives can be less admirable. The goal might be to protect a seated board of directors from a different merger that might put their jobs at risk, or it might be to squelch a stockholder reform initiative. Not all mergers and acquisitions maximize shareholder wealth, and in some instances, quite the opposite holds true.

What are some legitimate reasons that a company might decide on a merger or acquisition? It begins with knowing what each is and how they occur. 

The Nature of an Acquisition 

An acquisition tends to be a far less complicated process than a merger. The acquiring company purchases a major stake in another business entity. The acquired company might retain its own name and identity, or it might not. Its very existence might be absorbed by the acquiring company.

In the usual scenario, the acquiring company is larger and far more solvent. An acquisition is sometimes referred to as a takeover, and both terms carry a somewhat negative connotation, suggesting that the smaller company is being seized against its will. 

A tender offer bears similarities to an acquisition in that one company buys a usually significant portion of another company's stock, but this is typically arranged directly between shareholders. It sidesteps the involvement of the boards of directors. An acquisition tends to depend on the cooperation and consent of a board of directors and sometimes management as well. 

How Is a Merger Different? 

A merger creates a new, previously nonexistent business entity when Company A and Company B join forces. Company A and Company B are usually similar in size, and they act as equal partners in the newly formed venture. 

A consolidation is very similar to a merger. Think Citigroup, which used to be two companies: Citicorp and Travelers Insurance Group. They consolidated. 

Product and Investment Diversification

Mergers and acquisitions sometimes happen because business firms want diversification, such as a broader product offering. If a large conglomerate thinks that it has too much exposure to risk because it has too much of its business invested in one particular industry, it might acquire a business in another industry for a more comfortable balance. The acquiring firm would no longer have all its eggs in one basket.

If a company with a strong product line of CD burners sees the market shifting toward digital downloads and streaming, it might want to acquire another company that's active in one of those market sectors.

Foreign Market Acquisitions and Mergers

Another kind of diversification aims to reduce risk by merging with firms in other countries. It reduces foreign exchange risk and the dangers posed by localized recessions. Fiat, the Italian multinational, merged with Chrysler Corporation in 2014, making Fiat more competitive in U.S. markets while also reducing foreign exchange risk.

The successfully merged conglomerate Fiat Chrysler began seeking another merger with a third corporate automobile giant in 2018 in an effort to further increase its market share and capital base.

Acquisitions and Mergers to Improve Financial Position

Improved financing is another motive for mergers and acquisitions. Larger businesses might have better access to sources of financing in the capital markets than smaller firms. The expansion that results from a merger might enable the recently enlarged business to access debt and equity financing that had previously been out of reach.

Apple, one of the largest corporations in the world, successfully issued about $17 billion in bonds in 2013, despite the fact that it already held unprecedented amounts of capital. A smaller company, such as Dell, would be unlikely to succeed with a bond issue of this size.

A company might look for another company to acquire it if it's in financial trouble. The alternative could be going out of business or going into bankruptcy

Tax Advantages 

Mergers and acquisitions offer several possible tax advantages, such as a tax loss carry-forward. If one of the firms involved has previously sustained net losses, these losses can be offset against the profits of the firm it has merged with. This provides a significant benefit to the newly merged entity, but it's only valuable if the financial forecasting for the acquiring firm indicates that there will be operating gains in the future. Otherwise, this tax shield would not be worthwhile. 

Another often-criticized corporate merger/acquisition scheme involves a company in a high-corporate-tax-rate state or country merging with another corporation in a low-corporate-tax-rate state or country. Sometimes the corporation in the low-tax environment is much smaller and would normally not be a candidate for a major corporate merger. With the merger, however, the new company would become legally located in the low-tax jurisdiction and could subsequently avoid millions and sometimes billions in corporate taxes.

Operational Efficiency Advantages

If two companies merge that are in the same general line of business and industry, operating economies can result from a merger. Duplication of functions such as accounting, purchasing, and marketing efforts within each firm can be eliminated to the benefit of the combined firm.

It is sometimes particularly beneficial when two relatively small firms merge. Business functions are expensive for small firms. The combined business entity would be better able to afford the necessary activities of a going concern, but operating economies can be achieved by larger mergers and acquisitions as well. 

Economies of scale often come into play to increase operational efficiency. The cost of doing business generally decreases, especially in manufacturing industries, when materials and other purchases are scaled up.

The Risks of Mergers and Acquisitions

Even when the CEO and the board of directors are honestly motivated to merge with or acquire another corporation to improve the company's financial position somehow, things sometimes don't work out as intended.

Shortly after the massive merger of communications giants AOL and Time-Warner, AOL—the acquired company—posted an almost unimaginable $100 billion loss, putting Time-Warner in financial jeopardy. It led to the problematic exits of top executives in both companies when they were held responsible for the financial disaster. In some ways, the underlying cause was simply bad timing because the merger coincided with a growing dot-com financial meltdown. 

Mergers can also fail because the corporate cultures of the two corporations are simply incompatible. At other times, mergers can achieve the desired financial goals yet operate against the public good, creating an anti-competitive monopoly.