Business synergies are important drivers of value in mergers and acquisitions. They are based on the notion that the two companies when combined are worth more than they are when valued separately.
Understanding business synergies
The term “synergy” has become somewhat of a buzzword in business in recent years, but it can also be used very specifically to describe any factor that increases the value of the resultant company in a merger or acquisition.
Consider this basic example. Two companies, Company A and Company B, have decided to merge.
Before the merger, Company A was worth $250 million and Company B was worth $75 million. Once the merge has been completed, the new company was valued at $400 million and as a result, a synergy of $75 million was created.
Exactly how and where this extra value is created is explained later in this article.
For the buyer in a merger or acquisition, the presence of synergies determines how much they can afford to pay for the other company.
In the above example, it is incumbent on Company A to determine how much extra value can be attributed to Company B when deciding on a purchase price and whether it makes economic sense to move ahead.
Conversely, for the seller, it is important to understand the synergies the buyer is looking to extract and profit from.
Company B could negotiate a higher purchase price than $75 million if it was able to successfully prove the extra value it would bring to Company A.
Three types of business synergies
Let’s now take a look at the three broad types of business synergies.
Revenue synergies
Revenue synergies occur when the two companies in question can sell more products or services than they otherwise could separately.
For example, the integration of Instagram’s photo-sharing features into Facebook would boost user engagement there and increase advertising revenue.
Cost synergies
Cost synergies present a way for the merged company to reduce costs. This can occur in several different ways:
Reducing employee headcount because of duplication of roles and responsibilities.
Reducing rent via the consolidation of offices.
Any cost that is reduced by the exchange of industry best practices.
Consolidation of suppliers and/or the ability to negotiate more attractive contracts due to economies of scale or increased purchasing power.
Capital cost reduction via more efficient use of transportation or manufacturing facilities.
When Australian broadcaster Nine Entertainment Co. merged with Fairfax in 2018, the former identified $65 million in cost savings that would be realized from synergies in IT, media sales, and corporate overhead.
Financial synergies
Financial synergies relate to the cost of capital. In other words, the costs the company needs to meet to finance its operations.
Smaller companies that borrow money to fund their business activities usually attract a higher interest rate to compensate for the extra risk to the lender.
When the smaller company merges with a larger company, however, the interest rate should reduce to reflect the larger company’s stronger balance sheet or cash flow.
Synergies are thus created when the merged company can make lower repayments on the loan.
Not all synergies benefit from mergers and acquisitions
There are two types of synergies that do not benefit from mergers and acquisitions.
The two synergy types whose benefits are better realized from a strategic alliance are:
Sequential synergies
Where one company completes some of the task and passes it along to another company.
For example, a big pharma company may purchase the marketing and distribution rights from a smaller drug manufacturer in return for a share of the profits.
Modular synergies
Where two companies pool their resources, manage their resources separately, and pool the results.
Commercial airlines and hotel chains often enter into this form of strategic alliance where frequent flyer and other loyalty points are shared.
Key takeaways
Business synergies are important drivers of value in mergers and acquisitions. They are based on the notion that the two companies when combined are worth more than they are when valued separately.
The three broad types of business synergies are revenue synergies, cost synergies, and financial synergies. They may appear to be similar at first glance but each has different and specific applications.
Not all business synergies will benefit from mergers and acquisitions. The benefits of modular and sequential synergies are better realized with a strategic alliance.
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Gennaro is the creator of FourWeekMBA, which reached about four million business people, comprising C-level executives, investors, analysts, product managers, and aspiring digital entrepreneurs in 2022 alone | He is also Director of Sales for a high-tech scaleup in the AI Industry | In 2012, Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy.
