What’s it: A vertical merger is a combination of two companies at different value chain levels into one entity—for example, a merger between a company and its distributor or supplier of inputs.
The purpose of vertical mergers is to increase synergy, gain more control over input or distribution, and increase business value. This strategy often results in reduced costs and increased productivity and efficiency. And in general, it combines the profits in the value chain into one entity.
Two types of vertical mergers:
- Forward vertical merger
- Backward vertical merger
Companies merge with their suppliers under a backward vertical merger, perhaps suppliers of raw materials or capital goods. Meanwhile, in the forward vertical merger, companies merge with their distributors or retailers. Because they control the entire production process, we consider the company to be vertically integrated.
The difference between vertical merger, vertical integration, horizontal merger and conglomerate merger
Vertical merger and vertical integration are often used interchangeably. In fact, both have several differences.
The merger means the incorporation of two different businesses. There is only one surviving entity; the others will dissolve.
Meanwhile, vertical integration means coordinating several operations under one command or ownership. It wasn’t just through a merger. Companies can also do this through the acquisition or establishing a new subsidiary, which allows the company to have control.
An alternative to vertical mergers is horizontal mergers and conglomerate mergers. A horizontal merger involves merging two companies producing on the same supply chain. In other words, it is a merger of two companies that are in direct competition with each other. A merger between two carmakers is an example.
Meanwhile, a conglomerate merger involves two companies with different businesses, such as car manufacturers and palm oil companies.
Advantages of a vertical merger
A vertical merger basically combines the value (profit) in the production chain into one. That yields several advantages, such as:
- Gain control and continuity over input supply (backward vertical integration)
- Gain access to different markets or control over the distribution of the company’s products (forward vertical integration)
- Increase the revenue stream
- Eliminates the risks associated with relying on external suppliers or distributors
- Combines the resources and core competencies of the two companies
Increase control over an input supply
Take, for example, a merger between a cooking oil company and a crude palm oil company. Such a merger reduces the input costs of crude palm oil as it is produced internally, allowing it to lower prices. If previously, the cooking oil company obtained supply at market price, then the company obtained it artificially at the production cost after the merger.
Assume that the price of crude palm oil is $120 per tonne, with the producer setting a profit margin of around 20%. In this case, the production cost is $100 per tonne (selling price after deducting the markup of 20%). After the merger, the surviving entity artificially gets an input price of $100 per tonne because there is no profit markup.
Apart from reducing input costs, vertical mergers also increase control over the input supply. The company can ensure that inputs are available in a more timely manner with the specifications’ quality.
Increase control over product sales
Mergers with distributors allow the entity to control the distribution channels. Such controls are essential to ensure goods are sold at the right price, quality, and location without damaging its reputation.
The surviving entity can also combine the core capabilities of the two previous companies. Say, a distributor has a reliable capability in post-purchase service. Meanwhile, the company has the core ability to create reliable quality. So, the surviving entity not only produces high-quality goods but also has super post-purchase services.
Such benefits increase added value, enabling the company to offer products at a premium price.
Furthermore, the surviving entity can utilize product marketing information to capture more information about customer needs and perceptions. The company then leaves it to the research and development division to develop new products.
Of course, combining two companies means combining two revenue streams. For example, in cooking oil and crude palm oil companies, revenue is from selling cooking oil and crude palm oil sold to other companies.
Furthermore, the reduction in post-merger costs also allows the company to capture more profit.
Disadvantages of a vertical merger
Merging the two companies raises several problems. Differences in leadership style and culture, loss of strategic focus, increased bureaucracy in organizations can lead to failure. Well, here are some disadvantages of vertical mergers:
- Two corporate cultures clash. The new boss may not be as lovely as the old boss because of the different leadership styles. Self-interest motives also often create problems in synergy. For example, after a merger, those who used to be bosses may have to accept the fact of being subordinates.
- Loss of key personnel. Forced to become subordinates, they may prefer to leave and find a better position elsewhere. If they are key employees, that is, of course, to the disadvantage of the company.
- Increased bureaucracy. The size and operations of the business become large and complex, giving rise to several overlapping jobs.
- Lower productivity. Restructuring and downsizing often follow mergers. And it can lower employee morale and productivity.
- Stricter oversight by regulators. Vertical mergers are one way to block competitors from accessing raw materials or distribution channels. For example, the surviving entity can control the supply and price of inputs, thereby potentially destroying fair competition.
- Losing focus. The surviving entity should focus on two different core competencies. It may destroy the company’s competitive advantage in the long run by increasing the costs of coordination and managing the business.