Business Strategy Notes Alliances and Acquisitions1 Strategic Alliances A strategic alliance is where two or more independent organizations

co-operate in the development, manufacture, or sale of products or services.2 Common forms of alliance include the following: o Joint Ventures: Under this scheme, the cooperating firms set up another organization and each takes an ownership position in that venture. The venture can be incorporated, but need not be. Ordinarily, each cooperating firm agrees to invest something into the venture usually cash, other assets, or expertise. Some ventures are intended only for one specific project while other ventures may last for decades. o Equity Alliance: In this situation, at least one of the firms invests in the equity of another firm. Depending on the jurisdiction, it may be possible for two or more firms to hold shares in each other. In what ways can equity ownership strengthen an alliance? o Non-equity Alliance: Many alliances do not involve investments in a joint venture or between partners. Instead, those alliances are governed by contracts. Examples include licensing agreements and distribution agreements.

Reasons for Entering an Alliance Value Creation Probably the most common reason for entering an alliance is to create value. Usually the companies hope to create or strengthen a competitive advantage, though in some cases the alliance may have the more modest objective of enabling a firm to catch up with the capabilities of rivals i.e. in order to achieve competitive parity. Some ways in which value can be created are listed below: o Economies of Scale: If a firm is too small to achieve minimum efficient scale, it may wish to form an alliance with one or more other firms to obtain the necessary scale. For example, small retailers can form buying groups to give themselves enough bargaining power to get good prices from their suppliers. o Learning: A firm may also enter into an alliance to develop its competencies in some area. For example, GM and Toyota entered into a joint venture to build cars at a plant in California. GM did this to learn Toyotas lean manufacturing methods, while Toyota did this to learn how

By Don Wagner, UPEI, March 2, 2007. Much of this material is based on chapters 9 and 10 in Jay B. Barney and William S. Hesterly, Strategic Management and Competitive Advantage Concepts, Pearson Prentice Hall, 2006. 2 Barney and Hesterly, page 278.

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to manufacture in North America. (Until then Toyota had no plants in the US.) o Develop Technical Standards: In many high-tech industries, technical standards need to be developed to make products from different companies compatible with one another. For example, when VCR machines were new, there were two main technologies Betamax and VHS. Sony developed Betamax, while Matsushita developed VHS. Unlike Sony, Matsushita licensed its technology to numerous other firms, and VHS ended up becoming the industry standard, even though many experts believed that Betamax was the superior technology. Currently, HD-DVD and Blu-Ray are fighting it out, but this time both technologies involve alliances. The HD-DVD group is led by Toshiba, but also includes NEC, Sanyo, Intel, Microsoft and RCA. Meanwhile, the Blu-Ray group is led by Sony, but also includes HP, Apple, Dell and Panasonic. Speed Another reason for entering an alliance is to gain market share, or acquire a competency quickly. Developing a market oneself or developing a competency oneself can take time. If speed is important, a firm may choose to use an alliance to achieve its objectives quickly. For example, when Neilson International (a Canadian chocolate bar producer, whose brands included Mr. Big and Crispy Crunch among others) entered foreign markets, it went through local distributors who already had familiarity with the local markets. Neilson could have developed the distribution networks itself, but entry would have been much slower.

Risk Sharing Some ventures involve high risks. To lower the magnitude of these risks, companies can use alliances so that those risks are shared. Oil and gas projects often involve numerous companies for that reason. Consequently, a failed project is less likely to devastate the company. Consider the cases weve studied so far. Why did Airborne have an alliance with RPS (before FedEx acquired that company)? Why did Fogdog seek an alliance with a bricks-and-mortar business?

Problems Associated with Alliances Disappointing Partner In some cases, a partner may claim to have expertise that it in fact does not have. (During negotiations, that partner might knowingly stretch the truth, or may genuinely believe it has the expertise it claims it has). How can a firm avoid being misled by such a partner?

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If a firm finds itself in an alliance with such a partner, what can the firm do about it? In other cases, a partner may actually have the expertise or resources it claimed to have, but may withhold them from the alliance. When this happens, it is not always out of malicious intent. In some cases the partners may each perceive that the other is contributing less than promised, and may therefore scale back its contributions. Over time, the partners actually do contribute less than promised only because they believed the other partners were doing so. In other cases, the economic environment may have changed, leading one party to pursue other priorities that do not involve the alliance. What can a firm do to improve the likelihood that its partners will act as good partners?

Hold-Up Suppose two parties form an alliance. One party contributes assets that are not relationship-specific, while another party contributes assets that are relationshipspecific (i.e. the asset required extensive design to make it very useful to that alliance, but it is considerably less valuable for other purposes). When it comes time to renew the relationship, the first party can hold up the second party; the first party can easily withdraw from the alliance without suffering a loss, whereas the second party cannot. The first party can therefore use its bargaining advantage to extract concessions from the second party. What can parties do to avoid the hold-up problem in an alliance?

Mergers and Acquisitions An acquisition occurs when one firm (the buyer) purchases another firm (the target). There are numerous variations on how an acquisition can occur. o One consideration is whether to buy shares or assets. If the buyer buys shares, it pays the shareholders of the target company and thus becomes a shareholder of the company. Alternatively, the buyer can purchase the assets of the target company (usually the buyer also assumes some or all of the targets liabilities too). In this case, payment is made not to the shareholders of the target, but rather to the corporation of the target business. The decision of whether to buy shares or assets is usually based on tax considerations. o Another consideration is how much of the target to buy. In some cases, the buyer may wish to only purchase one division of the target, rather than the entire business. In this case an asset purchase is usually necessary (unless that division had already been in a separate corporation). In the case of a share purchase, the buyer could potentially buy all of the stock (making the target a wholly-owned subsidiary), or buy a majority of the voting stock of the target (making the target a controlled subsidiary), or buy a minority stake in the company. What are some reasons that a buyer would opt to buy less than a controlling share of a subsidiary?

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o Another factor is how the buyer pays for the acquisition. In some cases the buyer pays with cash. It may already have the cash on hand, it may need to borrow the cash, or it may need to issue additional shares to finance the acquisition. Alternatively, the buyer may pay for the target with shares of its own stock. For example, in the Fogdog case, that is how Global purchased Fogdog. o Acquisitions can also differ in how friendly they are. A friendly acquisition occurs when the management of the target does not oppose the acquisition. In contrast a hostile takeover occurs when the management of the target does not want to be purchased. Why would management of the target object to an acquisition? How can a buyer purchase a target without the managements consent? What can the targets management do to prevent hostile takeovers? Acquisitions normally involve a larger company buying a smaller company. In contrast, a merger normally involves a business combination of equals. A merger is normally achieved by having the shareholders in the separate companies become shareholders in the combined company.

Reasons for Acquisitions Vertical Integration There are a number of reasons why firms may wish to vertically integrate. Before examining some good reasons for vertical integration, let us first address a common misconception concerning cutting out the middleman. It is often thought that vertically integrating reduces costs because it eliminates from the supply chain a company that takes a profit and therefore adds to the cost of the product. The logic can be illustrated as follows: o Suppose a manufacturer makes a product at a cost of $1, and sells the product to a distribution company for $1.15, taking a 15% profit. Suppose the intermediary incurs transportation, warehousing and marketing costs of 35 cents (making its total cost $1.50) and charges a 10% mark-up to retailers, who buy the product for $1.65. If the retailer applies a 20% mark-up, it can sell the product for $1.98. According to the logic, if the retailer takes over the distribution activity (incurring the transportation, warehousing and marketing costs itself), it could have the product for a cost of $1.50 instead of $1.65 because it no longer has to pay for the distributors profit. If the retailer then applies a 20% mark-up, it can sell the product to customers for $1.80 representing an 18 cent savings. o The problem with this logic is that it ignores the investment required to perform the distribution activities, and the fact that whoever provides the necessary capital expects to earn a return on its investment. Unless the distributor possesses unusually strong market power, the return it earns on its assets used in the distribution activities is likely a normal market return

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on capital. It doesnt matter who owns that capital the owner of the capital expects at least a normal return on the investment. Better reasons for vertically integrating include: o Control over buyers or suppliers: By acquiring suppliers, a company can ensure that the product is produced according to its standards and in a manner that suits its needs. Can a company not accomplish the same thing without acquiring the supplier? Consider Nike. o Avoid transaction costs: Imagine a world in which there were no firms, and everyone did his/her activities as a separate business. In such a world, each individual would have to negotiate prices for the services he/she provides. As you can imagine, much time would be consumed with negotiations. One of the main reasons that firms are combined into single entities is that it eliminates the burden of making those transactions. o Avoid hold-up: Acquisitions can be used to prevent another firm from holding the buyer up. However in some cases, vertically integrating can actually increase a firms vulnerability to hold-up. How so? o Shift to a new business: Over time, competitive forces can reduce the attractiveness of one business and increase the attractiveness of another. For example, IBM failed to realize that the operating system business was much more attractive than computer manufacturing. Had IBM recognized this early on, it might have acquired Microsoft at that time to shift its attention to that business.

Horizontal Integration The most commonly-cited reasons for horizontal integration are the following: o Economies of Scale: The advantages of obtaining economies of scale can be very alluring. A merger or acquisition can save costs by reducing two finance departments down to one, two HR departments down to one, etc. One of the main reasons for the DaimlerChrysler merger was to enable the combined firm to spread the engineering costs of new models across more units, lowering the average cost per vehicle. o Complementarities: The other main reason for horizontal integration is to take advantage of potential synergies. For example, in the DaimlerChrysler merger, it was argued that Daimler Benz had stronger engineering capabilities, but Chrysler had a stronger dealership network in North America. Thus Chrysler could benefit from Daimler Benzs engineering while Daimler Benz could benefit from Chryslers dealership network. There is another reason for horizontal integration, but it is usually not advertised. Horizontal differentiation can eliminate a competitor, reducing competitive pressures on the acquirer. For this reason, Canadas Competition Bureau reviews significant mergers and acquisitions and has the right to disallow deals that are likely to reduce competition excessively. The U.S. and other developed countries have similar rules.

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Product and Market Extension The purpose of an acquisition may also be to obtain a manufacturer of a product that is complementary to ones own product. The acquisition enables the firm to ensure the products are made and sold in a manner that optimizes the benefits of the complementarity. A firm may also acquire a company when it seeks to enter a new geographic market. Often an acquisition provides a much faster entry.

Diversification In the 1960s and 1970s, many firms became large conglomerates that operated in many different industries. An advantage to doing this is that it diversifies risk for the company. Theoretically, shareholders do not need firms to diversify risk, because shareholders can diversify risk themselves by buying shares in numerous companies. Diversifying risk may, however, reduce the risk of the firms managers! In the 1980s, it became popular for firms to divest themselves of unrelated businesses, and to become more focused. The tobacco industry is one industry that has pursued a diversification strategy for a somewhat unique reason. The industry is highly profitable, producing more cash than can realistically be reinvested in the business. Moreover, the risk of large lawsuits and new laws designed to curb smoking make the industry risky. Consequently, tobacco companies have used their cash to invest in other industries.

Underperforming target A firm may also purchase a company if it believes the target is underperforming. The reason for the targets poor performance may be poor management, or may be a lack of access to key resources. The idea behind such an investment is that the target can be acquired for a price that reflects its current profitability, and can then be made much more valuable by fixing the targets problems. As we shall see next, the acquirer may not be the one who gets the economic value of that acquisition.

Who Gains from an Acquisition? In class we will do yet another negotiating exercise this time to illustrate the role of bargaining power in an acquisition. Research shows the following: o On average, the shareholders of the target company gain considerably from acquisitions. Buyers usually pay a premium to take over a company, particularly if the sellers know that the buyer expects to get greater value from the business under its ownership than the business stand-alone value. o On average, buyers do not gain from acquisitions. The benefits all go to the targets shareholders.

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This finding raises the question of why firms bother to make acquisitions. Some acquisitions work out, but just as many backfire. Why do firms keep making acquisitions? Some potential explanations are listed below: o Survival: In some cases failing to make an acquisition would result in a reduction in the buyers value (or perhaps bankruptcy), and the acquisition while not adding value halts a decline. o Agency Problems: Managers may gain from an acquisition even though they provide nothing for shareholders. Diversification may reduce the risk of dramatic losses. Also, through acquisitions, managers can expand their sphere of influence. Moreover, since executives compensation is correlated to the size of the operation they manage, there may be larger salaries and bonuses. o Overconfidence: Managers may believe they are better than the targets existing managers, or that they are better than others at overcoming the challenges of acquisitions.

Organizational Challenges of Mergers and Acquisitions Distrust New ownership often creates stress on a companys employees for several reasons: o Job security concerns: Employees normally expect that changes will occur after an acquisition, and some of those changes may involve lost jobs. If the buyer believes the acquired firm was poorly managed, the managers of the target company will certainly feel threatened. If the buyer seeks economies of scale, it stands to reason that some of the acquired companys activities will be cut out as the buyer takes over those activities. o Culture changes: Companies normally try to hire employees that fit their culture, and employees are likely to stay if the companys culture suits them. If the culture changes, the work-place can become much less appealing to the existing employees. How can a buyer dispel the concerns of a targets employees and managers?

Processes and Culture When acquiring a company or merging with a company, changes are almost inevitable. Indeed, if a buyer saw synergy opportunities or economies of scale opportunities, the organization will need to be changed to take advantage of those benefits. The changes necessary can be extensive. For example if the two companies had different information systems, different accounting systems, and different human resource practices and policies, those systems will likely need to be made compatible and consistent. This is an enormous task. Moreover changes will likely create some winners and some losers within the organization. (For example, a computer

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technician may be a loser if the company switches away from the information system he/she is familiar with.) The most difficult integration challenge is usually the corporate culture. Processes can be re-engineered, but one cannot just engineer a desired culture. Why not?

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