Synergy can be defined as a concept which states that the combined return of the whole is far greater than the sum of returns from the individual parts. The additional value that is generated after two or more firms combine their assets, expertise and experience is synergy, which represents the extra value generated compared to a situation where the firms operated independently.  When two entities are combined, it leads to creation of a new and more valuable entity.

Businesses around the world have often paid billion of dollars as premiums while acquiring or buying-out other companies, in order to reap the benefits of synergy. For example, Facebook recently paid over $2 billion for Instagram. Some analysts believe that Facebook overpaid for the acquisition, but they underestimate the value of synergy. Analysts have a good reason to be skeptical, since it is difficult to place a monetary value on synergy, since historically the value of a merger is assessed monetary.

Synergies have two main categories: Operating synergies impact and enhance the operations of the combines firm, owing to economies of scale, monopolistic power over prices and increased growth potential. Consequently, operational synergies increase company’s cash flow in the longer run. Financial synergies bring the benefit of tax breaks/benefits, diversification into other areas of business and increased debt capacity, which might allow the company to grow drastically, since acquiring finance for new projects is easier after the merger. Financial economies of scale also play a part in enhancing company potential to make efficient use the capital resources. 

Valuing Synergies

Some experts claim that synergy is too nebulous too be measured monetary or otherwise, since all of assumption have to be taken in order to do so. Although estimated are drawn before mergers and acquisition takes place, since companies cannot be expected to spend million, if not billions of dollars based on an assumption with substantial research. Two fundamental question need to be explored before a company acquired another company hoping for synergy:

  1. How much will the synergy add to the company in terms of revenues, profits and how the growth factors will improve once the companies are merged. Anticipated rate of return, profit margin, cost reduction, and overall financial position of the company needs to be determined before a decision is taken.
  2. The company also needs to evaluate the impact on cash flows. Since synergies often start to benefit companies over time, a timeframe needs to be developed. If the benefit of a synergy won’t be visible until couple decades, the value of synergy is significantly less, compared to the one which starts the venture immediately.