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A Guide to Vertical Acquisitions: Their Benefits, Risks, and Alternatives

Vertical and horizontal acquisitions are strategies that businesses use to solidify their positions, increase market share, and turn more profits. Read on to learn more about vertical acquisitions and their advantages over horizontal mergers.

Vertical Acquisitions: What Are They and How Do They Work?

Vertical acquisitions, mergers, and integrations are competitive strategies by which companies assume control over various stages of production and/or distribution. It’s covered in most major business courses, including MBA degrees. A great example of a vertical merger is that of Carnegie Steel, which didn’t just buy iron mines to ensure a plentiful supply of raw materials, but also purchased railroads to strengthen their distribution network. This all-encompassing strategy helped Andrew Carnegie make cheaper steel, and it boosted the company’s standing in the marketplace.

What is a Horizontal Merger?

A horizontal merger or acquisition is another strategy companies sometimes use. The simplest definition is that a horizontal acquisition is the purchase of a related business. For instance, a fast food chain may merge with a company in a different country to gain access to foreign markets.

Vertical Acquisition Strategies

As we’ve seen here, vertical mergers combine companies with their suppliers (backward integration), or with their distributors (forward integration). For instance, supermarkets may buy farms to ensure a steady supply of fresh produce, or they may buy a fleet of vehicles to make it easier to get those products to market. There’s another type of vertical merger, known as balanced integration, which is an even mix of these two methods.

When is a Vertical Acquisition a Good Idea?

Multiple factors affect the decisions that go into forward and backward integration. Companies may use such strategies in these scenarios:

  • When their current suppliers or distributors are unreliable
  • If raw material prices are unstable or distributors’ fees are high
  • When distributors and suppliers earn sizable margins
  • If the company has the ability and resources to manage the supplier’s or distributor’s business
  • When the industry is entering the growth phase

The Benefits of Vertical Acquisitions

What are the biggest advantages of a vertical merger? Allow us to use the example of an automobile manufacturer.

With a vertical acquisition, the car-maker can smooth out its supply chain, make its service and distribution networks more efficient, and absorb profits that would have otherwise gone to parts suppliers and other entities. The automaker would, by assuming control of its supply and distribution networks, raise entry barriers for other companies while developing its own core competencies.

The Drawbacks of Vertical Mergers

Though vertical acquisitions are advantageous in most cases, there are some pitfalls to consider.

  • The quality of the goods (those once supplied by outsiders) may diminish due to scarcer competition.
  • The ability to decrease or increase raw material and component production might be lost as a company may have to sustain a certain production level in pursuit of an economy of scale.
  • It may be hard for a company to sustain its core competencies as it shifts its focus to the integration of its new units.

There are some alternatives to the vertical merger, such as market purchases (like auto parts) and long- or short-term contracts (with service stations and showrooms).

Strategic Examples of Horizontal Acquisitions

Horizontal integration is a firm’s acquisition of a competitive or similar business. It may purchase, merge with, or take over a different company to grow in capacity, grow in size, achieve an economy of scale, to reduce risk and competition, or to get into a new market.  The most prominent examples of horizontal acquisition are the purchase of numerous refineries by Standard Oil, or the purchase of Compaq by Hewlett-Packard.

When Should a Business Consider Horizontal Acquisitions?

A firm may think of a horizontal integration in one of these situations.

  • When an industry is entering a growth phase
  • When its rivals lack a similar level of expertise
  • When an economy of scale is attainable
  • When it can manage the other company’s operations after the merger is complete

Some cubes and one of them is highlightedThe benefits of a horizontal merger are the economy of scale, an increase in differentiation (aspects that help a company stand out from the competition), and the ability to tap into new markets. These benefits are explained here.

  • An economy of scale: The bigger, horizontally-integrated firm can produce more than the merged company at less cost.
  • An increase in differentiation: The firm can offer more features and services to customers.
  • Increased market share: Because of the acquisition, the new firm will become a bigger buyer for its suppliers. It will have a bigger market share and it may have more power over the distribution network.
  • Entering new markets: If a merger is with a foreign company, the new firm will have another ready-made market.

The Disadvantages of Horizontal Mergers

As we briefly mentioned earlier, a company’s managerial staff should be able to handle the larger firm if it is to realize the benefits of the merger. The acquisition’s legal consequences will have to be considered, as most countries have stringent antitrust laws: if the combined entity will force competitors out of business, those laws may be used. Taking Standard Oil as an example, the company was later broken into more than 30 competitors.

As companies grow with horizontal mergers, they may become excessively rigid, and practices may become set in stone. This may prove dangerous to the company’s future. Additionally, predicted synergies may be scarce or even non-existent (for instance, the failed merger of a software and a hardware company in the expectation of compatibility between products). Here is how you avoid common mistakes during the Post Merger Integration Process.

In Closing

The decision to employ horizontal or vertical integration has a long-range effect on a company’s business strategy. Every firm will have to select the most suitable option based on its position in the market and the value it offers to customers. With an in-depth analysis of its resources and strengths, a company can make the appropriate choice.

Looking Out for Deal Breakers During Mergers and Acquisitions

While both sides of a merger or acquisition hope the deal will go through without any issues, that’s not likely to happen. Issues are expected during this process, but they shouldn’t be enough to cancel the deal. Buyers, however, will want to make sure they understand what could be a deal breaker and what they should watch out for during the entire process so they know if they need to walk away.

What is a Deal Breaker?

A deal breaker can be just about anything that causes the buyer or seller to cancel the merger or acquisition. Buyers are going to want to make sure the merger or acquisition is going to go as smoothly as possible and that it will be a success in the end. To try to reach this goal, they’ll want to look for anything that could be a large problem. These large problems are the deal breakers that could mean a merger or acquisition is just not a good idea any longer.

Knowing When to Walk Away

When a lot of time has been spent working on a merger or acquisition, it can be easy to think that large problems will be solved eventually. The issue is, it may cost a lot more in the long run to solve the issue or it might be impossible to actually solve. Deal breakers should be carefully considered to make sure the deal could be successful and that the merger or acquisition is not going to be the end for either of the businesses. Buyers and sellers will want to make sure they know when to walk away from any deal that could be potentially a poor decision.

Miscalculations or Higher Than Expected Costs

When price starts to be discussed, there’s a lot to go into it. Buyers can be shocked when the seller prices the business more than they expected. Sellers might be surprised when buyers value the business much higher or lower than they expected. The value often goes hand in hand with forecasting the potential financial future of the business, which can be difficult to do.

Miscalculations can come when there are inflated numbers for the business or the financial history doesn’t equal the financial past of the business. It’s better to be conservative with the calculations for the future of the business to get a more accurate idea of the current and future value of the business. Since mergers and acquisitions can take time to complete, miscalculations can become apparent during the deal. If this happens, careful consideration of what was miscalculated and the impact it has will need to be done to ensure the deal is still a good deal.

Unclear Terms for the Merger or Acquisition

The Letter of Intent (LOI) is basically what the final deal will include. This should include more than the price. It should include all of the terms of the deal, the closing date, any protection if the deal falls through, and more. This is often more important than the price because the terms are what both sides will need to agree to. With the LOI, make sure all terms are as clear as possible. Unclear terms could lead to issues down the road where one side believes something is happening and the other side believes it should be handled differently according to the terms. Unclear terms in an LOI should be rewritten before it’s accepted or the deal may not be able to go through.

Business Erosion During the Process

Mergers and Acquisitions can take up to a year to complete, which can lead to huge changes for the business being sold. Employees, clients, and vendors may be uncertain of the business’s future, so there may be changes with them during the deal. Advisors should be able to handle this during the negotiations, but it’s possible the business changes to the point it’s no longer a good deal. If this happens, it’s best to walk away.

Irreconcilable Differences Between Businesses

For mergers and acquisitions to be possible, the businesses need to be able to blend together. Looking into the cultures of both businesses is crucial as this enables buyers and sellers to ensure the deal is going to be one that is beneficial for most businesses. It’s important to find this out as early as possible, before the negotiations get too far. If the businesses have mismatched strategies, the systems applications cannot be combined, or if there will be any other major issues between the two businesses, it may not be a good deal for the buyer.

Insufficient Planning Before Merger or Acquisition

The planning that goes into a merger or acquisition is crucial. Proper planning makes the entire process possible and can help attract more buyers or help the deal go smoother. Sellers will want to watch out for deals where the buyer is not prepared for the merger or acquisition and doesn’t know what the business is worth, the true value of everything the business has, or what needs to be done to complete the merger or acquisition.

Inflexibility of Seller or Buyer

Mergers and acquisitions involve a ton of negotiations. There are points that the buyers and sellers will need to discuss before they can find a common ground to agree on. If the buyer or seller is not willing to negotiate, it could be a sign that there is a lack of seriousness in the deal. Buyers who are not willing to negotiate might mean they aren’t really interested in buying the business and sellers who won’t negotiate might not be ready to commit to the sale yet. Inflexibility on either side can mean the end of the deal.

Buyer Financing Issues

Buyers need to be able to purchase the business. Many times, they need to be able to get a loan to cover the cost of the business. However, it’s possible the buyer will have trouble getting funding to purchase the business. When this happens, it may end up being a deal breaker if the funding is not eventually obtained. Sellers will not want to delay the sale indefinitely while they wait for funding to be arranged.

Data Privacy Issues

Data privacy will be crucial for both businesses. Before the merger and acquisition can be completed, this needs to be discussed between both sides. There should be a discussion over how information is collected during the merger and acquisition process, what happens to the data after the deal is complete, and how the data will be kept secure during and after the process. If the information that needs to be kept private cannot be secured and kept private, the deal may not be viable.

Issues Meeting Regulations

Some businesses will need to meet laws and regulations. This is common in highly regulated businesses like those in healthcare, finances, or businesses that deal with children as consumers. The business should already meet all regulations, domestic and international, and should provide disclosures about the regulations for the buyer. If regulations are not already met, it could mean the business is going to have issues in the future that the buyer will need to deal with. This could mean the deal is not a good deal for the buyer and it may be better to walk away.

Extended Delays Throughout the Process

Wann Firma verkaufenThe entire process can take up to a year or longer. When the seller isn’t prepared, the buyer cannot obtain financing, or there are other issues that delay the process, the deal may not be able to be completed. Some delays are expected through the process and should be handled as they occur. However, if there are too many delays because of one side, if the delays go on for too long, or there just isn’t progress being made in the deal, there is more time for potential issues to occur. Delays can be a sign that the deal should not go through or that one side is not really ready for the sale. Extended or numerous delays can definitely be a deal breaker.

Due Diligence to Find Deal Breakers

There is a lot that goes into the sale of a business. Buyers and sellers should be aware of potential deal breakers and which ones they can impact to make it less likely the deal will fall through. During the merger and acquisitions process, the buyer needs to ensure they do their due diligence. This enables them to find deal breakers like incompatibility that simply cannot be fixed to allow the deal to go through. Doing this enables them to make sure they can find these issues before it’s the final hours of the deal to minimize the time and money spent on a deal that simply won’t work.

If you’re planning on going through the mergers and acquisitions process, understanding potential deal breakers will allow you to see when you should negotiate further or when you should walk away from the deal. Pay attention to the potential deal breakers here and do due diligence to ensure you know how to handle the process and what could happen during the merger and acquisition.

Mergers

Mergers And Acquisitions: Past, Present, And Future

Mergers and acquisitions (M&A) have become a major part of the modern corporate landscape. Under this process, two businesses will either combine to form a single entity (merger) or one will purchase the other (acquisition) and, typically, take over its operations.

With startup culture thriving and businesses needing to think on their feet to stay afloat in the changing financial landscape, the thought of absorbing a potential competitor or bringing in a new asset to revitalize operations is more appealing than ever. A dataroom can be a secure and highly useful solution to support all M&A transactions.

In fact, 2015 and 2016 were the biggest years ever for major M&A transaction acquirers and post-merger integration. The tech industry, in particular, is a focus for M&A activity, but it’s not the only arena in which this can be a smart strategy. Learn more about what companies considering either a merger of assets or an acquisition need to contend with in the digital age.

New Challenges Posted By Digital Acquisition

Acquisition

Digital acquisitions are a driving factor in the prevalence of M&A transactions across the globe, but there have been some notable failures in this arena in the past. Most startups are created with the end goal of being acquired by new parent firms that can boost the brand and provide access to new resources for the continuation of successful innovation.

But not all corporate parents are ready for this kind of responsibility. There are many legal and financial factors to consider in the M&A process, but when it comes to digital businesses, there are a few additional elements to watch out for.

Corporate Culture Differences

Digital businesses operate differently than what most seasoned businessmen and women are used to seeing, and it’s driving major corporate culture changes that pose major challenges for acquiring companies.

From flexible work arrangements to relaxed leadership structures and a focus on innovation over the status quo, tech company employees are often used to management and office environment styles that are much different from what their new bosses are ready to present.

calture

But tech companies often build a culture around the service they provide, meaning their users come to expect a certain ethos and style from the products they love. Sometimes, there’s not enough attention paid to the unique, intangible factors behind a tech company’s success. Initial valuation doesn’t tell the whole story. For example, Condé Nast acquired Reddit in 2006, but its plans for the site weren’t initially clear.

After a couple of years, it became obvious that Condé Nast and its parent company, Advance Publications, simply didn’t know what to do with the Reddit brand. The old-school publication approach wasn’t going to work well with the Wild West style Reddit thrives on.

Reddit was never going to be able to successfully rebrand as a straightforward online publication and it didn’t take long for Advance Publications to cut Reddit loss and restore its independence. However, rather than selling Reddit off entirely, Advance Publications remains a majority shareholder in the company, making its initial investment a bit more worthwhile.

Reddit’s original founders took back over and are steering the site (relatively) smoothly into the future. Replicating the original success of some of these companies’ founders isn’t always an easy prospect, especially if the acquiring company doesn’t have a deep, organic understanding of what the product is all about.

Plans For Integration And Improvement

Ideally, a tech merger or acquisition will benefit both the buyer and the seller in the long term, not just in the temporary sense of jumping stock prices and a sky-high sell out the payday. Companies that buy tech startups really need to think carefully about how they’re going to integrate this new technology into their existing approach and how they can improve this new technology even more.

new technology

Very few tech companies are sold having reached their full potential. Arguably, no tech company will ever truly reach its full potential since there’s so much room to innovate and grow in this area. So the acquiring organization needs to have a game plan in place to justify the purchase and ensure it’ll pay off in the long run. Often, it seems that corporate acquisitions are motivated by a certain degree of cluelessness.

There are a few high-profile examples of this. Fox’s 2006 purchase of MySpace, for example, couldn’t have been more ill timed or poorly managed. Right as Facebook was starting to rise, Fox bought MySpace and made a strange attempt to repurpose the social media site into a music-focused portal, but the shift was abrupt and, most importantly, wasn’t really responding to any particular demonstrated need.

It was a clumsy attempt to leverage one of the more successful elements of MySpace, independent music discovery, into a more profitable model, and it failed miserably. Plus, there didn’t seem to be much, if any, investment in improving the MySpace user experience, which left the stalwart social network vulnerable to the challenge posed by upstart Facebook’s streamlined design. Five years later, Fox sold MySpace for a massive loss. Fox just wasn’t ready to do what needed to be done to make MySpace enduringly successful.

Realistic Cost/Benefit Analysis

Both of these factors point to a broader issue: how will the acquiring company benefit from the presence of this new brand? Due diligence is different on this new frontier. Most tech startups aren’t yet profitable at the time they’re acquired.

The acquisition itself is considered the necessary step in that brand’s road to financial success. Valuation numbers can appear sky-high and a buyer that isn’t savvy enough to really understand tech may think that valuation tells the whole story. But it doesn’t.

Realistic

To successfully integrate a valuable new entity into the fold, the acquiring organization needs to carefully determine how this new tech product will actually bring in revenue. There needs to be a plan in place for helping the digital asset reach its full potential. Simply acquiring a digital company isn’t going to suddenly transform everything.

The acquiring organization has to have a specific reason why this particular entity is a good fit for their mission and needs to be prepared to nurture their new acquisition immediately following the sale and in the future. Post-merger integration isn’t an organic process but a deliberate, well-organized effort. If a corporate parent can’t think of a way to integrate the new brand, chances are they won’t benefit from the purchase very much, if at all.

Why Do M&As Fail?

We’ve just given some examples of failed (or nearly failed) M&A efforts in the tech space, but this isn’t the only area where an acquiring parent can succumb to blind spots and bad analysis. There isn’t a single reason why a merger or acquisition fails; each one presents its own case. However, there are some consistent factors. As indicated above, a failure to properly plan and consider what the new brand will do can really do a lot of damage.

prolonged

Simply seeing that an entity is successful on its own does not provide sufficient evidence that that entity will continue to succeed once acquired or merged. There are examples in other industries of a company that overestimates the value a new asset can add. For example, in the pharmaceutical industry, Teva Pharmaceuticals’ purchase of Allergan’s generics business resulted in claims of gross overpayment from both investors and financial analysts.

There are a few reasons why the deal was thought to have failed before it even went through. For one, Teva was somewhat desperately chasing a solution to the potential revenue gap caused by the patent expiration of its most expensive branded medication. But there were also external factors in play, including the prolonged scrutiny from US and EU government regulators responding to growing public anger over drug prices.

This isn’t to say that the acquisition can’t pay off for Teva in the long run. But the ball was already rolling, the deal in progress, when external factors arose to make the deal seem less beneficial. Depending on who you ask, it could be argued that Teva didn’t really have a way of seeing what was coming when they pursued this option. As with all business activities, M&A is a calculated risk.

The key is to actually perform those calculations before taking the risk rather than diving in headfirst without really analyzing all potential outcomes. Focusing on the human element, both in terms of the people who make up the newly combined organization and the consumers who will respond, is an essential part of the process. Numbers alone can’t tell the whole story.

The Current And Future M&A Landscape

There have been a few notable M&A events in 2017 that indicate just how much businesses can benefit from either merging with or acquiring (or being acquired by) another organization. One of the most notable is Amazon’s $15 billion acquisition of Whole Foods, signaling that the e-commerce giant credited with destroying retail may realize that in-person purchases remain highly appealing for many consumers.

Landscape

Amazon’s exact intentions remain a mystery, but it’s safe to say they wouldn’t have spent such a massive sum on an uncertain strategy. Some companies have used M&A as a strategy to sidestep the traditional IPO process, which is exactly what Purple Mattress did in the summer of 2017.

Direct-to-consumer mattress sales are big business and Purple actually merged with a publicly traded shell corporation, which instantly gives Purple public status and secured the mattress manufacturer a $1.1 billion valuation overnight.

Another 2017 M&A, this time the acquisition of a startup, MindMeld, by an established industry leader, Cisco, highlights one reason why M&As have become so common. MindMeld is an AI startup that built a conversation-monitoring bot that can interject useful information in the midst of a conversation.

Their initial use case involved running the program in the background on a mobile device at all times so user conversations could be annotated and supplemented with information. The problem? Not many people are interested in having their private conversations tracked in this manner. But Cisco can certainly make use of this tool to supplement their corporate communications technology.

On its own, MindMeld likely wouldn’t have found its market, but as part of Cisco, it’s got a clear and sensible purpose. Tech is by far the hottest sector for M&A activity; as a whole, tech, media and telecommunications (TMT) made up the lion’s share of deals reflected in Deloitte’s 2017 M&A index.

There’s no reason to assume this won’t continue, especially as startups continue to receive the necessary funding to develop technologies that will be highly appealing to potential parent companies looking for a way to secure relevancy in the coming years.

Startups can continue to expect some sort of corporate interest from large, established companies, though whether this will level out as more and more companies realize they’re not making the best long-term investments remains to be seen.

Healthcare may also be a sector to watch and not just in the space where it overlaps with tech. However, an uncertain legal landscape surrounding the industry in both the US and the EU may lead to more potential disasters like Teva/Allergan. Retail is also an interesting industry for M&A. Will Amazon/Whole Foods go bust or will it result in the retail apocalypse some are predicting?

We’re currently living through a major M&A boom and it’s hard to know what the future holds. It could be that this is just the way it is now, but antitrust watchdogs and competition advocates might not be too happy to see small enterprises slowly get absorbed by larger entities.

2016 did see a slight dip in M&A activity from 2015, but that may have been a result of the wild uncertainty associated with politics and finance last year. This year isn’t necessarily more stable, but it could be that organizations have adjusted sufficiently to bounce back to previous highs. Even if 2017 doesn’t match or top the two previous years, it’s clear that there’s still a lot of interest in M&A. Acting on that interest could be the right move.