In the first article in our series on M&A, we focus on the dimensions that make up different types of deals. We unpack the motivations driving companies to pursue certain types of deals and drill down on revenue and cost synergies. We then highlight some of the risks and hurdles associated with both types of deals and provide metrics to support decision making.
Defining the M&A Spectrum
There are a few ways to classify deals, depending on their intent and structure. In this article, we focus on the two main classifications of deals based on functional roles: vertical mergers and horizontal mergers. (A third type, conglomerate mergers, won’t be covered because there is a weaker relationship between these tools and innovation.)
A horizontal merger, according to Investopedia, “occurs between firms that operate in the same space, as competition tends to be higher and the synergies and potential gains in market share are much greater for merging firms in such an industry.”
Historically, when a company pursued a horizontal M&A and acquired another entity in the same industry or sector space, the purpose was typically to subsume a direct competitor, increase market share, and achieve economies of scale by decreasing average cost. Some of the most visible horizontal deals in recent history have been large companies acquiring startups that have built significant and fast-growing user bases.
It would be impossible to talk about this without mentioning Facebook’s $1 billion acquisition of Instagram. At the time, people were confused by this deal. Why did Facebook pay $1 billion for an app with no revenue and 13 employees? But since the acquisition, Instagram has grown from 30 monthly active users to over 800 million. It’s no surprise that the deal has been lauded as one of the greatest acquisitions of the 21st century.
While some analysts were focused on the startup’s non-existent revenue, Facebook saw a product that was taking hold of the younger demographic. It was built for mobile phones, which were experiencing rapid technological advancement at the time. Facebook also understood the opportunities made possible by integrating the two products. Without this integration and symbiotic relationship, it’s doubtful that Instagram would have been able to reach such scale.
“Today most organizations pursue vertical integration from control, risk, and flexibility standpoints. Control of resources, limiting or taking risks and flexibly changing direction quickly without the burden of commitments.” Erik Kayser, partner and management Consultant, Implement Consulting Group.
Vertical deals are an effective way to transform businesses and improve the efficiency of a firm’s value chain. Vertical mergers can give firms better control of shipping and logistics, for example, through gig economy shipping, digital platforms, or the acquisition of suppliers.
Target’s recent acquisition of Shipt is an excellent example. The retailer paid $550 million to acquire the gig economy delivery service, which gives the company access to same-day fulfillment capabilities in addition to the retailer’s existing operations. This illustrates a broader trend within retail: integrating the entire vertical. Pressured by Amazon, retailers are using acquisitions to quickly gain access to the whole value chain including supply, fulfillment, e-commerce, physical stores, and more.
Controlling the supply chain can mean controlling the market. Acquiring a vendor or supplier can help the company improve operational efficiency and increase profits by controlling costs and product availability. Starbucks, for example, has vertically integrated from the bean to the cup. The company owns coffee bean farms, roasting plants, warehouses and distribution centers, and the retail outlets.
- When and when not to vertically integrate – McKinsey
- This article by John Stuckey, director for McKinsey, and David White, principal for McKinsey, is an essential read for anyone thinking about pursuing vertical integration. It is dated 1993 but provides a robust examination of the core components of these deals.
The Search for Synergy
“We look for many singles and doubles on revenue synergy, instead of one home run.” – VP of Strategy, Deloitte, 2017.
Companies pursue both vertical and horizontal deals in an attempt to gain synergies, and two types of synergies generally arise from M&As: 1) revenue synergies, when a combined company generates more sales than the two companies could separately, and 2) cost synergies, when the combined company can reduce average costs to a greater extent than could the separate companies (economies of scale).
In a Deloitte survey of 528 executives involved in mergers, almost 60 percent of the deal synergies they were seeking were anticipated to come from revenue rather than cost sources. But anticipating synergies is much different than experiencing them. According to McKinsey research, “The greatest errors in estimation appear on the revenue side – which is particularly unfortunate, since revenue synergies form the basis of the strategic rationales for entire classes of deals, such as those pursued to gain access to a target’s customers, channels, and geographies. Almost 70 percent of the mergers in our database failed to achieve the synergies expected in this area.”
How can firms increase their chances of experiencing synergies?
In its report, “Revenue Synergies in Acquisitions In Search of the Holy Grail,” Deloitte gives an overview of how to achieve revenue synergies, explaining that combining short-term, quick wins with longer-term innovation could achieve revenue-synergy success. For example, pursuing shared distribution channels can increase synergy and boost revenues in the short term, and pursuing multiple channels can sustain those revenue synergies for longer.
From the beginning, as soon as a deal is announced, Deloitte assigns a project management officer with a relentless focus on synergies and incorporates targets into the operational plan to incentivize teams. The operation plan, according to Deloitte, looks a bit like this.
- Pursue the low-hanging fruit
- Align around cross-selling and channels
- Enforce efficient decision making on goals, being mindful of operating model implications
- Cast a wide net
- Pursue multiple types of synergy initiatives to increase chances of success
- Lead change management activities across both organizations
- Enlist partners, clients, and other key stakeholders in guiding and informing key decisions
- Lead with innovation
- Invest in growth opportunities with long-term potential
- Balance near-term and long-term synergy initiatives
- Lay the foundation for go-to-market transformation
- Dig into the data details
- Use quality data to drive analytics-driven insights
- Establish and empower a dedicated integration team
- Budget for success and incentivize teams
- Plan the work; work the plan
- Plan for pre-close synergy and clean room (or data room) activities
- Activate integration teams with commercial analytics capabilities
- Remain focused on targets
Source: Deloitte, 2017
According to Deloitte, initiatives such as cross-selling, early planning, and establishing integration teams are integral to realizing revenue synergies from a merger. But what about the risks?
The Risks and Hurdles Associated with M&A
According to KPMG BOXWOOD, after a merger, “everything is uncertain – office locations, job titles and roles, reward systems, organizational structures, culture and values, the people you work with – they’re all up for discussion.” Announcing key decisions early in the merger discussion process can mitigate the uncertainty among employees and its knock-on effects on revenues.
Another hurdle for the leadership team, according to KPMG BOXWOOD, is to define the new goals of the organization and obtain stakeholder buy-in so that the two entities collaborate from the outset. Preferably, the new goals should not require major changes in thinking from either the collective post-merger organization or the individuals within.
Getting people to let go of old models and ways of thinking is difficult. In the case of Dixons and Carphone Warehouse, KPMG BOXWOOD states that culture surveys and change ready assessments were used to prepare staff for the next steps in the merger and to help them understand and come to terms with change. Staff were shown how the new merged stores would work so that they could envision their roles and anticipate how to manage post-merger day-to-day practicalities. The reason for a merger, and the benefits that it will bring, need to be compelling enough to justify the disruption to staff who are affected.
Before any merger is contemplated, KPMG BOXWOOD suggests that companies should identify key indicators as benchmarks where improvements are expected. As the merger progresses, these metrics can be used to sustain efforts to make the merger successful. Positive results will build trust in the new leadership and boost morale and productivity. Metrics will also show where changes need to be made, increasing the chance that the merger is ultimately the right decision.
Metrics for a Realistic Picture of Deals
Steve Carnes, an M&A specialist, suggests that companies clearly define goals before deciding on what metrics to use in measuring merger outcomes. According to Carnes, an organization must decide whether it is focusing on measuring sales or products, building a footprint in a target market, or eliminating a competitor.
Carnes recommends a Sales Inventory Operations Planning (SIOP) process: “Within a company, people are selling things, making things, and keeping track of how it’s all going. Consider each step, think about your goals, and ask yourself “where are the gaps, and how are you going to improve them?”
Metrics for Integration
Establishing metrics and key indicators that can help companies assess the value of entering into a deal will help mitigate risk and facilitate communication with shareholders.
PwC experts Vinay Couto, John Plansky, and Deniz Caglar are the authors of “Fit-for-Growth.” It is a discipline the authors recommend for companies working through the different stages of preparation for a transformative deal. The discipline calls for alignment of cost structures and capabilities; it also calls for the design of an operating model that enables and sustains cost reductions and then creates the right conditions for managers to drive growth.
For early-stage M&A, Carnes recommends determining whether the target firm’s performance is better than the market average. If not, why do the deal? Carnes suggests looking at year-over-year growth rates for the last three years along with projections for the next three. Market context matters: explosive growth in a hot market might not be impressive.
Carnes also points to benchmarking employee sales versus the cost ratio with the industry average to determine a company’s performance and potential. Typically, Carnes finds that a lower-than-average ratio indicates problems that might range from brand and market positioning to sales process efficiency to overstaffed departments and a lower level of automation. Carnes advocates looking at the cost of sales per employee and as a percentage of revenue.
Service-Level Agreements (SLAs) are another useful metric. Important items are the targets set for order fulfillment and lead time: does the company meet them, and are these targets essential? Does the value added justify the cost or are the SLAs not, in fact, a true competitive advantage?
West can help you develop your M&A strategy. We’ve done the research and understand deals from both sides of the table.
Leading companies are using deals to expand their product lines and to be more competitive in new product development. The next article in this series, “M&As and Technological Transformation,” specifically addresses technology-driven M&As for transformation.
West Stringfellow spent over 20 years launching products and leading innovation at corporate giants and startups, holding management roles at Target, PayPal, VISA, Rosetta Stone, GraysOnline and Amazon.
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