What it is: External growth refers to the expansion of business by relying on the synergy of internal and external resources and capabilities. The most common strategies are mergers and acquisitions. Alternatively, the company can also form a joint venture or strategic alliance with another company.
We call mergers and acquisitions an integration strategy. The company integrates other companies’ resources and capabilities, whether merged into one entity (merger) or as a subsidiary (acquisition).
Integration is a quick way to grow. Soon the company’s operations became larger, which is critical in this competitive and growing market.
Reasons for businesses to adopt external growth
Internal growth has some drawbacks. Companies may lack funds to expand their operations. It grows more slowly, leaving them at a disadvantage position because the market requires fast growth to remain competitive. Or, they might have the insufficient new market knowledge to develop business internally.
On the other hand, external growth offers a faster way to grow. Or, companies may be looking for ways to reduce competition and increase their market power. Also, external growth mode is a suitable way to synergize new resources and capabilities with the existing.
External growth types
Integration: Companies do so through acquisitions or mergers, which synergize two resources and capabilities under one entity or control. In the acquisition, the acquirer takes over the target company and makes it a subsidiary.
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Two types of acquisitions:
- Friendly acquisition
- Hostile acquisition
A friendly acquisition is when the target company’s management and shareholders agree to be purchased. Meanwhile, in a hostile acquisition, the target company’s management and shareholders disagree, encouraging the acquirer to pursue alternative strategies (such as a tender offer and a proxy fight) to expedite the purchase. The term “takeover” usually refers to a hostile acquisition than a friendly acquisition.
Furthermore, a merger takes place when the two join into one and leave one surviving entity. That may involve downsizing for some overlapping job.
- Horizontal integration – occurs between two companies that compete with each other. They are at the same supply chain level. For example, Facebook acquires Instagram in the internet business or Disney purchases 21st Century Fox in the entertainment business.
- Vertical integration – involves two companies at different levels in a supply chain. Two types of vertical integration are backward and forward integrations. Backward vertical integration is if the company merges/acquires the upstream companies, such as an automaker, take over the aluminum producer. Forward vertical integration is if the company merges/acquires downstream firms, such as an automaker, buys the car distributor.
- Conglomerate integration – takes place between the two companies are in the different supply chains. For example, an automaker acquires a palm oil producer.
A joint venture is a cooperative agreement of two or more companies by forming separate legal entities. Each party contributes to the initial investment, shares profits or losses, and owns shares in the joint venture.
Strategic alliances are a collaborative agreement between two or more companies to pursue common goals. Each party remains an independent organization and doesn’t involve the formation of a new entity. Alliances can end when goals are achieved and are less permanent than joint ventures.
Advantages and disadvantages of integration
Companies merge or acquire companies for several reasons, including:
- Fast. Mergers and acquisitions address the timescale involved in internal development. That’s because the target has its own production facilities, products, markets, and customers. With a merger or acquisition, they can get bigger in a short time.
- Economies of scale. Acquiring or joining a competitor (horizontal integration) allows a company to combine production facilities and markets, resulting in more extensive operations and achieving economies of scale.
- Competition landscape. In horizontal integration, competitive pressure decreases because the target company is under the control (as a subsidiary) of the acquirer. In a merger, the number of players in the market decreases because only one entity survives.
- Bargaining position. Due to the larger business size, mergers and acquisitions allow for higher bargaining power over suppliers, customers, or setting prices.
- Control. The integration provides greater control over the quality, price, and delivery time of inputs and outputs.
- Profit. Vertical integration allows companies to enjoy the profit margins that their distributors or suppliers have enjoyed. Companies can exploit value in each supply chain.
- Diversification. Conglomerates strategy reduces overall risk impacts. Profits in one business compensate for losses in another.
- Entry barriers. By acquiring key suppliers and distributors, the company increases the barriers to entry for new players. Potential entrants may find it challenging to access quality raw materials, develop distribution networks, and operate at lower costs.
- Legal compliance. Regulators in the financial sector may require businesses to merge to comply with minimum capital requirements. That way, they can be healthier in absorbing business risks.
But, integration also failed more often, because:
- Synergy failure. Cultural conflicts, corporate value mismatch, and managerial problems hinder efforts to synergize each company’s resources and capabilities.
- Too confident. The acquirer is often willing to pay a premium higher than the target company’s fair value. Nevertheless, the synergy’s failure may have a more significant impact on overall profit than the premium price it pays.
- Monopoly power. Horizontal integration can lead to monopoly because the acquirer/surviving entity has more market power than before. For this reason, regulators usually monitor such corporate actions.
- More complex operation. That can raise managerial problems, especially if integration involves two unrelated businesses. Lack of managerial experience can lead to failure.
- Expensive costs. Acquisitions involve high costs than can be funded by internal sources. For that reason, many acquisitions rely on external funding, such as by issuing bonds.
- It takes longer to realize profits. Integration usually involves restructuring and organizational changes. The process is long, and therefore, companies cannot immediately reap the benefits of synergies.
Advantages and disadvantages of joint ventures
Establishing a joint venture is an alternative to growth while maintaining control of internal resources and capabilities. Companies can gain access to new technology and expertise while maintaining their own identity and brand.
But, management styles and cultures may be very different, creating problems when making strategic decisions.
Advantages and disadvantages of strategic alliance
Creating value through synergy. The collaboration of skills, resources, and experience yields benefits more than if the two companies operate independently.
Faster and cheaper. Companies are more flexible in moving to new products or markets. They don’t have to be involved in other permanent arrangements and burdens. When companies do not match, they can break off cooperation with partners without having to bear significant risks than in the mergers and acquisitions.
Still, the alliance also had some weaknesses.
Share the profits. Companies may regret having to share profits with partners. And, the alliance adds no value to the company. Management thinks they can do it on their own, instead of having to make an alliance.
Decision-making problems. Partners may have a different management style than the company. It often raises communication and control issues, for example, about who will make the final decisions. Problems persist and can lead to conflict and alliance failure.