Why do companies feel compelled to acquire other businesses? After all, the typical buyer knows its own market niche quite well, and can safely increase its revenues over time by continual, careful attention to internal organic growth. Nonetheless, thousands of acquisitions occur every year. Here are some reasons for doing so:
- Business model. The target’s business model may be different from that of the buyer, and so generates more profits. For example, a target may operate without labor unions, or have a substantially less burdensome benefits plan. The buyer may not be able to re-create this business model in-house without suffering significant unrest, but can readily buy into it through an acquisition.
- Cyclicality reduction. A buyer may be trapped in a cyclical or seasonal industry, where profitability fluctuates on a recurring basis. It may deliberately acquire a company outside this industry with the goal of offsetting the business cycle to yield more consistent financial results.
- Defensive. Some acquisitions take place because the buyer is itself the target of another company, and simply wants to make itself less attractive through an acquisition. This is particularly effective when the buyer already has a large market share, and buying another entity in the same market gives it such a large share that it cannot be bought by anyone else within the industry without anti-trust charges being brought.
- Executive compensation. A buyer’s management team may be in favor of an acquisition for the simple reason that a larger company generally pays higher salaries. The greater heft of the resulting organization is frequently viewed as being valid grounds for a significant pay boost among the surviving management team. This is not a good reason for an acquisition, but it is a common one.
- Intellectual property. This is a defensible knowledge base that gives a company a competitive advantage, and is one of the best reasons to acquire a company. Intellectual property can include patents, trademarks, production processes, databases that are difficult to re-create, and research & development labs with a history of successful product development.
- Internal development alternative. A company may have an extremely difficult time creating new products, and so looks elsewhere to find replacement products. This issue is especially likely to trigger an acquisition if a company has just decided to cancel an in-house development project, and needs a replacement immediately.
- Local market expertise. In some industries, effective entry into a local market requires the gradual accumulation of reputation through a long process of building contacts and correct business practices. A company can follow this path through internal expansion, and gain success over a long period of time – or do it at once through an acquisition. Local market expertise is especially valuable in international situations, where a buyer has minimal knowledge of local customs, not to mention the inevitable obstacles posed by a different language.
- Market growth. No matter how hard a buyer may push itself, it simply cannot grow revenues very fast in a slow-growth market, because there are so few sales to be made. Conversely, a target company may be situated in a market that is growing much faster than that of the buyer, so the buyer sees an avenue to more rapid growth.
- Market share. Companies generally strive toward a high market share, because this generally allows them to enjoy a cost advantage over their competitors, who must spread their overhead costs over smaller production volumes. The acquisition of a large competitor is a reasonable way to quickly attain significant market share.
- Production capacity. Though not a common acquisition justification, the buyer may have excess production capacity available, from which it can readily manufacture the target’s products. Usually, tooling differences between the companies make this a difficult endeavor.
- Products. The target may have an excellent product that the buyer can use to fill a hole in its own product line. This is an especially important reason when the market is expanding rapidly, and the buyer does not have sufficient time to develop the product internally before other competing products take over the market. Also, acquired products tend to have fewer bugs than ones just emerging from in-house development, since they have been through more field testing, and possibly through several build cycles. However, considerable additional effort may be needed to integrate the acquired products into the buyer’s product line, so factor this issue into the purchase decision.
- Regulatory environment. The buyer may be burdened by a suffocating regulatory environment, such as is imposed on utilities, airlines, and government contractors. If a target operates in an area subject to less regulation, the buyer may be more inclined to buy into that environment.
- Sales channels. A target may have an unusually effective sales channel that the buyer thinks it can use to distribute its own products. Examples of such sales channels are as varied as door-to-door sales, electronic downloads, telemarketing, or a well-trained in-house sales staff. Also, the target’s sales staff might be especially effective – in some industries, sales is considered the bottleneck operation, and so may be the prime reason for an acquisition offer.
- Vertical integration. To use a military term, a company may want to “secure its supply lines” by acquiring selected suppliers. This is especially important if there is considerable demand for key supplies, and a supplier has control over a large proportion of them. This is especially important when other suppliers are located in politically volatile areas, leaving few reliable suppliers. In addition to this “backward integration,” a company can also engage in “forward integration” by acquiring a distributor or customer. This most commonly occurs with distributors, especially if they have unusually excellent relationships with the ultimate set of customers. A company can also use its ownership of a distributor from a defensive perspective, so that competitors must shift their sales to other distributors.
No matter which of the reasons above are central to a buyer’s acquisition decision, it ultimately involves enhancing the price per share of the buyer’s stock. This may not be immediately apparent, especially for smaller acquisitions where resulting share price changes are trifling, but a long-term acquisition strategy should gradually build a company’s price per share.