Businesspeople frequently talk of mergers & acquisitions (M&A), but the emphasis is usually on acquisitions, with relatively little thought given to mergers. Yet in today’s financial markets, it may make even more sense to consider mergers.

Why is this the case? Consider the following (very common) scenario: due to anemic economic conditions, two companies in the same industry may both be hurting. Both of them may be experiencing much lower than usual profitability and cash flow, perhaps even a loss. Both of them may be experiencing a liquidity crunch. Both of them may be reluctant to exit at what would most likely be very low valuations. Furthermore, lack of liquidity would make it difficult or impossible for one company to acquire the other.

In this type of scenario, a merger may be the perfect solution: with a cash-free transaction (e.g. a merger), two marginal or unprofitable companies may combine to form a profitable company, with greater market share, economies of scale, and rationalized costs. This is the definition of synergies: 1+1 = 3. Because investors prefer to invest in larger entities, a merged entity may also be a more saleable entity in the longer term. Hence corporate value is enhanced, in preparation for the day when financial markets (and valuations) improve.

Sounds too easy? While the upside in such a scenario is more often available than business owners realize, there are also numerous potential pitfalls. Allow me to enumerate some of these pitfalls, both with respect to doing a merger transaction, as well as pitfalls with respect to making the merged entity work.

A merger is often a much more complicated transaction than an acquisition:

• Each party must perform a due diligence and valuation of the other (as opposed to the case of acquisitions, where only the acquirer values and performs a due diligence on the target company). It is often very tricky for the parties to come up with the relative valuation that each party will obtain in the new merged entity.

• How will the owners of the merging companies share the governance of the new entity? Will they be equal partners? Will one or both have veto rights? Will there be rights of first refusal, put or call options?

• A party may need to give up control of his or her company, without receiving cash in the transaction. This often gives at least one party to the merger cold feet.

• How will the loans of both merging corporations be handled? Will banks become joint lenders to the merged entity? Or will there be a refinancing? Banks of both merging entities will likely need to approve any merger, or be paid off on or before the merger closing. Banks may be afraid of the risks associated with the merger, for example, whether management will be capable of realizing the merger synergies.

   

Pitfalls in making the merged entity include:

• Joint management of any company, among people who have typically been used to being sole CEOs, can be very trying.

• The realization of synergies may prove elusive. For example, on paper it might appear simple to rationalize expenses, in practice there may be resistance from within the organization.

• The two organizations may have different corporate cultures, which may create difficulties in implementing any merger. A merger seldom if ever works unless the corporate cultures are fused into one.

It requires enormous expertise to successfully execute a merger. The potential upside of a merger may be huge; but the potential pitfalls and risks are also great. In times of recession a merger is nevertheless one of the best ways that “financial engineering” may create corporate value.