Assessing a change in scale

Organic growth definition: when a firm expands its existing capacity or range of activities by extending its premises or building new factories from its own resources, rather than by integrating with another firm

Likely to occur where:

• a firm's product is in the early stage of its life cycle and is not yet fully established in the marketplace
• a firm's product is highly technical and the firm needs to gain experience in dealing with it, ensuring that any problems can be ironed out
• the costs of growth need to be spread over time

External growth definition: when a firm expands by integrating with another firm as a result of either a merger or a takeover (also known as an acquisition)

Integration definition: the coming together of two or ore businesses via a merger or takeover

Merger definition: where two or more firms agree to come together under one board of directors

Takeover (acquisition) definition: where one firm buys a majority shareholding in another firm and therefore assumes full management control

Technical economies of scale: the lower unit costs that arise because larger firms are able to use more efficient techniques of production and to benefit from the law or principle of increased dimensions

Purchasing economies of scale: a reduction in unit costs as a result of buying in larger quantities; these are sometimes called buying economies of scale

Managerial economies of scale: larger firms have greater scope to benefit from the specialisation of labour at supervisory and manager level in each of the functional areas of the firm

Economies of scope: cost advantages that result from firms providing a variety of products rather than specialising in the production or delivery of a single product

The experience curve: indicates that the higher the cumulative volume of production, the lower the direct cost per new unit produced; essentially, the more experienced a firm gets at making a product, the better, faster, and cheaper it is likely to be at making it

Synergy: the whole is greater than the sum of the parts; sometimes summarised as "1 + 1 = 3"

There are two main kinds of synergy:

Cost synergy: where cost savings are achieved as a result of external growth

Revenue synergy: where additional revenues are achieved as a result of external growth

When two businesses are combined there is often significant scope for achieving cost savings. These might include:

• Eliminating duplicated functions & services (e.g. combining the two accounting departments)
• Getting better deals from suppliers - which might be possible if combining two businesses gives them improved bargaining power
• Higher productivity & efficiency from shared assets: can capacity utilisation of the combined businesses be improved, perhaps by closing down spare capacity?

Example of successful cost synergies:    Back in 2004, investors and analysts were doubtful that Spanish banking giant Santander would be able to achieve its ambitious plan of  £300 million of costs from Abbey National which it bought for £9.6bn. In fact, Santander delivered the £300 million of cost synergies a year ahead of schedule.

Potential revenue synergies include:

• Marketing and selling complementary products
• Cross-selling into a new customer base
• Sharing distribution channels
• Access to new markets (e.g. through existing expertise of the takeover target)
• Reduced competition

• The primary objective of any takeover is to create value for shareholders that exceeds the cost of the acquisition. In fact, synergies are fundamentally the only tangible justification for a takeover.
• Synergies represent the extra value that can be created from the takeover. Assuming that the buyer has to pay a reasonable price for the takeover target, then no value has been created at that point.
• For example, consider a business valued at £10 million by the market (e.g. from the market capitalisation on the stock market).
• A buyer comes along and, after negotiation and due diligence, agrees to pay £13 million to complete the takeover. The buyer has paid a bid premium of 30% (or £3 million) to complete the takeover.
• The shareholders of the target business are happy. But the shareholders of the buyer business will need to be convinced that the price was worth paying. They have had to pay £3 million over the apparent value of the business to achieve the takeover.

How can the bid premium be justified? Only if the takeover achieves synergies worth at least £3 million in value terms (e.g. the NPV of future synergies).

Overtrading: takes place when a business grows too quickly without organising sufficient long-term funds to support the expansion. This puts a strain on working capital

The five predicted crises of growth according to the model are:

Growth Phase: Direction - Crisis of Leadership

• Informal communication starts to fail
• The business now too big for the leader to get involved in everything

Growth Phase: Delegation - Crisis of Autonomy

• The business now has functional management
• But founder/leader still struggling to let go

Growth Phase: Coordination - Crisis of Control

• More formal management structures in place
• But new layers of hierarchy needed to keep control

Growth Phase: Collaboration - Crisis of Red Tape

• A dangerous growth in organisational bureaucracy
• Slowing decision-making & missing external changes

Growth Phase: Alliances - Crisis of Growth

• Growth slowing as the business runs out of ideas
• Alliances are sought (including new business owners)

• a larger company entering a new market may not have the necessary technical expertise and may thus acquire smaller companies with that expertise
• The cost of the acquisition or integration may be more favourable than the costs of internal growth, and the speed of growth may be a high priority
• Brands are expensive to develop, in terms of both time and money, and therefore acquiring companies with prominent brand names is a way to avoid such expense
• The resulting organisation can exploit any patents owned by the company it has acquired - particularly important in takeovers in the pharmaceuticals and computing industries
• An organisation may have identified the market value of a particular company is considerably less than its asset value
• The benefits of synergy can be exploited

Ventures: the term is used for a range of different arrangements between two or more firms; most usually involve companies in the early stage of development with high growth potential; venture capitalists or larger companies invest in these companies knowing that the risk is high but the rewards are equally high

Franchise: when a business (the franchisor) gives another business (the franchisee) the right to supply its product or service

Vertical Integration: the coming together of firms in the same industry but at different stages of the production process; vertical integration can be backwards or forwards

Backwards Integration: the takeover of a firm closer to the supplier. For example, a bakery merging with a farm

Forwards Integration: the takeover of a firm closer to the supplier. For example, a farm merging with a restaurant

Horizontal Integration: the coming together of firms operating at the same stage of production and in the same market

Conglomerate Integration: the coming together of firms operating in unrelated markets