VPS | Mergers and Acquisitions (M&A) - An Overview

The difference between a merger and an acquisition lies in how two businesses are combined. In a merger, both parties negotiate and bargain on equal terms. If both sides perceive benefits from the merger, the transaction proceeds.

An acquisition can be either friendly or hostile. In a friendly transaction, the target company agrees and supports the acquisition. In this scenario, the target company sees M&A as an opportunity to access resources, such as capital, to develop new areas that they couldn't pursue alone. Successful small businesses lacking capital for expansion and facing increasing competition often turn to M&A as a sustainable solution.

The motivations behind an M&A deal:

1. Acquiring a company

The decision to acquire a company depends on whether the action will increase shareholder value. Companies engaging in M&A typically expect to achieve results through synergy, strategic planning, tax savings, acquiring undervalued stocks, or diversification strategies.

The most important motivation for the acquirer is synergy resulting from the combination of operations. Common types of synergy include:

• Cost-saving synergy, achieved through economies of scale or scope.
• Revenue synergy, created by combining the revenues of two companies and cross-selling their products.
• Financial synergy, resulting from reduced capital-raising costs.

The second motivation is the attractiveness of the target company's stock price. A company seeking to expand its operations may acquire another existing company. If the cost of new investment is higher than acquiring an existing company, M&A becomes a more favorable option. The q ratio, defined as the market value of a company divided by the replacement value of its assets, is used to assess the attractiveness of the target company's stock price. A q ratio <1 indicates that M&A is preferable to developing the business independently. The smaller the q ratio, the more attractive the target company's stock price. This theory was particularly successful in explaining the surge in M&A activity in the 1970s when inflation and high-interest rates led to a sharp decline in stock prices, making asset replacement costs expensive and thus reducing the q ratio.

The third motivation arises from the conflict of interest between management and shareholders under agency theory. If executive compensation is based on the scale of the company's operations, management will be motivated to expand through M&A. Some profitable businesses with idle cash reserves also choose to expand through M&A to avoid being easy targets for hostile takeovers. With this expansion, management hopes to maintain their managerial positions.

The final motivation for the acquirer is to diversify business operations. Diversification can help reduce systemic risk. Broadening the business horizontally can achieve economies of scale, while expanding vertically can achieve economies of scope.

2. Selling a company

There are many reasons why shareholders or management may sell a company. Common motivations for business owners and individual shareholders to sell a company include retirement plans or real estate investments, or simply having the capital and time to pursue other business ambitions. Another straightforward motivation is the need to release capital to implement basic business expansion plans when capital raising in the market is difficult or unavailable.

For some private businesses, the motivation to sell may simply be to rid themselves of personal liabilities associated with the company's operations, such as personal guarantees for business loans. Personal guarantee commitments can threaten the safety of the owner's entire estate.

For larger companies, divestment often occurs with subsidiaries and business segments no longer aligned with the core business strategy, aiming to focus on the company's core business activities or conglomerate.

Selling a company may also be driven by other motivations and reasons. Some companies with venture capital investors may want to sell the company to realize their investments. Additionally, companies in difficult situations or financial crises may have the motivation to sell part or all of the business.