Vertical Merger: Definition and Types

A vertical merger happens when two or more companies at different levels of the same supply chain become one entity. For example, a company can buy the business that supplies them with the raw materials for a product. The goal of this strategy is to own as many parts of the supply chain as possible and minimize transaction costs typically spent on outsourcing. A vertical merger will be successful if the integration has a positive net effect, such as lowering a distributor’s operational cost or streamlining production processes for overall higher profits.

There are competitive concerns about vertical mergers that make them subject to antitrust laws as the Federal Trade Commission and the Antitrust Division of the Department of Justice enforces. If a company owns many different stages of production, they could end up with too much market power and cause competitive harm by blocking raw materials or assets from other businesses in the industry. These anticompetitive effects have led to vertical merger guidelines and strict antitrust violation laws that help keep competition fair and equal.

A horizontal merger happens when two companies that share similar product lines consolidate into a single entity. A vertical merger is when two companies—selling different products or services—that operate in the same supply chain join forces. There are still horizontal merger guidelines based on antitrust laws that put them under merger review similar to vertical merger enforcement.

The two main types of vertical integrations are backward integrations and forward integrations.

1. 1. Backward integration: A backward integration is when a company merges with an upstream firm in their supply chain to improve its ability to control its own manufacturing. Rather than rely on other companies for raw materials, a company will either purchase their existing supplier or develop a new company to make these materials itself. This shortens the pipeline from raw materials to an end product. Consider a publishing house for books. For this company to manufacture books, they rely on and must pay individual paper, ink, and glue companies to help them print and bind books. In a backward integration business strategy, the publishing house would subsume one or all of these businesses to cut costs and control its own manufacturing.
2. 2. Forward integration: A forward integration is when a company merges with a downstream firm. In contrast to backward integration, a forward integration strategy relies on acquiring distributors rather than manufacturers of raw goods. Consider an online book retailer who relies on postal workers or private delivery companies to send out their books to retail stores and individual consumers. In a forward integration strategy, the retailer would purchase these distributors or develop its own distribution channels.

The benefits of a vertical merger include:

• Access to new finances: The consolidation of merged firms means they will be able to share finances. This means that the new company could pay down debt that was burdening a supplier or invest funds in improving a manufacturer’s facility. A merger can open up cash flow opportunities for improving the overall supply chain process or even prevent foreclosure of a supplier.
• Opportunities for structural improvements: This type of merger can be a great opportunity to restructure the leadership of a company to increase managerial synergy. This can be a risky business strategy that threatens to lower morale at the company, but you may be able to remove employees with poor performance on your management team.
• Streamlined supply chain: A vertical merger is an opportunity to have more control over the supply chain to lower costs and improve operational synergy. A company would no longer have to pay production costs from the supplier, they would have more power over quality control, and the company has direct access to the raw materials or product they previously had to purchase from their supplier.

The downsides of vertical mergers include:

• Higher operating costs: Vertical mergers and acquisition may lower costs on the supply chain, but companies may not expect higher operating costs that come with acquiring new facilities and employees as well as managing an overall larger corporation.
• Possible incompatibility of work cultures: A vertically integrated firm may struggle when two company cultures and their production processes suddenly collide. Having incompatible work forces may threaten your operational efficiency.
• Potential for losing key employees: A merged company has the potential to lose important employees who disagreed with the merger. Sometimes the threat of losing critical team members is enough reason to not go forward with mergers and acquisitions.

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