Mergers and Acquisitions: Basic Terminology

In order to grow and/or achieve adequate diversifications, companies often take the route of mergers and acquisitions. An acquisition is when a portion of a company, or the company in its entirety, is purchased by another company.

If the latter is the case, the acquisition of the entire company is also referred to as a merger or the complete amalgamation of one company by another. In most cases, mergers occur when two smaller companies combine their assets and liabilities to form a bigger company.

Mergers can also be defined as takeovers, although a takeover usually implies a hostile transaction. In contrast, in a friendly transaction (takeover), management of both companies usually agrees on the merger and encourages its approval with their respective stakeholders.

Statutory Mergers

When one company ceases to exist as a legal entity and merges all of its assets and liabilities into the purchasing company, this type of a merger is called a statutory merger. There are two types of statutory mergers:

  • a subsidiary merger; and,
  • a consolidation.

In a subsidiary merger, the purchased company (target company or simply target), becomes a subsidiary of the acquiring company (or acquirer). The reason why is often that the target company owns a popular brand and renaming it could potentially cause customer alienation.

In a consolidation, both merging entities cease to exist as former legal entities and agree to form a completely new legal entity. This type of statutory merger occurs when two companies are approximately similar in size and operations.

Horizontal Mergers

In a horizontal merger, the two merging entities operate in the same kind of market, typically as competitors. One of the main reasons why companies pursue horizontal mergers is to achieve economies of scale, which is achieving larger combined operations through consolidation of operations, resources, and trimming of the excess “fat.” As a by-product, with two former competitors now operating as one, higher market presence is also achieved by having one less competitor to worry about and by becoming a larger entity that cannot be easily “pushed around” by other players.

Vertical Mergers

In a vertical merger, the two companies merge along the production process. For example, the acquirer could be a supplier targeting a distributor. Through this type of merger, aside from cost savings, a newly formed entity achieves greater control of the production and distribution.

If an acquirer buys a target company ahead of it in the production chain (e.g. a jewelry manufacturer buying a precious metals mining company), this type of vertical merger is called backward integration. Alternatively, when the acquirer buys a company that is down from it on the production chain (e.g. an iron ore mining company buying a steel manufacturer), this is called a forward integration.

Conglomerate Mergers

Conglomerate mergers occur when the two merging entities’ core businesses are unrelated to each other. For example, General Electric transformed itself into a conglomerate after purchasing numerous companies operating in a wide spectrum of industries, from home appliances, finance, aircraft parts, media, and medical equipment.

Conglomerate corporate structure was very popular during the 1960s to 1980s. The rationale was diversification across both cyclical and non-cyclical industries in an effort to offset potential cash flow volatilities.

At this point, it would be useful to review a short history of mergers in the U.S., which can be read about in the next article in the series.