Microsoft announced last month that it will acquire LinkedIn for $26.2 billion, a 50% premium over the social networking service's closing share price around that time.
Massive merger and acquisition (M&A) transactions like this are one reason why the largest US corporations expanded in the last two decades. Between 1994 and 2013, the gross revenues of Fortune 500 companies grew from 58% of nominal GDP to 73%.
Why are these firms growing so fast? Nobel laureate Ronald Coase’s 1937 essay, “The Nature of the Firm,” gives a hint at the classical reasoning behind this trend, but acquisitions like the Microsoft-LinkedIn deal may not be rational according to its framework.
If supply and demand efficiently directs resources, independent contractors and one-off sales should organize economic activity, not firms, the private equivalent of planned economies. Coase writes, however, that there are disadvantages to using the market. Firms try to avoid transaction costs — the costs of learning the market price, negotiating with suppliers, and writing contracts — by controlling factors of production they would otherwise need to acquire from the market.
This applies most directly to the labor market. Consider how impractical it would be to negotiate a fee and hire a contract lawyer every time your boss asked you to do something. It is difficult, however, for your employers to predict everything they might ask of you in a long-term agreement, so they agree to pay you a salary to do whatever the firm needs, within agreed-upon limits. When buyers obtain control over factors of production in this way, they establish firms.
So Why Shouldn’t One Big Firm Do Everything?
Firms face increasing marginal costs of incorporating additional transactions into the firm relationship. At some point, firms will face diminishing returns to management or scale. A firm will take control over transactions until the marginal cost of doing so is equal to the marginal cost of performing the transaction with another firm or in the market.
Coase’s theory applies most directly to a firm buying one if its suppliers, but it also explains why conglomerates form. In the basic model, a firm acquires a supplier. The large firm cannot run the supplier’s business as efficiently, but if the transaction costs avoided are greater than the difference between the supplier’s cost of running itself and the large firm’s cost, it makes economic sense to purchase the supplier.
The LinkedIn acquisition does not strictly follow this framework because Microsoft and LinkedIn are in dissimilar industries. Though Microsoft may save on some transaction costs incurred when recruiting or advertising, LinkedIn does not build semiconductors or write code for Microsoft.
Coase was quick to point out that firms can participate in more than one industry. Like sharks, firms need to keep moving to survive. Only so much cash flow can be reinvested in the same thing. Increasing marginal costs lead firms to diversify or improve market penetration with new products. In Coase's words, “There may be a point where it is less costly to organize the exchange transactions of a new product than to organize further exchange transactions of the old product.”
This explains why a conglomerate like Berkshire Hathaway expanded from textiles to a variety of holdings by acquiring undervalued companies. What Coase’s theory cannot explain is why the majority of mergers fail.
And Yet They Do
It is unlikely that so many firms would routinely underestimate the operating costs of acquired firms and overestimate the transaction costs avoided. Likewise, firms would have to be inept at identifying companies with growth potential for M&A deals to provide negative value on average. LinkedIn, only months removed from a poor revenue forecast and an $11 billion sell-off, may be an overpay.
“The Nature of the Firm” does not address the possibility of synergies, the hope of many mergers. Buyers often think they can provide capital, skills, oversight, or capabilities to make their new subsidiaries more profitable.
Statistically, they are wrong most of the time. The lessons from “The Nature of the Firm” are simple: Vertical integration and expanding into industries where high economic profits can be had are often rational. Banking on synergies to grow revenue or save on costs, on the other hand, is a gamble with poor odds.
LinkedIn is neither part of Microsoft’s supply chain, nor is it a firm with strong or even positive profit margins. It is not a competitor Microsoft can acquire to achieve market hegemony, as it has in the past. The acquisition of LinkedIn depends on synergies to succeed. Specifically, Microsoft needs to sell Office 365 to LinkedIn members, and use its new data on them to improve its other services.
These synergies may not materialize. Microsoft is no stranger to regrettable acquisitions, having written down $6.3 billion after acquiring aQuantive and $7.6 billion related to its Nokia acquisition.
LinkedIn might better mesh with Microsoft, but as with all mergers, the deck is stacked against it.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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