What Is a Merger?

A Merger Explained in Less Than 5 Minutes

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Table of Contents
Table of Contents

A merger is a combination of companies of about the same size that results in a new company. In a merger, the two companies blend their assets and liabilities.

Mergers can involve more than one company, but most often they involve just two companies. Let’s explore some of the reasons why companies may merge, and what it means for shareholders.

Definition and Example of a Merger

A merger is when two companies that are approximately the same size combine in a way that results in a new company. In a merger, the two companies combine their assets and liabilities.

Technically, a merger is different from an acquisition in that a merger combines the two companies’ resources equally to form a new entity. In an acquisition, one company purchases another company outright and assumes its assets and liabilities so it becomes a larger company.

However, in practice these days, the term “merger” is often used to refer to an acquisition. A true merger is very rare.

A company typically merges with (or acquires) another for the financial benefits. The merger can help the acquiring company to expand its services, increase its market share, eliminate a competitor, and achieve economies of scale (cost reductions from increased production).

A merger of two large corporations can drastically reduce or eliminate competition, which can lead to higher prices, fewer or lower-quality goods or services, or less innovation. Mergers that affect commerce and that involve companies over a certain size are reviewed by the FTC and the U.S. Department of Justice, which aim to protect consumers and prevent monopolies or duopolies.

One notable merger in recent history was the 2001 merger of media conglomerate Time Warner and America Online, the leading internet service provider at the time. The combined value of the two companies when the merger was first announced in 2000 was $350 billion.

There was a significant amount of opposition to the merger for consumer protection reasons, but the Federal Trade Commission (FTC) ultimately approved the merger.

The dot-com bubble burst shortly after the merger was approved, a recession followed, and AOL Time Warner’s advertising revenue dropped significantly. In 2002, the combined company posted a loss of $98.7 billion, and then Time Warner spun off AOL in 2009.

Other mergers have enjoyed greater success, such as the 1999 merger of Exxon and Mobil, which formed Exxon Mobil Corp. That company continues to operate today.

How a Merger Works

A merger often requires approval by the shareholders or major stakeholders, depending on state laws.

If you own shares of a public company involved in a proposed merger, you should receive information about the merger from the company, according to Securities and Exchange Commission (SEC) regulations. The notice should include information about the target company, the acquiring company, and the terms of the merger.

Merging companies must also register the changes within their state according to the laws of the states they are located in, get new state and federal tax IDs, and take steps to legally dissolve the old businesses.

Common mistakes companies may make while executing a merger include failure to move the discovery process along swiftly, poor due diligence, not enough security with information, and inflating expectations and assumptions.

After a merger, shareholders of both companies receive shares of the newly formed company.

Types of Mergers

Mergers are often categorized according to the goals of the companies involved. These categories include:

  • Horizontal merger: This is when two competitors combine. It is the classic example of a merger that eliminates a competitor and creates economies of scale. The merger of Exxon and Mobil is an example of a horizontal merger.
  • Vertical merger: This is a merger of two companies that operate in the same industry but at different levels in the supply chain. The 2016 merger of AT&T with Time Warner is an example of a vertical merger because Time Warner was an entertainment company while AT&T was a communications company.
  • Conglomerate merger: This is when merging companies are involved in unrelated business activities and do not have a buyer-seller relationship. These help companies extend their brand reach and product range.
  • Market extension merger: This is when two companies offer the same product or service but operate in different markets. As the name suggests, this type of merger is typically initiated to extend the reach of both companies and increase the number of customers.
  • Product extension merger: This is a merger of companies that offer different but related products or services in the same market. This type of merger allows the companies to bundle their offerings, take advantage of economies of scale, and increase their customer base.

Mergers can be part of a company’s long-term strategy to increase market access, extend product lines, and create shareholder value by establishing a larger new entity. They also can bring challenges for companies that may struggle to match workplace cultures and align objectives.

Key Takeaways

  • A merger is when companies that are approximately the same size form a new company from both companies’ resources.
  • Mergers can help companies increase their customer base, expand product lines, gain market share, and take advantage of economies of scale.
  • Mergers of public companies usually are approved by the shareholders of all companies involved, and they are subject to approval by the Federal Trade Commission (FTC).
  • The FTC aims to protect consumers against monopolies and unfair competitive practices.
  • Mergers can be an effective way to build a stronger, more profitable company, although not all mergers are successful.