This article describes size of firms. It explains why growth of firms is important and identifies basic methods of business growth. It shows the difference between a merger and a takeover with examples.
Additionally, this post outlines the various types of merger with recent real world examples and explains the reasons why firms may seek a merger.
Size of firms
There are several ways the size of a firm is measured, for example sales revenue, capital employed and profit.
Sales revenue refers to the total sales a company has made.
Profit may also be used. There are different margins that can be measured such as Gross Profit and Net Profit. Both can vary due the state of the economy, the strength of the competition or the current status of Product Life Cycle (PLC).
Other measures of the size of a firm include capital employed which is the amount invested within a company. Limited liability companies have much larger capital investment than sole traders or partnerships. They can sell shares and have larger reserves than smaller companies. It is easier for limited companies to acquire other external sources of finance such as loans.
Why business growth is important?
A big company has the following advantages:
- It is easier to acquire resources and gain market share.
- It may have greater control over a market and becoming, or remaining, a market leader is easier.
- It could attract new better employees because of job security, opportunities and reputation.
- It could be more stable in management style, culture and its financial situation.
- Economies of scale become more and more attainable.
Internal business growth
The easiest and most simple way a firm can grow is through internal growth, which is sometimes called ‘organic growth’. This method of growth is achieved by using retained profit to help increase output. These reserves are invested back into the company.
Depending upon the size of the business this investment could be into:
- New Product Development (NPD), people, machinery, land or other assets.
- A sole trader may over time be able to use retained profits to expand their retail business.
- Perhaps an ‘extension’ to the front of the shop (making it bigger), or buying some more efficient shelving – allowing more stock to be displayed
- A large company such as Microsoft has (compared to other companies) almost limitless potential with billions in cash reserves.
External business growth
For more rapid growth, a firm is more likely to attempt integration (external growth). External growth may occur through two possible methods:
A. Takeover. Takeover when a company buys another company – ownership changes.
B. Merger when two companies join together – ownership does not change.
A. Takeovers
A takeover occurs when one firm purchases another.
During a takeover bid, the management of a firm is given an offer from the firm that wishes to buy it. If the management agree with the bid, they recommend the sale to the owners (the shareholders) and an ‘amicable’ takeover occurs.
Alternatively a ‘hostile’ takeover bid occurs, if management recommend the owners refuse the offer. If the buyer or ‘predator’ firm can convince over half of the owners to sell, then they are successful.
B. Mergers
There are three different types of mergers known as horizontal, vertical and conglomerate mergers.
1. Horizontal merger. A horizontal merger occurs when companies of the same industry and type of production join. For example, in 1995, Lloyds and TSB merged – both were large British banks and both were in tertiary industry.
2. Vertical merger. Vertical Mergers occur when companies of the same industry, yet different stages of production join. There are two ways in which a vertical merger can occur – forwards or backwards.
a. Forward vertical merger. A forwards vertical merger could be, if an oil extraction company were to merge with an oil refinery (a company merging with a customer). This represents a primary industry merging with a secondary industry. Alternatively, an oil refinery may merge with a petrol station company (manufacturer to retailer). This represents a secondary industry merging with a tertiary industry.
b. Backward vertical merger. A backwards vertical merger could be, if a wine maker were to merge with a vineyard (a manufacturer merging with a supplier). This represents a secondary industry merging with a primary industry. Alternatively, if a wine retailer was to merge with a wine maker. This represents a tertiary industry merging with a secondary industry.
3. Conglomerate. The third way to merge is a conglomerate. This is when companies from unrelated industries merge. This may be done by a company in order to increase their product portfolio – a larger product range decreases a company’s risk of failure. This type of merger also allows a business to enter a market in which it has no experience. The management and workers from the company merged with can provide the knowledge and experience required to operate effectively within the new market.
Reasons for mergers
There are many reasons for business mergers with the following ones including:
- Economies of scale. A horizontal merger will have even larger purchasing power and will also see an increase in its ability to produce, finance and market its business. A vertical merger will gain in the form of finance and risk bearing economies. If a merger results in a substantially bigger and better firm, it is called synergy.
- Competition. A company’s ability to fight competition will be greatly increased. A larger company is more resilient in a price war. It will have greater control over suppliers and market price.
- Cost. Merging is cheaper than using internal methods – a company to be merged with may have what the company needs and can be merged with much less effort and expenditure than other methods of growth. A merger may also allow a company to acquire brands which are difficult to compete with and maybe impossible to build. For example, Squaresoft and Enix merged creating Square Enix – two huge Japanese software companies, one owning Final Fantasy and the other Dragon Quest.
- Asset stripping. Normally associated with takeovers. If the assets are worth more than the stock market value, a company may purchase another firm in order to break it up. Individual parts of the company are sold separately in order to make a profit. Any parts of the taken company deemed profitable or useful are kept as part of the predator company.
- Rewards to management. Management have much to gain from a merger; a stable occupation and increased salary, bonuses, benefits and prestige.
Summary
In short, growth of a firm is important as it can help a firm to achieve success, survivability and economies of scale. It can be done internally with retained profits on one hand, or externally through a merger or takeover on another.
