Valuing “Synergies” in M&A
When does 1 + 1 = 3? In mergers and acquisitions (M&As), it’s often said that the combined entity is more valuable than the sum of its parts. The reason is related to a concept known as “synergies,” which are benefits to a specific strategic buyer.
Saving Costs vs. Generating Revenue
Synergies typically break down into two broad categories:
- Cost-saving. These are simple to visualize and predict. Common examples of postmerger cost savings include staff reductions (such as downsizing offices and consolidating positions), strategic reassessments (such as spinning off product lines or closing poorly performing divisions) and consolidated overhead expenses (such as eliminating redundant marketing and administrative expenses). The combined entity also can achieve better economies of scale by buying more supplies in bulk or reducing IT expenses by consolidating networks.
- Revenue-generating. These synergies are harder to quantify and are affected by many other factors, such as interest rates and market conditions. For example, a buyer might be able to cross-market its acquisition’s products to its own current customers and vice versa. Lower costs might also enable the company to offer more competitive pricing, which can increase market share. However, coming up with an accurate estimate of such future revenue can be difficult.
Sharing the Wealth
Synergies can be quite lucrative — so, sellers may expect buyers to share synergistic value with them during price negotiations. Doing so can ease the postmerger integration process by providing sellers with incentives to assist in the transition process.
Sharing synergies may require the use of creative deal terms. For example, a seller might ask for a percentage of any potential synergy-related profits over an agreed-upon period on top of the sale price. In exchange, the seller might be willing to concede to a lower sale price. Buyers find this latter proposal appealing because it reduces the price and lowers their risk. If the merged organization fails to save on synergies, the buyer has no further obligation to the seller.
Sharing synergistic value with sellers can be particularly advantageous for public companies. A sharing strategy can boost the stock price of the newly merged company because it shows investors that both parties have a stake in ensuring a smooth transition and quickly realizing cost savings.
A Different Approach
Valuing synergies requires a thorough analysis of the combined entity’s future annual growth potential and accurate estimates of savings that could be achieved from consolidation. The discounted cash flow (DCF) method is routinely used in M&As to value synergies, but how it’s applied is often far from routine. Special risk-based adjustments may be made when valuing synergies. In some situations, synergies are valued separately from “normal” business operations due to the inherent risk that they won’t be achieved.
For example, valuation experts may assign different types of synergies into separate “buckets” and assess them separately according to risk. Others use a higher discount rate, such as the cost of equity, for synergies. Still, others give synergies a “haircut” — that is, they reduce synergy-related cash flow projections to reflect the risk they won’t be realized.
The approach depends in part on the nature and risk of the synergies. For example, easily achieved cost synergies — such as those derived from eliminating redundant management — might not require a separate valuation. But revenue synergies, such as those derived from cross-selling to a new customer base or sharing distribution channels, might need to be treated separately, given the higher risk involved.
We can Help
Valuing synergies can be challenging, especially when buyers and sellers have unrealistic expectations about the combined entity’s expected future performance. A valuation professional can help the parties stay grounded and improve the chances of a successful deal.