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Emerging Trends in Corporate Business Strategies

January 8, 2013

Emerging Trends is a regular feature from Kaye Scholer, answering crucial questions about emerging legal or business issues and the potential ramifications for companies operating in a particular space.

“Acquisition of a company almost always brings some inefficiency. To get what you want, you must buy a whole company, almost always with some problems that you don’t want, machines you don’t want, taking on staff that you don’t want. But in a strategic alliance there is greater flexibility to shape it as the parties desire and do essentially what you want, as well as not do the things that you don’t want.”—Kaye Scholer Partner Fred Marcusa

Q. Based on the volatility of the markets on a global scale, what key trends have corporations seen with regard to their developing strategy?

A. I think there are two things which lead to a third. The first involves the increasingly difficult fundamentals of lower demand in Europe and the US and unsettled conditions in Asia. Difficult financial markets affect both companies and their customers. While challenging fundamentals are the number one problem, they have led to the second problem: a negative psychology of fear and hesitation in the marketplace, which creates a negative feedback loop.

The third problem, and the challenge for corporate strategists, arises from the other two: how to be flexible in a way that gives their company what it needs, without exposing it to risks that seem hard to justify to management and investors. And those are risks of many kinds. The hiring problems around the world are structural, in the sense that people don’t want to make long-term commitments to hiring until a world view of growth is clear. With the various kinds of approaches I work on, which may be joint ventures, licensing arrangements or strategic alliances, short and mid-term solutions are possible, without the long-term commitments an acquisition or major capital expansion necessarily involves. Thus, it is often possible to create “virtual organizations” by contracts that provide tailored solutions, without the excesses and risks a more permanent structure would involve. For example, joint product or marketing development can often make sense where going alone might seem too risky.

Q. So when looking at strategy, should organizations and corporations be operating in a defensive or offensive manner these days?

A. I recently read a book by Will and Ariel Durant called Lessons of History in which they observed that nature loves competition and rewards successful offense. Business to me reflects the same dynamics, but offense in nature and business requires boldness, and that implies risk. Whether an offensive strategy that implies growth is feasible is a question that involves risk tolerance on one level, but maybe more significantly for an operator also charged with prudence, is an altered risk-reward analysis, reflecting lower tolerance for risk in a lower reward environment.

The famous business commentator Peter Drucker observed that in tough times, market leaders often gain market share at the expense of marginal players. This can only happen with an offensive strategy. Unfortunately sometimes the only defense is an offense. This is the case, for example, when competitors in a shrinking market can only grow, or perhaps even survive, by taking someone else’s market share. I think each situation has to be looked at in terms of its own dynamics.  Almost everyone in business and in life analyzes the costs and risks of doing things. Sometimes equally or more important is analysis of the costs and risks of not doing things. For example, a company contemplating a defensive strategy has to analyze the cost of not pursuing an offensive strategy—the cost of not doing something. Thus, the opportunity cost of not doing the drug development or market development has to be analyzed as well as the obvious costs of doing these things.

Q. So what would provoke a company to choose that defensive strategy versus an offensive strategy?

A. Sometimes an offensive strategy isn’t available at all, or isn’t available with existing resources at an acceptable cost and risk. This can happen, for example, in a down economy with fewer buyers of a high-priced product. In this case, maybe there’s no alternative to a defensive strategy. Generally if opportunities for growth and market share exist with available resources with acceptable cost and risk, businesses favor an offensive strategy. If these aren’t available, then the defensive strategy is left by default. Examples I’ve worked on include various JVs, strategic alliances and joint arrangements in aerospace in a time of tightening defense budgets, and in media as the world shifts from print to digital.

Q. What are the major differences between each strategy?

A. Different people have different definitions, but for me an offensive strategy is essentially a growth strategy, while a defensive strategy is one of two things: It’s either a cost-reduction strategy or the protection of a vulnerable position. (For example, vulnerable positions are often defended by efforts to keep competitors out with reduced pricing to customers or increased product or service value, both of which usually require reduced costs for the company employing them.)

Thus, an offensive strategy is a growth strategy, while a defensive strategy assumes that a growth strategy is not available, requiring an alternative. Often this is cost reduction, where spending more won’t produce growth, but will just waste money. Greater utilization of resources, through contracts which can reduce costs or generate additional revenue at acceptable marginal cost, such as licensing IP, subcontracting parts production and facilities JVs, are all common ways to implement a defensive strategy through strategic alliances.

Q. Moving on, what is the burden business model?

A. People sometimes speak of “burden” as the fixed overhead of a factory. To me the “burden model” is a defensive approach which seeks to reduce the overall cost of each unit by spreading the fixed overhead over as many units as possible, even if that requires sale of the product with low or no recovery of variable cost. Let’s suppose the fixed cost of something is a dollar and the variable or marginal cost is one cent; one view is that if you sell it for anything less than a dollar and one cent, you lose money. But if it’s very cheap to produce and you sell it for less than fully-allocated costs, as compared to not selling it at all, sometimes you recover enough fixed-costs to increase overall profit.

A burden model seeks more fully to absorb the fixed overhead, the “burden,” by spreading it over more units sold at a low price, resulting in overall greater profit than you would otherwise have. That’s why sometimes people sell things below apparent total cost, as a rational way to absorb fixed cost, increasing total profit. All situations don’t lend themselves to this approach, of course. Most suited are those where (1) marginal cost is low relative to fixed cost and (2) sale of some products at a low price won’t unduly cannibalize other company product sales. At Kaye Scholer we help clients define, finance and implement deals that serve this purpose.

Q. When it comes to the topic of unconventional M&A, what is your definition of that?

A. It’s probably an oxymoron, because it’s really not unconventional mergers and acquisitions, it’s alternatives to mergers and acquisitions that use the same skills. An example might be a joint venture or strategic alliance where instead of buying a business from somebody, you make an investment which the two of you run. A strategic alliance is any contractual arrangement where the two of you have a shared business goal. A lot of times we see strategic alliances either in defense industries or in pharma. Pharma arrangements often involve the joint development or marketing of a new drug; defense arrangements might create a teaming agreement to produce something that requires inputs neither party alone can or wish to provide, perhaps for political, financial, or technical reasons (an American company needing a political partner to sell a product elsewhere or a large development project with costs too risky for one company to bear alone, or a project requiring classified technology not available to both parties). For example, a few years ago I worked on a project to develop a new refueling tanker for the U.S. government, with a European and an American partner in a strategic alliance. They didn’t form a company, but had a teaming agreement to produce a product they thought would best meet their business needs.

What I love about strategic alliance work is that it challenges the imagination, because it often allows tailored solutions without certain inefficiencies inherent in mergers. Acquisition of a company almost always brings some inefficiency. To get what you want, you must buy a whole company, almost always with some problems that you don’t want, machines you don’t want, taking on staff that you don’t want. But in a strategic alliance there is greater flexibility to shape it as the parties desire and do essentially what you want, as well as not do the things that you don’t want.

Q. So looking back on that burden business model, what does it reflect with regard to unconventional M&A or the alternative M&A structures?

A. I think it opens the imagination to do things that you couldn’t or perhaps wouldn’t do otherwise with conventional M&A. Every deal that tries to take advantage of under-used facilities is trying to share the fixed cost with another business to reduce the facility’s products’ overall unit cost. Thus, various ways to achieve joint utilization of facilities can allow greater profits through greater absorption of overhead, including, in certain cases, the possibility of a strategy involving burden sales. Sometimes you can simply contract for a product or its components to be made by somebody else to avoid a high fixed-cost operation. Based on experience with a wide variety of contractual tools, lower risk strategies may be possible more often than would occur to pure M&A experts who necessarily focus more on structural issues than on specific business problems.

Let’s suppose you’re a company that used to sell a hundred units of something. You can only sell fifty now, but need to keep an operation running to do that fifty. It may be economic to pair with somebody else who has the same or a complementary problem. There are countless ways, through contracts, including strategic alliances, to spread fixed costs or use in a creative way assets owned by somebody else that are underutilized. Through our broad contacts, we often help clients find suitable partners who share a philosophy and a confidence and belief in a “virtual” solution a strategic alliance or other contractual arrangement can provide.

Q. Do you have any examples or studies on how this model has worked?

A. The starkest example to me is the US glassware business. Basically making glass requires two components: (1) sand, which is not very expensive as a raw material, and (2) a lot of expensive energy to heat it, until it melts into glass. The process requires you to put sand into a big tank and heat it with a lot of expensive energy. Whether you make one glass from that tank or a million, the cost of the energy is the same, and yet the marginal cost of each glass is very low because sand is cheap.

So if you can make and sell a hundred glasses instead of one, both the marginal and fixed costs are almost the same, yet the overall profit is a lot greater with a hundred glasses. Because of that dynamic, over a number of years the US glass industry has consolidated and basically operated with a lot of people doing burden business, meaning selling glasses very cheaply. And even today, whether you look on Amazon or any place else, the price of American-made drinking glasses is pretty low because people depend on a very high unit volume to justify the cost of these enormously energy-expensive facilities. Similar results could be obtained by higher risk M&A, buying other companies, or a lower risk strategic alliance with contracts for joint use of facilities and absorption of overhead.

Q. Before we conclude, is there anything else you want to touch on?

A. I think the question for people who are contemplating corporate strategy is, “what is the quickest way to solve a business problem at the lowest cost and risk?” For businesses which are perfectly sized and economic and have everything they need in-house to fulfill a growth strategy and have no problems, there is obviously no need to do anything. Most businesses are not in that position. Businesses missing elements to implement a strategy who consider a merger to acquire them, have to go through an elaborate analysis of buying something and then persuading both companies to do the deal. That’s often cumbersome, expensive and difficult. Whereas, sometimes a strategic alliance—a contractual arrangement which can solve a problem—can be conceived, approved and implemented in a shorter, easier and organizationally more expedient way. Sometimes antitrust issues are simpler to deal with as well in a strategic alliance scenario.

I’d like those contemplating strategic problems to think that it is often possible through imagination and experience to apply existing tools and strategies, including joint ventures, licensing, distribution, production or marketing arrangements, to new or existing problems. Someone once said that the only way you can keep everything the same is to change everything else around it. So if you want to do the opposite and make a change with the same facilities, you need to have some new elements.

I guess I’m an optimist, and think the downtrodden mentality in the world today is in part due to a lack of imagination in seeing what can be done with existing resources.

Q. Have you seen organizations really taking this imagination to heart and exploring that in the volatile economy? Or are their strategies set in stone?

A. I think everybody likes simplicity, so if you can solve a problem through a simple process of buying a new company or raising or lowering prices then that is considered ideal. But when companies can’t do what they want with a simple thing and are punished for that by investors, they tend to look at other things, of the sort I have mentioned. When people afraid of risks of a large transaction see there’s something that can be done to solve a problem that doesn’t involve an acquisition—such as a joint venture or other contractual arrangement—they often enthusiastically come to see that as a great idea.

I think many problems exist in the world because someone hasn’t found a quick and easy way to solve them without unacceptable collateral damage. In the same way that most medicines have side effects, most corporate medicine has side effects as well. The goal in medical development is to find targeted strategies without side effects, and I think the same thing is being done in solving corporate problems. So for me the art is like trying to solve a Rubik’s Cube. The goal for me is not only getting one face lined up, but getting all of them aligned with minimal mess and side effects.

When it comes to the skills needed to do that, first by far is understanding the business. Financial fluency and the operational fluency to know what can work are important, as is humility—one cannot be arrogant. Nobody knows everything. So you need to put together a team that has the requisite expertise and get rid of the “not-invented-here” mentality. I think anytime that you develop something that solves a problem, you do the organization, your group and yourself well. While techniques for using many of the tools I’ve mentioned are probably widely known among dealmakers at many levels, the art which creates real values comes from 1) knowing which tools over time have proven themselves in particular strategic situations and 2) having the expertise, vision and confidence to employ them. I think these are the highest values that corporate development and its advisors can bring to corporate strategy.

Fred Marcusa, a senior Partner in Kaye Scholer’s Corporate Department, practices principally in the areas of corporate and international law. He has had many years of experience in domestic and international strategic alliances, joint ventures, mergers and acquisitions, financing and commercial transactions, licensing and sales, and representation agreements. He has also had extensive involvement in complex and sensitive international negotiations and investigations. Fred is widely recognized for his writing and advice to senior executives and others in strategic alliances, international commercial transactions and leveraged buyouts, as well as advice to senior executives on various matters, including their employment agreements. He can be reached at fred.marcusa@kayescholer.com

This interview originally appeared in slightly different form as part of Argyle Executive Forum’s “Argyle Conversation” feature and can also be found on the Argyle Executive Forum site here.

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