Organic Or Inorganic Growth? How To Decide
Last week, Adobe announced that it would acquire Figma for $20 billion, and this deal announcement declined Adobe’s market cap by $34 billion. The decline in Adobe’s share price is mainly centred on the deal purchase price at 50x Figma’s 2022 ARR, implying that Adobe has overpaid. However, before judging whether Adobe has overpaid for this deal, the question is whether Adobe can substitute this acquisition with organic growth. In this post, i provide my insights on a framework that can help a firm decide the best way (organic or inorganic) to expand to a new business. After i explain this framework, let us answer through this framework if Adobe made the right decision to go for inorganic growth. This post does not comment on the deal structure or whether Adobe has overpaid for this deal but merely helps budding strategy professionals arrive at a systematic decision-making process by comparing organic and inorganic growth.
What Is Organic Growth?
I refer to growth strategy as organic when a firm decides to enter a new business/develop a capability by hiring resources, making investments in sales, marketing and developing a new business unit or repurposing an existing business unit. The firm develops a new value chain/modifies the existing value chain for the new business by building resources and capabilities.
Deciding on Organic vs Inorganic growth is not analogous to the Make vs Buy decision. In make vs buy, the firm decides if it is optimal to develop a product/service internally, assuming it has the capabilities to procure the same from an external supplier that can provide these services at a better cost/quality. Here, the decision drivers are transaction costs (to deal with suppliers) and production cost differences (developing the service in-house). Organic vs Inorganic growth is the decision a firm has to make between developing the resources and capabilities needed to deliver a product/service to customers internally from scratch to acquiring the same from outside. A better comparison is “build vs buy”.
Synergies and Cost Of Entry — Organic Vs Inorganic
To compare the economics of acquiring a new business vs organically developing in-house, let us assume the following:
V(A) — NPV of the Standalone value of the new business
C(B) — Cost of entering a new business
V(AB) — NPV of jointly operating businesses A and B
A firm should enter into a new business (organic or inorganic) only if,
V(AB) — C(B) > V(A)
If a firm decides on organic growth, it will have complete control over the newly developed business and possible synergies with its existing business units.
If a firm decides on inorganic growth, it has to pay a premium to acquire control and spend money on integration costs. The integration costs include the cost of restructuring the target business, divesting non-core assets and the costs of aligning the systems and process of buyer and target so that they are compatible. In addition, there are cultural issues in cross-border acquisitions, and these differences can result in the loss of synergies.
Here, we assume that the synergies the firm realizes are the same for organic and inorganic growth strategies. However, if the firm realizes higher synergies through organic growth, then the firm should prefer organic growth to inorganic growth.
To estimate the cost of entry for organic growth, we do a capital budgeting exercise by estimating the investments needed, the time duration involved and the underlying risks in the project. However, before we embark on the capital budgeting exercise, we need to assess if there are conditions that make the cost of entry for organic growth cheaper than inorganic growth. Therefore, I analyze the gap between the resources needed to enter the new business and existing resources. If the firm has a gap, but there are no partners outside that can fill that gap, then the firm has no choice by developing resources internally.
If there is a target firm that can fill this resource gap; the buyer should evaluate the following:
- Can the buyer imitate the target resources? If the target has an IP, then there is a legal barrier for the buyer to imitate. In many scenarios, the target has developed sticky customer relationships that the buyer cannot develop despite having similar capabilities as that of the target because it is challenging to imitate customer friendliness.
- If the target has developed a reputation or a brand, the buyer cannot imitate these intangible assets.
- If the target has an excellent culture, good management skills and outstanding leadership, it is challenging for the buyers to imitate the same. For instance, everyone understands Toyota’s production system capabilities, but few can replicate them.
Assuming that the buyer can replicate the target’s resources and capabilities, the next question for the buyer is the time taken to catch up with competitors who already have a headstart by possessing those capabilities.
If the firm lags behind the competitors in capabilities, the competitors have a first mover advantage while the firm has a second mover disadvantage.
What are the drivers of the second-mover disadvantage?
Let us assume the firm does not have the resources and capabilities to enter the new business. The firm can spend on marketing, R&D or training its employees to build capabilities to gain entry to the business. These expenses get reflected in the firm’s income statement. However, the competitors already have the capabilities (R&D, Sales and technical) and developed reputation. These capabilities get reflected as assets in the competitor’s balance sheet. To compete with their rivals, the firms must convert these expenses in the income statement to assets on their balance sheet. Then the firm’s assets should have a competitive advantage over its competitor’s assets. If the firm can convert these investments to assets, and when these assets have a competitive advantage, then the firm does not have to face a second-mover disadvantage.
In many cases, by their longevity, the competitors can accumulate learning difficult for the firm to replicate quickly in the shorter term. For instance, drug companies take years of experience to develop a drug and then patent it; it is difficult for the competitors to develop a drug in a short period. In addition, Mckinsey has had consultants trained in management consulting for years; it is difficult for a new firm to replace Mckinsey with their homegrown talent that does not have the training that McKinsey consultants have.
However, in some scenarios, the firm can beat competitors and nullify the second mover disadvantage if they already have capabilities/assets related to the new business. For instance, if the companies want to enter Europe and firm already has developed a brand reputation in Europe, it can invest in a sales force to sell its services rather than acquire a new business.
Thus, the notion that firms prefer inorganic growth because of speed and the time to market is false. It is not speed but second mover disadvantage.
If a firm has relevant assets that can replace competition, organic growth is a better option than inorganic growth. However, if the firm finds it difficult to replicate competition, it has a second-mover disadvantage, and in this situation, inorganic growth is a better option.
Thus, in a nutshell, if I have to develop a checklist for organic vs inorganic growth, the following are the conditions:
Go for Organic growth if,
- It is easy to imitate the competition’s resources and capabilities
- It is easy to substitute the competitor’s services
- If the firm has the resources and capabilities to imitate the competition
- If the firm generates higher IRR by developing these capabilities internally
The organic growth strategy does not suffer from control premium, resolving cultural differences or synergy integration costs that the inorganic strategy faces.
Thus, the magnitude of second mover disadvantage relative to control premium, cultural differences and integration costs determine if the firm has to go for an organic or inorganic growth strategy.
Coming back to Adobe’s acquisition of Figma, the big question is whether Adobe has the capabilities and resources to imitate Figma and if it has a second-mover disadvantage.
Figma is cloud-native from the beginning, whereas Adobe’s legacy software makes it difficult to offer the multi-user collaboration that Figma does. Thus Adobe has a second-mover disadvantage, and acquiring Figma helps it to address this thorny issue. However, I am not commenting on the deal structure or whether Adobe has overpaid, as that discussion requires a new post.
However, firms should not ignore organic growth as it is a viable alternative to a growth strategy. However, firms should not assume that organic growth is more manageable because there is no control premium and integration costs. Moreover, the failure rates of organic growth are as abysmal as inorganic growth. Thus a selective approach to addressing the resource gap is necessary to arrive at the right growth strategy.