As your company seeks to diversify and obtain sustainable competitive advantage, you may consider acquiring another company because together you can create unique and additional value. This additional value is known as a synergy, which can exist in the form of reduced costs, higher revenues without a proportional increase in costs, consolidation of capital, operational efficiencies, or other factors. The purpose of this article is to explain synergies and costs of an acquisition, describe how to determine if an acquisition creates value, and show how value-adding acquisitions commonly distribute value between the target and the acquirer. This article also describes factors that destroy value in acquisitions and offers some suggestions to avoid this result.
Synergies and Costs of an Acquisition
Many executives may think that growth and diversification are good reasons to acquire another company; however, these reasons are not enough to justify an acquisition. Shareholders can diversify and buy growth companies more effectively on their own. A better reason to pursue an acquisition is when the combined company will be more valuable than the two companies are apart. Increased value is accomplished through synergies that equity holders cannot create by themselves through their own portfolio investing. Synergies are value-creation factors that are possible by operating in multiple businesses, markets, or industries. These factors can include enhanced revenue generation, cost reduction—such as through economies of scale or scope1—improved market reach, enhanced talent or technology, and cross-selling opportunities.
While acquisitions can create some significant value, they also create costs that should be considered in the decision-making process. Some of these costs include fees for accounting and legal work, investment banking or broker services, due diligence, and other consulting services. Other implementation costs may be less visible, such as costs arising from challenges in combining company software, managing cultural differences between the two companies, and implementing proposed synergies. The benefits of the acquisition must outweigh the costs to be beneficial. Below we will describe several valid reasons to acquire another company, followed by insufficient reasons and factors that can destroy value in an acquisition.
Valid Reasons to Acquire
An acquisition may be preferable to internally developing a product or service if the industry has high learning or experience curves, large economies of scale, or a necessity to quickly expand to be competitive. These reasons favor quick expansion over slower internal development because capturing the experience and scale quickly will improve the company’s competitive advantage. Diversification may create value because it allows the combined company to expand and/or exploit its set of resources and capabilities. For example, the Walt Disney Company competes in multiple markets, such as films and theme parks. By acquiring Pixar in 2006 and Marvel Entertainment in 2009, the shared value in the consolidated Walt Disney Company is greater than the companies are separately. Part of the increased value comes from increased revenue generated through combining the distribution network and intellectual property licensing for media. Disney extends the market reach for Pixar and Marvel films and increases supplier power in future negotiations. This effect is magnified with the combination of Disney’s other resources and capabilities.
Another example of diversifying to create synergies is SAP’s recent acquisition of Qualtrics. Combining SAP’s vast operational data with Qualtrics’ experience data will “enable customers to better manage supply chains, networks, employees and core processes.”2 SAP’s global scale will allow Qualtrics to grow faster around the world, and the experience data Qualtrics provides will enrich insights for SAP clients. Acquisitions can create value in many ways beyond these examples, but some kind of synergy is necessary to justify an acquisition.
Insufficient Reasons to Acquire and Overpaying for an Acquisition
Simply diversifying into a new market or industry without any value creation is a poor reason to acquire a company. Equity holders can choose to diversify by investing their money elsewhere, so they don’t need the company to expend its resources only for the sake of diversification. Unless the firm can offer some additional value that investors can’t receive through their own diversification, the acquisition is unneeded. According to a study in 2010 by Barney and Hesterly, only 17% of diversified firms in the U.S. create value from diversification.3 Other studies debate the exact percentage, but a study by Mackey and Barney in 2006 shows that corporate diversification, on average, destroys firm value.4
When potential synergies do exist, acquirers should be especially cautious to avoid overpaying for them, because implementing the proposed value from all synergies may be difficult. Since acquirers typically pay a premium above market value to acquire a company, they should verify the benefits from synergies outweigh the costs of the premium to avoid overpayment and hurting their own shareholders. One example of overpayment occurred when Microsoft acquired substantially all of Nokia’s Devices and Services business (NDS) for a total purchase price of $9.4 billion in 2015. Microsoft expected the acquisition to accelerate the growth of their Devices and Consumer segment through faster innovation, synergies, and unified branding and marketing. Within a year, Microsoft reported a $5.1 billion goodwill impairment charge against the phone hardware acquired through Nokia, and integration and restructuring costs brought expenses to over $10 billion.5 Such a large impairment in a short period of time suggests Microsoft overpaid for the synergies in the acquisition. Another example of overpayment occurred when Google purchased Motorola for $12.5 billion in 2012 and subsequently sold them to Lenovo for $2.91 billion in 2014. The deal gave Google access to Motorola’s design and engineering process and intellectual property, which would help Google to tailor its own Android OS software and hardware, among other synergies; however, the subsequent sale at such a large discount indicates overpayment.
In some acquisitions, value may be destroyed or lost due to cognitive biases, managerial hubris, culture clash, lost customers, additional regulatory costs, and/or structural complexities. Cognitive biases are heuristics, or mental shortcuts, people take that can bias their decision making. For example, an executive may be biased toward pursuing an acquisition with little or no hard analysis or adequate supporting data. The decision makers for the acquisition may only rely on knowledge that is readily available and avoid checking whether their valuation is supported by broad benchmarks outside their immediate knowledge base.6 To avoid these biases, use multiple valuation measures and seek larger amounts of data to confirm synergistic value. When only limited information exists, acknowledge the limitation and be aware that one measure may be distorted.
Managerial hubris occurs when the executives who make the decision for an acquisition suffer from an unrealistic belief that they can manage the assets of the target firm more efficiently than the target firm’s current management. Although this may be true in some cases, managers may overestimate potential synergies and underestimate risk and uncertainty in managing the new company due to an overconfidence bias. Overconfidence bias is the tendency for people to be more confident in their abilities than is objectively reasonable. One of the best ways to overcome this bias is to seek disconfirming information and diverse views from others who can test the assumptions.7 Use proactive reframing to think about the decision from a different perspective before rushing into an acquisition. For example, when a board member is not supportive of an acquisition, seek to fully understand his or her divergent view before proceeding.
Another value destroyer in acquisitions is culture clash, which exists when two companies are unable to fully capture synergistic value due to cultural differences and incompatibility. For example, Sprint’s merger with Nextel in 2005 resulted in a $29.7 billion goodwill impairment charge just a few years after the merger, which stemmed in part from cultural differences.8 Kim Hart from the Washington Post explained that Nextel employees felt their “aggressive, entrepreneurial style” was stamped out by Sprint’s more “bureaucratic” approach.9 Some Sprint employees described feeling deceived by Nextel’s deteriorating network, which caused some deep customer losses. Each company maintained their own headquarters after the merger. The company began seeing signs of distress such as decreases in operating income and average revenue per user in 2007, which prompted the impairment analysis. This example illustrates how important culture is when considering an acquisition.
Structural complexities and liabilities of size exist when an acquisition fails to capture value due to the bureaucracy or complexity of the combined organization. For example, the AOL and Time Warner merger that cost $164 billion in 2001 later recorded a $98.7 billion goodwill impairment primarily in their America Online unit. This loss was due to difficulty implementing two large bureaucracies, challenges arising from cultural differences, and other factors. Michael Hiltzik and Stuart Silverstein from the LA Times explained how the pure complexity of blending different organizations in the biggest deals can be a large stumbling block.10 The more bureaucratic levels in an organization, the greater the risk of squeezing out creativity and causing culture clashes.
Once a company has determined if an acquisition is the correct strategy, they should consider how the value from the expected synergies will be shared between the acquirer and the target. One common research technique is to observe the cumulative abnormal returns11 (CARs) of the target and acquirer upon announcing the transaction. CARs are just one tool used to analyze the public’s reaction to a news event, such as the announcement of an M&A transaction; CARs measure the difference between the expected return and actual return on a publicly traded stock. A study by Bradley, Desai, and Kim in 1988 found that the target shareholders generally capture most of the synergistic value in a deal. Although buyers occasionally capture value, they receive much less.12 In Salesforce’s acquisition of Tableau in 2019, Tableau’s shareholders (the target) captured most of the value in the form of share price appreciation. Soon after Salesforce’s announcement to acquire Tableau for $15.7 billion, Tableau’s stock price jumped 34%, while Salesforce’s stock price fell 2.7%.13 The value of the synergies between Salesforce and Tableau was evidently captured by the target based on the higher than expected actual return. Salesforce suffered a loss in share value, which is supported by the study mentioned previously.
Deciding whether an acquisition is the proper strategy for your company is a critical decision. Properly identifying and capturing synergies through implementation of your strategy can improve competitiveness and performance. However, an ill-planned M&A transaction could result in a large goodwill impairment or significant losses. Other factors could also lead to destroyed value resulting from an acquisition, such as cognitive biases, managerial hubris, and culture differences, among others. Be aware as an acquirer that most of the synergistic value is likely to be captured by the target, especially when multiple bidders drive the purchase price higher. Due to the complexity of acquisition decision making, we recommend hiring an experienced professional to evaluate and facilitate your acquisition.
- Economies of scope are a type of cost advantage synergy created when producing two or more products or services together rather than separately.
- SAP News Announcement
- Strategic Management and Competitive Advantage: Concepts and Cases 5E by Barney and Hesterly pg. 215
- Is There a Diversification Discount? Diversification, Payout Policy, and the Value of a Firm
- Microsoft’s 2015 10-K, Notes 9 and 10
- How Cognitive Bias Undermines Value Creation in Life Sciences M&A
- Escalation of Commitment by Kelly & Milkman
- Sprint’s 2008 10-K, Item 1
- No Cultural Merger at Sprint Nextel by Kim Hart
- AOL, Time Warner Face Many Merger Obstacles
- “Cumulative abnormal return is the difference between the expected return on a publicly traded stock and the actual return” How to Calculate Cumulative Abnormal Return by Soren Bagley
- Bradley, Desai, & Kim, 1988 and Elad, Bongbee, 2017 Event Study on the Reaction of Stock Returns to Acquisition News
- Tableau’s Stock Rockets After Salesforce Buyout Deal Valued at $15.7 billion by Tomi Kilgore