Synergy Concept: types of synergies, reasons, and examples
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Synergies are an integral part of mergers and acquisitions (M&A) transactions when the seller seeks beneficial offers from strategic buyers and private equity firms.
What are synergies in business? What types of synergies exist? Explore the financial synergy concept in this short guide.
What are synergies?
Synergy is a concept that the combined value and performance of two companies after their integration will increase compared to the sum of the separate entities.
In other words, if company A, worth $200 million, acquires company B, worth $50 million, and if their combined value grows to $290 million, the merger results in a synergy of $40 million. The value of the combined firm is obviously more valuable and profitable than when two firms operate separately.
For a better illustration of the synergies finance concept, experts use this equation:
By achieving synergies, merged firms can profit by realizing results such as increased revenue and market share, a reduced tax burden, or combined technology.
More specifics about the synergy definition in business further.
Types of synergies
There are three main types of synergies M&A: cost synergies, revenue synergies, and financial synergies. Let’s review each type in more detail.
Revenue synergies are based on the concept of two companies increasing total cash flows after their integration compared to the sum of their cash flows when operating separately.
The only reason for revenue synergies is the increased revenue after the strategic buyer and target company unite.
Revenue synergies most commonly occur between companies that sell in the same industry.
For example, company A sells cheap new laptops, and company B sells used laptops. They’re not direct competitors but operate in the same market. Company A is a small organization with lower capital, but it still competes with company B, which is a big corporation that seeks possibilities to get more revenue.
A more profitable firm acquires the target company, and the expected revenue synergies increase the cash flow of the combined firm.
These are the main types of synergies for boosting revenue:
Such revenue synergy allows the merged firm to access the patents and intellectual property of the other firm and, thus, improve production, resulting in increased revenue and better capital structure.
- Complementary products
Two companies that are not direct competitors but operate in the same industry unite to produce more sales and increase revenue.
- Complementary customers and geographies
Two firms that serve customers from different locations merge to expand the geography of their strategic buyers and. As a result, their product is introduced and available to a new customer base, which should produce higher revenue.
The main goal of cost synergies in mergers and acquisitions is cost reduction or cost savings.
During cost synergy, the total revenue of the combined company after the merger does not increase, but there’s also no additional cost spending.
Let’s explain cost synergies with the help of the before-mentioned example.
Company A sells cheap new laptops, and company B sells used laptops. Mergers and acquisitions are the chance for both firms to increase their revenue without increasing expenses. The cost for storage, logistics, marketing research, and training will be lower, as companies will unite their forces and won’t incur additional expenses while attaining better results.
Usually, cost synergies are achieved through:
- Lower salaries
When two companies merge into one firm, they most likely won’t need two identical C-level positions, as they form one management team. Salary spending is greatly reduced, however, it doesn’t always have to involve lay-offs.
- Shared resources
Cost synergies allow smaller companies to access the research and development outcomes of a profitable firm, which results in a lower production cost without losing the quality of products.
- Improved sales and marketing strategy
Such mergers allow companies to reduce the cost of market research and expand marketing channels at the same time.
- Shared supply chains
If one company has better supply chains, it’s a chance for the merged firm to take advantage of the potential cost savings.
- Reduced rent
A merger integrates two separate companies into one physical business entity, which can reduce the rent pay.
Financial synergy basically includes revenue and cost synergies and improves a combined company’s position in the market.
Financial synergies relate to the company’s cost of capital — mergers and acquisitions transactions allow companies to reduce their cost of capital.
Let’s illustrate financial synergy by describing a mid-sized company that wants to get a loan from a bank. In this case, the bank may charge higher interest rates. However, when two mid-sized companies unite into one big company, the loan borrowing conditions improve. Firms get benefits since they have a better cash flow and capital structure and, thus, are more likely to repay their loan on time.
Common benefits a company experiences from a financial synergy include:
- Tax benefits
Existing tax laws allow companies to take advantage of the financial synergy during the merger. When a profitable company acquires a loss-making company, there’s an opportunity for the former to reduce its tax burden. Another example of tax benefits is when one company uses another company’s depreciation allowance to help reduce its own tax burden.
- More debt capacity
Financial synergy allows two separate companies to get better interest rates on loans. The debt capacity increases due to the improved cost of capital and better cash flows of the combined firm.
- Lower cost of equity
Such financial synergy benefit often occur when a larger firm acquires a smaller one. This creates less competition and increases the customer base and market share, which results in a lower cost of equity.
Successful synergy examples
Successful financial synergy is when the merger of two companies results in increased revenue, tax benefits, and better debt capacity.
Below are some ideal examples of successful synergy:
- Disney’s acquisition of Pixar
This is an excellent example of revenue synergy. Disney acquired Pixar in 2006. At that time, Disney’s revenues were $33.7 billion. In 2011, they increased to $40.89 billion. They were able to achieve this because Pixar’s characters were being promoted in Disney’s theme parks. Furthermore, Pixar’s merchandise was being sold in Disney’s stores around the world, and Pixar could release movies more regularly.
- Facebook’s acquisition of Instagram
This is a great example of financial synergy. Facebook acquired Instagram in 2012 for $1 billion. At that time, Instagram’s revenue was close to zero, and the number of users was less than 50 million. As a result of this M&A synergy, Facebook benefited from its fast-growing platform with millions of prospective customers, access to the best developers and other technical specialists, and a chance to integrate the best photo-generating technology. Since the merger, Instagram has grown exponentially.
- Exxon and Mobil merger
This is the perfect example of cost synergy. The companies’ merger in 1998 allowed the two separate organizations to become the largest oil company in the world. They united their manufacturing processes, which allowed them to sell many refineries and 2,400 service stations. Also, about 16,000 employees were laid off, which resulted in a positive synergy of $5 billion.
Negative synergy examples
Negative synergy occurs when the combined firm’s revenue is lower than the value of each company operated separately.
Below are a few negative examples of synergy in business:
- Quaker Oats and Snapple deal
In 1994 Quaker Oats acquired Snapple for $1.7 billion. One reason that this deal failed was that both companies were selling their products in completely different sales channels (Quaker Oats in large supermarkets, Snapple in small stores or gas stations), and they had completely different branding and marketing strategies. Moreover, with the Snapple acquisition, Quaker Oats aimed to compete with Coca-Cola, which was almost impossible at that time.
- eBay and Skype merger
In 2005, eBay Inc. acquired Skype for $2.6 billion, while Skype revenues totaled only $7 million. eBay’s CEO wanted this merger to happen to provide its users a chance to better connect with sellers. The deal failed mainly because the proper market and customer research were missing. In 2011, eBay sold Skype to Microsoft.
- Google and Motorola merger
In 2012, Google acquired Motorola for $12.5 billion in the hope of gaining potential synergies by profiting from Motorola’s patents and technology. The goal was to produce high-quality Android-operated mobile handsets. The deal failed mainly because of unclear expectations and poor performance.
Merger and acquisition synergies should be well-thought-out during every stage of the deal.
Synergies in M&A are often easy to imagine and plan but harder to implement. It always takes time to gain awaited results, and all the parties involved in synergy analysis should realize that.
Having realistic expectations from synergies in business is more likely to result in a successful deal.