Business entities are formed and operated with the primary purpose of generating profits. In this pursuit, they are constantly on the lookout for means to maximize their profits. Mergers and acquisitions are one of the strategies that companies may follow to achieve this. A merger is a financial arrangement in which two or more companies are combined to form a single new company. Essentially a merger follows a business strategy that seeks to benefit from factors such as economies of scale, larger market share, reducing external competition etc., that arise on merger of businesses of both the companies.
This article looks at meaning of and differences between two types of merger – horizontal and vertical merger.
Definitions and meanings
A horizontal merger is a merger of two or more companies that belong to the same industry, to form a new merged company. In this type of merger, those companies are combined together whose core business is the same or similar. Before merger, these companies, infact, are likely to have been competitors for each other.
The primary purpose of horizontal merger is to eliminate or reduce competition and gain a larger market share or customer base.
Example of horizontal merger
There are primarily 3 companies operating in the telecom sector; ABC Inc, XYZ Inc AND PQR Inc. The approximate market share of each is:
- ABC Inc – 30%
- XYZ Inc – 25%
- PQR Inc – 40%
- Others – 5%
ABC Inc. and XYZ Inc. merge to form a new entity ABXZ Inc. Their combined market share would now be 55% (30% + 25%). Furthermore, as their businesses combine, they can achieve economies of scale and may eventually get an even bigger market share. This is an example of horizontal merger.
The basic premise of a horizontal merger is around the synergies that develop on merger of two similar companies. That is to say, from the perspective of a merger, the combination of 1+1 will likely be greater than 2.
A vertical merger is a merger of two or more companies that are part of the same value or supply chain. A supply chain in a manufacturing industry involves several participants – from raw material production to manufacturing the final product to selling them to distributors and retailers from where the product finally reaches the ultimate consumer.
A vertical merger involves merger of two companies who operate in the same broad industry but manufacture different products. Generally, the input of one of these companies forms the output for the next company, making them part of the same supply chain for a particular product or process.
The main purpose of a vertical merger is to cut costs and increase operating efficacy through quality control over large part of the supply chain.
Example of vertical merger
ABC Inc. is an automobile manufacturing company. It procures some of its input materials from another smaller manufacturing company XYZ Inc – a spare parts manufacturing company. Both ABC Inc. and XYZ Inc. decide to merge to form a new company. This new merged company will thus manufacture both the spare parts and final automobile. The automobile business will get improved margins as it will now get spare parts at production cost and the spare parts business can expand by using the extensive distribution chain of ABC Inc. This is an example of a vertical merger.
Difference between horizontal and vertical merger
The main points of difference between horizontal and vertical merger are listed below:
- Horizontal merger is the combination of two or more companies engaged in manufacturing the same product or providing the same service.
- Vertical merger is the combination of two or more companies that operate within the same supply chain.
2. Nature of companies involved
- All companies involved in a horizontal merger are involved in the same business i.e.: manufacture the same products.
- All companies involved in a vertical merger belong to the same broad sector but have different businesses i.e.: manufacture different products.
- The main purpose of a horizontal merger is to increase market share and customer base of the combined business.
- The main purpose of a vertical merger is to reduce costs and improve functioning of the supply chain.
- The synergies that can result from a horizontal merger include – scaling up of combined business, use of combined distribution chains to widen customer base, use of combined technological resources to innovate. Thus, it results in reduction of competition for the combined business and an all in all increase of business.
- The synergies that result from a vertical merger include – improved efficacy of the supply chain thus improving quality and cutting costs.
- A horizontal merger does not contribute to the business becoming independent in its operations. The combined business still depends on other entities to complete the supply chain.
- A vertical merger on the other hand may result in the combined business becoming fairly independent. This is because it has internalized different parts of the supply chain within a single company.
Two automobile manufacturing companies merging to form a new larger automobile manufacturing company is an example of a horizontal merger. When the same automobile manufacturing company merges with its input suppliers to form a new company which dominates the supply chain, it becomes a vertical merger.
Conclusion – horizontal vs vertical merger
While both horizontal and vertical mergers result in creation of a new legal company, their core purpose and modus operandi are quite different. Both these mergers may however face several hurdles such as clashing working culture or management styles. Further more they also face significant legal scrutiny. This is because in addition to positive synergies, these mergers can also result in anti-competition practices. For example, a horizontal merger may seek to create a monopoly in the market and artificially increase prices for consumers. A vertical merger can also attempt to block out access to the supply chain to other companies in the industry, hampering fair competition. This is why these mergers are thoroughly monitored by legal bodies.