Why does one company buy another? We already understand the mergers and acquisitions theses and how they relate to each other. We already understand the relationship between them and a potential perception of greater value for one stakeholder than for the other.
But where does the perception of value actually come from, beyond a classic discounted cash flow, to justify a merger or acquisition transaction. Why are some companies acquired for a value much higher than their current capacity to generate revenue or margin?
Besides the future growth and margin formula that we have already studied, the answer usually lies in the possibility of generating synergies with this union.
Synergy
My notion of value creation in the word Synergy is not in the original definition:
Synergy
simultaneous action or effort; cooperation, cohesion; associated work or operation.
(source: Oxford Languages)
This dictionary definition is all based on cooperation, joint and simultaneous work. However, for a complete alignment of joint work intentions, a union of the two entities is necessary. Furthermore, it is from this cooperative work that an incremental value emerges that justifies the union of the parties.
But where does this value creation come from? Why is it common to define synergies as 2+2 =5? We will dive deeper into different ways of generating value in synergy, but we can basically divide them into: increasing revenue or reducing costs.
Revenue synergies
When we bring together two complementary companies, it is possible to generate revenue synergies, that is, possibilities to unlock an increase in revenue from the combined operation that would not be possible without this combination. Let's discuss examples
Increase in Sales or Cross-Selling
Can one company's product be sold by the other? If so, there is potential synergy through cross-selling. As director of TOTVS M&A, this was a synergy thesis which I often considered. The technology giant has an extremely powerful distribution network, which was created through a software sales franchise model, innovative at the time it began.
Franchises create a strong local presence in almost all states in Brazil and also in other countries. As a result, they speak the language of the customer in each location, which makes sales easier for them. Delivering more products that can be purchased by these customers to this magnificent sales network is a real possibility of creating value.
Another very simple example that we discussed was the possibility of Petz sell Cobasi's own brand products on your network and vice versa.
In practice, motivating a sales network requires an alignment of the commercial model, an average ticket compatible with expectations and sales campaigns. In a retail chain, it may be simple to add another product to the shelf. In a software or services sales channel, things are more complicated. It is worth putting a little skepticism into the expectations of this type of synergy, but this concept can certainly be used to help justify a transaction.
Increased Pricing Power
In a simple operation selling a product, revenue can be defined by multiplying the quantity sold by the price. If the first source of revenue synergy (cross-sell) involves increasing sales volume, the second implies increasing the price.
The most direct way has to do with the joint sale of products from both operations, even if they have a software or service format. The price of combined products increases the average sales ticket and, consequently, revenue.
A good example is the combination of brands acquired by Disney under the Disney+ umbrella. Even though these acquisitions took place before the launch of the new service, it is easy to imagine that Disney would not have the same pricing power if it did not also offer content from the Star Wars, Marvel, Natgeo and Pixar franchises in the same package.
Brand
There are other, more complex ways to create pricing power synergies. For example: brand. Let's go straight to my favorite example: Heartbrand! The brand at the heart of Unilever, which in Brazil we have known for many years as Kibon, was created in 1998 to ship several regional ice cream brands acquired by the consumer goods giant.
In different countries the brand has different names, which (at least not yet) have not been unified. But brand is much more than name. When we travel to Italy we come across the brand's popsicles, we recognize it and we have the same mouth-watering taste as when it happens on a hot beach in Brazil. If we pay attention, we might even say “look, Kibon here is called Algida”. The brand is so strong that the name is secondary.
When Unilever acquires new ice cream brands such as Ingman (Nordic countries) and Inmarko (Russia) and places them under the Heartbrand umbrella, it gives the products all the value of this brand built over years.
Cost synergies
Another way of generating value with the combination of operations is cost reduction. This reduction can happen in several ways, such as cutting expenses and costs through redundancies or reducing costs through supply chain integration.
Expense and indirect cost cuts
Reducing costs by integrating back-office operations is perhaps the most common form of synergies in mergers and acquisitions. Every company over a certain size needs a financial area, a purchasing area, legal, etc. But when two of them come together, they still only need one from each of these areas. What happens next, then, is the joining of these areas and the cutting of personnel. Yes, anyone who works in an area like these at a company that is merging or being acquired has every right to be concerned. But if the process is done well, the best professionals from each company are selected to continue in the combined operation.
At TOTVS, like many large companies, we had a shared services center. This structure is designed to make it even easier to "plug in" new operations and start serving them with financial, accounting, supply and even legal processes. This was a basic synergy in our acquisition business cases.
Direct cost cuts
When two companies in the same value chain merge, it is possible to "destroy" revenue to improve the profit margin. These are cases of vertical integration. Acquiring a supplier means no longer having to pay full price the full price of its product or service. Instead, the acquirer only has to pay the costs, and incorporates the margin.
The purchase of Essilor (lens manufacturer) by Luxottica is a good example. The margin of the combined operation is higher, but the acquired company's revenue from sales to the acquirer is neutralized. It may even continue to exist, but in the combined operation it generates what accountants call pro-forma revenue (because the revenue of one of the companies is the cost of the other). If the company has other customers and continues to sell to them, this part of the revenue is maintained.
Lock-In
When the union of companies helps retain customers, we can consider this an avoided cost. That's why I classify Lock-In synergies as a cost-reduction synergy.
Software is an industry that can benefit from this type of synergy. When Oracle buys Netsuite and is able to deploy the new product to its customers, it becomes more difficult for these customers to leave the vendor. This is because deploying software is expensive and time-consuming. Changing suppliers is not as simple as choosing another brand of ice cream.
Therefore, if there is an opportunity for Cross-Sell, there may be an increase in Lock-In.
Why the Founder needs to know the synergies
When we map a company with which it makes sense to join forces, mapping also the synergies potentially generated by this union generates important inputs to motivate a transaction. Inside the Most Valuable Product Journey, it is part of the homework to map companies and identify synergies. These inputs will be used to compose what I call Implantable Idea Pitch, the speech that the founder can use to implant the idea of the transaction in the head of the potential interested party.
How to use synergies to nurture opportunities
Keep reading with a 7-day free trial
Subscribe to Exit Strategy to keep reading this post and get 7 days of free access to the full post archives.