Synergistic

What Does Synergistic Mean?

Synergistic effect or synergy is traditionally defined as “a mutually advantageous conjunction or compatibility of distinct business participants or elements.” Its meaning is expressed by the old saying, “The whole is greater than the sum of its parts,” and can be expressed as 1 + 1 > 2.

Synergy, as used in finance, describes the possible financial gains from combining two businesses through mergers and acquisitions (M&A). When the merged company's value exceeds the sum of the values of the two separate firms, synergy is said to have been realized.

Getting synergy is frequently the primary motivation for a merger or purchase. Therefore, it is essential that financial professionals comprehend the meaning of synergy, its many forms, the potential pitfalls associated with it, and how to apply it to their models.

We turn to the efficient market hypothesis (EMH), which holds that stock prices should fully, immediately, and swiftly absorb all the information to demonstrate synergy's role in mergers and acquisitions.

Thus, since companies almost always pay a premium on the market price in an M&A transaction, we can only reason that there must be something that is not reflected in the information available before the deal but is prevalent at the deal’s close.

We can then call this information, or improved financial performance, which will come to be true only if the deal goes through, synergy or synergistic effect. Therefore, realizing synergy is the only reason for a company to engage in an M&A transaction in an efficient market.

It is important to note that this line of thought is not merely hypothetical. Since advanced economies have at least weakly efficient markets, that is, efficient markets over the long term, and since deals take a long time to close, this line of thought holds.

Types of synergy

There are many classifications of synergy. The most common ones classify synergies into three types:

• Revenue synergy
• Cost synergy
• Financial synergy

It is important to note that while many different classifications exist, they all point to the same concepts, albeit under different names. For example, some people classify synergy into just two types - revenue and cost - and incorporate financial synergy into them as revenue or cost benefits.

In this article, however, we will focus on the most common classification of synergy, that is, the classification into revenue, cost, and financial synergies.

Revenue Synergy

Revenue synergy refers to the potential financial benefits that arise in M&A as a result of combining strengths. Increased ability to generate revenue can be achieved by exploiting several opportunities, such as cross-selling, enhanced market reach, and complementary offerings.

Cross-selling is one of the primary sources of revenue synergies and is often the dominating one. If the two merging companies have complementary products or services, they can leverage their combined customer base to cross-sell each other’s offerings and increase revenue.

Through cross-selling, businesses may profit from their current customer bases. Businesses may enhance customer happiness, retention, and lifetime value (LTV) by providing a wider array of products and services to their customers. This will also optimize sales prospects.

Revenue synergy can also be achieved by combining complementary offerings into new bundles and solutions. These more complete offerings can: 

• Enhance cross-selling to existing customers
• Attract new customers
• Command premium pricing
• Provide a competitive advantage

Furthermore, revenue synergy can be achieved through enhanced market reach, allowing the combined company to tap into previously untapped revenue streams. Exploiting enhanced market reach opportunities increases sales volume, market share, and competitive positioning.

These opportunities can be exploited by selling existing products in new geographic markets and through new distribution channels, penetrating deeper into existing markets. Moreover, forming strategic partnerships presents an opportunity to reach a wider customer base.

However, according to a McKinsey & Company study, revenue synergies are more challenging and take longer to realize than cost synergies. On average, companies realize only 77% of their revenue synergy targets, and revenue synergies take 3 more years to realize than cost ones.

Executives surveyed in the study cited several difficulties in realizing revenue synergies, such as:

• Setting realistic targets
• Changing salesforce behavior
• Executing across functions
• Measuring financial impact
• Getting the organization to focus on the right things

Cost Synergy

Cost synergies refer to the financial benefits that can be realized when two companies merge by increasing operational efficiency. Combining resources, streamlining processes, and eliminating redundancies allow the combined company to achieve cost reductions and improve profitability.

One of the primary sources of cost synergies is the elimination of duplication functions and departments. When two companies merge, there are often overlapping functions and roles, such as accounting, human resources, and procurement.

By consolidating these overlapping or duplicate functions, the combined company can reduce staffing needs and realize economies of scale, leading to significant cost savings in terms of salaries, benefits, and administrative expenses.

Another source of cost synergies is the harmonization of processes and systems. By aligning and standardizing operational processes, the combined company can eliminate inefficiencies, reduce errors, and improve productivity.

This operational simplification can result in cost savings and economies of scale due to higher outputs and lower inputs by lowering labor costs, better allocating resources, and improving operational efficacy.

Finally, cost savings can be attained through streamlining the procurement and supply chain. Decreased input costs may arise from this optimization, which would eventually decrease the cost of goods sold (COGS).

By merging, companies can leverage their combined purchasing power to negotiate better terms with suppliers, obtain volume discounts, and streamline the procurement process. They can also leverage their combined logistics network to reduce supply chain expenses further.

Financial Synergy

Financial synergy refers to the potential financial benefits that can be realized when two companies merge as a result of the optimization of financial resources and capital structures to create value and improve financial performance.

One way financial synergies can arise is through improved credit ratings. An improved credit rating allows the combined company to borrow more at a lower cost, thus allowing it to fund growth opportunities while reducing expenses at the same time.

When two mid-cap companies combine, they form a larger-cap company. This larger entity now has a stronger financial position and a higher cash flow generation ability, leading to a better credit rating than the individual companies.

Additionally, financial synergies can be realized through tax optimization. The resulting tax advantages can lead to reduced tax liabilities and increased after-tax (bottom-line) earnings, leading to better financial performance and more value creation.

By combining, companies can take advantage of tax efficiencies, such as: 

• The ability to offset profits and losses
• Utilize tax credits
• Access favorable tax jurisdictions

However, exploiting these opportunities requires heavy due diligence and is often conditional on regulatory approval.

For example, in 2015, Pfizer attempted to purchase Allergan, a pharmaceuticals business located in Ireland, in a $160 billion transaction that would have saved New York-based Pfizer an estimated $1 billion in taxes annually by allowing it to domicile in Ireland, where corporate tax rates are lower.

However, the arrangement was scuttled in 2016 by new Treasury Department guidelines aimed at reducing tax cheating through offshore relocation. Because of the deal's collapse, Pfizer was forced to pay Allergan $150 million to repay its expenditures.

Example of successful synergy: Disney-Pixar merger

The Disney-Pixar merger is considered one of the most successful mergers ever and a prime example of successful synergy. The Walt Disney Company acquired Pixar Animation Studios in 2006, bringing together two highly respected entities in the entertainment industry.

Disney, an established player in the entertainment industry with a rich history in traditional animation, was looking to acquire Pixar’s cutting-edge computer-generated animation technology and innovative character development and storytelling techniques.

At the same time, Pixar was looking to access Disney’s vast distribution network and long experience in the entertainment industry. The merger proved highly fruitful for both companies and resulted in significant value creation and mutual benefit.

First, Disney-Pixar films have achieved remarkable box office success.  Toy Story 3 grossed over $1 billion, becoming the highest-grossing animated film at the time and the highest-grossing film of 2010. Other highly successful films include Finding Dory and Incredibles 2.

Second, the merger has fueled the expansion of merchandise sales and licensing opportunities. Characters from Pixar’s films, such as Woody and Buzz Lightyear, have become highly popular and lucrative for Disney.

In 2006, Disney’s Consumer Products segment reported $2.1 billion in revenue. By 2022, that number had more than doubled to $5.2 billion, demonstrating Pixar’s positive influence on Disney’s merchandise lineup.

Third, the merger has significantly contributed to theme park success. The addition of Pixar-themed attractions to Disney’s theme parks, such as Cars Land, has attracted larger audiences, increased park attendance, and fueled international expansion.

In 2006, the revenue of Disney’s Theme Parks segment amounted to $9.9 billion. By 2022, the number had also more than doubled to $24.4 billion, another testimony to the hugely positive impact of the merger.

Finally, the success of the merger is reflected in Disney’s financial performance. Disney’s total revenue increased from $34.4 billion in 2006 to $82.7 billion in 2022, and its stock rose from $24 per share in January 2006 to $82 per share in September 2023.

We can attribute the merger’s huge success and the realization of its synergies to:

• Cultural alignment
• Creative collaboration
• Expanded content production
• Technological advancements
• Cross-promotion and brand synergy

Disney has successfully realized the synergies of its merger with Pixar, ushering in an era of commercially successful and critically acclaimed animated films and creating substantial value for all stakeholders.

Negative Synergy

Synergy does not always have to be positive. Buckminster Fuller defined synergy as the “behavior of whole systems unpredicted by the behavior of their parts taken separately.” That definition means that synergy can be negative as well.

Negative synergy in finance occurs when the value of a combined company is less than the sum of the values of its two constituent companies. In other words, when 1 + 1 < 2. It arises when the integration faces unforeseen challenges, failing to deliver the expected benefits.

Several factors pose a risk to the achievement of successful synergy and can contribute to the occurrence of negative synergies. Understanding these factors is key to understanding negative synergies and preventing them from arising.

1. Cultural clashes and organizational misalignment

Negative synergies can arise as a result of cultural clashes and organizational misalignment. When two companies with opposing corporate cultures or management styles merge, conflicts arise.

Incompatible values, communication breakdowns, and resistance to change hinder collaboration and the smooth integration of operations. Such cultural clashes lead to decreased employee morale, increased turnover, and a loss of productivity, negatively impacting performance.

2. Operational challenges

Negative synergy can also be caused by operational challenges. When merging companies have incompatible systems, technologies, or processes, these incompatibilities can lead to disruptions in daily operations, delays in project execution, and a loss in efficiency.

In addition, overlapping or duplicate functions or roles, if not eliminated, can lead to redundancies and increased costs rather than the cost savings anticipated under the scenario of positive synergy.

3. Financial challenges

Financial challenges can also lead to negative synergies and a failed merger. These financial hurdles can strain the combined company’s financial resources, hindering its ability to achieve the desired synergistic benefits.

Merging companies may encounter unexpected financial complexities, such as high integration costs, difficulties in consolidating the financial statements, or unanticipated tax liabilities. They may also encounter an increased debt burden associated with financing the merger itself.

Example of negative synergy: Quaker-Snapple merger

One of the worst mergers in history is thought to have occurred with Quaker and Snapple. The Quaker Oats Company, a prominent food giant at the time, paid an astonishing $1.7 billion to purchase the Snapple Beverage Corporation in 1994.

Quaker considered the transaction as a calculated step to build on Snapple's success and increase Quaker's market share in the beverage industry. Snapple was a well-known beverage producer. Nevertheless, the combination did not produce the anticipated advantages and instead produced negative synergy.

The cultural mismatch between Quaker's more conventional and hierarchical corporate culture and Snapple's unique entrepreneurial culture, which prioritizes creativity and invention, was one of the major issues that emerged. 

This clash led to conflicts and difficulties in integration operations and the decision-making processes and made the other challenges faced by the company even more serious, contributing significantly to the eventual failure of the merger.

Operational challenges also emerged following the merger. Quaker was primarily a food company, and its lack of expertise in the beverage industry became evident. The resulting operational inefficiencies led to declining sales and market share for Snapple.

Quaker struggled to effectively manage Snapple’s distribution networks, maintain product quality, and adapt to the dynamic nature of the beverage market. It also failed to integrate the two supply chains, leading to several logistical challenges.

Financial challenges further compounded the negative synergy of the merger. The high acquisition cost, coupled with the challenges in integration operations and the declining sales, led to a significant financial strain on Quaker.

The company experienced a sharp decline in its stock price and had to significantly write down the value of the Snapple brand, resulting in substantial losses.

Ultimately, this negative synergy led to severe consequences. In 1997, just three years after the merger, Quaker sold Snapple to Triarc Companies for $300 million, about one-sixth of the original acquisition cost.

The merger and the subsequent divestiture have since served as a cautionary tale highlighting the importance of due diligence, cultural alignment, and operational expertise in mergers and acquisitions.

Synergy valuation in M&A

Damodaran (2005) proposed a general formula for valuing target companies in M&A deals accounting for synergies, as follows:

Value_target = Value_{target, standalone} + Value_synergies + Control premium

To calculate the value of synergies, the following factors have to be considered:

• Benefit impact: effect of synergies on each line item of the financial statements
• Probability of realization: likelihood of realizing synergies, considering potential challenges
• Timing of benefit generation: time horizon over which synergies are realized
• Cost of integration: costs incurred after the deal is closed in order to realize synergies

Failing to perform adequate due diligence and analysis to quantify each of these factors properly will most likely lead to an inaccurate estimate of synergy value and overpaying. Companies may ultimately find themselves ending up with negative synergy.

The net present value (NPV) of synergies can then be calculated by adding the discounted present values (PV) of each of the synergy types and subtracting the cost of integration as follows:

NPV_{total synergies} = PV_{revenue synergies} + PV_{cost synergies} + PV_{financial synergies} - Cost of integration

It is important to note that the value of synergies should not be thought of as a precise figure. Rather, just like the value of a standalone company, it is a range of possible values and should be incorporated into the overall valuation model as such.

After the deal is closed, goodwill, the excess of the purchase price over the target company's book value, may appear on the consolidated balance sheet. However, goodwill is an accounting figure and does not necessarily reflect the value of synergies.

If you want to learn more about modeling M&A transactions, check out WSO’s M&A Modeling Course!

Researched & Authored by Adham Touny | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Financial Synergy
• Synergy
• Mergers & Acquisitions (M&A)
• Mergers Acquisitions M&A Process
• Timing of Synergies