Build, Borrow, or Buy. Laurence Capron
the local bank lacked sufficient expertise to develop a private-equity offering internally. Nor did the parent company have private-equity experience—which requires a deft understanding of activities ranging from deal origination to exit strategies. The CEO considered hiring away a competitor’s team to support internal innovation. However, not only would that be expensive, but the bank would also risk being unable to retain and leverage the outside team’s expertise. After concluding that internal resources lacked relevance for the new business, the CEO began reviewing external options.
You might think answering this first question is easy. Yet companies often vastly underestimate the actual distance between their existing resources and the targeted resources. Like many print publishers, business leaders more easily see the similarities than the profound differences: “Reporting, writing, and editing are the same for a Web page as a printed newspaper, right?” Well, yes and no. Traditional publishers failed to grasp radical shifts in the business model, technology, customer and revenue strategies, and the implications of community interaction—all of which continue to evolve. Seeing only what’s similar, a business can fixate on internal development because it doesn’t know what it doesn’t know.
Internal development is fraught with obstacles that firms often overlook—until later. Businesses choose the build path as their first option and only consider external sources after encountering major setbacks. Among our sample of telecom firms, 75 percent used internal development as their preferred means of obtaining new resources. But when asked to evaluate the effectiveness of the internal path, many executives admitted they were disappointed. Almost half said that they failed to create the desired new resources because they were unable to properly manage internal development, and nearly two-thirds reported friction associated with integrating and diffusing the internally created resources throughout their organization.
In chapter 2 we will review how to assess the relevance of your existing resources for internal development and how to recognize—even at the outset of the selection process—when it is best to go straight to external sourcing.
Question 2. Are the Targeted Resources Tradable?
Once you’ve determined that you need to look externally for resources, you must weigh which type of external sourcing mode to use—from the simplest and most straightforward to those of higher cost, complexity, and commitment. (By tradable, we mean that you can negotiate and write a basic contract that will both protect the rights of the contracting parties and specify how they will exchange resources.)
The first option is obtaining what you need via contract, a basic form of borrowing resources that another firm has created. Arm’s-length contracts often help companies identify, evaluate, and obtain bundles of new resources and absorb them quickly. Pharmaceutical firms commonly license the rights to register and market other companies’ drugs in particular geographic markets. Chemical firms have long used contracts as a way of obtaining new molecular compounds. In turn, the companies sometimes out-license the rights to compounds or applications that they do not want to develop themselves. For example, W. L. Gore and Associates licenses the rights to use DuPont’s PTFE polymer for use in medical implants and rain-resistant clothing. The two companies have always managed these relationships using basic contracts.
Contracting is often the simplest way of obtaining needed resources. However, companies often overlook it. Instead, they seek first to pursue an alliance or acquisition. We found that many firms overestimate their need for strategic control while underestimating the likelihood of achieving adequate control through third-party relationships. Overvaluing your need for control can lead you to paths that waste resources and, worse, deny you the opportunity to learn from independent partners. Yes, you need to protect your firm’s core resources, but selecting the wrong sourcing mode can inhibit your ability to replenish that core.
Trust plays a role in answering this question. Firms often fear that an external party may not play fair in the agreements or that they may have to give up too much revenue to a contractual partner if they do not control commercialization. Only a third of the telecom firms we surveyed actively use contracts to obtain new resources. In fact, 70 percent said they would choose an alliance or acquisition over a contract, especially when the targeted resources affect core parts of their business. Only 30 percent of the surveyed firms had made systematic efforts to assess external resources available from suppliers. Thus, most firms decide on more complicated external sourcing options without first considering the simpler expedient of licensing through a basic contract. Such an oversight is often counterproductive.
It is important to carefully weigh potentially favorable conditions for a basic contract before turning to alliances and acquisitions—which require substantially greater management time and attention. Obtaining new resources via contract requires clarity in defining the targeted resources. Likewise, you must understand how the value of the new resources will be protected (and have some familiarity with, and confidence in, the relevant legal system).
Of course, sometimes a contract is inappropriate. But a company can’t make that judgment without first investigating the option. Recall the global investment bank that wanted to launch a private-equity service through its Eastern European unit. Its leadership team initially weighed whether to contract with a local private-equity firm. In such an arrangement, the global business would provide products, brand equity, and global coordination while the local partner would provide local investment selection, deal structuring, monitoring, and exit skills. Such a contract would have required a solid incentive structure to secure strategic alignment with the partner. Alignment was critically important because the bank alone would have dealt with clients regarding investment results, processes, ethics, and partner due diligence. Moreover, the arrangement would require the private-equity firm to hire new employees to handle tasks that it did not explicitly contract to perform. After reviewing this option, the team concluded that the transaction costs between the two parties would be prohibitively high—driven up by the extensive coordination needs and by concerns that the partners might either take advantage of the relationship or fail to execute their responsibilities fully.
Chapter 3 will review how you can assess the tradability of your targeted resources. Tradability will help you decide when to obtain targeted resources via basic contracts, such as in-licenses and out-licenses, and when to consider more complex arrangements, such as alliances and acquisitions, with other firms.
Question 3. How Close Do You Need to Be with Your Resource Partner?
If your targeted resources are not easily tradable, you will need to consider an alliance or acquisition. Given a choice between those options, our message is simple: because M&A is the most complex path, reserve it only when it really pays to have a deep collaboration with the resource provider.
Alliances can take many forms, ranging from R&D and marketing partnerships to freestanding joint ventures. Thus, alliances might be relatively simple agreements or complex relationships involving multistage contracts, cross-investments, and complicated rights stipulations. All alliances, however, rely on ongoing interactions in which independent actors—these may be competitors, complementary firms, or other organizations (such as universities and public institutes)—commit resources to a joint activity.
Pharmaceutical companies commonly use alliances to develop and market specific drugs. In many cases, simply in-licensing the rights to a molecule would be risky because of the need to participate actively in the development process. Falling short of the intense control of an acquisition, alliances allow partner firms to collaborate on focused projects with explicit aims.
Of course, some projects are so complicated that the level of partner interaction renders the collaboration unworkable. In the Eastern European bank unit, for example, the alliance option at first seemed promising. It combined the strengths of global and local resources and strong incentives for the local partner to work hard to expand the business. The team rejected this option—after much consideration—because the bank’s dominant motive in undertaking the strategy was to build a broad set of skills for itself and to keep tight