Mergers and Acquisitions Explained

What happens when two companies decide to buddy up? Here’s your definitive guide to the often crazy world of M&As.

Feb. 5, 2021

Mergers and acquisitions are a regular feature of the business world.

However, you don’t have to be an expert to figure out that not all deals are the same.

The reality of mergers and acquisitions is a little more complex than you might think. But as an investor, it’s important that you understand exactly what’s going on should one of the companies in your portfolio find itself acquired by another.

The term mergers and acquisitions is used in a broad sense to describe the consolidation of two or more companies into a new entity. But not all mergers and acquisitions are the same. In fact, a merger and an acquisition aren’t even the same thing, strictly speaking.

A merger is when the boards of two companies seek shareholder approval to combine both businesses into a single entity. In most cases, one company will cease to exist entirely and simply become part of the other (usually larger) company.

The key members of both organizations are supposed to remain equal partners in a merger deal, but this is sometimes not the case.

An acquisition, however, is when one company buys all the outstanding shares of another company and assumes control over its running. The acquired company might not change its name, but will be entirely under the control of the new company.

The term ‘takeover’ is also sometimes used, although it carries more negative connotations.

Although these are the two most common types of joint ventures that companies pursue, there are other variations. An asset merger, for example, is when one company buys the assets of another (usually bankrupt) company. Or a management merger, where the top-level employees in a company buy up all outstanding shares and take it private.

So now that we know the difference between mergers and acquisitions, the obvious question is — why?

Every deal struck between two companies will have its own distinct reasons for coming to pass. The complexity of different industries means that it’s important to take a close look at the context surrounding every new merger or acquisition to come on the scene.

That said, there are a few broad categories into which most deals fall in some way.

A lot of companies see a merger as an opportunity to grow in size and dominance very quickly. By acquiring a smaller company, or joining up with a similar-sized company, a business can rapidly become one of the biggest players in its specific field or industry.

Bigger is better for a few different reasons. Not only will they have more resources and assets available to them after a merger, but they will also benefit in terms of economies of scale. This means that a large company can end up actually saving money on things like production and manufacturing when they’re bigger.

Another advantage of increasing company size is the extent of its market reach. By acquiring an established company in a different state, country — or even continent — a new market and existing customers are inevitably opened up almost immediately.

There can be issues with a company getting too big in terms of market dominance and competition, however, which we’ll come to in a moment.

Another reason why mergers and acquisitions take place is that large companies might identify a smaller competitor to be a potential rival in the future — or indeed, that current rivals might snap them up before they do.

This mindset of preemptive competition often inspires large companies like Alphabet and Apple to acquire promising young start-ups and incorporate them into their ecosystem. Having done so, they can then take advantage of all the resources that come with the new company while ensuring they don’t lose out to rivals.

Finally, and perhaps most cynically, is the fact that some companies can use mergers or acquisitions as a way to manipulate the taxes they pay. In such instances, a company might buy a smaller overseas rival in a country with favorable tax rates. They can then set up the company’s tax base in this location, and avail of cheaper rates on their business transactions.

Rumors about potential mergers and acquisitions are quite common, so it’s important not to base any important investing decisions on speculation. But even if a merger looks to have been agreed by both sides, there are still a myriad of things that can prevent its realization.

One of the big things that puts the skids on a merger is regulation. Most countries and governing bodies have laws protecting against anti-competitive practices, which essentially stop companies becoming too influential. For example, Microsoft was forced to back out of a deal to acquire Intuit in 1995 because the US Justice Department threatened to sue. The government claimed the acquisition would give Microsoft a dominant position in personal finance software and was therefore anti-competitive.

Shareholders can also stand in the way. Typically, an individual or group who holds the largest stake in a company is the one that gives the go-ahead for a deal to be struck. However, if a merger or an acquisition goes against the wishes of the majority of other shareholders, they can sometimes band together and block the deal.

Bidding wars can hold up a deal too. If a company has some lucrative product or asset, expect to see numerous companies enter the fray with competing bids. We saw this kind of thing occur a few years ago as Yahoo tried to sell off its core internet business, with the likes of Verizon, AT&T, and a consortium backed by Warren Buffett all putting in competing offers. If only they knew what they do now!

Finally, it’s worth mentioning that even if a merger or an acquisition is completed successfully, the long-term success of the deal isn’t assured. Diworsification is a term that was coined by Peter Lynch to describe what happens where an ill-fated merger or acquisition ends up doing a company more harm than good.

For example, Coca-Cola decided to get into the movie business in the 1980s and bought Columbia Pictures. After clumsily inserting their products into a number of box-office flops, shareholders decided they should stick to selling soda, and the great plan was abandoned.

When one company buys another, they usually pay in cash or stock — sometimes both.

That means that if you’re a shareholder in a company that becomes acquired, you might get cash for your stocks (usually at a premium on their current price), new stocks in lieu of the ones you own, or a bit of both.

Every merger and acquisition is different though, so it’s important to look into it and figure out exactly how it affects your standing.