How Businesses Grow
Over time, businesses can grow in any of the following ways:
__Organic Growth __– This means the firm increases in size by reinvesting its profits back into the business and/or raising more capital, either from its owners or by borrowing. This is the main way in which businesses grow across all sectors of the economy, but it is particularly important for smaller businesses, which do not have the resources to buy up other companies. Organic growth is sometimes referred to as internal growth, since the business can achieve it on its own.
- Existing owners retain control of the business
- Avoids problems associated with mergers and takeovers
- Can be achieved by all firms, regardless of their size
- Less likely to attract attention from the Competition and Markets Authority
- It can be slow and take many years for a small company to become a large one.
- The company may not have the resources or expertise to expand into new markets or products. It may be better to merge with or take over a company that is already established in those markets or products.
Vertical Integration – Growth can also be achieved through __mergers __(companies joining together) and __takeovers __(one company buying a majority shareholding in another company). Vertical integration involves companies in the same industry, but at different stages of the production process.
Vertical integration can be forward or backward. Forward vertical integration is integration between a company and one of its business customers; for instance an oil company taking over a chain of petrol stations, or a brewery buying a pub. Backward vertical integration occurs when a business merges with, or takes over a supplier, for example a computer manufacturer taking over a memory chip maker.
- Forward vertical integration gives more control over the market. A brewery that buys up pubs has more access to beer drinkers and it can stop pubs it owns selling rival beers.
- Backward vertical integration gives a firm more security of supply and therefore reduces risk.
- Vertical integration may reduce costs. It may be possible to close some offices for instance and have a single headquarters for the combined businesses. It may also be possible to share some management functions, such as finance and human resources.
- Firms taking over suppliers or customers may not have sufficient knowledge or expertise of the target company’s business. A breakfast cereal manufacturer may have little understanding of agriculture, so buying up farms may result in less efficiency, higher costs and a poorer product.
- Merged companies often have different cultures, values and ways of doing things. This can lead to conflict and inefficiency, and a loss of morale and motivation amongst staff.
- Mergers often result in redundancies in order to reduce costs. This can cause morale problems and experienced workers may leave, taking their expertise to rival firms.
Horizontal Integration – This occurs when a firm merges with or takes over another firm in the same industry and at the same stage in the production process. Examples include mergers and takeovers between banks, car manufacturers and supermarket chains.
- More control over the market. Horizontal integration leads to greater market concentration, reducing the number of competitors. Big companies sometimes buy small companies that are seen as potential long term competitors, particularly if the target company has developed a new product or technology that could give competitive advantage.
- Economies of scale. Two smaller firms becoming one larger firm may give opportunities for cost savings (see notes on 3.3.3)
- Possible difficulties in implementing the merger. Differences in business culture and ways of doing things can create problems for managers. Horizontal mergers are particularly likely to lead to redundancies and plant closures to reduce costs, creating uncertainty and morale problems.
- Horizontal mergers often attract the attention of the Competition and Markets Authority. Companies that are considered to have too much control over the market may be forced to de-merge.
The majority of vertical and horizontal mergers and takeovers tend to be regarded as unsuccessful in the long run, driven by an over-estimate of the benefits and an under-estimate of the problems. Profits therefore ten to be lower than expected.
__Conglomerate Integration __– This occurs in takeovers or mergers between companies in unrelated industries. The Virgin Group is a good example of a conglomerate business. It has expanded from its initial business in recorded music into financial services, telecoms, airlines and trains.
- Conglomerates spread their risks across different products and markets. This means they are less dependent on any one market. If some parts of the business are struggling, others may be doing much better.
- Some conglomerates specialise in buying up businesses that are struggling, but which are thought to have valuable assets (eg technology, well known brands, highly skilled workers or prime retail locations). Such companies can be bought up cheaply. The conglomerate then uses its expertise to restructure the company, reduce costs, cut out waste and then sell the business for a profit. Sometimes it involves asset stripping which means breaking up a company and selling off its assets. It’s a bit like buying a cheap second hand car which has failed its MOT and breaking it down and selling off the parts as spares.
- The conglomerate may lack the experience or skills needed to succeed in different, unrelated markets.
- Conglomerates can lack focus. They have no ‘core’ business and directors may have too many distractions to run the whole company successfully.
- Asset stripping may benefit the owners, but not employees, who may lose their jobs when a company is bought up, broken up and its assets sold off.
Constraints on Business Growth
There is a number of reasons why some some businesses remain small:
- Difficulty raising capital – Most small businesses are sole traders, with a single, self-employed owner. Such businesses depend on the owner alone investing in the business, by ploughing back profit or re-mortgaging his/her house. Banks may be reluctant to lend if the business does not have substantial assets that can be used as security for the loan. Bigger businesses, such as PLCs can sell more shares to raise capital or borrow large sums at favourable rates of interest as they have valuable assets.
- Objectives of owners – Not all owners want the business to grow. A smaller business is easier for one person, or a small group of people to control. Growth may involve bringing in more owners.
- Size of the market – Businesses which serve small markets, such as a village shop, will find it difficult to grow organically, as they do not generate sufficient profit. The owner may need most of the profit as income.
- Business regulation – Local authorities can use planning laws to restrict businesses from opening in new areas. A supermarket for instance may be refused permission to open a new store in a town that is considered well served by existing supermarkets and independent shops. The Competition and Markets Authority can prevent mergers or takeovers that it believes are against the public interest, especially if it believes the takeover will leave a company in a dominant position in the market.