Types of Firm, Operations and Growth

After talking about the costs a firm faces and explaining how they vary with its size (economies, diseconomies of scale), there is more to cover: Here we outline the main types of firm, their interest groups and the main conflicts of interest. We then move onto how firms grow and the way they behave. If this wasn’t enough to excite you, we digress into the advantages and disadvantages of M&A activity – this isn’t essential for your exams, but it’s some handy info to know.

Relating to supply and demand, picture each firm being a part of the market’s overall supply curve.

Types of firm

Unincorporated–

These are generally firms not registered under the Companies Act, and have unlimited liability (debts, damage claims for instance aren’t limited to the entity’s assets). They cover sole traders, which are probably the most common form of this type. I would be a case of this if I went out selling ice creams, or if things got so unfortunate to be selling copied DVDs – illegal, please do not try

 

Incorporated–

These can be divided into the following:

Private Limited: This is the most common you will see as firms registered under the Companies Act. Have Ltd after the company name. The firms’ liability if it were to be subject to litigation, for instance, is limited to the value of its assets.

Public Limited: These are usually the largest firms, having plc after their names for example Tesco plc. These firms have outside shareholders and you can buy their shares on the stockmarket, whether it be it FTSE or AIM. Their liability, as before, is limited to the value of the company’s assets.

Nationalised: These are government owned firms. In this case the government controls them, funds them and they do can lumber about and not go out of business if the government keeps funding them. Historically, industries which are said to have ‘natural monopolies’ have had a dominating nationalised firm. For instance in Great Britain British Gas, British Airports Authority, British Rail were once all nationalised entities, but not anymore as they were privatised a while ago.

 

Interest Groups

Now we know the types of firm we need to know, let’s move on to the people involved in a firm’s dealings. These groups of people are owners, managers, workers and the customer. Each has their own interests of what they want from the firm, and these interests can conflict, which we’ll see in a bit. Please remember that us Economists have generally thought of people as quite selfish, unfortunately (although lots of us are nice people, honest: please see Rational Economic Man) so altruistic motives aren’t taken on board here.

1. Owners. They want to: Maximise profits. Say if you owned a business, you’d want wide margins to take home or reinvest to expand. In large firms these will be outside shareholders, which can be pension funds, hedge funds or parent companies. In smaller firms these are often an individual or family.
2. Managers. They want to: Get promotion and performance bonuses. Performance bonuses which are usually offered have often related to the level of sales the firm gets. This though can conflict with max profits, banking good example, when managers pushed forwards any loan to customers, even when unlikely to be repaid(it went as far as ‘self certified mortgages’ and ‘115% mortgages’ hardly in firms best interests but guaranteed commission).
3. Workers. They want to: Follow managers orders and targets, to get consistent pay rises and better working conditions. Trade unions strive to achieve this which many a worker has belonged to.
4. Customers. They want to: Achieve the best value for money. Customers keep the firm alive by they’re spending and hence as a whole are in a position of great power, encouraging the firm to keep its service or product up to standard. Where they have most power over what the firm makes is known as consumer sovereignty

Conflicts of Interest.

The prime ones to know are:

Owners v Managers.

A.k.a The principal agent problem. Managers following their own interests to gain promotion-commission may be at some expense to the owner and their often inferior knowledge of the nitty gritty of the business. For instance owners can be investment funds which are usually quite passive in the dealings of things.

Examples of this conflicts are when managers make sales which are costly to the firm but add to their credential, paying themselves too high a bonus, perhaps even making the firms’ accounts look better than they really are (this is a serious example, but it has happened e.g. Bernie Ebbers, former CEO of WorldCom(now MCI) or the classic Enron case). This issue can decrease the profit for the owner, and over time the company value which is bad for the owner

Owners v Customers.

This is more simple. Customers want the best service possible at the lowest price. Owners want to charge the highest price, but need their product to be bought. The compromise is reached where profit is maximised, and the customers are happy to buy at the price set – that’s it.

Owners v Workers.

Owners want minimum costs to max profits, and this means, rather cynically, to push down wages whilst still keeping workers. However workers will  only take so much of this before they resign and/or perhaps take industrial action. A middle ground must be reached in this power struggle, which is emphasised in Marxist labour theory.

Fundraising for Growth

An investment is made, to enable a firm to trade. But then a business may want to make that next big move in its (or another) market to plan world domination. To do it though it needs funding from somewhere. It does this through two methods: By either using the money they have already (internal funding), or getting it from somewhere else (external funding).

Internal Funding

Simply reinvesting savings or profits into whatever new ideas the firm has. It can also be a subsidiary using funds from its parent company, for example Walmart to Asdas or Unilever to the many household brands it owns. This can then pay for developments and growth.

External Funding

There is then funding from outside the firm. If profit is predicted for an idea but you just don’t have the cash, then this is the way to achieve it. Usually funding is obtained this way at the start up stage, but it can happen in any situation when a business needs money. These are the main forms to raise it:

Loans: Simple and most common way for fundraising.

1. Bank Loans: With or without a security.
2. Corporate Bonds A longer term loan made by the public.
3. Commercial paper A short term loan made by the public for very large corporations.

Venture Capital: Ever seen Dragon’s Den? Theo Paphitis and co are venture capitalists, and there are firms which specialise in this way of helping start up. The firm wanting funds is given cash by the ‘venture capitalist’ (investor, sometimes called also private equity) so they can go full-steam ahead, in return for a percentage ownership of their business which must be given up.

Share Floatation When a firm gets large, it may ‘go public’ and sell off its shares to raise capital. The first time it does this is known as an initial public offering (IPO). Its shares are then able to be traded on the stockmarket it decides to be listed on, which need not be domestic, for instance the 2011 IPO of Glencore on the London Stock Exchange.

The firm however through offering shares loses control of their decision making, and may be susceptible to a takeover if the outside shareholders are willing to sell off for their current value. This brings a trade off between fundraising and control, and also the principal-agent problem described above may also take effect (as holders-owners are outsiders).

Business Growth

Funds enable growth. It wants this for various reasons, mostly so it can increase profit and have the brand/product to stay around. Here we look at stories of different types of growth achieved by certain firms.

Horizontal Integration: Tesco.

This is simply increasing market share in the same market, by buying out rivals(by merger or takeover, ‘external growth’) or driving them out(outcompeting on price and quality ‘internal growth’). Tescos in the last 10 years have done so. They are the dominant supermarket in the UK and have replaced the high street electricals or grocers all over.

Vertical Intergration: Sony

You know the supply chain, well this is expanding into another stage, such as that of you’re supplier, or who you supply to. Sony make their electrical equipment, and also sell it in their Sony stores you see around. So they are in the manufacture and retail stage of the product. This has an advantage as, for instance, you can give Sony the edge over other stores if you(Sony) are the chief supplier.

Lateral Integration: Virgin.

This is growing by entering another industry altogether keeping the same brand. A firm which produces in different industries is sometimes called a ‘Conglomerate'(*American accent*).  Doing this spreads risk as demand in one industry cannot be guaranteed in the long term as new products may be switched to( MP3 market before iPod comes along for example).

Richard Branson’s powerhouse started with records in the early 70’s, then came the airline(in 1984 the dawng dawng dawngggg advert), then the media now space travel! Linking fairly random industries has been an extreme success for Virgin. They now have an F1 team too:).

Organic or M&A Growth?

Once a firm has the financing available, it can grow vertically, horizontally or laterally through 2 ways.

Organic growth is the typical way companies grow, which can range from buying off property (not companies or their divisions) to building commerical or industrial property itself to releasing a new product.

Mergers and Acquisitions growth involves the firm buying other firms and hence taking over their management, brand and locations, although it can include taking over divisions of a business through a ‘spin-off’, such as when RBS bought some of the retail banking operations of ABN Amro (which proved a bad move). This is in a simple, workable form, you need not worry about controlling and noncontrolling interests…

M&A Advantages:

Firms can favour the buyout approach for the following reasons

1. Quick Growth: When Nomura took over the UK division of Lehman Brothers in 2008 it was able to expand immediately. Companies looking to grow fast take this approach e.g Tyco in 1990’s
2. Diversification: Lateral integration can occur without product R&D and marketing when you take over a company already accomplished in a certain sector.
3. White Knight: A firm may stop a rival company from taking over a smaller company by stepping in and offering a better price or management policy.
4. Asset Stripping: If the buyer believes it can get more value by selling off parts of the firm than it costs to buy it whole, it may buy it out to sell off parts. Usually hostile as management and workers are often replaced as parts are sold.
5. Economies of scale: Combining operations can cut costs by streamlining back and middle office roles such as IT and Finance form 2 to 1 division; only 1 CFO is now needed for instance. All EoS can be realised other than perhaps the technical until, say, 2 production plants are sold up and a large one is bought. R&D costs split in the Pfizer-Wyeth buyout another example
6. Synergy: Valuation of the two companies together can be greater than the sum of them individually, although this is rarer is practice.

M&A Disadvatages:

1. Valuation problems: Just as the shareholders of BCCI, Worldcom and Cisco Systems weren’t aware of the full picture, so may the buyer of a company get the valuation wrong via tweaked annual reports and improper valuation research, ending up paying far over the odds due to assymetric information. A near worthless company called Chromatis Networks was bought in 2000 for $4.8 billion, and was closed down a year later!
2. Principal-Agent problem: Imperfect knowledge can also work during the running of the business, through the principal-agent problem,especially if the firm is in a totally different sector to what the buying firm’s executives have worked in.
3. Investment Banking fees: Often to do the due diligence and valuation work you need an investment banker who lets the prospective buyer know all the legal and financial issues and prospects of the target firm to ensure valuation is correct. This can be costly.

Mentality

What is the behavior of the firm, and its approach to being run? In reality its behavior as a whole reflects how much power each interest group has, and how they agree. Here we look at three broad categories( in the course this may be referred to as ‘theory of the firm’)….

Profit Maximising Or the ‘traditional goal’, this is the assumption how firms behave in economic theory.  The owners have the most power, with a hawk-eye on how things are done. They make sure the workers/managers act in the firms best interests(keeping costs down and making lucrative sales).

Every firm has this goal to a large extent, because if it didnt minimise its costs and max revenues it could be priced out of the market, or overtaken its competitors in product due to development and advertising funds.

Managerially This may partly be due to the principal-agent problem discussed before and is common in larger firms, as the owner does not quite have the insight. Sales are usually maxed rather than profit and much is spent on advertising(things which max the bonuses/pay managers get).

Satisficing The firm does not maximise, but each group does just enough and satisfactory results are achieved. The product improves just enough over time to keep the user happy, managers achieve balances owners are satisfied with and the owner is happy enough to sit back and not intervene too much.

This is typical of a firm which has achieved great success already, feeling little pressure to maximise(a near monopoly, this goal is tied in with my Diseconomy of scale ‘Boardroom complacency’). I feel Microsoft has reached this stage(slowly imporving product, assured position).