instances, the demands of close integration necessary to realize benefits may dictate closer business ties. But other targets may have a weaker relationship to the core and thus may not require close ties.2 Need for ownership and control. Control would be a priority in cases where the intentions of the partner are unclear and there is a risk that the partner will defect to a competitor, or worse, become a competitor. High control might also be dictated where the partner holds assets of strategic value to your firm, which would create a disadvantage if they fell into a competitor’s hands. In many cases, total ownership is not required. Partial ownership may deliver a place on the board of directors and a say in management. But in other cases, simply doing business through a contractual agreement (i.e., with no ownership) may be sufficient to deliver the strategic needs.
3 Manage risk exposure. The risks of some target operations will be well known to the buyer, appear to be manageable, and may be at an acceptable level. But for other targets, the risks will be uncertain, unmanageable, and potentially large—in these cases it may be desirable to isolate the target with legal “firewalls” that will contain the risk exposure to your firm. Another aspect of managing risk is in being able to intervene in the operations and financing of a weak partner with know-how and funds. As detailed in Chapter 19, a variety of acquisition structures permit the management of risks in a target. Nevertheless, the limited liability of minority investment or joint venture permits your firm to acquire a stake in the expansion business pending the resolution of uncertainty. Staged investing through these intermediate structures is a time-honored way to deal with uncertainty.
These three criteria convey the complexity of the choice. One could compound the complexity further with considerations of the desirability of a local identity (as in cross-border expansions) and size of the deal (i.e., large transaction costs for lawyers, due diligence, and financial advice may not be warranted for small transactions).
These considerations suggest a decision flowchart such as presented in Exhibit 6.20. First, one confronts the strategic perspective: How material are the benefits from a relationship in the expansion opportunity? Next is the need for control: Is this high or low? The third regards the risk exposure in the opportunity, and the possible need to isolate the risks: Are the risks and the need to isolate them high? Will the expansion opportunity need our capital? Is it financially weak? Tracing the branches of this decision tree over to the right-hand side one sees the array of transaction alternatives from merger or acquisition at the top extreme, to a simple contractual arrangement at the bottom. This tree was built from just these three considerations. Other considerations may dominate the thinking of senior executives, or they may bear influence in a different order of priority. But this decision tree is sufficient to illustrate a few conclusions about the choice among inorganic growth alternatives:
EXHIBIT 6.20 Decision Tree for Selecting among Inorganic Growth Opportunities
One kind of transaction does not fit all needs. Be skeptical of “one-trick ponies,” those proposals by brokers and advisers that always amount to an acquisition. As the diagram suggests, you can achieve strategic aims of inorganic growth through a variety of alternatives.
The choice among the alternatives is a logical result of balancing important considerations. Start the process by making a careful inventory of the decision criteria that are important to you. The three illustrated in Exhibit 6.20, relationship benefits, control, and risk management, will appear often in studies of inorganic growth alternatives. However, other considerations may be unique to a particular company or time, but no less important.
Retain a bias for simplicity. Contractual arrangements are probably easier to structure than relationships based on an equity investment. Also, simple agreements may be a better foundation for getting to know a partner; with complexity come more opportunities for misunderstanding.
Consider starting small. Staged investing will dominate lump-sum investing where risks are material. More is said about staged investing in Chapter 22.
Remember value creation. The subtext for any comparison of alternatives should be their impacts on shareholder welfare.
FRAMEWORK FOR CHOOSING A PATH FOR RESTRUCTURING
The selection among alternatives for restructuring rests on the considerations illustrated in the decision tree of Exhibit 6.21.
EXHIBIT 6.21 Decision Tree for Redeployment and Restructuring
Relationship to the core business of the parent. If the target operation is unrelated to the core it might be sold outright with no adverse effect on the rest of the firm. But if the benefits of relationship are material, your firm might consider retaining a partial interest in the target either as a joint venture or as a minority investment.
Need for control. Whether or not the asset or business remains strategically significant, your firm may want to retain some influence or control over the target if for no other reason than to assure that it does not fall into the hands of a competitor.
Can the business or asset operate as an independent entity? Assets such as land, factories, or equipment may be too small or isolated to sustain an independent existence. Such assets might be earmarked for outright sale. On the other hand, disposing of an ongoing business in the form of a firm can capture for the seller a premium reflecting growth prospects and franchise value.
Here again, to complete any strategic analysis of alternatives, one must assess the implications of each choice for shareholder value. This is done by means of a valuation analysis. No choice should be final until its implications for your firm’s share price are estimated and understood. The capital markets perspective embedded in valuation analysis may presuppose very different outlooks than the product markets perspective of the strategist. Also, there may be an information asymmetry reflected in the perspectives of the insiders and capital market outsiders (e.g., perhaps the discount rate derived from the capital markets is inconsistent with the inside strategic perspective).
DOES IT PAY TO DIVERSIFY OR FOCUS THE FIRM?
One of the robust debates today deals with whether and how the strategic efforts to diversify or focus the firm pay. The question is significant because of the prevalence of diversification-based business strategies among large firms today, and because of the relatively high volume of transactions motivated in part by a theory of the need to diversify or focus. Villalonga (2003) noted that between 1990 and 1996, diversified firms accounted for half of the employment in the United States, and 60 percent of the assets of traded firms. Following World War II, the U.S., European, and Japanese economies witnessed a dramatic increase in diversification and divisionalization.6 Rumelt (1974) found that 70 percent of the Fortune 500 firms were heavily or exclusively focused on one segment. By 1969, that group had fallen to 35 percent, as shown in Exhibit 6.22. The icon of this trend was the conglomerate
