When two or more companies combine to either generate more profits or reduce costs together, they generate a synergy.
In M&A, companies have a clear top priority: to unlock the full potential of the financial benefits associated with the M&A process, hence the importance of synergies and of maximizing them. Numerous studies indicate that achieving initial synergy targets poses a significant challenge to corporates. For example, research conducted by Deloitte reveals that only a meager 25% of acquirers actually manage to achieve at least 80% of their synergy targets.
This article aims to equip companies with the knowledge to navigate the complexities of synergies in mergers and acquisitions. It offers a comprehensive, but non-exhaustive description of the types of synergies, explaining how to calculate them, and giving examples of companies that demonstrated significant success after M&A.
What are M&A synergies?
M&A synergies, also known as merger synergies or acquisition synergies, refer to the benefits or advantages that can be achieved from merging two companies or the acquisition of one company by another.
More specifically, M&A synergy refers to the notion that the combined value, operations, resources, capabilities, and market presence of the new entity are greater than the sum of separate entities, both in cost savings and incremental revenue.
Let’s consider this example: Company A is valued at $300 million, while Company B is valued at $150 million. However, after the merger, the combined company is valued at $500 million. In this scenario, the merger has created an M&A synergy of $50 million.
This means that the value of the merged firm exceeds the sum of the individual values by $50 million, demonstrating the potential financial benefit.
Here are some real-world examples of M&A synergies:
- Disney and Pixar. When Disney acquired Pixar Animation Studios in 2006, they combined their animation capabilities, talent, and production resources. This integration allowed for the creation of successful Hollywood blockbusters like Toy Story, Finding Nemo, and Frozen.
- American Airlines and US Airways. The 2013 merger between American Airlines and US Airways created the biggest airline in the world. The combined firm gained access to an expanded network of routes, increased flight frequencies, and a larger customer base.
Note: Learn what a SPAC merger is in our dedicated article.
Types of synergies in M&A
Usually, cost and revenue synergies are considered as the two key types of synergies, but there are also other types as we will see later on.
Cost synergies in M&A refer to the potential cost reduction that can be achieved when two separate companies consolidate.
The most common ways in which companies seek to extract cost synergies include:
- Workforce optimization. Workforce-related cost synergy can be achieved through staff reductions, eliminating redundant positions, optimizing the organizational structure, and reducing professional services fees.
- Supply chain optimization. Combined companies can optimize their supply chains by consolidating suppliers, improving logistics, reducing transportation costs, and enhancing inventory management.
- Facilities consolidation. Cost synergies M&A can be realized by eliminating redundant facilities and consolidating offices or other capital assets such as factories or warehouses.
- IT systems integration. Integrating information technology systems can result in cost savings by eliminating duplicate software licenses, hardware infrastructure, and IT support.
Revenue synergies in M&A refer to the potential increase in revenue that can be achieved when two companies combine their operations. These synergies arise from the complementary nature of the merging entities’ products, services, or customer bases.
Here are some examples of revenue synergies M&A:
- Cross-sales. Merged firms can leverage their combined product portfolios and customer bases to cross-sell products or services. For instance, a technology company acquiring a software firm can offer their existing customers the newly acquired software as an add-on product for more revenue. In fact, about 40% of revenue synergies come from cross-selling.
- Market expansion. By combining businesses, a new entity can expand its geographic presence, reach a new market with a broader audience, and produce higher revenue.
- Patents. Access to patents or other intellectual property can enable the companies combined to develop more competitive products, resulting in revenue synergy.
Financial synergies vs. operating synergies
Apart from the above-mentioned cost and revenue synergies, there are other two types of synergies in M&A: financial and operational synergies. The first one is the result of the improved efficiency of financial activities (e.g. the reduction in the cost of capital), while the second arises from the improvement of operating activities (e.g. the reduced costs from economies of scale).
Here are some examples:
- Tax benefits. Mergers and acquisitions can provide opportunities for tax efficiencies, such as optimizing tax structures, utilizing tax losses, and taking advantage of tax incentives, leading to reduced tax liabilities and improved financial performance.
- Increased cash flow. Financial synergies M&A can contribute to increased cash flows for the merged entity, improving liquidity, investment capabilities, and financial flexibility.
- Better capital structure. Mergers and acquisitions can result in an improved capital structure by optimizing the debt and equity mix, reducing borrowing costs, enhancing credit ratings, and achieving a more efficient allocation of capital resources.
Examples of synergy in mergers and acquisitions
Here are 3 real-life synergies examples that demonstrate tangible benefits that companies can achieve through successful M&A in business.
1. Facebook and Instagram
Facebook’s acquisition of the photo-sharing app Instagram in 2012 demonstrated significant success of synergies in business. By integrating Instagram’s visually focused platform with Facebook’s massive user base and advertising capabilities, the acquisition:
- Expanded Facebook’s reach and engagement, particularly among younger users
- Provided Facebook with access to the best photo-generating technology, which it had unsuccessfully tried to develop on its own earlier
- Facilitated Instagram’s user growth.
2. Amazon and Whole Foods
Another example of successful synergy is Amazon’s acquisition of Whole Foods in 2017 which allowed the e-commerce giant to enter the grocery market. This acquisition is also an example of conglomerate merger. It allowed:
- Provided Amazon with a physical retail presence and access to Whole Foods’ loyal customer base
- Enabled Amazon to leverage its e-commerce capabilities, such as online ordering and delivery, to enhance the customer experience at Whole Foods
- Allowed Whole Foods to leverage Amazon’s digital platforms and technologies to improve its online presence and reach.
3. Procter & Gamble and Gillette
The merger of P&G and Gillette in 2005 resulted in several synergies. More specifically, the operation:
- Allowed for cross-promotion of P&G and Gillette products, leveraging their respective customer bases and distribution channels
- Expanded international presence of two companies
- Facilitated the exchange of talent and expertise between P&G and Gillette.
How to value synergies in M&A?
Valuing synergies is an important aspect of M&A. It involves determining the monetary worth of the expected benefits resulting from the merger or acquisition. While there is no one-size-fits-all approach, there are several commonly used methods:
1. Comparable transactions
Analyze similar M&A transactions in the industry to value the premiums paid and the market’s perception of synergies.
2. Discounted cash flow (DCF) analysis
Forecast the future cash flows expected to be generated by the united entity and discount them to present value. Incorporate the estimated synergies to determine their impact on the overall value of the transaction.
3. Market capitalization method
Assess the market value of the target company before the announcement of the merger or acquisition. Compare it with the post-announcement market value to estimate the value attributed to the expected synergies.
How to calculate synergies?
To calculate potential synergies, it’s recommended to:
- Establish the transaction assumptions using one of the methods for evaluation, like comparable transactions, DCF analysis, or market capitalization
- Combine the revenue of the acquirer and target to determine the total combined revenue
- Calculate the combined cost of goods sold (COGS) by adding the individual COGS of the acquirer and target, adjusting for any cost synergies identified
- Determine the combined operating expenses (OpEx) by summing up the individual operating expenses of the acquirer and target, taking into account any identified synergies in this area
- Calculate the combined net income by considering the impact of expected revenue synergies, cost savings, and operational efficiencies on the net income of the merged entity.
Strategic buyer vs. financial buyer
There are two types of buyers in merger and acquisition transactions:
- Are expected to pay greater premiums
- Focus on cost and revenue synergies
- Come from the same industry as a target company and can provide industry expertise to capture synergies
- Aim to enhance competitive position and generate value over time.
- Are representatives of private equity firms
- Target cost synergies and financial improvements for higher returns
- Provide expertise in financial management and operational enhancements to achieve synergy
- Focus on shorter-term investment horizon and exit strategies.
Here are the main insights about merger and acquisition synergies:
- M&A synergies refer to the benefits or advantages that result from the combination of two companies in a merger or acquisition. The essence of M&A practice lies in achieving synergies.
- Revenue synergies result in increased revenue generation for the parties involved, cost synergies lead to reduced expenses, and financial synergies result in enhanced financial performance.
- Examples of successful business synergies include Disney and Pixar, American Airlines and US Airways, Facebook and Instagram, Amazon and Whole Foods, Procter & Gamble and Gillette.
- Common methods for synergy evaluation include comparable transactions, discounted cash flow analysis, and market capitalization.
- The process of calculating potential synergies in an M&A transaction involves establishing transaction assumptions, combining revenue and expenses, and considering the impact of synergies on net income.