What are Synergies?

Financial synergies refer to the value created when two companies join together. If the two entities join up and create more value than when they operated separately, it’s considered synergy. 

In other words, it’s a test to see how valuable a merger or acquisition would be. If the combined value of company A and company B is greater than their separate value, that creates synergy.

What are synergies?

You would typically calculate synergy in the context of mergers and acquisitions, or M&A. This term relates to how combining two businesses would improve their financial performance in terms of:

  • Increasing revenue
  • Reducing costs
  • Improving cash flow

Synergies usually result in a larger business that has more bargaining power. That leads to a lower cost of capital, which is good news for any corporation that’s trying to grow.

However, synergy can be negative, too. If the combined power of two businesses is less when they merge, that’s not a synergy that benefits the companies’ shareholders. For any merger to benefit shareholders, synergies need to exceed any lost value or revenue during the deal. 

How to calculate synergies

Typically you calculate synergies with this formula:

V(A+B) > V(A) + V(B)

The benefits of synergies

Financial synergy happens when two firms combine to form a more financially powerful entity. Synergies are usually the motive behind M&A because the value of the whole is greater than the sum of its parts.

Firms usually pursue synergies for 5 reasons.

  1. Increase revenue — Revenue increases usually happen when large firms acquire smaller firms. This also happens when publicly traded firms acquire private firms. Revenue increases are a type of synergy that comes from diversifying and selling more goods and services. With more avenues to distribute its products and services, the new company can find more customers and earn more.
  2. Decrease expenses — M&A gives two businesses the opportunity to combine and streamline, significantly reducing costs by pooling their resources. For example, you wouldn’t need two CEOs or CFOs — M&A synergies optimize these positions for financial efficiency.
  3. Process optimization — When two companies merge, they become one entity. That means everything from branding to strategy to marketing is shared between the two businesses. This form of synergy allows both companies to use better, more streamlined processes that make them more profitable. For example, maybe each company has proprietary IT systems. One company might have better R&D efforts. When you get both businesses on the best system for the job, it’s easier to find cost savings that lead to better profits.
  4. Improved distribution — Sometimes a firm will acquire another one solely because of its client relationships. If one company has access to better customers, vendors, or other favorable relationships, it can benefit both entities.
  5. Financial economy — There are plenty of financial benefits to M&A. First, both businesses can get better tax benefits. If a profitable company acquires a company operating at a loss, the profitable company can reduce its tax burden because of the net operating losses (NOL) of the acquired company. A merger can also allow a business to increase its depreciation expenses to save on taxes, too. Second, synergies allow for increased debt capacity. Cash flow and earnings are usually more stable after a merger, which means the new entity might qualify for more debt. That reduces the overall cost of capital, which helps the new business grow faster.

Financial synergies are at the heart of corporate mergers and acquisitions. While a typical consumer might not have to deal with synergies on a daily basis, it’s still an important basis for understanding a business’s financial performance and how M&A affects your returns as an investor.