Definition - What does Operating Synergy mean?

Operating synergy is when the value and performance of two firms combined is greater than the
sum of the separate firms apart and, as such, allows for the firms to increase their operating income
and achieve higher growth.

Divestopedia explains Operating Synergy

Operating synergies can arise from the following:

 Economies of scale;
 Greater pricing power and higher margins resulting from greater market share and lower
competition;
 Combination of different functional strengths such as marketing skills and good product
line; or
 Higher levels of growth from new and expanded markets.

Operating synergies are achieved through horizontal, vertical or conglomerate mergers. Mergers of
firms which have competencies in different areas such as production, research and development or
marketing and finance can also help achieve operating efficiencies.

Operating synergy is an important reason why significant premiums are sometimes paid by strategic
buyers. Mid-market business owners that are approached by strategic buyers should try to quantify
the operating synergies that buyers might be able to realize post-acquisition. This can go a long way
to obtaining a premium valuation upon exit.

Definition - What does Financial Synergy mean?

Financial synergy is when the combination of two firms together results in greater value than if they
were to operate separately. Financial synergies are most often evaluated in the context of mergers
and acquisitions. These type of synergies relate to improvement in the financial metric of a
combined business such as revenue, debt capacity, cost of capital, profitability, etc.

Financial Synergy occurs when the joining of two companies improves financial
activities to a level greater than when the companies were operating as separate
entities. Usually, M&A transactions result in a larger company, which has a higher
bargaining power to get a lower cost of capital. Achieving a lower cost of capital as a
result of a merger or acquisition is an example of Financial Synergy
Divestopedia explains Financial Synergy

Examples of positive financial synergies include:

 Increased revenues through a larger customer base

 Lower costs through streamlined operations
 Talent and technology harmonies

In addition, financial synergies can result in the following benefits post acquisition:

 Increased debt capacity

 Greater cash flows
 Lower Cost of Capital
 Tax Benefits

When evaluating a merger or acquisition, the positive synergies usually produce a successful result.
While financial synergies are often used with a positive connotation, these synergies can also be
negative in some situations. For instance, an acquiring company may have to incur additional costs
in the target company to bolster the management team or implement systems to meet the standards
of the acquirer.

Although financial synergies are usually experienced by strategic buyers, a financial buyer may be
willing to pay a premium for the acquisition of a mid-market business due to the benefits associated
with a more efficient capital structure and lower cost of financing.

Examples of positive financial synergy benefits:

1. Tax Benefits
Many tax implications arise when two or more firms merge. Tax benefits can arise
from a merger, taking advantage of existing tax laws and using net operating losses to
shield income. If a profitable firm acquires a loss-making company, it can manage to
reduce its tax burden by using the net operating losses (NOL) of the target company.
Also, a firm that can increase its depreciation charges after a merger can save in tax
costs and increase in value.

The firm’s unused debt capacity, unused tax losses, surplus funds, and write-up of
depreciable assets also create tax benefits.
2. Increased Debt Capacity
Debt capacity can increase because when two companies merge because their cash
flows and earnings may become more steady and predictable. A merged firm may also
manage to acquire more debt from lending institutions, which can help reduce the
overall cost of capital. Smaller companies usually need to pay higher interest rates
when taking out a loan in relation to bigger companies.

Combined firms are able to get better interest rates on loans because they achieve
better capital structure and cash flow to secure their loan. Since banks base their
interest rates on the liquidity and leverage of a specific company, a combined firm is
able to get loans with a more favorable interest rate.

3. Diversification and Reduced Cost of Equity

A lower cost of capital through reduced cost of equity arises from diversification. It
often happens when large firms acquire smaller ones or when publicly traded firms
acquire private firms that are in a different industry. The diversification effect may
reduce the cost of equity for the combined firm.

When firms merge, they gain a wider customer base, which can result in lower
competition. The expanded customer base can also result in increased revenue,
market share, and cash flows. Therefore these competitive advantages can reduce the
cost of equity. However, this is highly dependent on the size and industry of the
business.