In this post, I tackle one of the most maligned – but, ultimately, vital – terms in business strategy: the infamous synergy. It’s an awful, awful, AWFUL word. But understanding what a synergy is and how to leverage it is crucial.

Yes, Synergy Really Is a Thing

What is a synergy? It’s a neologism for saying that something is more than the sum of it’s parts. The best analogy I can give is that a synergy is like a really well balanced party in an RPG or a well balanced team in Overwatch or Battlefield.

Think of the original Final Fantasy. You start making a party and toss in a fighter first. If you just have a one man party, the fighter’s ability to handle certain contingencies – such as monsters resistant to physical attacks or enemies that dole out status effects – will be severely compromised. You can compensate for these short comings by grinding, but that’s an expensive (in terms of time) learning curve saddled with some serious diminishing returns. Alternatively, you could add another fighter, but all you would accomplish is increasing the scale of physical damage you can dole out. You have more capacity for bloodshed, but no additional flexibility.

However, if you add a black mage, you now have two ability sets that compliment each other and the range of scenarios the two of them can handle together is greater than either of them could handle alone. Add in a white mage for healing and buffs and a thief or martial artist for specialization, and you have yourself a fierce unit that can over come any contingency with proper preparation and equipment.

Real World Synergy

In the real world, synergy is a byproduct when business units or companies have complimentary abilities and merge or establish a partnership. Let’s say your company makes loaves of bread in Pittsburgh and you have enough capacity to satisfy demand. In that case, merging with another bread company in Pittsburgh doesn’t accomplish much other than putting a damper on competition. And the Department of Justice and other regulatory agencies hate that sort of collusion and would probably intervene.

However, merging with a bread maker in Philadelphia is a different story: you would get access to customers in a new city. Or if you merged “upstream” and acquired your primary supplier of flour (this is known as “backward integration”). Or if you acquired a “downstream” company like a delivery service to take your bread to stores (“forward integration”). Or if you acquired a company that makes cake to get into that market without having to start from scratch (“horizontal integration”).

Why Does This Matter?

Here’s the funny thing about finance: you don’t get anything for free. Financial forecasting is such that it’s generally not a great idea to buy a company just for its future cash flows. If you are buying a company because it makes a lot of money, the owners of that company will ask you to pay the present value of all of those future earnings. Basically, you pay up front for all of the money you think you’ll receive in the future. The two cancel each other out. Okay, it’s not an exact science (it’s a forecast after all), but it’s close enough to be prohibitive.

So why bother buying a company? Well, assuming its not just a power-hungry CEO going on an empire-building rampage, companies typically acquire each other to get access to something. Examples:

Access to intellectual capital (patents, brands, copyrights, trade secrets, etc)
Access to new markets (as in the Philadelphia example above)
Access to some upstream resource (natural resources, raw materials, etc)

Synergies Are What Make These Moves Profitable

I make bread. You make flour. I acquire you and we consolidate our logistics. Now we have the same two products (bread and flour), but the consolidation means that our combined overhead is smaller than the total overhead of our separate, pre-merger logistical chains. Then we jointly acquire Fred’s delivery services, and consolidate our management overhead with his. Now we have three products under one corporation and a logistical network that’s smaller as a unified entity than it was as three separate companies.

Those savings are the synergies. The companies that can create the largest synergies are the companies that will profit the most from acquisitions and partnerships. They’re also the companies that can afford to pay more for those acquisition. If you and I are both bidding to acquire the same company, but your anticipated synergy with that company is worth $500MM more than mine, you’ll be willing to bid $500MM than I will.

Synergy: Shitty Name, Important Concept

It’s an awful word that epitomizes what people hate about corporate America. But don’t throw the baby out with the bath water. Synergies are a crucial element of business strategy. If your company is looking to acquire another firm, or if somebody is looking to acquire your company, ask yourself what the synergy potential is? If you can’t think of one, you might just be looking at a bad idea.