An acquisition is a type of corporate transaction in which a company takes over another entity and establishes itself as its new owner. It is a growth strategy that aims to achieve results in the short-term by purchasing businesses that are already well-positioned in their respective markers or fields.

An acquisition takes place when one company takes ownership of another company’s stock, assets or equity. It is a consolidation process that aims to create synergies to increase the profitability of the acquirer.

This concept usually refers to the purchase of a smaller firm by a larger one. In general, acquisitions are friendly procedures. In those cases, the transaction has already received a green light from the target company’s board of directors, employees and shareholders.

This means that the target company agrees with the sale and cooperates with the negotiations. On the other hand, in some cases, an acquisition can be a hostile transaction. This means that the board and/or management of the target company are not willing to sell but the acquirer forces them to do so through different strategies.

An acquisition may be made by stock purchase or by asset purchase. For legal entities such as sole proprietorships, partnerships or Limited Liability Company (LLC), the deal could only be made by asset purchase.

If the business is incorporated, the buyer and seller must decide if he wishes to structure the deal as an asset purchase or a stock purchase. Both types are explained below.

Key Takeaways

Types of Company Acquisitions

There are two main types of company acquisitions: stock and asset purchases. Let’s explain both.

#1 Stock purchase

When the acquirer uses the stock purchase method, it will aim to acquire only the target company’s common shares. This means that the ownership of the business entity is transferred to the buyer. The entity continues to have the same assets and liabilities that it had before the transfer but now all of them are owned by the acquirer.

If the selling company does not have a large number of shareholders, a stock transaction will normally be less complicated and easier than an asset purchase, but, in most cases, it has to be approved by the Board of Directors. When companies conduct a stock transaction, they can avoid state taxes that may apply to asset sales. Depending on the tax rate, this could result in significant savings.

#2 Asset purchase

If the buyer chooses the asset purchase method, it will only own the target company’s assets. These commonly include vehicles, buildings, tools, equipment, and inventory, among other items. In contrast to a stock purchase, the seller of the assets remains the legal owner of the entity, while the buyer purchases specific assets of the company.

The buyer can dictate which assets and liabilities and this limits his exposure to unknown liabilities that could be brought on through a stock purchase. However, it is necessary that the assets sold are re-titled in the name of the buyer. This is not required in a stock transaction.

A major tax advantage of an asset purchase is that the buyer can obtain tax deductions for depreciation and/or amortization. Additionally, with an asset transaction, goodwill can be amortized on a straight-line basis over 15 years for tax purposes.

Due to the application of securities law to stock purchases, some firms prefer acquiring assets as it is a less complicated process. On the other hand, by purchasing assets rather than stock, the buyer avoids the problems presented by minority shareholders who may refuse to sell their shares.

Step-by-step process of a Company Acquisition

The process of a company acquisition involves several detailed and strategic steps, designed to ensure that the acquisition is beneficial for both the acquiring and target companies. Here is a step-by-step overview of this process:

#1 Strategic Planning: The acquiring company identifies its strategic goals and how an acquisition could help achieve these objectives, such as entering new markets, acquiring new technologies, or expanding product lines.

#2 Searching for a Target: Once the strategy is clear, the company searches for potential target companies that align with its strategic objectives. This may involve hiring investment bankers, consultants, or using internal resources.

#3 Initial Evaluation: The acquiring company conducts a preliminary evaluation of potential targets to assess strategic fit, financial health, and potential synergies.

#4 Due Diligence: After selecting a target, the acquiring company undertakes a comprehensive due diligence process, examining the target’s financial statements, legal liabilities, operational systems, and other critical areas in detail.

#5 Valuation: The acquirer evaluates the target’s value using various methods such as discounted cash flow analysis, comparable company analysis, or precedent transactions. This helps in determining a fair price for the acquisition.

#6 Financing the Deal: The acquiring company decides on the financing method for the acquisition, which could include cash, stock exchange, debt financing, or a combination of these.

#7 Making an Offer: Based on the valuation and financing strategy, the acquirer makes an offer to purchase the target company. This usually involves negotiations between both parties.

#8 Negotiating Terms: If the offer is accepted, both parties negotiate the terms of the acquisition, including the purchase price, payment method, and any conditions to be met before finalizing the deal.

#9 Drafting and Signing the Agreement: Once terms are agreed upon, legal documents outlining the details of the acquisition are drafted, reviewed, and signed by both parties.

#10 Regulatory Approval: Depending on the size and scope of the acquisition, regulatory approval from relevant authorities may be required. This step ensures the deal complies with antitrust laws and other regulations.

#11 Closing the Deal: After receiving all necessary approvals, the deal is formally closed. The acquisition is finalized, and the payment is made to the target company’s shareholders.

#12 Integration: Post-acquisition, the focus shifts to integrating the target company into the acquiring company’s operations. This includes merging systems, processes, and cultures to realize the anticipated synergies.

#13 Post-Acquisition Review: Finally, the acquiring company conducts a review to assess the success of the acquisition against its initial objectives and to learn lessons for future acquisitions.

This structured approach helps in mitigating risks associated with acquisitions and maximizing the potential for success.

Acquisition Examples

There are many real-life examples of acquisitions. Some of them were successful business decisions while others were not. Let’s look at two well-known cases in the recent US business history.

In 1994, Quaker Oats bought Snapple for $1.7 billion with the purpose of complementing its Gatorade line with the popular bottled teas and juices produced by Snapple. Just 27 months later, Quaker Oats sold Snapple for just $300 million to Triarc Beverages.

According to some analysts, Quaker Oats failed in managing Snapple’s product lines properly and soon after the purchase, the brand started to lose revenues. Quaker probably failed to properly assess its own capabilities to maintain the success of the target company and this was a clear example of an unsuccessful acquisition.

In 2006, Walt Disney Co. acquired Pixar for $7.4 billion. Pixar was a small but successful business that revolutionized the way animated movies were made. In 2009, the company decided to buy Marvel Entertainment for $4 billion, which dominated the world of superheroes.

Those acquisitions made possible the launch of many movies that resulted in billions of dollars in revenues. That strategy allowed Disney to expand significantly its range of movies and provided massive gains to this globally-recognized corporation. Undoubtedly, these two were successful acquisitions.

Difference between an Acquisition and Merger

The difference between an acquisition and a merger lies in the details of the deal structure, the relationship between the involved companies, and the outcome of the transaction:

Acquisition

An acquisition occurs when one company, the acquirer, purchases another company, the target. In an acquisition, the acquirer gains control of the target company, which may continue to exist as a subsidiary or have its operations fully integrated. The identity of the acquired company may or may not be maintained, and the transaction can be friendly or hostile.

Merger

A merger involves two companies combining to form a new entity, with both companies ceasing to exist in their previous forms. The companies involved in a merger are typically of similar size and agree mutually to the merger, aiming to pool their resources, eliminate competition, or achieve synergies.

The result is a new company with a new identity, jointly owned by the shareholders of the original companies.

In essence, the key distinction is that an acquisition involves one company taking over another, while a merger is the combination of two companies into a new entity.

Acquisition  Advantages

An acquisition is assumed to bring more benefits than costs.

Some of the advantages that of completing an acquisition for the acquirer are the following: economies of scale if the enlarged size gives the acquirer the possibility to secure lower prices of its raw materials, access to new distribution channels, reduced labor costs when it some of the staff is laid off due to redundant position in the organizational structure, and an enhanced financial situation that may result in a lower cost of capital.

Acquisition Disadvantages

Any acquisition carries costs. Money has to be spent in legal and consulting expenses and also a lot of time is employed by senior managers to make sure the deal is completed successfully.

Aside from that, absorbing another company may bring cultural differences that should be assessed and reduced as soon as possible. Additionally, when there is a modification in the brands, products, or distribution channels, there is a risk that consumers may react negatively to the changes introduced.

Bottom Line

An acquisition is a transaction in which a company buys another firm partially or completely. In most cases, a larger company purchases the assets or the equity of a smaller firm.

When acquiring a firm, the acquirer expects to create synergies and grow quickly. It foresees a scenario of expanded markets, reduced costs and wider product lines, among other benefits.

However, the potential advantages must be analyzed carefully before making the decision as an acquisition is a process that also comes with difficulties and costs. Not all acquisitions result in a better situation from the acquirer’s perspective as shown in the example outlined above.

Frequently Asked Questions

What constitutes a successful company acquisition?

A successful company acquisition is characterized by the seamless integration of the target company, realization of anticipated synergies, and achievement of strategic objectives that enhance shareholder value.

How do companies finance acquisitions?

Companies finance acquisitions through various means, including cash reserves, issuance of new equity, debt financing, or a combination of these methods, depending on their capital structure and strategic goals.

What role does due diligence play in the acquisition process?

Due diligence is a critical phase in the acquisition process where the acquiring company thoroughly examines the target company’s financials, operations, legal standing, and potential risks to ensure an informed investment decision.

Can an acquisition affect the stock prices of the involved companies?

Yes, an acquisition announcement can affect the stock prices of both the acquiring and target companies, typically leading to an increase in the target’s stock price and a variable impact on the acquirer’s stock price, depending on investor perception of the deal’s value.

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The acquisition premium, also known as the takeover premium, is the difference between the actual price paid for a target company during a merger or acquisition based on its pre-merger value.

A premium is commonly paid if the acquirer has identified potential synergies resulting from the transaction that will offset the cost of the premium paid.

Takeover Premium Formula

The takeover premium (acquisition premium) formula is calculated by subtracting the value before merger from the total amount paid by the acquirer.

Here is the formula

TP = Amount Paid – Pre Merger Value

Where:

Amount Paid: The total cost of purchasing or merging with the target company. It can be expressed in terms of the equity value of the transaction or the full value paid for both the company’s equity and debt.

Pre-Merger Value: The market value of the firm before the transaction was brought.

Key Takeaways

Why would a company pay an acquisition premium?

An acquirer is willing to pay for an acquisition premium because of the potential synergies that will be created as a result of the merger or acquisition. These synergies derive from the combination of both businesses and will only be achieved if the process is completed successfully.

The pre-merger market value of the firm is, therefore, considered lower since it doesn’t account from these synergies. As long as the value created by these synergies is higher than the acquisition premium, the acquirer should be willing to pay it.

Takeover Premiums and Synergies

Here are some of the usual synergies that can be created as a result of an M&A operation:

Cost savings

The combination of both operations could lead to economies of scale and an improved bargaining position for the resulting enterprise. In this sense, a cost-savings synergy would justify an acquisition premium.

Financial analysts usually forecast how the total costs of the merged businesses would look like if the transaction moves forward and the ideal result should be higher profit margins.

Revenue increases

By combining their client’s databases, distribution channels, marketing programs, and other sales tools, merged companies can ultimately produce a revenue increase that surpasses their individual capacities. This revenue increase should lead to higher earnings and, therefore, an acquisition premium would be justified up to the point that it is covered by the excess revenues and earnings created as a result of the operation.

Increase efficiencies

There are instances when patented or highly complex technologies can be the reason why a company decides to acquire another firm, as these could help the businesses improve its productivity and overall efficiency. In those cases, the synergy should generate lower costs, faster processes, and improved structures that could result in a reduction in costs, a higher quality, or larger earnings.

Acquisition Premium Takeover Example Calculations

Depending on the way the M&A is appraised, the calculation of the takeover premium can be analyzed based on the equity portion acquired or the full value of the target company.

Let’s say Eagle Constructions is looking to purchase a company called Leaf Suppliers, which is a company that commercializes wooden materials for construction businesses. Leaf Suppliers shares are being traded at $12.6 right now and Eagle Constructions is offering $15 to complete the transaction.

On the other hand, based on the market value of Leaf Suppliers, its current Enterprise Value is $3.39 billion. From this perspective, Eagle Construction is offering $4 billion to settle the deal. By using the following two formulas we can calculated the Acquisition Premium paid on the equity and the Enterprise Value, as follows:

Example using share price

TP = (Proposed price per share – Current price per share) / Current price per share

TP = ($15 – $12.6) / $12.6 = 19.0%

Example using enterprise value

TP = (Proposed Offer – EV) / EV

TP = ($4.0 – $3.39) / $3.39 = 18.0%

This means that Eagle constructions is paying an acquisition premium of 19% on the equity and 18% on the Enterprise Value (EV) of the firm. Eagle Constructions expects that as a result of these operations the costs of their projects would be reduced by more than 5% aas they will be able to secure lower costs from the newly incorporated wooden material business unit created from the acquisition.

What Factors affect Takeover premium value?

The takeover premium is mainly affected by the financial impact of the synergies created as a result of the M&A operation, along with the complexity involved in completing the transaction successfully.

If the forecasted financial impact of the M&A on the acquirer’s finances is significantly positive, the takeover premium will be higher. On the other hand, if the complexity of the deal is high, the acquirer may feel less prompted to offer a large premium as there’s a significant risk associated to the completion of the M&A.

Additionally, the existence of other potential acquirers that would compete for the deal could boost the takeover premium as acquirers could be more inclined to bid higher prices to secure the acquisition.

What is the right acquisition premium price?

The acquisition premium should be estimated based on a comprehensive analysis of the financial value of the potential synergies.

A 5 to 10 year forecast of the financial contribution of the synergies and a subsequent discounted value of the resulting figures could provide a maximum limit for the acquisition premium. If the acquirer goes beyond this value, the transaction will be seeing as a overvalued.

Where is the takeover premium recorded on the acquirer’s books in accounting?

After the consolidation of the acquirer’s and the target company’s financial statements occur, the takeover premium will be recorded as goodwill in the acquirer’s Balance Sheet.

This goodwill will be amortized against earnings for a certain period of time that is usually in line with the time horizon during which the company will receive the financial contribution of the synergies created as a result of the M&A.

Bottom Line

Acquisition premiums are also used as a way to entice the target company’s shareholders to approve the deal and, while they are an standard practice in the M&A industry, the must be carefully calculated as they could result in financial losses for the acquirer if the deal is significantly overpaid.

Frequently Asked Questions

What is an acquisition takeover premium?

An acquisition takeover premium refers to the extra amount an acquiring company pays over the current market value of the target company’s shares to purchase and gain control of it.

How is the takeover premium calculated in an acquisition?

The takeover premium is calculated by subtracting the target company’s stock price before the acquisition announcement from the offer price, then dividing by the pre-announcement stock price and multiplying by 100 to get a percentage.

Why do companies pay a premium in acquisitions?

Companies pay a premium in acquisitions to incentivize shareholders to sell their shares, compensating them for potential future gains they forego as a result of the acquisition.

Can the size of a takeover premium indicate the acquiring company’s outlook on the deal?

Yes, a higher takeover premium can indicate the acquiring company’s strong belief in the strategic value or synergy potential of the acquisition, suggesting a positive outlook on the deal’s benefits

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Below, there are some real-life acquisitions that have taken place over the past decades. The first three examples are successful cases where expectations proved to come true. On the other hand, the last one is an example of a transaction that went wrong with tragic results.

What is a Company Acquisition?

A company acquisition occurs when one company, the acquirer, purchases and gains control over another company, the target. This transaction can involve the purchase of the target company’s stock, assets, or both, and can be conducted through cash transactions, stock swaps, or a combination of both.

Acquisitions are a strategic tool for companies to expand their operations, enter new markets, enhance their product offerings, or achieve other business objectives such as economies of scale or increased market share.

The process involves negotiation, due diligence, and approval from both companies’ boards of directors, as well as regulatory approval in some cases.

List of 4 Famous Company Acquisitions and Changed the Business World

Here is a list of the most famous company acquisition examples in modern history:

#1 Google Acquires Android

In 2005 Google purchased the startup company Android for just $50 million. Android reportedly developed operating systems for wireless devices that were location-sensitive or personalized for the owner. By that time, Google did not seem like the giant tech that we know these days. It was mostly known as a search engine.

But three years after the acquisition, the first public version of Android was launched with T-Mobile’s G1 phone. Throughout the years, Google has been able to perfectly integrate all its tools and software with Android.

In 2016, it was reported that Google made $31 billion in revenue from Android. Another estimate says that Google receives a contribution of $2.75 per device per year from Android. Although Android is free to be used by any OEM, Google makes money from mobile advertising and Apps sold at Play Store.

That huge amount of money is possible because, as of 2019, Android is the most popular mobile operating system in the world. There are more than 2.5 billion active Android users and, aside from smartphones, Android is also used by smart watches, tablets, smart TVs, cars, and many more electronic gadgets.

Android facilitates the positioning of Google as one of the most influential companies in the technology business. Estimates from the research firm Gartner claim that Android was used in more than 80% of all new smartphones shipped worldwide in 2018.

#2 Disney Acquires Pixar

The Walt Disney Company is a legendary enterprise founded in 1923 and one of the largest media and entertainment corporations in the world. It is the owner of numerous theme parks and television networks, including the American Broadcasting Company (ABC). Since its beginnings, Disney was mainly known by his animated films such as Snow White and Pinocchio, which were adaptations of children’s fairytales.

Pixar Animation Studios was started as a computer graphics division owned by the famous filmmaker George Lucas. In 1986, Steve Jobs purchased the computer graphics division for $10 million and established it as an independent company named Pixar which he co-founded with Dr. Edwin E. Catmull. 

In 1995, Pixar Animation Studios impacted the future of filmmaking with the release of its first feature film, Toy Story, which went on to become the highest-grossing film of that year with $362 million gross revenues.

Before the acquisition, there was an agreement in 1997 between the two companies to work together. Within that agreement, Disney had rights only over the films and characters used to produce Pixar’s films, as well as 10 to 15 percent of each film’s revenue as a distribution fee, for 10 years.

Pixar and Disney had ongoing disagreements since the production of Toy Story 2 but they were resolved. Finally, Disney acquired Pixar’s shares for $7.4 billion and Pixar became Disney’s subsidiary in 2006. The company offered 2.3 shares of its stock for each Pixar share, which was a 3.8% premium on the stocks’ closing price.

The success was undeniable. The combination of Pixar’s technological innovation and Disney’s powerful distribution and mass media achieved spectacular results. The following five films released from 2007 to 2011 obtained revenue for approximate $3.5 billion and these included Ratatouille, Wall E, UP, Toy Story 3, and Cars 2. In the subsequent years until 2019, Disney Pixar released other nine films with revenues that totaled almost $7 billion.

#3 Pfizer Acquires Warner-Lambert

In 2000 Pfizer acquired Warner-Lambert for $90 billion in an all-stock deal. The acquisition resulted in the creation of the largest drug company in the U.S. and the second largest worldwide behind Switzerland’s Novartis, ranked by sales.

This is known as one of the most hostile acquisitions in history because Warner-Lambert was originally going to be acquired by American Home Products, a consumer goods company. American Home Products walked away from the deal, resulting in large break-up fees, and Pfizer swooped in. 

Pfizer had its eye on Warner-Lambert because of its highly demanded cholesterol medication Lipitor. With the acquisition, Pfizer obtained control of Lipitor’s profits, which amounted to over $13 billion, after some years of co-promotion between Pfizer and Warner-Lambert.

With the addition of Warner-Lambert, Pfizer hoped to be the fastest-growing pharmaceutical company. It added 2,500 sales representatives to its 5,000 workers in the United States.

The combined Pfizer and Warner-Lambert also had a total number of research staff of 12,000 – the largest in the world, along with six state-of-the-art research campuses, and the largest R&D budget with a total of $4.7 billion per year. The new company reached the world’s leading position in various therapeutic areas, including cardiovascular, lipid-lowering, CNS and infectious diseases, with several star products.

Additionally, the huge R&D budget was expected to allow the progress of its development pipeline, which at the time was comprised of more than 138 compounds in areas including central nervous system diseases, oncology, cardiovascular, metabolic and infectious diseases. 

#4 Kmart Acquires Sears

Kmart purchased Sears in 2005. The combined companies would operate around 3,500 locations, save $500 million yearly, and obtain at least $300 million per year in cost savings, mostly because of synergies in the supply chain and administrative staff.

The resulting firm, Sears Holdings, experienced higher sales in 2006, but then fell in each of the following nine years. Profits reached $1.5 billion in 2006, but the following years they dropped significantly. Total loses from 2011 to 2016 exceeded $10 billion.

The management team tried to save the chain through a wave of store closures, hour and pay cuts, but sales continued falling. Customer experience deteriorated as the debt increased. Finally, Sears had $6.9 billion in assets but $11.3 billion in liabilities.

Although Amazon took a big part of the retailing industry during that period, other brick-and-mortar retailers performed well. In 2011, Sears lost over $3.1 billion but Walmart made $17.1 billion. Sears filed for bankruptcy in 2018 and it that year its stock prices fell below $1.

Key Takeaways

Bottom Line

Acquisitions are a common strategy to accelerate the achievement of strategic goals. They take place in every industry and facilitates consolidation and development processes. Some of them go very well and result in stronger and more profitable corporations that push the boundaries of technology, innovation and wellness.

Those are the cases of Google-Android, Disney – Pixar and Pfizer – Warner-Lambert. Other acquisitions proved to be bad decisions that brought massive loses, such as the acquisition of Sears by Kmart.

Frequently Asked Questions

What motivates a company to acquire another company?

Companies pursue acquisitions to achieve strategic objectives such as expanding their market presence, accessing new technologies or products, or realizing cost synergies.

How is the purchase price determined in a company acquisition?

The purchase price in an acquisition is typically determined through negotiations between the acquiring and target companies, often based on a valuation of the target company’s assets, earnings, and market potential, along with premium payments for control of the company.

What are the key steps involved in the acquisition process?

The acquisition process involves several key steps including due diligence to assess the target company’s financials and operations, negotiation of terms, securing financing if necessary, and obtaining regulatory approvals.

How does an acquisition differ from a merger?

An acquisition occurs when one company takes control of another, whereas a merger involves two companies combining to form a new entity, often with shared ownership and control.

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What Does Verticle Merger Mean?

What is the definition of verticle merger? Vertical mergers are a strategic way for companies to increase their business and have more control over supporting steps of a supply chain. In a supply chain, a supplier provides raw materials to a manufacturer who creates a product which is then distributed to retailers who sell the product to the end customer. After completing a vertical merger, companies are often able to develop synergies that lead to more efficient operations, reduced costs and increased business.

Vertical integration is a similar concept in which a company expands its operations into other phases of the supply chain. However, this can be achieved internally and does not always require a merger of businesses. The opposite of a vertical merger, is a horizontal merger, in which two companies that create competing products and operate in the same stage of the supply chain, merge their businesses. An example would be the Exxon-Mobil merger in 1998 / 1999.

Example

There have been several examples of vertical mergers. In 2002, Ebay, a prominent online auction and shopping website, acquired PayPal, a company that supports online payments and money transfers. Although both businesses provided different services, PayPal was used for a growing number of transactions on Ebay and therefore very relevant to their operations.

Another recent example of a vertical merger was the acquisition of Ticketmaster by LiveNation in 2010. LiveNation was a prominent owner / operator of over 100 entertainment venues as well as dozens of entertainment promoters, while Ticketmaster was the world leader in ticket sales and also had a related business in talent management. Through this merger, LiveNation was able to capture Ticketmaster’s retail services which directly complement LiveNation’s core businesses.

Summary Definition

Define Verticle Merger: Verticle integration means combining two companies or departments and control two steps in the value chain.

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What Does Merger Mean?

What is the definition of merger? A merger is a financial activity that is undertaken in a large variety of industries: healthcare, financial institutions, private investments, industrials, and many more. There are two main types of mergers: horizontal and vertical.

Horizontal mergers occur when two businesses in the same industry combine into one. This type of combination can cause anti-trust issues depending on the industry. For instance, GM and Ford may not be allowed to merge because of anti-trust laws.

Vertical mergers occur when two businesses in the same value chain or supply chain merge. For example a hamburger restaurant might merge with a cow farm.

Let’s look at an example.

Example

The largest car manufacturer in the United States, Cars Incorporated, has announced an acquisition of the number three car manufacturer, Trucks Incorporated for a price of $45,000, paid through a combination of stock, cash, and debt. At the time of the announcement, Trucks, Inc. stock rose 10% to $45, and Cars, Inc. stock rose 5% to $73. In order to carry out this process, both firms must contact investment bankers and other financial professionals in order to verify the transaction and carry it through. Cars, Inc. will pay 2% of the purchase price, or $900, to the financial advisors for their help throughout this process.

The reason that Cars, Inc. chose to acquire Trucks, Inc. was due to an array of revenue and cost synergies, or savings, which could be realized by the joint entity: employee count could be cut by 5,000, and truck revenue can be boosted by $50,000, for combined revenue of $200,000. Additionally, it is reported that consumers will now pay 15% less per vehicle, due to the cost savings realized in the merger.

Mergers are a large part of our financial landscape and often help create more efficient and beneficial organizations, both for shareholders and for consumers.

Summary Definition

Define Mergers: Merger means the combination of two companies.

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What Does Horizontal Merger Mean?

What is the definition of horizontal merger? This business strategy is used by a firm that seeks growth through acquisitions. Most mergers take place in highly concentrated industries where fewer firms compete, and the synergies are favorable. Because the two firms compete on the same stage of the supply chain, they are able to develop economies of scale by combining operations.

In the long-run, they are able to increase their market share and lower their marginal costs. Furthermore, they can offer a wider range of products to their customers without having to invest in new resources.

Let’s look at an example.

Example

A potential merger between Pepsi and Coca-Cola would be one of the mergers of the century. Both companies compete in the same industry, and the combination would create a new, larger company with a higher market share. Furthermore, as the two firms have very similar operations, a horizontal integration would allow them to lower their costs. This would be the case for McDonalds and Burger King or for Daimler-Benz and Chrysler as well.

On the other hand, mergers between large organizations are perceived as monopolistic. A firm that capitalizes on its financial, technological, and human resources can become a monopoly. Also, if one firm has 35% of the market and the other firm has 15% of the market, the new firm will have 50% of the market. This is a relatively unfair competitive advantage for these firms as they create an oligopoly through merging.

If two smaller companies merge horizontally, the effect on the market won’t be too strong. For instance, a small dairy with the know-how and the capital seeks to capitalize on the distribution channels of a competitor to further expand its activities. This type of combination won’t cause any ripple effects in the industry.

Summary Definition

Define Horizontal Merger: Horizontal mergers means two businesses within the same industry combine together to make a bigger company that operates in the same industry.

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