External Growth (AQA A-Level Business): Revision Notes
External Growth
What is external growth?
External growth is when a business expands by working with or taking over other businesses, rather than growing organically from within. This approach allows companies to grow much more quickly than internal methods would allow.
When businesses pursue external growth, they can rapidly increase their capacity, workforce, technology, skills and assets. This expansion also helps increase market share, which directly boosts sales. The specific reasons and motives behind growth will determine which type of external growth strategy a business chooses.
The key advantage of external growth is speed – businesses can achieve in months what might take years through organic growth alone.
Forms of external growth
External growth can take several different forms, each with its own characteristics and benefits.
Mergers
A merger occurs when two companies join together to form a single company. When this happens, the businesses might keep the name of one of the original companies, or they might create an entirely new name for the merged entity.
The key feature of a merger is that shares of the newly merged company are transferred to the shareholders of both old companies. This means both sets of shareholders become part-owners of the new business.
The main motive for mergers is synergy – the idea that the combined business will be more valuable than the two businesses operating separately. This synergy means the merged business generates more revenue or achieves cost savings (for example, through economies of scale) compared to what the independent businesses could achieve on their own.
Takeovers (acquisitions)
A takeover (also called an acquisition) happens when one business buys enough shares in another business to gain control – specifically, more than 50% of the total shares. This is called a controlling stake, and it means the buyer will always win in a vote of all shareholders.
Takeovers can be either agreed or hostile:
Hostile takeovers occur when a public limited company (PLC) buys a majority of shares in another PLC against the will of that company's directors. This is possible because PLC shares are traded on the stock exchange and anyone can buy them. The acquiring company encourages existing shareholders to sell their shares by offering a premium – an extra payment on top of the current share value.
Agreed takeovers happen when shareholders (or other types of owners, such as sole traders) voluntarily agree to sell the business to someone else. This usually occurs because the owners believe the sale would benefit the survival of the business.
The crucial difference between hostile and agreed takeovers lies in whether the target company's directors support the acquisition. Hostile takeovers are only possible with PLCs because their shares are publicly traded on the stock exchange.
Ventures (joint ventures)
Ventures are small businesses or projects set up by existing businesses in the hope of making a profit. They're often created to try out new ideas and meet needs that aren't currently being met in the current market.
When more than one business invests in a venture, it's called a joint venture. In a joint venture, businesses share their resources, but there is no change of ownership for the businesses involved. When the joint venture is terminated, bills are paid off, profits are shared, and the businesses remain separate.
Joint ventures offer several advantages:
- They're an excellent way to set up a new business if you don't have the capital to do it yourself
- They're useful for businesses wanting to enter different countries
- They involve risk, but that risk can be spread among all the businesses involved, making ventures more preferable than going it alone
Types of integration
External growth can be classified into three main categories based on the relationship between the businesses involved.
Horizontal integration
Horizontal integration occurs when a firm combines with another firm in the same industry at the same stage of the production process. For example, this could be two suppliers merging, or two retailers joining together.
This is a very common type of takeover or merger because it reduces competition in the marketplace. When competitors join forces, they eliminate rivalry between themselves.
Example: Horizontal Integration in Retail
The Morrisons supermarket chain bought out Safeway to extend its branch network and reduce competition in the UK grocery market. Both companies were retailers operating at the same stage of the production process, making this a clear case of horizontal integration.
Vertical integration
Vertical integration happens when a firm combines with another firm in the same industry but at a different stage of the production process. For instance, a retailer might take over a manufacturer, or a manufacturer might merge with a distributor.
Vertical integration can be forward or backward:
Forward vertical integration is when a business combines with another business that is further on in the production process. For example, a manufacturer merging with the outlets where its products are sold (such as retail shops). This gives the manufacturer direct access to the retail market, allowing them to control what is sold and exclude competitors' products.
Backward vertical integration is when a business combines with another business at an earlier stage in the production process. For example, a retailer taking over its suppliers. This allows the retailer to control production of their supplies, ensuring that supplies won't be disrupted.
Remember the direction: Forward integration moves towards the customer (downstream), while backward integration moves towards the source of raw materials (upstream). Think of it as moving forward or backward along the supply chain.
Conglomerate mergers
Conglomerate mergers happen between unrelated firms – businesses that aren't competitors and aren't in each other's supply chain. There are two main types:
Product extension mergers occur between firms making related products. For example, a company making hairbrushes merging with a company making hairspray. These products complement each other, even though they're made by firms in different markets.
Geographic market extension mergers are between firms in the same industry but competing in different geographic markets. They serve similar customers but in different locations.
Reasons for external growth
Businesses choose external growth strategies for various strategic reasons:
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Diversification: Some businesses want to diversify by combining with an existing business that already operates in the market they want to enter. They gain valuable experience from the employees of the business they combine with.
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Reduce competition: Businesses can reduce competition by merging with or taking over companies that operate in the same market. This removes rivals from the marketplace.
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Enter new countries: Businesses wanting to move into another country often combine with companies that already operate there and have established infrastructure in that location. This is much faster than building infrastructure from scratch.
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Economies of scale: Companies in the same industry may combine to benefit from economies of scale and economies of scope. Larger operations typically enjoy lower average costs.
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Access resources: In industries like car manufacturing, companies such as Ford, Peugeot, BMW and General Motors have bought out overseas car manufacturers. This allows them to switch production from country to country where labour costs are lower, while taking advantage of existing expertise.
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Access technology: If businesses lack certain technology or expertise needed to develop new products and processes, they might combine with a business that already has the required technology and expertise.
The choice of external growth strategy should align with a company's overall business objectives. Whether seeking to reduce competition, access new markets, or gain valuable resources, each reason drives a specific type of integration.
Benefits of external growth
External growth offers several key advantages over organic growth:
Speed: External growth is much quicker than organic growth. Instead of slowly building capacity and market presence, businesses can instantly gain assets, workforce, and market position.
Increased resources: External growth rapidly increases the capacity, workforce, technology, skills and assets available to a business. This immediate access to resources would take years to develop internally.
Market share: By combining with or acquiring other businesses, companies can quickly increase their market share, which directly increases sales.
Risk sharing: In joint ventures, businesses can share the risks involved in new projects, making risky ventures more manageable.
Risks and challenges of external growth
While external growth offers significant benefits, it also comes with considerable risks:
Integration difficulties: There can be tensions between staff from merged businesses as they try to establish their status in the new organisation. It takes time for staff to learn new procedures, which may lead to poor customer service during the transition period.
Closures and redundancy: Some parts of the new organisation may be sold off or closed. This often means additional redundancy costs, which will reduce profitability.
Cultural clashes: Businesses involved in mergers and joint ventures may have different objectives and cultures. This can lead to clashes on important issues and inefficiency, potentially resulting in diseconomies of scale.
Taking on liabilities: When one business buys another, it takes on all the liabilities of the other business. These could include compensation claims for long-standing disabilities suffered by ex-employees.
Regulatory restrictions: The Competition and Markets Authority investigates whether proposed mergers will restrict competition in the marketplace. If concerns are found, the government can stop the merger from taking place or place restrictions on it. The finance used to plan the merger would then be wasted.
Diversification risks: If a takeover is part of a diversification strategy, the purchasing business will have limited experience in the new industry. It will take time to learn how it works, and mistakes will reduce profitability during this learning period.
International challenges: When companies expand overseas, they must consider the different laws, languages and cultures of the host country. Just because a growth strategy is successful in one country doesn't mean it'll be successful in another.
Critical Risks to Consider:
Before pursuing external growth, businesses must carefully evaluate:
- Cultural compatibility between merging organizations
- Hidden liabilities that may be inherited
- Regulatory approval requirements and potential restrictions
- The true cost of integration, including redundancy and restructuring expenses
Poor planning in any of these areas can turn a promising merger into a costly failure.
Key Points to Remember:
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External growth involves working with or taking over other businesses – it's much faster than internal growth but carries more risks.
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Three main forms exist: mergers (joining together as equals), takeovers (one business buying control of another), and ventures (businesses sharing resources for a specific project).
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Integration can be horizontal (same industry, same stage), vertical (same industry, different stage), or conglomerate (unrelated firms) – each serves different strategic purposes.
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Forward vertical integration moves towards customers; backward vertical integration moves towards suppliers – remember "forward = further along the chain."
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Key risks include cultural clashes, staff tensions, regulatory blocks, and taking on unknown liabilities – external growth requires careful planning and integration management to succeed.