How Mergers and Acquisitions Work in Business

Mergers and acquisitions (M&A) is an umbrella term for one or more types of financial transactions that result in the consolidation of companies or [assets](https://www.masterclass.com/articles/what-is-an-asset). A merger, or merger of equals, refers to a transaction in which two firms of similar size agree to legally unite to form a single, new entity for restructuring, company growth, development of new products, or entry into new markets. The most common types of merger strategies are horizontal and vertical integration. A horizontal merger is when two companies that share similar product lines consolidate into a single entity. A vertical merger is when two companies—selling different products or services—that operate in the same supply chain join forces. An acquisition, or takeover, typically involves a larger company purchasing a smaller company or firm (commonly known as a target company or target firm). Acquisitions are also divided into public and private transactions, depending on whether the target companies appear on a public [stock market](https://www.masterclass.com/articles/what-is-the-stock-market). Acquiring companies, which become the majority [stakeholders](https://www.masterclass.com/articles/stakeholder-explained) in the acquired company, retain their company name and organizational structuring. If the acquiring company purchases the target company against its wishes, the situation becomes an unfriendly or hostile takeover. A number of financial reasons can influence M&A activity. However, most focus on increased cash flow or reduced risk. Acquiring firms often use two strategies for acquisition: horizontal and vertical integration. Horizontal integration involves a company buying another business entity that shares its position on the supply chain to increase production and dominate a larger section of that market. This [economies of scale](https://www.masterclass.com/articles/economies-of-scale) strategy allows the acquirer to reap the cost advantages of mass production. Meanwhile, vertical integration is when a company buys an entity that creates an element of its product or business. Synergy—a concept that anchors on the belief that the combination of two companies will generate greater value than if they remain single entities—is also often cited as a motivation for this tactic. Companies may also attempt this strategy for diversification, which involves the acquisition of another company to boost shareholder confidence. However, these tactics don’t always generate greater value for either entity. There are several different types of mergers and acquisitions, including: 1. __Asset purchase__: In an asset purchase, one company acquires the assets of another company upon approval from its shareholders. Assets can range from physical goods like office equipment to real estate and [intellectual property](https://www.masterclass.com/articles/intellectual-property-guide). Asset acquisition typically occurs during bankruptcy proceedings, or when a failing company sells off its assets for liquidity. 2. __Carve-outs__: An acquiring company may “carve out” or purchase divisions, subsidiaries, or other small elements of another company to add revenue, sales territory, or a customer base to their operation. A company may also generate carve-outs as divestitures from their business. 3. __Consolidation__: A consolidation (or amalgamation) is a merger in which two companies combine their businesses to create a new company. Stockholders must approve the merger from both companies and will receive equity shares in the new firm in exchange for their approval. 4. __Management acquisition__: Management acquisitions, or a management-led buyout, require that an executive at one company purchase a controlling interest in another company, which in turn makes the company private. 5. __Reverse merger__: In a reverse merger, a private company can purchase a publicly listed shell company with limited assets and business operations to generate corporate finance. The private company then merges with the public company to create a new public entity with the capacity to trade the new company’s shares on Wall Street. 6. __SPAC merger__: A SPAC merger involves a special-purpose acquisition company (SPAC) or “blank-check company”—public companies formed by management teams—that raises capital through an [initial public offering](https://www.masterclass.com/articles/initial-public-offering-guide) (IPO) to acquire an existing company. 7. __Tender offer__: A tender offer is a merger that involves an offer by one company to buy the outstanding [stock](https://www.masterclass.com/articles/common-stock-vs-preferred-stock-explained) of another company at a special purchase price rather than the current market stock price. The company’s shareholders receive this offer rather than its executives or [board of directors](https://www.masterclass.com/articles/board-of-directors-explained). M&A transactions may work in the following manner: - __Due diligence__: M&A deals usually begin with a [letter of intent](https://www.masterclass.com/articles/letter-of-intent-explained) from the acquiring company, summarizing the transaction details. The letter is not a binding agreement, but it may contain a confidentiality exclusivity agreement between the two parties that allows lawyers, tax advisors, and other professionals to begin the due diligence process. Once due diligence is complete, the legal team will draw up a merger agreement outlining the merger or acquisition conditions and any regulatory filings regarding shareholder approval. - __Valuation__: The acquiring company can determine an objective valuation through several metrics, including offers based on multiples of the target company’s earnings or revenues or discontinued cash flow (DCF), which determines a company’s value by estimating future cash flows. The acquiring company may also use a formula called EBITDA—short for “earnings before interest, taxes, depreciation, and amortization”— to determine the company’s profitability. - __Negotiation__: Dealmakers from the acquiring company present their M&A deal to the target company, whose [chief financial officer](https://www.masterclass.com/articles/what-is-a-cfo) (CFO) will review the deal value for potential risks and rewards and then present it to the [chief executive officer](https://www.masterclass.com/articles/what-is-a-ceo) (CEO) for signature. Both the buy-side and sell-side of the deal may consult investment bankers and representatives from law firms for financial and legal advice during this stage. - __Financing__: Acquiring companies can finance mergers and acquisitions using cash, stock, or the target company’s debt assumption. The purchase of a company from cash borrowed from private equity firms, investment banks, or other financial services is a leveraged buyout. Once the purchase agreement is accepted, and the deal is signed, it’s officially closed. - __Integration__: Depending on the nature of the merger and acquisition, the acquiring company or newly merged companies may begin restructuring the new entity or integrating both companies’ cultures and responsibilities. Shareholders may note a drop in share value and a dilution of voting power in the period following the merger due to an increase in the number of shares created by the merger. Get the [MasterClass Annual Membership](https://www.masterclass.com) for exclusive access to video lessons taught by business luminaries, including Bob Iger, Chris Voss, Robin Roberts, Sara Blakely, Daniel Pink, Howard Schultz, Anna Wintour, and more. From asset purchases to carve-outs, companies can take advantage of a few different types of mergers and acquisitions to grow their business or even absorb the competition.