External Growth Definition
External Growth refers to the inorganic growth strategy wherein a company uses external resources and capabilities, but not the available internal resources, to expand its business activities. This strategy results in an increase in sales and profitability through the purchase of other companies or building a business relationship with them.
Strategies of External Growth
The strategies can be broadly classified into two primary vehicles: mergers & acquisitions and strategic alliances. The differentiating factor between the two strategies is in the way the ownership changes. In mergers & acquisitions, the ownership between the companies gets exchanged, while in a strategic alliance, businesses are able to retain their independence while pursuing their collective objectives.
- Mergers and Acquisitions: Typically, in a merger and acquisition transaction, the companies exchange their ownership. A mergerMergerA merger is a voluntary fusion of two existing entities equal in size, operations, and customers deciding to amalgamate to form a new entity, expand its reach into new territories, lower operational costs, increase revenues, and earn greater control over market share. refers to a transaction wherein two companies combine to form a new entity with the consent of the boards of both the involved companies. On the other hand, an acquisitionAcquisitionAn acquisition is defined as the act of taking over or gaining control of all or most of another entity's stocks by purchasing at least fifty percent of the target company's stock and other corporate assets. refers to a transaction wherein the acquiring company bids to purchase a controlling stake in the target company, which can be either with the approval of the board and shareholders of the target company or without it.
- Strategic Alliances: A strategic alliance is slightly different from mergers & acquisitions as it doesn’t involve a complete exchange of ownership between the companies involved. Rather, under this transaction, the participating companies pool their resources and assets in order to achieve collective goals while retaining their independence. A strategic alliance can either be an equity alliance or a non-equity alliance.
There are several reasons that businesses opt for external growth, and some of the major ones that drive this strategy are as follows:
- The growth of smaller businesses is constrained by limited resources, and in such a scenario, the external growth strategy fits in perfectly.
- This strategy results in a reduction in the cost of production, an increase in turnover rate, and higher profitabilityProfitabilityProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance..
- With the increase in size, the firms are able to control a larger share of resources, which results in better bargaining power.
- This strategy also facilitates a combination of non-managerial and managerial skills of different firms into one, which results in higher performance standards.
Some of the primary uses of this strategy are as follows:
- It allows companies to access newer and bigger markets.
- It helps companies to grow bog so that they can command more market power.
- At times companies acquire another company in order to obtain access to noble technology or a stronger brand.
- It facilitates product and service diversification.
- It helps in increasing the operational efficiency of a business.
External Growth vs. Internal Growth
- In internal growthInternal GrowthInternal Growth Rate is calculated by multiplying ROA of the company with the retention ratio of the company. The equation is as follows: IGR = ROA*r/(1-ROA*r)., in-house resources are put to use to grow operations, which can be financed either internally or from the debt and equity market. On the other hand, in external growth, a company engages in merger and acquisition deals in order to grow.
- Internal growth focuses on the improvement of the existing operational efficiency and cost efficiencies. On the other hand, external growth emphasizes on branding, marketing, and advertising, etc.
- Implementation of an internal growth strategy takes a longer period of time to yield results, while external growth is a relatively faster approach.
- An internal growth strategy involves lower risk as compared to external growth strategy, given that the latter is more expensive.
Some of the advantages are as follows:
- It helps in eliminating inefficient expenses while promoting more cooperation among the participating companies.
- It enables better utilization of resources that can result in an increase in profitability.
- It helps in penetrating newer markets, acquiring more customers, and product diversification.
- It offers benefits of synergy, which means that the collective output of the participating companies is more than what each individual company can produce.
- Increase in size results in economies of scaleEconomies Of ScaleEconomies of scale are the cost advantage a business achieves due to large-scale production and higher efficiency. .
Some of the disadvantages are as follows:
- This strategy is quite expensive as compared to the internal growth strategy.
- It results in a concentration of power in the hands of the few who may end up misusing it.
- Merger and acquisition deals result in large-sized companies that may resort to monopoly.
- The alliance may end up in a big failure if there is a vast difference in the level of competency and ability of the combined companies.
This has been a guide to External Growth and its definition. Here we discuss strategies, business, and uses of external growth along with advantages and disadvantages. You may learn more about financing from the following articles –