Theory of the Growth of the Firm

by Edith Penrose

  In addition to this kind of personal element reducing the value of a firm to its existing owners are a variety of special institutional considerations. Of these, the role of taxation is particularly significant. Taxation may affect the decisions of businessmen with respect to the form in which income is best received or wealth best held; it may limit the extent to which firms can without penalty retain earnings; may in some circumstances put a penalty on the distribution of earnings; and may even convert the losses of some firms into assets for others who can acquire title to the right to deduct these losses from taxable income.

  To illustrate, the closely held small firm may be sold to increase the liquidity of the owner’s estate and thus enable heirs to meet the estate tax on the owner’s death; if capital gains are taxed at a lower rate than income, the relative worth of cash (or securities) received through a sale now and of profits to be received in the future is accordingly affected; the retained earnings of a firm may be considered excessive and subject to a tax which can be avoided if the firm is sold to another for which the earnings would not be considered excessive;169sometimes mergers can be effected by tax-free exchanges of stock; and finally, provisions in the tax law which permit losses to be offset against profits enable a profitable firm acquiring an unprofitable one to reduce its taxable profits to the extent of the losses taken over, and this in effect converts the losses into assets for the acquiring firm. Tax considerations of these kinds were found to be a major reason for the sale of medium-sized firms in the only extensive study of the problem that has been made in the United States.170

  An undervaluation by the market of the shares of a firm may be another reason why a particular firm may be acquired relatively cheaply. There may be a variety of special conditions at any given time which lead to undervaluation of the publicly traded stock of a firm, but probably the most important general conditions are a lack of knowledge on the part of the investing public of the value of the firm, a lack of confidence in its management, or a discounting of the less marketable stocks for lack of liquidity. The undervaluation of stock is apparently still of some importance as a factor promoting mergers in the United States, 171 although probably not so significant as has been the case in the past, and is of considerable importance in some countries where capital markets are less developed. In Australia, for example, there have been waves of acquisition through what are called ‘take-over’ bids, by which outsiders desiring to gain control of a particular firm buy its stock in the market at prices which, though above current market prices, still substantially undervalue the firm relative to its earnings prospects. One of the chief reasons advanced for the successful use of this technique of acquiring firms relates to the lack of information provided to investors by Australian firms. When annual reports, balance sheets, and operating statements are designed as much to conceal as to reveal the true condition of the firm, outside investors have less ability to judge the value of their stock and may be easily induced to sell out when an offer significantly higher than the ruling market prices is made for it. A thin market reducing the marketability and consequent liquidity of stock is, of course, a contributing factor.

  Special considerations, whether relating to the personal characteristics of the owners and managers of firms, to the impact of a particular system of taxation, to the nature of the market for securities, or to other similar things, are always present and account for a fair proportion of the small and medium-sized firms on the market at any given time. They are not, however, particularly related to the processes of growth nor to any general relationship between the positions of the acquired and acquiring firms, although their importance is different for different sizes of firm. The question to which I now want to turn is whether there is a more or less systematic tendency towards merger and acquisition in an economy characterized by growing firms of different sizes, apart from any power of the larger firms to put monopolistic pressure on the smaller ones.

  Critical Points in the Process of Expansion

  When a firm is relatively small the division of managerial labour will not be extensive (indeed it cannot be) and the most important decisions are sometimes made by only one man. As the firm grows it reaches a point where a change in its managerial structure must take place because of the necessity, if growth is to continue, of subdividing the managerial task, and especially of decentralizing managerial ‘decision-making’. As we have seen, growth is not for long, if ever, simply a question of producing more of the same product on a larger scale; it involves innovation, changing techniques of distribution, and changing organization of production and management. Accounting control and budget-making and forecasting techniques must be refined and adapted to replace many of the quasi-instinctive judgments of one or two individuals that may predominate in the simpler form of organization suitable for small-scale operations. Tax calculations become more complicated and tax experts may have to be hired; if invention and innovation are important, patent problems arise and a special staff of patent experts may be called for; labour and personnel relations may require the creation of a specialized personnel section. There is no need to elaborate the details: the growing small firm inevitably reaches a critical point where the managerial services appropriate for the efficient organization of production and distribution on a small scale are no longer sufficient.172 A thorough knowledge of the problems of production, a keen understanding of market forces, an ability to make shrewd business decisions always remain important, but much more is needed. The additional managerial resources required to set up and control a more complicated administrative organization can of course be hired, but for the transformation in the structure of the firm to take place an understanding of what is happening and what is needed, and a willingness to accept substantial changes in the old ways of doing things are required of the original management.173

  In some concerns management is not only willing but eager to delegate decisions and functions, to hire the requisite new services, perhaps first on a consultant and then on a permanent basis, and thus gradually to adapt the structure of the firm to the requirements of growth. In such cases the ‘critical’ point may pass unnoticed and it becomes virtually impossible even to identify the period of transition. But for others, the pressures build up to a point where ‘a man is willing to give in’ 174 and to face the necessity of adapting or getting out.175 We do not at present have enough information to say for what size of firm these problems become of crucial importance. An executive of one large United States concern that had just completed a series of acquisitions pursuant to an expansion programme, wrote in a discussion of the characteristics which had induced the acquired firms to sell out that

  because of the complexity of doing business today, with our many government regulations, taxes, unions, etc., a small, growing business finally reaches a point where life is just too complicated for the original management. At this point the best solution to the problem is to sell out to a large corporation which has the necessary financial resources and all of the legal and accounting experts and industrial consulting facilities that a small company cannot afford. A company seems to reach this point when sales pass the ten million [dollar] mark. 176

  In addition to the management problem is the financial one. It is often difficult for a small company to generate sufficient internal funds to finance even those amounts of expansion of which it is otherwise capable, partly because of the tax laws and partly because of competitive pressures and restricted markets; its lines of external credit are often limited and equity capital is often difficult to attract unless the firm possesses unusual entrepreneurial ingenuity in raising capital.177 But perhaps more important than the difficulty of raising equity capital is the fact that owner-managers of small firms, if faced with the choice of losing control through dilution of their equity or of losing control through sale to a larger firm, may well find substantial advantages in the latter course, especially if the large firm is willing to take over their services. Not only may they feel a p
restige associated with being a ‘vice-president in charge of ...’ in a large firm, but if they are going to lose sole control and thus lose the status of ‘independent’ businessmen, they may well prefer to rid themselves of the types of strain which go with the continuance of the sole responsibility of management.

  Whether these managerial and financial considerations can be looked on as inducing a systematic tendency for small firms to sell out when they reach the point where substantial changes in the managerial and financial structure of the firm are required depends on whether it can reasonably be assumed that a significant number of small firms are started by people who are capable of efficiently running a small concern but incapable of the adaptations required when the firm begins to leave the ‘small’ category. If this were so, if, say, even 30–40 per cent of small firms had such management, then clearly we would be entitled to state that such a tendency existed. There are only three alternatives for such firms: to sell out, to stop growing significantly, or gradually to become more inefficient and fail. Many firms follow the last two courses, and the first and third from some points of view come to the same thing. We have no statistical evidence on any of these questions. Few studies have been made of merger from the point of view of the acquired firm and I know of no extensive statistical analysis of the history of a significant sample of small firms. Hence we are forced back on the general impression to be gained from ‘business biographies’ (which in general deal with the successful firms) and from the fairly large number of acquisitions which have been described in the literature. From both of these sources one can fairly conclude that it is highly probable that small growing firms very often find in merger the solution to problems they are otherwise unable satisfactorily to meet.

  The Competitive Expansion of Alpha

  Let us now turn to those aspects of acquisition that are especially related to the relative size of the acquiring firm and to its expansion processes. It has been shown that to explain acquisition one must explain why Beta (the acquired firm) is worth more to Alpha (the acquiring firm) than it is to itself. An analysis of acquisition with reference to the size and expansion of Alpha, therefore, can be expected to centre on the question how these factors alone can be expected to influence the price of Beta in relation to its value to Alpha. We shall not consider those situations in which Alpha is in a position to exert pressure on Beta through the use of various types of ‘unfair’ competitive practices. There is little doubt that small firms have on occasion been forced to sell out on unfavourable terms to large firms because of the predatory activities of the latter. Although in most, if not all such cases, unfair competitive pressure is possible only because Alpha is substantially larger than Beta, discussion of such mergers is omitted here because no further analysis is necessary to understand them. They have at times been important but their importance seems to have substantially declined under the influence of law and custom.

  Assume that Alpha plans an expansion which it considers profitable regardless of the possibility of acquiring another firm in the relevant field. It is reasonable to suppose that if a firm plans to expand in markets already occupied by other firms (whether it be further expansion in its present markets or expansion into new markets), it does so because it believes that it has some competitive advantage which will ensure the profitability of the investment that will be tied up in the expansion. The advantage may be based on a technological superiority of some kind, on marketing strength, on access to larger supplies of funds, on the prospects of obtaining operational economies of scale not available to existing firms in the market (who may, for example, be too small to undertake an amount of expansion large enough to achieve the significant economies), and on other economies of growth of the kind discussed earlier.

  If an existing firm plans an expansion of output which is large relative to the size of the market for the products in question, the increased output can be expected to affect adversely the sales of other producers. Hence if other producers know of the planned expansion and believe that the expanding firm has genuine advantages in costs or in marketing ability, or merely that it has sufficient financial power to withstand losses during the initial period when it competes for a larger share of the market, the mere expectation that their markets will be affected will reduce their expected profits and hence their present value.

  If the competitive power of the expanding firm is believed to be very great, each of the other firms in the market becomes a potential Beta. On the one hand, the larger the expansion in relation to the size of the market, the greater will be the reduction in the present value of existing firms; on the other hand, the larger the expansion and the greater the total investment outlay required for it, the higher the price that the expanding firm would be willing to pay for suitable Betas permitting the same amount of expansion. This can be clearly seen if we consider the case of a firm planning entry into a new field where the outlay required to enter the field is high.

  This outlay may include not only the costs of building and equipping new plant but also the cost of acquiring new customers and new channels of distribution and of building up trade connections in order to ensure a smooth flow of supplies and favourable conditions for obtaining them. We are assuming that after due consideration of cost and revenue possibilities, Alpha has decided that expansion into the new field is profitable even if it cannot acquire other suitable firms. Nevertheless, if such firms are available, Alpha may, through acquisition, obtain at one stroke not only existing plant and equipment, perhaps the least item in the outlay required for expansion, but also customers, good-will, sales channels, connections with suppliers, sometimes accepted brand names and peculiarly qualified and experienced personnel. Not only may the cost of developing these from the beginning be considerable, but the process takes time and adds to the uncertainty of the venture. In circumstances where demand is unusually high, speed of expansion may be unusually important, and the cost of delay proportionately greater. In some lines of activity there are genuine economies of large-scale production to be obtained and a new venture must start on a large scale. Yet if a market has to be built up, the firm may have to count on making losses for a long period. The firm, therefore, may be willing to pay handsomely for existing firms with the characteristics it requires.

  But the very fact that such outlays would be required of any firm wanting to enter the industry would normally raise the gross profits of the firms already in the industry and therefore the price at which they would be willing to sell out. These are outlays that any firm considering entry would know it had to make, and to the extent that they are sufficient to deter potential entrants, the level of demand and of prices will be correspondingly raised for existing firms.178 But can we conclude from this that if Alpha plans to enter the industry it will have to pay a correspondingly higher price for a Beta—quite apart from any personal or special considerations inducing Beta to sell out?

  Clearly we cannot, for if Alpha intends to enter the market and is merely deciding whether to ‘build or buy’ its way in, then the prospective profitability of each existing firm (potential Betas) is immediately adversely affected provided that it views the competitive threat seriously. In the extreme case in which Beta believes that Alpha could capture the entire market in a relatively short period, the value of Beta would rapidly sink to the present value of whatever margin over direct costs it could expect to make until Alpha became established, plus the scrap value of its assets. This figure will be far below the present value of the firm before the threat of Alpha’s competition and may be far below the outlay required of Alpha in entering the industry; clearly a merger will then be profitable for both firms.

  When high investment outlays are required to start production in a field, competitors whose financial strength is small will be deterred. Hence new entrants will have to be financially powerful and will be able to operate on a large scale. Unless the market is growing so rapidly that there is ‘room for all’, existing firms may become ver
y worried for their future profits. Since Alpha can afford to pay large sums for suitable Betas, there will often be a large margin for negotiation, depending on Beta’s estimate of the alternative investment outlay required of Alpha and of the effects of Alpha’s competition upon its own worth. A weak Beta might feel happy to sell out for anything above the scrap value of its assets, even though it had been very profitable before the threat of new competition arose from Alpha. The greater the anticipated investment outlays of Alpha, the greater must be the revision of the expectations of existing firms if Alpha decides to enter the market. At the same time, the greater these outlays, the more Alpha can afford to pay to acquire existing firms. 179 Clearly merger may be profitable for both Alpha and Beta. 180

  There are, in addition, a variety of situations in which the expansion of Alpha may have especially adverse effects on the future of smaller firms with which Alpha has commercial relationships. For example, expansion which involves the vertical integration of Alpha may leave smaller suppliers without adequate alternative outlets and such suppliers will, in turn, often find it more profitable to sell out than try to remain in business.181

  Where Beta Blocks the Expansion of Alpha

  In the above analysis it was assumed that existing firms had assets, tangible or intangible, which were of value to Alpha but which were not indispensable for its profitable expansion. Under such circumstances Alpha’s expansion became a threat to the value of existing firms. But if existing firms possess assets which are indispensable for Alpha’s plans, the competitive power of Alpha is no longer a factor reducing the value of existing firms. On the contrary, presumably firms controlling such assets could expect to obtain from a potential Alpha their full monopoly value and thus wipe out the profitability of acquisition for Alpha.