It's a simple concept, ubiquitous in the world of M&A. The value two independent firms create is less than the value the two firms would create if they were combined. Take company A and Company B for example. A wishes to buy B. Separately they produce independent levels of revenue, levels of operating costs, and levels of operating income. Combined, through the magic of synergies, the two can generate value that make the combined company better off than they were as separate entities. Expressed as a simple inequality:
NPV(A) + NPV(B) < NPV(A + B)
There are several sources to derive synergies. Here are a few:
REVENUE SYNERGIES
- Cross-sell: If there are complements between the acquirers and acquires products and services portfolio, it offers the opportunity to sell more of one or the other, and may also open doors to new sales if the two combined are more attractive together than they are as standalone entities.
- Supplier Power (customers): If the acquisition results in larger market share, it can result in the company having more upward influence on its customers input prices (the company is the supplier).
- New Customers/Channels: Acquiring a firm may open the doors to previously untapped customers, verticals, and channels, opening the flood gate for new sales, cross-sells, routes to market, etc.
- New Geos: Same concept as new customers/channels, only this opens the doors to an international foothold outside your established geography.
OPERATING COST SYNERGIES
- Employee Redundancies: Job duplicity will be inevitable for most acquisitions, necessitating layoffs. The result is most often little to no impact to the top line after reducing the headcount which reduces operating expenses, which in turn gives a nice little boost to operating income.
- Employee Productivity: If the new employees can do more with the resources of the acquiring company, employee productivity can rise. This is most applicable to the sales team.
- Buying Power (supplier): A byproduct of an acquisition is that it strengthens its position in the value chain. If the acquisition makes the company a larger, more significant purchaser of inputs from its supplier(s), it can put downward pressure on the price it pays for inputs.
ASSET SYNERGIES
- Property, Plant, and Equipment: These can be sold off if not critical to the core operations of the business and/or there is excess capacity.
-Economies of Scale: In its simplest form, Economies of Scale refers to the reduction of the average cost per unit produced achieved principally through excess capacity utilization.
FINANCIAL SYNERGIES
- Tax Reductions: If the acquired firm has a net operating loss (NOL), this can be applied to the acquiring firm’s income, effectively reducing taxable income. Also, if an acquired firm has a level of debt, the debt expense can be used as a Debt Tax Shields (DTS). All tax reductions will reduce the companies WACC and optimize its bottom line.
These are the synergies that come to mind. I’m sure there are more. Now, it's all fine and dandy to use synergies as justification for an acquisition, but we mustn’t forget that this is just one piece of the puzzle. Synergies only materialize on the income statement if the integration goes off without a hitch (this is the real source of value creation in M&A). Furthermore, what the acquiring company pays for the acquired firm will play a critical role in determining if the acquisition added value to its shareholders1.
This is just a brief look. There’s SO much more to cover. Message me if you wish to dive a bit deeper.
1) This is a hot topic - studies show value in an M&A deal is transferred almost entirely to the acquired firm, with a slight loss to the acquiring firm. Others argue the opposite if the M&A deal is executed well and the price is at or below market.
